SPIA or QLAC? Good Annuities
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 an in-depth 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!
Good Annuities and Their Role in Retirement
Let’s look at the role good annuities play in retirement income planning.
You don’t invest in annuities, you buy them. They are insurance products that transfer risk. This is important to understand. The purpose of an annuity is to transfer 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.
Instead of possibly running out of money, a good annuity guarantees a stream of income that won’t stop until you die (or you and your spouse). 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.
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. The good annuities, 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.
Single Premium Immediate Annuity (SPIA)
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)
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.
Which Account Type?
Remember, there are different account types. There are non-qualified (also called taxable or brokerage accounts) and qualified accounts (pre-tax retirement accounts).
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, eventually (hopefully) you get your basis back and taxation changes. There is an exclusion ratio which the insurance company calculates yearly for you. You don’t have to do the math, but taxation can get complicated.
Until recently DIAs could only be purchased in your brokerage account. Enter QLACs.
QLACs are Good Annuities, Too!
There is a newish 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.
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 an apples-to-oranges 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 2020, 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.
The Good Annuities in Different Account Types
In a nutshell, either 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. That is no way to plan for a retirement replete with cat food and box beds under the overpass.
A real longevity plan requires careful consideration. There are tradeoffs involved.
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.
Good Annuities are 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?
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?