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What are SPIA Annuities?

Single premium immediate annuities (SPIA) have been around in various forms for centuries. In their simplest form, they were a promise made to Roman citizens by the government to pay them an annual stipend for life in return for a deposit made to the government for its use. Similar arrangements were used by governments throughout the centuries and the deposits helped to finance wars as well as major construction projects. The SPIA of today is not very different in terms of its basic functions; however, the contract that is issued by a life insurer is a bit more complex than the simple arrangement of yesteryear.

SPIAA Essentials

SPIAA annuities are essentially used for the same purpose today that is to create a stream of income that lasts for a lifetime. Life insurers obligate themselves to that promise in return for a lump sum of money that they then invest in their own portfolio to generate a return that can be credited to the annuity balance as well as a profit for the insurer.

How do SPIA annuities work?

Upon receiving a lump sum deposit, which is an irrevocable investment on the part of the annuity owner, the insurer then makes a calculation to determine how much income can be paid out. The income period could be for a specific time frame, or for the life expectancy of the annuitant. Either way, the number of periods for which the income is to be paid is established. Then the insurer makes an assumption about the rate of interest the annuity balance will earn over that period of time. Using these two factors, a payout rate is established and fixed for the life of the contract.

When the income payments commence, typically within 30 days of the deposit, the amount paid includes interest earned on the account balance as well as a portion of the principal. The amount of principal that is returned in each payment is dependent on the number of pay periods. The objective is to pay out the entire principal by the end of the income period. The annuitant is only taxed on the interest portion of the payment.

At the end of the income period, the principal is exhausted and the income payments stop, except in the event that an annuitant lives beyond his or her life expectancy. Even though the insurer calculated the amount of payments based on an assumed number of years in which the annuitant would live, the insurer is obligated to continue to make the full payment for as long as the annuitant lives. This is the “insurance” aspect of annuities and the primary reason why people buy them.

How SPIA Annuities are Structured

A straightforward SPIAA would be structured as a single life annuity in which the income is paid to the annuitant, and if he or she should die before the end of the income period, the annuity balance is retained by the life insurer. In many cases, the annuitant is married and would want to ensure that the spouse was able to continue receiving income payments, so the SPIAA could be structured as a joint-life annuity. The income payments from a joint-life SPIAA would be slightly less than those from single-life because of the extra cost of insuring both lives.

Also, it’s not uncommon for an annuitant to want his or her heirs to receive some or all of the remaining annuity balance in the event that both spouses die prematurely. So, SPIAs can be structured to provide a refund of the balance, typically in installments. Some arrangements allow for a refund for a period certain after which a refund would not be available. These arrangements also add to the cost of the annuity which is recovered by reducing the income payment some more.

Additional Toppings

One complaint about SPIAs is that the fixed income it generates won’t help the annuitant over time when the cost-of-living increases. Most SPIA contracts allow for an inflation hedge option that, for an additional cost, will index the income payments to inflation.

What to Expect from an SPIA

SPIA annuities stand apart from other types of retirement income vehicles, and while they are not for everyone, they are unmatched in the benefits they can provide the right investor.

Security:

The principal balance and income payments are guaranteed by contracts issued by the strongest financial institutions in the country. Life insurers have a solid history of paying their obligations and those that receive the highest ratings (AAA from S & P and A++ from A.M. Best) are as rock solid as it gets.

Guaranteed lifetime income:

No other investment vehicle can do this.

Tax Advantages:

The interest earned on the annuity account balance is tax deferred. And, the income, as it is received, is only taxed on the interest portion.

Peace-of-mind:

SPIAs are also known as “sleep insurance” for those who might otherwise lie awake at night fearing that they might outlive their income source.

Are SPIA Annuities Right for You?

SPIAs are only suitable for anyone who has an immediate need for a guaranteed income stream. If you are retired and you want to build in an income safety net then an SPIA may be an appropriate investment. It is important to have available other liquid assets that can be used to cover short term needs or emergency expenses.

SPIAs are best used as part of an asset allocation strategy that includes short term liquid assets, some conservative growth investment, and other income investment. In that context an SPIA provides the stability that every retirement portfolio needs.

Best Sources of Retirement Income

Perhaps the most shocking development to spring from the economic malaise of recent years is the precarious state in which many Baby Boomers find themselves as they approach the cusp of retirement.  Reports are pouring out on the ever dimming prospects for a secure retirement for millions of Boomers who have suffered through one of the worst recessions in history.   Chalk it up to a decade of poor stock market returns, the elimination of defined benefit plans, and a pitifully low savings rate over the last ten years.  Going forward, for the Boomers and future generations, it has become critically important that only the best sources of retirement income be considered for a secure future,

The experience of this retiring generation has clearly shown that we can no longer rely on any one source of income and that sound retirement planning needs to incorporate a mix of sources that, when combined, can provide income longevity as well as stability.  Over the years, more products have come out designed to give retirees more control over their investment income. Among the many retirement income vehicles available, two are being touted as the best sources for providing a sustainable and stable income.

Target Retirement Funds

Among the more recent innovations in mutual funds is the target retirement fund which is based on the premise that a portfolio can be managed to parallel a pre-retiree’s evolving risk tolerance as the retirement date approaches, and then continue to manage it to generate an income for the life of the retiree or until it runs out, whichever comes first.

The target date is the retirement date (or any date selected) and the portfolio is allocated among stocks, bonds and other securities.  As the time horizon shortens, the allocation is gradually adjusted to a more conservative allocation. At retirement, a calculation is made to determine an amount of income that can be paid out over the retiree’s life based on an assumed rate of return.

Among the concerns that some retirees have is that these funds tend to remain invested in stocks or risk oriented securities more so than they think is safe.  However, as recent experience has shown us, retirees are in greater need of growth-like returns on their retirement assets in order to stretch them through their retirement years.

Target retirement funds are subject to market risk which could impact the amount of income available over time, and they should only be considered by pre-retirees who have at least a 10 to 15 year time horizon.

Immediate Annuities

The only individual retirement vehicle that can guarantee a lifetime of income is an immediate annuity. In exchange for a lump sum deposit, a life insurer will promise to pay a stream of income that is calculated to last until a person’s life expectancy or death, whichever is later.  The payout is based on the age of the person in relation to his or life expectancy and the interest rate credited to the annuity balance.  Because a portion of the payout is a return of principal, the older a person is at the time of annuitization, the higher the payout.

In a fixed immediate annuity, the income payments are fixed for the duration of the annuity, so, over a long period of time, they are not likely to keep pace with the increasing cost of living. Some annuity contracts offer an inflation rider that, for an additional cost (which is deducted from annuity payments), will adjust payments based on an inflation index.

Alternatively, a variable immediate annuity, in which the annuity payments are tied to the performance of the stock and bond markets, could potentially generate an income that, over time, will outpace inflation.  There is a risk that income could decline in down markets, however, most contracts include a minimum income guarantee, or one can be added for an additional charge.

Choosing the Right Source

As with any investment, the right income source for you is going to be based on your own financial situation, needs, risk tolerances and investment preferences.  Forward looking retirees are coming to the realization that they are going to need some combination of growth and income predictability if they are going to enjoy a comfortable retirement.  The best option for most people is to create some combination of vehicles which, when working together, can provide the ideal level of security, growth and income stability.

A strategy that combines a vehicle such as a target retirement fund (if you are younger than age 60) and an immediate annuity can be structured to optimize asset growth while ensuring that your income will last a lifetime. Depending on your age and risk tolerance, a larger portion of your assets can be invested in a target fund that can potentially keep your assets and income growing.

Another portion can be invested in a deferred annuity which can be converted to an immediate annuity at a later point in your retirement.  The immediate annuity can provide the additional income you might need to cover cost of living increases, and it also creates the assurance that you won’t outlive its income.  By waiting until you are older to annuitize, your income payout will be higher due to the return of principal.

While this particular strategy may or may not work in your situation, the bottom line is that it will take some creativity and some combination of tools and resources to ensure that you won’t join the millions of Boomers who are now lying awake at night.