In my previous article on annuities, I defined annuities (introducing the concept of risk pooling and mortality credits), explained why investors might purchase one, and gave two simple examples. There are many types of annuities available. In this article, I describe the simplest type of annuity, the Single Premium Immediate Annuity, or SPIA.
What is a SPIA?
A SPIA is a contractually- based insurance product that immediately (or in less than a year from purchase) converts a lump sum of money into a guaranteed stream of income payments for a specified period or for the annuitant’s (purchaser’s) lifetime. Investors typically use it for retirement income planning to ensure financial security and longevity protection. There can also be more than one annuitant assigned to an annuity contract, such as a married couple where the spouses are joint annuitants.
How does a SPIA work?
All annuities consist of two time phases:
- Accumulation phase, in which money (the principal) is initially deposited into the annuity at time of purchase, with the expectation of growth either through investing the money or from a fixed interest rate;
- Income phase, in which the money comes out of the annuity and provides income.
A SPIA truncates the accumulation phase to only one day, the day the annuitant hands over the principal to the insurance company. With SPIAs, the emphasis is not on any expectation of growth but rather on a guaranteed income stream that starts within one year of purchase (and often within one month). The annuitant can specify whether the income payments occur every month, quarter, or annually.
At time of purchase, the annuitant can also select whether these payments occur for a fixed period of years (called “Term Certain”) or over the annuitant’s lifetime. A third option, Life with Period Certain, guarantees payments for the annuitant’s lifetime. If the annuitant dies within a set number of years, payments will continue to a beneficiary for a predetermined period.
Once you purchase the annuity, you cannot access the principal. In other words, the annuitant forfeits the principal in return for the periodic payments.
How are annuities taxed?
Taxation of SPIAs differs depending on the funding source – after-tax (referred to as “non-qualified”) money such as from a bank or brokerage account, or pre-tax (“qualified”) money, such as a Traditional IRA.
If you purchase a SPIA with after-tax money, the income payments are partially taxable because each payment consists of two components:
- Return of principal: Since after-tax dollars funded the premium, a portion of each payment is considered a return of the original investment and is not subject to taxes.
- Earnings: The portion of each payment representing interest or growth on the investment is taxed as ordinary income.
An Exclusion Ratio determines how much of each payment is tax-free versus taxable. The formula is: Exclusion Ratio = Investment in Contract (Principal) / Total Expected Payments
Let’s say:
- You invest $100,000 into a SPIA with a lifetime payout. That is your principal.
- Based on your life expectancy, the insurer estimates that you will receive $150,000 in total lifetime payments.
- The exclusion ratio would be $100,000 / $150,000 = 66.7%.
This means 66.7% of each annuity payment is tax-free, and 33.3% is taxable as ordinary income.
This formula applies to each payment until the accumulation of the tax-free portion of the payments equals the principal. Thereafter, 100% of each payment is taxable. In a joint-life SPIA, (i.e., a married couple, where both spouses are annuitants), the exclusion ratio applies over both annuitants’ expected lifetimes.
If a SPIA is purchased with qualified money, such as from an IRA, 100% of every payment is taxed as ordinary income from the time of purchase through the term of the annuity (which is usually the life of the annuitant). Exclusion Ratios don’t apply to qualified annuities.
Why not just buy bonds or CDs?
Bonds and CDs definitely have their place in a retirement portfolio, but SPIAs solve a different financial planning problem – namely, Longevity Risk, or the risk of outliving your assets. SPIAs can pay over the annuitant’s lifetime, whereas bonds and CDs have finite maturity dates. In this way, SPIAs serve as “longevity insurance,” mitigating the risk of exhausting your assets before the end of retirement.
They achieve this utilizing two key actuarial principles: risk pooling and mortality credits.
- Risk Pooling: The insurance company pools the premiums from many annuitants and pays out benefits based on statistical life expectancy. Some annuitants will outlive their expected lifespan, and others will not, but the insurer manages this risk across the group. This allows insurers to provide guaranteed lifetime income without an individual worrying about outliving their assets.
- Mortality Credits: Mortality credits arise because some annuitants will not live as long as others.Those who die earlier effectively “forfeit” their remaining premium to the risk pool, allowing insurers to pay higher annuity payments to surviving annuitants. This is why SPIAs typically offer a better return than bonds or CDs with similar risk levels – because those who live longer benefit from the mortality credits.
However, because SPIAs and bonds/CDs solve different problems, comparing their rates of return at time of purchase doesn’t really tell you anything. Although bonds and CDs have fixed rates of return (a fixed interest rate) that are known at purchase, a SPIAs’ rate of return depends on how long you receive payments, which obviously cannot be known on the purchase date. In fact, a SPIA’s rate of return is negative until the after-tax portion of periodic payments exceeds the principal, which can be many years from the date of purchase.
One other important point: a SPIA’s rate of return is not the same as its payout rate, which you do know on date of purchase. A SPIA with a 6% payout rate does not mean that its rate of return is 6%. Therefore, comparing a SPIA’s payout rate with a bond’s or CD’s rate of return is not a valid comparison.
Just how ironclad are these payment guarantees?
The reason more people don’t annuitize some of their financial assets is the concern that the insurance company from whom they purchased the annuity will go out of business or otherwise become financially insolvent. This happens very rarely; state agencies strictly regulate insurers, requiring them to maintain sufficient liquidity to pay out the contractually agreed-upon amounts to annuitants. As a case in point, during the 2008 Great Recession, the annuity division at American International Group (AIG), a major insurer of annuities, didn’t skip one payment to its annuity holders even though other divisions were experiencing financial difficulties.
In the rare case where an insurer does run into financial trouble, state guarantee associations provide a backup level of insurance to keep the payments flowing. Each state sets its own limits (usually between $100k and $500k per annuitant, with further limits placed on each annuity purchased). States do not guarantee amounts exceeding these limits. When purchasing a SPIA (or any income annuity), it is not only important to choose an insurance company with high financial ratings, but also prudent to stay within the state guarantee limits to ensure full protection even under the most dire of circumstances.
In the next article, we’ll discuss who benefits most from a SPIA, and important considerations around inflation.
Photo courtesy of Towfiqu Barbhuiya on Unsplash