Why A Single Premium Immediate Annuity May Make Sense For Retirement Income
(As a Fee-Only advisor, I do not sell annuities, but believe a certain type can be helpful for some situations)
To the annoyance of conservative income investors, interest rates continue to hover near their historic lows. While it is likely we will see the yield on long-term bonds begin to inch up from here, no-one knows when this change will take place. So what are conservative income investors to do? The answer may lie in a traditional investment that can generate the income they’re looking for while providing greater long-term security – a Single Premium Immediate Annuity (SPIA).
Conservative income-seekers have few options when it comes to maximizing their income without having to assume more risk. They can look to higher-yielding, low investment grade bonds - but they can be as volatile as the stock market. (These bonds are loans you may to near-bankrupt companies, so it makes sense). For many investors, a SPIA may make the most sense because it can increase current income while even lowering their risk.
How Does a SPIA Work?
A SPIA is the oldest form of an annuity, dating back to Roman times when the government would provide citizens and soldiers and lifetime of income in exchange for a lump sum investment. Today, an SPIA is formalized under a contract between a life insurer and an individual, again exchanging guaranteed income for a lump sum of capital.
Income You Can’t Outlive
Payments can be guaranteed for a specific period of time or for the lifetime of the annuitant. If a specific time frame is the payment period (e.g. 10 years), the payments will stop at the end of the period. If the payments are to be made for the lifetime of an individual, they don’t stop until the individual dies. In fact, SPIAs are the one investment vehicle that guarantees you won’t outlive your income. To a great extent, buying an SPIA is like buying a monthly pension check.
The payout for a lifetime SPIA is based on several factors, including current age, life expectancy, the expected rate of interest and the amount of your investment. Essentially, the insurer calculates the number of months between the time of the investment and one’s life expectancy and then divides that into the investment amount. It adds an interest rate factor to determine the amount of the monthly payout. Technically, the monthly payout is calculated to run out at one’s life expectancy. But, by contract, the insurer is obliged to continue to make monthly payments for as long as the insured is alive.
High Low-Risk Payouts
For many conservative investors who fear outliving their income, the lifetime payout guarantee is priceless. But, here is where it gets interesting for those who want to maximize their income. The payout amount is actually comprised of both the interest earned on the investment and a portion of the principal. That means the payment is only partially taxed. The interest portion is taxed as ordinary income, but the portion that is a return of your principal is tax free.
The amount of the payment that is the return of principal is based on the number of years’ payments are to be made. For older investors, there are fewer months between their current age and their life expectancy, so their return of principal portion will be higher. That is why some financial planners will recommend waiting as long as possible to invest in an SPIA, so you can maximize your payout amount.
If inflation is a concern, many SPIA products have options that will tie the monthly income to a cost-of-living index. If that option is included, the initial monthly payout will be lower.
Stay Diversified
If you’re a conservative income investor, you may want to consider an SPIA for guaranteed retirement income. However, it’s always important to remember that this should be one part of an investment portfolio and not the whole portfolio. Having options in retirement and remaining diversified is as important as guaranteeing future income.