Inflation-Linked SPIAs Are A Bad DealAdvisor Perspectives
I recently traded emails with someone who is provably smarter than me. He was very interested in buying a single-premium immediate annuity (SPIA) with payments linked to inflation, which is also called a real annuity. In the finance literature, real annuities are often depicted as the perfect product/investment for a retiree.
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But after obtaining some quotes and running an analysis, I concluded the idea was “nuts.” I’ll explain.
I’m not against annuities. I’m generally a fan of guaranteed income for retirees. Guaranteed income can significantly simplify the incredibly complex retirement income decision process and ensures1 a retiree always has some minimum level of lifetime income. Most retirees would be better off with more guaranteed income.
I’m all for linking annuity payments to inflation, in theory. An annuity with benefits linked to inflation has been talked about lovingly by retirement researchers for decades. It’s the Holy Grail to help mitigate retirement consumption risk.
The problem with real annuities is the inflation cost of living adjustment is super expensive relative to plain vanilla nominal annuities and those with a fixed increase (e.g., 2% per year). You can overpay for anything, and at current prices people are overpaying for inflation protection. In other words, my criticism is about market realities, not about theory. Let’s dig in.
To explore payouts for annuities, I pulled some quotes from CANNEX on April 28, 2019. The annuitant was assumed to be a 65-year-old male buying a $100,000 annuity with annual payments that begin immediately, and no period-certain or cash-refund rider. (A period-certain rider provides guaranteed benefits for a certain period, usually to between 10 and 20 years, while a refund rider pays a beneficiary the difference between the annuity premium and the sum of payments received by the annuitant.) Only about 25% of annuities quoted on CANNEX are life-only, but focusing on life-only benefits simplifies modeling.
I obtained three sets of quotes for SPIAs: a nominal annuity (where payments are constant for life); an annuity with a 2% fixed annual compound cost-of-living adjustment (or COLA, meaning the payment increases by 2% per year); and a real annuity (where benefits are linked to inflation, defined as the Consumer Price Index for All Urban Consumers, CPI-U). You can see how the payments differ for the three annuities in the charts below for each $1 of initial payments. The payments for the real annuity are based on expected inflation, but the actual future payments are obviously uncertain.
For the nominal annuity, there were 21 companies offering quotes from ranging from $6,113 to $6,643. This is a reasonably tight spread, where the best quote is only 5.73% larger than the smallest.2 Annuity payouts are also often quoted in percentage terms, which is the annual payment divided by the premium. The nominal annuity with the highest benefit ($6,643) would therefore have a payout of 6.643% ($6,643/$100,000=6.643%).
For the 2% fixed COLA annuity there were 14 companies offering quotes ranging from $4,866 to $5,168.
For the real annuity there was only one company offering a quote with a payout of $4,449. The same insurance company offering the real annuity also offered quotes at $6,244 for the nominal annuity and $5,030 for the 2% fixed COLA. Neither of these quotes was the best for the respective annuity type, but I mention it here and include the insurer in the analysis for reference purposes.
We would expect the real annuity payout to be lower than the nominal annuity payout, since the payments will increase with inflation. What is surprising is that the real annuity pays out significantly less than the best 2% fixed COLA annuity quote. The payout rate for the 2% fixed COLA annuity is 16.16% higher than the real annuity. This suggests the real annuity isn’t a good deal, but it’s worth running some numbers to quantify the exact cost.
The value of an annuity
To determine the value of an annuity, I calculated the mortality-weighted net present value for each type (nominal, 2% fixed COLA, and real). I used mortality rates from the Society of Actuaries 2012 Immediate Annuity Mortality table with improvement to 2019, discount rates based on the Treasury High Quality Market (HQM) Corporate Bond yield curve (as of March 2019), and expected inflation from the Cleveland Federal Reserve (as of April 2019).
In the Exhibit below I provide an example of how the calculations work for the nominal annuity at five-year intervals.
The 20th payment, at age 84, would be $1 (column C). The payment is nominal, so it does not increase at all (i.e., it shrinks in purchasing power over time). There is a 66.9% probability that the annuitant survives to age 84 (column D). This means an insurance company would only need to set aside $0.669 for each $1 of expected payments (assuming a large pool of annuitants) for that age. Given a discount rate of 4.37% (column E), which I assume can be invested in zero coupon bonds for 19 years,3 the $0.669 payment is reduced to $0.296 when you factor in assumed investment returns. If we add up all the nominal factors (column F), to age 120, the total factor for the nominal annuity ends up at 14.55.
Read the full article here by David Blanchett, Advisor Perspectives