A Good Annuity Comprehensive Guide
What is a “good annuity?” It is an annuity an advanced investor might want to buy! Usually you are sold annuities; not so with a good annuity.
When considering retirement income, should you use “good” annuities such as SPIAs, DIAs or QLACs? What do those letters mean anyway?
Well, if you know a little bit about “good” annuities and are considering one, read on for a comprehensive treatment of your options. There are different types of good annuities! These will not be sold to you, so you need to go out and learn about them and sign yourself up. And as a warning: this is a tough read and not meant for a superficial glance. If you are looking for retirement income options via good annuities, you have found the right spot!
What is the Meaning of Good Annuity?
A Good Annuity means a product that you seek out and purchase to mitigate risks and provide income as part of your comprehensive retirement plan.
You don’t invest in annuities, you buy them. They are insurance products that transfer risk. This is important to understand. The purpose of a good annuity is to transfer your individual risk to a risk pool. You trade liquidity for income with good annuities. Remember, despite what wall street tells you, you don’t need to be 100% liquid at all times and in fact, liquidity comes at a cost.
What risk are you transferring? That you might run out of money!
Instead of possibly running out of money, a good annuity guarantees a stream of income that won’t stop until you (and perhaps your spouse) die. And no, the insurance company doesn’t “win” if you die early. The risk pool wins!
There are mortality credits that are paid out to you the entire time you take your income stream. What does that mean? Mortality credits are the increase (above bonds alone) in income you get from an annuity due to the fact that you have pooled your risk. The insurance company knows that some people will die early, and thus they can pay everyone a little more from the very start.
A lot of the fancy, expensive, complicated, agent-sold annuities don’t offer mortality credits. If you are being sold an annuity, chances are there are no mortality credits. A good annuity, on the other hand, feature mortality credits. Again, mortality credits are why you “make more money” with an annuity than if you own just the underlying bonds. Some say: “why own an annuity when you can just buy the same underlying investments as they insurance company does.” Do you understand why that is false? Good.
Let’s dive in and discuss the line up of GOOD ANNUITIES.
What is a Good Annuity to Buy?
Let’s next look at the (very few) good annuities to buy. They include:
Single Premium Immediate Annuity (SPIA) is a good annuity
A SPIA is an immediate income annuity meant to provide income and some longevity protection (the risk of running out of income if you live a long life). The income you get every month doesn’t stop until you (or you and your spouse if you purchase a Joint and Survivor annuity) die.
You get the mortality credits from the time you turn the income on (which must be less than 13 months from the lump sum payment to the insurance company). SPIAs are useful if you have an income gap now. As they are not inflation-adjusted, you will loose purchasing power with them in the future, which is why I don’t consider them longevity annuities.
Deferred Income Annuity (DIA) is a good annuity
Another annuity specifically for longevity insurance is a DIA (Deferred Income Annuity). With a DIA, you make an initial lump sum payment but defer turning on the income for a number of years. In exchange, you get a higher percentage of income when it eventually is annuitized.
You get mortality credits and a bonus for allowing the insurance company to use your money for a while. So, if you have an income gap in 10, 15, or 20 years, a DIA might be right for you. This is real longevity insurance, because it meets a future income need. If you die before the DIA starts, well, then I guess you don’t have that income need.
DIAs pay more because you irrevocably give the money to the insurance company to use until you turn on the income stream. This means that eventually they will pay you more per paycheck, which means that they are relatively protected against inflation.
Given that DIAs “lock in” current interest rates when considering future payments, I’m not all that excited about them currently. Another options is a MYGA that you 1035 into a SPIA. This may offer you an equivalent amount of future income, with less illiquidity. More about that later.
Qualified Longevity Annuity Contract (QLAC) is a good annuity
Before we get into QLACs, let’s talk about what account type in which you invest. Brokerage, pre-tax, or Roth?
A Good Annuity in a Brokerage Account, a Pre-Tax Account, or a Roth?
Remember, there are different account types. There are non-qualified (also called taxable or brokerage accounts) and qualified accounts (pre-tax retirement accounts). And don’t forget Roth, though you need to be really careful before you put a good annuity inside a Roth account.
You can buy SPIAs in both qualified and non-qualified accounts. The difference will be taxation of the income stream. This gets complicated quickly, but remember that pre-tax retirement accounts will always be fully taxable.
With a brokerage SPIA, only part of the income is taxable every year. Eventually (hopefully), you get your basis (that is, your original investment) back, and then the pure “growth” becomes fully taxable from then on. There is an exclusion ratio which the insurance company calculates for you which dictates how much you have to pay each year in taxes. You don’t have to do the math, but taxation can get complicated.
So you can get a SPIA in all three account types.
Until recently DIAs could only be purchased in your brokerage account. You could not get a DIA in a pre-tax account because of RMD issues. This problem was solved by congress: Enter QLACs.
A QLAC is a Good Annuity, Too!
There is a newer good annuity gaining interest: the QLAC (Qualified Longevity Annuity Contract). This is “a DIA for your IRA.”
A QLAC let’s you take money (up to $130,000) from your pre-tax retirement account and defer income from it into the future. This is useful longevity insurance, and may be a consideration for those who have a long life expectancy and large pre-tax retirement accounts. You can get joint and survivor payouts, and there are options for period-certain and return of premium as well. So, while there are more bells and whistles with QLACs, they can be an important part of your longevity plan.
Some are excited to use QLACs to decrease Required Minimum Distributions (RMDs). The money you use to purchase a QLAC is not included when calculating RMDs. QLACs, however, actually just delay RMDs, though, and you will pay eventually.
QLACs allow you to defer annuitization until as late as 85 years of age. As a result, they can be an interesting option for longevity insurance and for spouse protection/planning if used as a Joint and Survivor annuity.
Summary: Good Annuity Meaning
We are off to a good start! You can have a good annuity in different accounts. The usual suspects are brokerage accounts and pre-tax retirement accounts, which have different tax implications. Some can consider a good annuity in a Roth account (tax-free income for life!), but be careful using wonderful Roth money in an annuity.
Next, we have the product types. There are SPIAs and DIAs for your brokerage account, and SPIAs and QLACs for your pre-tax retirement accounts.
Since we have now had an introduction to the good annuity, I now want to challenge you. Let’s look at a a brokerage SPIA vs a QLAC!
Good Annuity Comparison SPIA vs QLAC
To familiarize ourselves with these good annuities, I thought it would be fun to compare them in a fictional couple.
Let’s start with an immediate income brokerage annuity vs. a deferred longevity IRA annuity. Try to say that fast a couple times. I told you this wasn’t going to be superficial. And now you see why no one likes annuities…
Also, this is not an apples-to-apples comparison, but it provides insight in how these products can be used in retirement.
Later, I will also briefly compare a brokerage DIA and a Qualified SPIA as well. Hold on to your hat, cause here we go.
Meet Our Couple
Assume a couple is 74 and 69 years of age. They both have longevity (they plan to live until 95 and 100 years of age respectively—a 30-year plan) and worry they may not have enough money left.
Current net worth is $2,000,000 and they spend about $7,500 a month—a 4.5% withdrawal rate.
They keep $250,000 in cash, and have a 50/50 stock to bond ratio (assuming 6% and 3% growth).
The Roth IRA has $250,000, and there is $750,000 in a roll-over IRA. The rest of the $750,00 is invested in a brokerage account. Assume inflation is 2.5% except for healthcare which is 5%. Finally, they receive $3,000 a month in social security.
Current Plan without an Annuity
Monte Carlo simulation shows only a 53% chance that their plan will succeed. In addition, stress testing shows particular sensitivity to interest rate and longevity risks.
Figure 1 shows the confidence levels that their money will last 30 years. The plan ends at 105 which is when the 69-year old partner expects to die at 100 years of age, a full 10 years after the older spouse passes. You can see the 50th percentile runs out of money at age 104, and the 25th percentile runs out at 99. The 5th percentile is gone at 95. What that means, is using historic returns, 5% of the time there is no money left after 20 years, and 50% of the time there is no money left after 30 years. Do you like those odds?
This plan upsets the younger spouse who is determined to live to 100, and they wonder if a SPIA would help.
What about a $260,000 SPIA from the brokerage account? They are offered a 7.2% yearly rate of return on a single life annuity on the younger spouse.
Of course, they can opt for a Joint and Survivor policy, but the younger spouse plans to outlive the older partner by 10 years. A single life policy has higher returns than a joint policy, which makes sense as you are only insuring one life. The percentage return depends on age, gender, and current interest rates.
With a $260,000 SPIA, the couple now has a 60% chance for success on Monte Carlo Simulation. That’s a little better than the 53% without a SPIA, but what does that actually look like?
Visualize a good annuity: the SPIA
Figure 2 above shows a drawdown comparison between the two plans. In light green, without a SPIA, their assets decrease slowly over time. In dark green, with a $260,000 SPIA, note their assets decrease immediately as the money is irrevocably paid to an insurance company in exchange for the income stream.
At age 97 the plans “cross over.” That is, they have more remaining assets as a result of the income from the SPIA after that point. If they live as long as planned, in the end they have an extra ~$102,000 more left over for their heirs. Take away here: SPIAs can decrease the amount you leave to your heirs if you die before the “cross over,” but increase the amount if you live longer than average.
In summary, we increase the Monte Carlo odds of success and offer a bit more income stability with a SPIA. What about a QLAC?
In 2021, you can transfer 25% of your IRA (up to a maximum of $130,000) into a QLAC. The couple decided to see what $130,000 from their IRA would buy, and were offered a 14.4% rate of return for a 10-year deferral of income. Note the higher interest rate due to the deferral.
Monte Caro simulation for the QLAC is 60%, and an asset simulation is seen below in figure 3.
Compare the asset simulation with a QLAC to no annuity in Figure 1. Note all of the percentiles are shifted to the right by about 5 years. So, a QLAC does protect you from running out of money if you live too long!
The drawdown comparison is pretty similar to figure 2 above, so not repeated here. The “crossover” point in this example is 99 years of age, when the QLAC plan has more assets than the initial plan.
Like the SPIA, the QLAC provides a slight increase in Monte Carlo odds, and both plans lower the risk of inflation and longevity on stress testing.
So—who is the winner of the Good Annuity competition? That is for our couple to decide.
Meanwhile, let’s briefly consider the two other possible combinations for immediate vs deferred and non-Qualified vs Qualified.
Running some simulations of a 10-year DIA in the taxable account, the Monte Carlo success rate increases the more you dedicate to the annuity.
We can blow all of the brokerage account on a DIA and achieve a 94% success rate. However, again, the cross over point is still at age 99. This means that longevity insurance comes at a price. The younger spouse has to live at least 25 years to see the large initial drop in their brokerage account return to the baseline amount. If the spouse dies prior to this, there is less money for the kids.
Like the other plan above, for a SPIA in a Qualified account, Monte Carlo success rates increase as you increase the money dedicated to the annuity. We can use the entire $750,000 in the IRA to purchase a SPIA and get up to a 79% success rate.
Figure 4 should look familiar to you. Note the large initial transfer of money to the insurance company results in a large depletion of assets. This is the cost of longevity insurance. They have to live past the age of 99 to reach the cross over point.
Summary: A Good Annuity in Different Account Types
I hope that wasn’t too overwhelming, but it is a comprehensive look at an example of a good annuity.
In a nutshell, any of these annuity options (SPIA or DIA) in either account type (Qualified or non-Qualified) increases the odds of success. This is especially true if the couple is willing to use a large sum to purchase the annuity. The risk is that you don’t live long enough to “get your money back.”
Actually, the real risk is that you live too long and run out of money because you didn’t plan for longevity protection. But that is why annuities are so unpopular. You “blow” your money if you die too early. That is why there are mortality credits, however, and that is why annuities work for longevity. That is risk pooling.
Everyone has a better chance of success because some people die early. Honestly, though, there is no more efficient way to plan for longevity. You can’t do it with bonds alone (think about the mortality credits). You can’t do it with a safe withdrawal rate. Roll the dice and see what the Monty Carlo Odds say.
There are tradeoffs involved in any retirement plan.
Of course, you don’t just need to buy one annuity. You can mix and match. Each spouse could get their own (or Joint and Survivor) QLAC from their IRA, with or without a SPIA or DIA from the brokerage account. Planning for income and longevity with multiple annuities is common.
A Good Annuity is Simply a Tool
There is a saying in retirement circles that annuities are simply a tool in your product allocation for retirement. As in all investing, decisions are tradeoffs.
Asset allocation, partial Roth conversions, and delaying social security are examples of tradeoffs between risk and reward. Annuities, when used appropriately, lower both potential risk and possible reward.
For significant current income needs, a SPIA is a good tool. If you have significant longevity risk and may run out of money, a DIA or QLAC can come in handy.
For folks with health and expectations to live a longer than average life, a DIA can help you sleep at night. Annuities have no under-writing or medical exams. Insurance company and other folks in your insurance pool “want” you to die early. You just have to live longer than the actuaries think you will to get your money back. But the point is insurance—not getting your money back. Do any of us complain when we don’t get our death benefits from term life insurance?
Opportunity Cost of a Good Annuity
Of course, there is opportunity cost—the lost opportunity to otherwise invest the money used to buy an annuity. No one, however, is going to guarantee that the stock market will give you stable, life-long income.
In addition, it is often said that annuities are sold rather than bought. Good annuities, however, are often rather difficult to track down and acquire. They don’t pay very large commissions compared the the more complicated, bad annuities.
While it is clear annuities do have strengths, each investor must weigh the guarantees against the money spent. Once you sign up for a good annuity, that money is gone and cannot be used for emergencies or given to heirs.
But, when buying insurance in case you live a long life, do you really want a refund if you don’t?
Next, let’s look at a Good Annuity in an IRA, as this is what most people will consider doing.
A Good Annuity and IRAs
Single Premium Immediate Annuities (SPIAs) are a so-called “good annuity.”
You can buy the good annuity either after-tax (in your brokerage account) or with pre-tax (such as IRA) retirement savings. With the after-tax SPIA, some of the income is taxable depending on the exclusion ratio. With a pre-tax SPIA, all of the income is always taxable!
Before we get too far into the weeds, why is a good annuity good? Do you want to consider an IRA SPIA?
Why is the Good Annuity Good?
Single Premium Immediate Annuities are NOT like the other annuities on the market.
This is not a Variable Annuity which is expensive and complicated.
This is not an indecipherable Fixed (or Equity) Indexed Annuity with non-guaranteed caps and participation rates. And this is not like the new kid on the sales block: are you being sold a RILA?
SPIAs are simple! You, in exchange for a lump sum of money, get a lifetime income stream.
In essence and in fact, SPIAs allow you to buy a pension.
They are so simple and easy, that the insurance “advisor” doesn’t sell them because the commissions are low. It is said that annuities are sold not bought. That is true for most annuities, but not SPIAs!
Consumers want SPIAs because they are the good annuity. They are bond replacements in your asset allocation. But to truly understand what makes a Single Premium Immediate Annuity the good annuity, you must understand mortality credits.
Mortality Credits make SPIA a Good Annuity
Without being too morbid, we are all going to die! Insurance companies know that, and they take advantage of that fact. They actually play both sides of that coin.
Insurance companies sell life insurance which pays out when someone dies. On the other side of the coin, they sell annuities which STOP paying out when someone dies! So, insurance companies can hedge their life insurance bets with annuities. Or, hedge their annuity bets with life insurance.
When SPIAs sell, they are placed in a “risk pool.” The actuaries know how many people are going to die each and every year in that pool. They don’t know who is going to die, but they know how many people in the risk pool die.
When you buy a SPIA, you get mortality credits because the insurance company knows they will pay less and less each and every passing year. People die; the living keep getting income.
Yes, insurance companies use bonds to cover their liabilities on the good annuity. DIY investors say they can get the same returns as SPIAs because they will just buy the same bonds. But the fact is DIY investors don’t have risk pools; they don’t get mortality credits!
Mortality credits are increased payments that everyone gets because the actuaries know that some people in the risk pool will die off every year. You get paid more (even initially) because the money is at risk.
A Good Annuity’s Largest Downside
And that is the good annuity’s largest downside. Your money is at risk.
If you die, the lump sum you turned into income dies with you!
Folks can’t seem to get over that fact, which leads to the annuity puzzle.
I want you to recognize that loosing your money when you die is a good thing! Seriously, it is what give you mortality credits and an increase in payment ABOVE what you can get from bonds! As you survive longer than the actuaries expect you too, you continue to benefit from the higher income that similar bonds alone can provide. All because of mortality credits.
An Example of a SPIA in an IRA
Let’s look at the Good Annuity in an IRA. You can transfer your retirement money into a SPIA at an insurance company. This is called an Individual Retirement Annuity.
Consider a single male aged 65 who desires lifetime income. He has social security, $500k in a brokerage account, and a $1M IRA.
He is smart so he avoids expensive, complicated Variable and Fixed Indexed Annuities. Instead, he desires to have secure, guaranteed, lifetime income and is looking at a qualified SPIA.
What happens if he invests a quarter, half, three quarters, or all of his IRA into a SPIA?
Lifetime Income from an IRA SPIA
First, how much income will he receive?
Income in retirement is important! Let’s see what $250k or $1M can buy for lifetime income with a SPIA.
Purple represents stable income from social security. Annuity income is in mauve, and withdrawals from the IRA are in orange.
His social security is $24,000 a year and has a cost of living adjustment indexed to a measure of Consumer Price Index. About 24% of his retirement income goals are met from social security.
The $250k SPIA on top adds $17,000 a year, an amount which is not cost of living adjusted. Now, about 36% of the income is stable.
For the $1M SPIA, $68,000 a year is paid and 70% of the income is stable.
Assuming his inflation is 2% per year, you can see the withdrawals slowly increase over time. It is important to note the withdrawals are quite small in the beginning, giving time for the tax-deferred investments to grow to meet the future income demands!
In addition, his income will never fall below 36% or 70% of his “needs,” which is important. In this case, needs include both floor expenses (rent, food, gas, electricity etc.) and desired spending goals (such as eating out, travel, etc.). Spending in retirement is lumpy, and usually goes down over time aside from health care need which tend to spike in the very late years.
Some of you are probably looking at the increasing income needs over time and wondering how he is going to afford all those withdrawals and a SPIA. Well, what effect does the purchase of a SPIA have on his portfolio value?
Visualizing Total Portfolio Value with a SPIA
Let’s look at the value of his portfolio with and without SPIA in the IRA. We know he had a $1M IRA in addition to $500k in a brokerage account to start.
Above you can see the total value of the portfolio over the years.
On top, a $250k IRA SPIA is demonstrated in green vs. no SPIA in lime. With the initial purchase, the portfolio value drops by $250k. Note, however, over time that the SPIA pays off as there are less withdrawal from his investments. The ending portfolio values are nearly identical after 35 years.
On the bottom, $1M is spent on an IRA SPIA. In this setting, given the stable income from the SPIA, the portfolio value actually increases over time! This is because the withdrawal rate on the remaining portfolio is small, so the remaining investments grow more rapidly.
Over time, despite 2% inflation, there is almost no decrease in his portfolio size over time. This is good to know as some folks are worried about legacy if they use a SPIA. In this example, you pretty much know how much you have to leave behind with a SPIA.
Many people want to leave behind a legacy. In fact, that is a large issue in the annuity puzzle; let’s look at it more closely.
If you buy a SPIA, how much will you leave behind? Probability distributions can help answer that question.
Probability Distributions of Single Premium Immediate Annuities
Again, on top is $250k IRA SPIA and $1M on the bottom.
The blue line demonstrates the average expected return of remaining assets. In dark blue, 25-75th percentile, and 5-95th percentile in light blue.
On the top, there is a small dip and the expect amount decreases to zero after 35 years. With the larger initial outlay in the $1M IRA SPIA, the line initially slopes up before slowly decreasing. In fact, there is the expectation of money remaining after 35 years. Stated explicitly, a large SPIA is more likely to leave a legacy after 35 years than a small one! That seems counterintuitive.
The 25%-75% confidence levels are dark blue. On the low side, this runs out of money at 94 and 97 years. On the upside, there is about $1M remaining portfolio balance in each plan.
The potential upside of staying invested in the market is seen in the 5%-95% confidence levels in light blue. Here, you may have $3.5M left with the smaller SPIA, and $2.5M left with the larger. The downside: you might run out at 86 or 92 years of age.
You can see that there is more upside potential with a smaller SPIA, as there is more market risk. If the market does well, your heirs do well as you have more assets left to chance in the market. However, a smaller SPIA has more downside risk, and counterintuitively, you are more likely to leave assets behind with a larger rather than a smaller IRA SPIA.
Does that solve the annuity puzzle? I doubt it!
Tax Considerations of IRA SPIAs
Let’s move on to taxes!
There are always tax considerations with annuities. This is especially true when required minimum distributions come due.
Let’s look more closely as to why there are more taxes with a Single Premium Immediate Annuity in an IRA.
In green, find yearly tax payments with just social security. You can see they are low until required minimum distributions kick in at 70. At 71, there is another small bump when The Tax Cut and Jobs Act expires. Over time, taxes increases with required minimum distributions. Eventually they slow down as the distributions eat away at the IRA balance.
With a $1M IRA SPIA (blue), initial taxes are higher as the income from the SPIA is fully taxable. SPIAs from pre-tax accounts (such as IRAs and 401k) are always fully taxable. Taxes stay flat over time, as the income from the IRA SPIA satisfy the required minimum distributions.
What are the expected Required Minimum Distributions for each account? Initial RMDs at age 70 are:
- Social security: $45,000
- 250k SPIA: $33,800
- 500k SPIA: $22,500
- 750k SPIA: $11,200
- 1M SPIA: none
So, SPIAs do decrease RMDs but overall, there is an increase in tax liability, especially early.
There must be additional advantages to a SPIA? Let’s look at sequence of return risk and income.
IRA Annuities in the Setting of Sequence of Returns Risk
The greatest risk in retirement is Sequence of Returns Risk.
Let’s see what happens if a sequence similar to 2000-2010 happens again at the worst time, right at retirement.
Above, see the effect a $250k IRA SPIA (top) and $1M IRA SPIA (bottom) have with Sequence of Return Risk. For both, the light green is social security without any SPIA.
With the small SPIA, there is very little dampening of volatility. There is minimal benefit as well and the portfolio expires an additional year after social security. Of course, social security continues for both. Social security starts at $24,000 a year and has inflation adjustment. With the SPIA, you get an additional $17,000 of floor income for the rest of your life as well.
With the large SPIA, there is much less volatility during a bad sequence. Indeed, as you need to withdrawal less from your investments during the down years, the income value actually drifts slightly up. After that, with the stable floor income, there is very slow decline in the portfolio value. When the portfolio expires at age 100, you are left with social security and $68,000 SPIA payment for the rest of your life.
Let’s review and decide if a Single Premium Immediate Annuity in your IRA is a good idea or not.
Summary Table for the Good Annuity and IRAs
Above, you can see the summary table.
Baseline means no Single Premium Immediate Annuity. Below that: the amount used to purchase an IRA SPIA from $250k up to $1M.
As you can see, Monte Carlo odds increase the more money you use to purchase a Single Premium Immediate Annuity.
The yearly Annuity income amount is next. This Annuity is 6.8% yearly income. The return percentage is from an online annuity website obtained for an IRA SPIA on a single 65 year old male.
Social security and the IRA annuity provide stable (or floor) income. You see just with social security, about 24% of the income is stable. A $250k IRA SPIA adds 11.7%, while a $1M SPIA adds 46.4% of stable income. This means $1M provides more than 70% of his expected lifetime income.
Lastly, an IRA Single Premium Immediate Annuity means more taxes owed. See the increase in taxes above the baseline above.
Conclusion: Single Premium Immediate Annuity in IRAs – A Good Annuity
Well, what did we learn?
Qualified Single Premium Immediate Annuities are SPIAs in your IRA. When you transfer funds from your qualified accounts (IRAs and 401k) to an insurance company, you can purchase a qualified annuity.
SPIAs in IRAs can improve the chances of success in your retirement. Even if you run out of nest egg, SPIAs provide ongoing, guaranteed income while you are alive.
In addition, not uncommonly you have even more of a legacy with a SPIA than without! While folks are worried about irrevocably “giving” away their money in exchange for purchasing a pension, it is not uncommon for their heirs to be better off. In addition, a SPIA in an IRA may protect against Sequence of Return Risk.
Taxation is an issue. Single Premium Immediate Annuities from qualified (pre-tax) sources are always taxable. This can have implications on taxation of social security and may cause issues with the tax torpedo.
In the end, you can use pre-tax money to buy an income stream. This income can cover your floor or fixed expenses. These expenses don’t go away with time, and neither does the income from your IRA SPIA.