From the April 2008 issue of Boomer Market Advisor • Subscribe!

What's a SPIA really worth?

When seeking income for retired clients, single premium immediate annuities can look attractive. But upon closer inspection, you may find that they don't offer as much protection as you think.

If you ask retirees about their biggest concern, most will tell you that they are concerned about running out of money. One possible solution to the longevity issue is to consider a single premium immediate annuity. Basically, under an SPIA, the retiree turns over a lump sum to an insurance company, and the insurance company guarantees an annual income to the investor for as long as he or she lives.

Consider a hypothetical 65-year-old retired couple with $1 million in retirement assets. A joint and survivor SPIA would provide the couple with lifetime annual income of $62,858, based on a recent quote I obtained from a triple A-rated insurer. This annual income stream represents about a 6.3 percent distribution rate on the $1 million of principal.

Given that most advisors recommend retirement distribution rates between 4 percent and 5 percent, the SPIA looks to have the advantage from an income standpoint. But when you include inflation, the analysis dramatically changes.

The SPIA payment is not inflation adjusted. The recommended 4 percent to 5 percent retirement distribution rate, however, is designed to be inflation adjusted. So, the true comparison should be between an SPIA payout and a non-inflation adjusted distribution rate.

When analyzing historical market cycles, retirement portfolios can prudently support higher initial distribution rates if the retiree does not intend to increase the distributions for inflation. For all rolling 30 year periods starting in 1926, the hypothetical portfolio failure rate for a 5 percent non-inflation-adjusted distribution from a balanced account was close to 0 percent. For a 6 percent non-inflation adjusted distribution, the failure rate only increased to about 6 percent.

Thus, based on hypothetical historical portfolios, retired investors run a small risk of depleting their investment account over 30 years at non-inflation adjusted distribution rates as high as 6 percent. While past performance is no guarantee of future returns, the numbers are helpful when comparing the benefits available from an SPIA.

If the SPIA's distribution rate is slightly above 6 percent and the retiree could prudently consider a non-inflation adjusted distribution rate of between 5 percent and 6 percent, does the slightly higher income from the SPIA outweigh the fact that the retiree must give up the ownership of his retirement assets?

Each client, of course, must make that decision based on his objectives. But retaining the principal provides retirees with a number of options that might put them in a better position to meet their income and estate planning objectives.

First, it is more likely than not that the financial markets will produce reasonably good returns over the investor's anticipated 30 year retirement cycle. Better returns would allow the retiree to consider increasing his distributions later to help keep up with the effects of inflation. In such cases, the retiree would have a higher potential income and ownership of all of his capital.

Second, the odds are the retired couple will not live 30 years; in which case, there would likely be assets to pass along to children and grandchildren. Many retirees would like a portion of their life's savings to benefit their heirs, if possible. Using an SPIA leaves no assets for heirs if a life only option is used.

Third, by retaining the principal, the retiree could consider an SPIA later in life when his age would allow for a higher payout. For instance, at age 75, the SPIA payout jumps to about 7.7 percent. If the couple is healthy at age 75 and is concerned about possibly outliving their assets, the SPIA may offer a better risk/ reward tradeoff at that point.

While there may be a place for SPIAs in retiree accounts, locking in a fixed, non-inflation adjusted distribution early in one's retirement will leave some retirees regretting the choice.

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