Tuesday, November 7, 2017

Income Annuities: Immediate and Deferred

Annuities are insurance contracts that you can purchase to provide a stream of income for as long as you live. Think of them as life insurance in reverse. With life insurance, you pay premiums periodically while you are alive and your beneficiaries receive a large lump-sum payment when you die. Annuities are just the opposite — you pay a large lump sum to the insurance company up front and they make periodic payouts to you until you die, no matter how long that might be.

The following diagrams show the cash flows for life insurance, single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs). Blue cash flows go to you and red cash flows represent payments you make to the insurance company.




The difference between an immediate annuity and a deferred income annuity is that immediate annuities begin payouts in less than one year, while deferred income annuity (DIA) payouts can be deferred for many years.

I can purchase a $500,000 single premium immediate annuity today and begin receiving payouts next month if I wish. I can purchase a $100,000 single premium deferred annuity today and elect to not receive those payouts for ten years, for example, if I prefer.

Why would I want to defer an annuity’s payouts? Because deferred annuities and immediate annuities solve two different retirement problems.

Immediate annuities can be purchased at the beginning of retirement to help provide a lifetime of safe "floor" income. Retirees with little secure income may want to augment that safe income with an immediate annuity. Retirees with significant Social Security benefits and a pension may have plenty of safe income and not need an immediate annuity.

The following diagram shows the problem an immediate annuity can fix. The retiree has only a small portion of income generated from pensions and Social Security and may be exposed to a good deal of market risk in the red area. The green "floor" of safe income can be raised throughout retirement with an immediate annuity.


Some households may feel that they have adequate income in early retirement but worry that they might not have enough remaining wealth to fund their desired standard of living late in retirement should they live a very long time. Deferred annuities, also referred to as "longevity insurance", can solve that problem.

An immediate annuity (SPIA) provides income beginning in less than a year and continues those payouts for as long as the annuitant(s)[1] live. A deferred annuity (DIA) begins payouts at some contracted date in the future if and only if the annuitants survive to that date. At that time, DIA payouts also continue for as long as the annuitants live, but because the insurer will make fewer payouts with a DIA, and none at all if the annuitants don't survive until the future date, DIAs are a less expensive way to fund late retirement than SPIAs and much less expensive than spending from an investment portfolio.[2]

A good candidate for a DIA might be a household that relies on spending from an investment portfolio and is confident that the portfolio will fund early years of retirement but concerned that it will be prematurely depleted. A study my son and I conducted found that depleting a portfolio before age 80 should be quite rare.[3,7] A DIA is a good way to insure income after age 80 or so in the event of a failed portfolio.


See how portfolio survival rates begin to decrease sharply (risk of ruin increases sharply) once we reach age 80 to 85? Deferred income annuities can provide cost-effective protection against that increasing risk in late retirement for retirees who depend on an investment portfolio for income.

Why buy a deferred income annuity now and defer payments 20 years instead of just waiting 20 years to buy an immediate annuity? Because the DIA will be much cheaper and because there is no guarantee we will still have enough remaining savings to afford an immediate annuity when that time comes.

Assuming 3% annual inflation, a 65-year old man could buy a DIA today that would generate $10,000 of income per year in 2017 dollars ($15,580 in 2032 dollars) beginning at age 80 for a one-time purchase of $41,560.

An 80-year old could purchase an immediate annuity today that will generate $10,000 of immediate annual income for $91,070. It's much cheaper to buy the late retirement income in advance.

The immediate annuity would generate significantly more lifetime income, of course, but it requires more than twice the initial outlay. For households that only expect to need additional income in the event of a very long life, the DIA is the better choice.

This is not an apples-to-apples comparison. This assumes that life expectancies and interest rates will remain roughly the same over those 15 years. I have figured in 3% inflation, which could be high or low. The SPIA purchaser will almost certainly receive some income while the DIA purchaser will receive nothing unless she survives to age 80.

Nonetheless, the annuitant who does live to 80 will fund income the least expensive way. The DIA is longevity insurance and that's how insurance works. We accept a certain loss (premiums) to protect us from a potentially very large loss (running out of money in late retirement). We pay someone else to accept our risk.

Deferred annuities, like retirement finance in general, have an accumulation phase and a distribution phase. But, the phases might be easier to understand if we describe them as two different products.


When to buy a deferred or immediate annuity and when you probably don't need one, at all.
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Imagine that the accumulation phase of a deferred income annuity (DIA) is like having a fixed-interest rate savings account. The money invested in this savings account is illiquid because the insurer can charge high surrender fees if the annuitant makes withdrawals sooner than the annuity contract allows. Taxes on earnings are deferred until they’re withdrawn, so sort of like a savings account held in a traditional IRA but without a tax break on the contributions.

The value of this account grows until the DIA is annuitized, or converted into a stream of lifetime income, or until the annuitants die, in which case the account value becomes zero. If the annuitants die during either phase, even if payouts have not begun, the results are pretty much the same as with an immediate annuity. That means that unless riders are purchased to guarantee some payout to your beneficiaries, the deferred income annuity will have no residual value.

The second product (the distribution phase) is a life annuity that you will choose to purchase with funds from the “savings account” if you survive the deferral period.  If the annuity is funded from an IRA or 401(k) — a “QLAC”, described below — you must begin annuitization by age 85. Funded outside a retirement account, you can often delay annuitization until age 90.

An annuitant might reach the age they expected to convert to an annuity, not need the income, and elect to delay annuitization until they do. Or, they might find they need the income sooner and move back the annuitization date a few years.

Inflation is a greater concern with deferred annuities than immediate annuities. While most deferred annuities don’t offer inflation protection, those that do offer it don’t provide inflation protection during the accumulation phase. The inflation protection kicks in only when the account is converted to an annuity. Since the deferral period can last a long time, inflation can become a significant issue as your axccount compounds during the accumulation phase at bond-like interest rates.

Another advantage of DIAs compared to immediate annuities is that they require a smaller cash outlay because they only provide income if you survive until late in retirement. According to researcher David Blanchett, "The cost of a DIA, for example, that would provide $10,000 a year of income, if you buy it at age 65, it would cost about 20% of what it would cost to have a SPIA starting today at age 65 to provide that same level of income." [4]

Wade Pfau wrote a column entitled Why Retirees Should Choose DIAs over SPIAs[5]. The short answer is that deferred annuities are the most economically-efficient way to finance the latter years of retirement should a retiree or spouse live a long time. The more technical answer is that DIAs "expand" the retirement income efficient frontier and create opportunities with higher expected returns for a given level of risk.

There is a special type of DIA worth mentioning, a qualified longevity annuity contract (QLAC). A QLAC is a deferred annuity that you can purchase with qualified funds from your retirement accounts with payouts deferred to as late as age 85.

According to Motley Fool[6], “a QLAC allows the insured to withdraw 25% — up to a maximum of $125,000 for single folks and $250,000 for married couples — from their qualified retirement accounts and exempt these funds from being considered in their RMD calculation from age 70½ onward.

I recently recommended a QLAC to friends. They plan to annuitize it at age 82, but if they reach that age and their portfolio has held up well, they can choose to defer payouts up to three more years and receive larger checks then. On the other hand, if their portfolio underperforms, they can choose to annuitize a few years earlier and receive slightly smaller checks sooner.

Annuities are not particularly popular although interest in DIAs has recently grown.

One of the problems, I believe, is that retirees often consider annuities in isolation and not as part of an integrated plan. True, the money used to purchase an annuity cannot be left to your heirs. (Unless you buy special riders to continue payouts to your beneficiaries for some guaranteed minimum number of years. Those essentially offset mortality credits and defeat much of the purpose of buying the annuity.)

On the other hand, if you purchase an annuity and die early in retirement, the good news (financially) is that you will have had a relatively brief and inexpensive retirement. That may mean you had plenty of savings apart from the annuity to leave your heirs.

If you live to an old age, an annuity might help you avoid spending other savings that you can leave to heirs. Owning an annuity may give you more confidence (or may not, depending on your personal risk aversion) to invest your portfolio more aggressively and improve your odds of earning a greater return. As Pfau’s research shows, annuitants often end up with greater terminal wealth.

The point is that you need to consider annuities as an integrated part of a retirement plan and consider the entire plan’s terminal wealth instead of focusing on the fact that the annuity has no value at death. If the annuity ultimately becomes worthless but it has preserved other assets, it will have done its job.

This isn’t a thorough treatment of deferred annuities. My goal is simply to explain their salient characteristics for comparison with immediate annuities and Social Security benefits. If you want more information — and certainly if you are considering purchasing one — please see the references below.

The most important takeaway is that deferred income annuities (DIAs) are the most economically-efficient way to fund late retirement by providing "longevity insurance." Single-Premium Income Annuities (SPIAs) are a better way to provide income throughout retirement for retirees with an inadequate "floor" of safe income. The correct choice depends on the problem or problems you are trying to solve — you might even need one of each.

As I have mentioned often, I believe that retirees should plan retirement in a way that makes them happy. Some people hate annuities; some won't invest in the stock market. If you understand the pros and cons of each and can't be persuaded, buy what lets you sleep at night.

REFERENCES


[1] An annuity can cover a single life (annuitant) or joint lives (annuitants).


[2] The 4% Rule-At What Price?, Scott, Sharpe, Watson.



[3] Competing Risks: Death and Ruin, Cary Cotton, Alex Mears and Dirk Cotton, Journal of Personal Finance Vol 15 issue 2, Aug 24, 2016, page 36.



[4] Pros and Cons of 2 Key Annuity Types, David Blanchett interview video.



[5] Why Retirees Should Choose DIAs over SPIAs - Articles - Advisor Perspectives, Wade Pfau, 2013.



[6] What Is a QLAC, and Why Might You Want One?. MotleyFool.com.



[7] Note that these curves show the cumulative conditional probability of portfolio survival. Most studies show the probability, for instance, that a 65-year old's portfolio will survive to age 95. A Kaplan-Meier curve shows the probability that a retiree who actually lives to 80 and has not depleted her portfolio, for example, will experience portfolio failure at later ages. Retirees who have already died or already depleted their portfolios are not included in the Kaplan-Meier calculation of future probabilities.

15 comments:

  1. Great post, Dirk.

    One might also consider a reverse mortgage as a alternative to a DIA, if late-retirement income augmentation is the goal AND a retiree plans to remain in their current home. The reverse offers the advantages of funding with otherwise idle assets - home equity, has no early withdrawal penalty and can be "annuitized" at any time, in whole or in part, tax-free. Further, if the retiree dies early, the unused home equity is available to the heirs.

    An important caveat, however, is that payments from a reverse are dependent upon occupancy of the home, among other terms of the loan. Where a true annuity payment will follow a retiree into a retirement community, assisted living or nursing home, the payments from a reverse will cease upon leaving the home securing the loan.

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    1. Jim, I'm a fan of HECMs for some uses, but a HECM should not be confused with an annuity. As you point out, an annuity guarantees income for the life of the annuitant(s) while a HECM guarantees income for so long as the borrower(s) live in that home.

      (It reminds me a little of looking into the TiVo "lifetime warranty" several years ago and finding out they were referring to the lifetime of the hardware, not mine.)

      As I have also pointed out in previous posts, a homeowner may be forced from the home by a financial crisis even if there is no foreclosure. The HECM loan would be called in that case, too.

      I would also point out that in some scenarios an annuity will replace spending from other savings, which can also be passed on to heirs.

      I appreciate your second paragraph. It is a critical caveat. But, I think it is important that retirees understand that reverse mortgages are not annuities, nor are sustainable withdrawal rate strategies. Each has its own benefits and risks that shouldn't be confused. Pick the one you need to solve the problem you have.

      Thanks for writing!

      Delete
  2. Once again, you help me plan for a secure retirement. The discussion of Deferred Annuities is really helpful to someone who is less worried about leaving wealth to heirs and more concerned about enjoying (responsibly) the fruits of many years of frugal living so that retirement would be adequately funded.

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  3. Hi Dirk Thanks for this post. It is timely for my wife and I as we are entering retirement and both of us could purchase a 125K QLAC. Regarding QLACs, my wife is opposed, I am leaning toward getting one, but have not decided. I am not sure it is a clear cut decision as we both are delaying pensions and SS (which is a pretty good DIA in itself..)and therefore our floor could cover a significant portion of expenses. It was interesting to learn there is flexibility in the start date, good to know. You have included some good reference articles-I am wondering if you would care to comment on some other bits that are out there in blogosphere on this topic: 1-QLACs are promoted as an RMD avoidance tool but in fact perhaps they should not be used primarily as such; 2-although QLACs are clearly insurance, when thinking about them from an investment perspective, are they primarily a bond or fixed-income alternative or should that even part of the thought process at all; 3-what tax considerations are there for the death benefit (lump sum vs monthly for the survivor); 4-how old would you be, on average, if you bought a 100K QLAC at 65 and started it at 85 before your principal investment was returned. My general view is I want to make sure my wife has income when I pass (I am 4 years older) so this seems like another decent tool. Thanks again Dirk.

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    1. Hi, Rob.

      "QLACs are promoted as an RMD avoidance tool but in fact perhaps they should not be used primarily as such." I assume this refers to the Michael Kitces post.

      I agree with Michael, although several commenters didn't. He isn't saying QLACs are a bad idea, only that you shouldn't buy one for the sole purpose of reducing RMDs.

      "although QLACs are clearly insurance, when thinking about them from an investment perspective, are they primarily a bond or fixed-income alternative or should that even part of the thought process at all"

      I don't think of them exactly in this way. I think of a "floor" of safe income investments with no market exposure and an upside portfolio. I think of the annuity as a floor component.

      Now, if I have an adequate safe floor, I can probably take more risk with my upside portfolio, which means buying more equities and fewer bonds. So, in effect, I would probably be reducing bond purchases by buying the annuity. It isn't a direct replacement because no matter how much floor income I have, there is a limit to how much volatility I can stand with my upside portfolio. So, I prefer to think of them as separate problems rather than to equate $100 of annuity purchase to $100 of bond investment.

      "how old would you be, on average, if you bought a 100K QLAC at 65 and started it at 85 before your principal investment was returned."

      I don't think of this that way, either. The purpose of the QLAC is to insure against running out of income late in life. I don't care so much about the probability of living long enough to collect on an insurance policy as I do about the consequences of losing my standard of living in old age.

      I think a lot of break-even analysis regarding insurance decisions is misguided. It's like asking how long you have to drive without an accident claim to make car insurance worthwhile. Whether or not you have an accident, you have purchased risk protection and you enjoy that protection whether or not you ever file a claim.

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  4. Your talk about 'cheapness' when comparing Delayed vs Deferred seems based on wonky metrics. For the specific example you gave of a 15-yr Dfd contract (yield 10,000 / 41,560 = 24.06% contrasting to a Delayed contract with yield 10,000 / 91,070 = 10.98%. It is not the Price (per $benefit) that matters, or even inflation adjusted P/Ben.

    To my mind you must calculate what after tax rate of return you would earn on the $$ during the 15 years before you buy the Delayed contract. The two options have equal $benefits if you can earn 5.37% after tax. Your choice is between ....

    a) Buy a Dfd contract now for $100,000. Wait 15 years and start receiving 24.06% = $24,060.
    b) Invest $100,000 for 15 years earning 5.37% to end up with $219,157. That would purchase an an immediate (at that time) annuity paying 10.98% = $24,060.

    So assume that rate of return making the options cost the same. Unexpected higher inflation may make the Def option poor in hind sight (because contracts issued when young are more price sensitive to inflation/interest rates), but then unexpected extended longevity rates may make the Delayed option poor in hind sight. What is really different between the contracts is what happens if you die in the interim. With a Dfd contract your beneficiaries lose 100% of the 100,000 (not cheap) while they keep both the $100,000 plus the profits with the Delay option (lucrative).

    I am not convinced by the 'you might not have the $$ later to make that delayed purchase'. Wealth does not just disappear over night. There is time to react. And annuity prices for older ages don't depend on market interest rates or inflation. They rely on mortality, so any delay won't expose you to price risk.

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    1. You're trying to compare a volatile investment return to a non-volatile annuity insurance payout. Volatility is an added cost that you're ignoring.

      The "might not have the money later to purchase the annuity" refers to the risk of losing money on your investments while you wait, not to an increase in the cost of annuities.

      If you die before the annuity begins payments then you didn't have the cost of a long retirement. The purchase was insurance that would pay for a bad outcome. Just because you may never make a claim doesn't make insurance invaluable. It transfers your risk to the insurer.

      Wealth doesn't just disappear overnight? Do you remember 2007-2009?

      Thanks for writing!

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  5. Nice primer on annuities, Dirk. Those considering the purchase of a deferred annuity may also wish to read our post of December 5, 2005 on how using the Actuarial Approach can address some of the challenges associated with purchasing a deferred annuity, including the development of a coordinated spending strategy designed to minimize disruptions in desired spending before and after the deferred annuity start date.

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    1. Thanks, Ken, can you provide a link to the post?

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  6. The clearest explanation of the pros and cons of DIAs I've seen. Thank you. My only question is the Motley Fool quote. It isn't clear whether there is a $125,000 for each spouse on their respective IRAs, which sums to $250,000, or a married spouse can withdraw up to $250,000 from just one IRA. If it is the latter, that is important and not something that I was aware of.

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  7. Thanks! This is a very helpful post. Almost all of our savings is in IRAs. We've maxed out on QLACs. As I understand it, we can't buy any more DIAs with IRA money if payouts would start after age 70 1/2. I'd like to understand better, from a tax and RMD perspective, what happens if we buy SPIAs with IRA money. Bob

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    1. I ran your question by Tom Morris, a financial planner in Durham, NC.

      As far as I know, you can use all your retirement account to buy SPIAs if you want, the issues arise with DIAs. As I mentioned, though, DIAs and SPIAs fill two different needs.

      You can buy more DIAs from your IRAs, you just can't buy more QLACs than you have already. Any DIAs you buy from those IRAs, unlike QLACS, must begin payouts by age 70½ to meet the RMD requirements and if you're close to that age, the DIA may not have time to defer enough to make it worthwhile. If you're younger, the DIA might be a better deal than a SPIA. You have to run the numbers.

      The big advantage of a QLAC deferred income annuity is that you can begin payouts much older and not be constrained by RMDs.

      Tom noted that another strategy is to use some of your non-qualified (taxable) money to pay taxes on a Roth conversion now, then use the Roth to fund a Roth DIA. (A Roth has no RMD requirement.) This would allow you to pick a distribution date of your choosing (even past age 85), further leveraging the power of a DIA/QLAC. This can be an effective strategy in the early years of retirement when taxable income is often low.

      Regarding SPIAs, they will meet RMD requirements if designed correctly by the insurer, but that design can be complicated in some situations. Here's how Ed Slott answered your question at irahelp.com:

      Do distributions from a SPIA (qualified money in an IRA) satisfy the RMD rules?

      Re: SPIAs and RMDs

      They can and should if the insurer is aware of the permitted rules in IRS Reg 1.401(a)(9)-6. Most of these IRS Regs are designed to assure that annuity design cannot result in a slower rate of distribution than allowed. For example, if the SPIA is based on joint life expectancy and/or period certain, there are limits to how much younger the beneficiary is or how long the period certain is allowed to be relative to the owner's age and life expectancy. A simple life annuity will meet the requirements, however in years after the annuitization year, the IRA RMDs for the annuity and other IRA accounts must stand on their own, i.e., cannot be aggregated since the annuity will no longer have a prior year end balance. The Regs are vague with respect to short period certain SPIAs - for example a 65 year old annutizing an IRA for 10 years. That 10 years bridges the period when RMDs must otherwise begin, so while the money is being distributed much faster than ordinary RMDs, there is a question in defining them as RMDs. Defining RMDs is key because if a given distribution e.g., at age 65 is considered to be an RMD, then it cannot be rolled over.


      Short answer: your insurer should be able to build a SPIA that meets RMDs.

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  8. The Motley Fool reference is unclear. Does the $250,000 limit for a couple mean they each take $125,000 from their respective IRAs, or can one spouse use $250,000 from their own IRA for a DIA for the couple? If the latter, that is good news. Thanks.

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    1. There is not a $250,000 QLAC limit for a couple. The limits are per tax-payer. So, each spouse can contribute up to 25% of the total balance of all of his or her own IRA and 401(k) accounts, or a maximum of $125,000, whichever is less. The amount increases to $130,000 in 2018.

      If both spouses have at least $500,000 saved in these accounts, then each could contribute $125,000 to a QLAC, totaling your $250,000.

      However, if one spouse has saved $1M in her own accounts and the other spouse has no retirement savings accounts, at all, then the maximum contribution will be $125,000 for the combined household.

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  9. Great post, Dirk. I think annuities are extremely valuable and underutilized retirement tools, especially because they're so separate from the rest of one's portfolio. I think there's a real opportunity to change the annuity distribution model so that they can actually be a part of one's retirement portfolio diversification, and solve the longevity risk exposure issue at the same time. I'd love to chat with you about this topic -- I sent you an email just now. Thanks for writing this blog!

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