There are many different types of annuities out there, and new ones are introduced every day. Most annuities are complex contracts between you, the hapless consumer, and an insurance company. The insurance agent or broker sales middleman likes the hefty commission annuities pay, but often doesn’t understand how the policies really work. Unfortunately, annuities don’t come with warning stickers.
The SPIA (Single Premium Annuity)
An SPIA (Single Premium Annuity), which is also known as a fixed income annuity, is often sold with at least one policy rider (or add-on) attached to it. These expensive riders offer a menu of options like lifetime monthly income, cost of living adjustments, death benefit for beneficiaries, or second-to-die spousal benefit. The idea is that one single premium annuity policy becomes customizable with multiple options to cover all of your retirement needs.
The Pension Replacement Pitch
Most of the time, SPIA policies are sold with a lifetime income rider to provide the retiree with “retirement income for life.” In other words, in exchange for a lump sum of money from you, you will be paid back a monthly amount by the insurance company as a sort of self-made pension plan for as long as you live.
The Benefit to an Income Annuity for Retirement
There is really only one benefit to a lifetime income annuity like this: peace of mind for people uncomfortable with managing money. A reliable monthly income amount can sound very appealing to the consumer who’s been trying to figure out how to make their 401(k) work—and last—as their main retirement income source.
Downsides to an Income Annuity
The downsides to SPIAs with lifetime income riders are numerous. Let’s go through a few of them:
1. An income stream for the rest of your life sounds great, doesn’t it?
Keep in mind, the insurance company actuaries have carefully calculated how long they think that will be. How do you think insurance companies pay for their big buildings and high commissions? Annuities are extremely lucrative for them because, chances are, you will die before recouping your investment.
As a hypothetical example, let’s say a man purchased an SPIA with a lifetime income rider for $100,000 at age 60. At current rates, that would pay him around $5,643 per year for life, or around $470 a month. He would have to live for another 18 years—age 78—for his investment to break even.
In other words, that would be 0% interest on his $100,000 for the first 18 years. A savings account at the bank is paying more than that! Remember, if he dies within that first 18 years, he never breaks even. Since he didn’t purchase a death benefit rider, his heirs don’t get anything—the insurance company keeps the money.
The news doesn’t get much better over time. Let’s say our hypothetical man lives another 24 years—age 84. By that time, he would have earned only 3% on his $100k. Even if he makes it to age 135, due to medical advances, he will only have earned 5.9% on his initial $100,000.
To put this in perspective, from 1958 to today, the S&P 500 has averaged an 8.5% return with dividends reinvested. Even 10-year CDs are paying from 2.4% to 5% now. Your CDs and stock market investments have the advantage of passing to your beneficiaries, unlike an income annuity, which disappears when you die or only pays a fraction of remaining money to your beneficiaries if you purchase a death benefit rider.
2. Many retirees put their entire retirement savings into an annuity without thinking about the fact they will have no liquidity.
Once you initiate that annuity payout structure and you start receiving your payment every month, you are stuck. If there’s an emergency, you can’t pull those funds out.
3. In addition to lack of liquidity, there’s also inflation to consider.
A hundred dollars in 1989 would be worth around $2 today, 29 years later. Had you invested those funds poorly, you would be cutting yourself significantly short due to inflation. Can you imagine the lack of buying power just trying to buy groceries and get by? Everything would be twice as expensive. That’s the kind of financial squeeze income annuities can put you in. (Our hypothetical man’s $5,643 per year could have a buying power of only $2,800 in 30 years.)
You can buy a rider or an inflation tool that will have your payments increase over time with a built-in cost of living adjustment (COLA), which is nice in theory. However, keep in mind, the insurance company does all the calculations when they put your annuity together. They expect you to die at a certain time, and if you die early it’s even more money for them. Either way, they write policies and run all their payment calculations with the intention of maximizing their profits.
Different Types of Annuities for Different Purposes
Keep in mind, there are many other types of annuities that have different structures and different uses. But, in general, the SPIA with lifetime income is not a good investment for most retirees.
Make Sure you Work with a Fiduciary
If you don’t hire a fiduciary to help you, you could be taken advantage of. Unlike an insurance agent or broker, a fiduciary isn’t a salesperson who wants to sell annuities or put your money in the market with a pie chart blend of stocks and bonds. A true, pure-bred fiduciary is legally obligated to put your best interests ahead of their own—ahead of everyone else’s. They are Series 65 licensed working for an independent company under a registered investment advisory (RIA) firm. There’s no Series 7 license, no Series 66, nothing else—just Series 65 licensed with an independent RIA business structure.
If you are working with a fiduciary to plan your retirement, they will lay out a retirement income distribution strategy for you. If they recommend annuities, they will understand them, and explain the architecture underlying the policy as well as the strategy for your individualized retirement plan. There will be complete transparency about fees and commissions, as well as historic and anticipated performance.
If you’re not working with a fiduciary now, you should be. Art Levitt, the past chairman of the SEC, said that if you have more than $50,000 of investable assets, fire your broker and hire an investment advisor, which is code for fiduciary. You need someone that’s looking out for your best interests. As Tony Robbins says, “only 1.6% of financial professionals are actual fiduciaries.” Make sure you find one!
