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 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.
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.
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.
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.
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.