Move over, SPIAs, and make room for DIAs.
Annuity lingo has always entailed an alphabet soup of complicated product options, often intimidating to consumers trying to provide for their income needs.
But for the financial planning cognoscenti, SPIAs (single premium immediate annuities) have long occupied a favorite place on the product shelf because these pure income products generally provide a higher return on retiree cash than the lot of annuity products.
That may soon change, according to a new study by David Blanchett, Morningstar’s head of retirement research.
The study, published in the Journal of Financial Planning, compares eight types of fixed income annuities across a range of potential retiree situations and preferences — different life expectancies, initial withdrawal rates, inflation, among them.
The number of different assumptions or retiree preferences as measured against the eight annuity types resulted in a universe of 6,561 scenarios, with Blanchett’s goal to find which annuities performed best on aggregate across this wide spectrum.
And while SPIAs did take top honors, the study suggests that DIAs (deferred income annuities) could soon snatch the annuity crown as the market in that relatively new product matures.
SPIAs, which immediately (they’re also referred to as immediate annuities) convert a lump-sum cash investment into a regular monthly paycheck based on current interest rates, have long been considered models of efficiency compared to other annuity types that add complexity and subtract returns.
Yet finance professor Moshe Milevsky a decade ago posited a type of annuity, which he called an advanced-life delayed annuity (ALDA), that should theoretically provide greater efficiency than SPIAs.
By delaying the income to later in life rather than paying benefits immediately, ALDAs, now marketed as DIAs, provide cheaper insurance.
That is because the benefit may kick in at, say, age 85 rather than age 65. Since many purchasers will not live to that age, the insurance company may pay no benefit whatsoever, and if the insured does live to that age, the insurance company may pay benefits for a relatively small number of years.
Thus, a DIA may greatly simplify a financial planner’s job in providing retirement income.
Knowing that a lifetime income stream will turn on at age 85, for example — and at a higher payout and lower cost — the advisor now has the discrete task of providing an income stream to a client from, say, age 65 to 85, avoiding the uncertainty of the client’s date of death.
In other words, the advisor now has an end date to work with — the date the DIA turns on (rather than the date of death, which is unknown).
Blanchett’s study compared SPIAs and DIAs, both nominal and inflation-adjusted and those with lifetime payouts and period-certain or cash returns (for consumers with bequest preferences).
The study was careful to take into account today’s low-rate environment in order to get realistic results. (For example, a 4% initial withdrawal rates is generally assumed to provide a 90% probability of success over 30 years, but Blanchett gives it a 67.4% probability based on today’s bond yields).
Many other precautions were taken to make the comparison fair, such as assuming the SPIA purchase amount represented 50% of portfolio wealth vs. 10% for the DIA, to make the annuities approximately equal at age 85.
The number of assumptions and study design attributes fills pages, and Blanchett emphasizes the potential for different variables to shape outcomes on numerous occasions. But seeking aggregate outcomes, the study tracks the percentage of times each annuity type ranks across the 6,561 scenarios.
In so doing, one can see that some variables have a greater impact on annuity rankings than others. For example, different equity allocations had little impact on the annuities’ relative rankings, but inflation assumptions and bequest preferences did.
A desire to leave a bequest strongly favors DIAs, and an absence of such a preference favors SPIAs.
If inflation is low, purchasing an inflation-adjusted SPIA would have been a mistake; yet that would have been the best product type in a scenario of high inflation.
These many variables imply a potentially important role for financial advisors since, Blanchett points out, many assumptions and preferences are known in real-life situations. The retiree knows the percentage of his income that Social Security will provide, how aggressive the portfolio will be, bequest ambitions, risk aversion and so on.
Since higher initial withdrawal rates, to cite one example, make SPIAs more attractive than DIAs, the study’s various findings should make it easier for an advisor to choose the right annuity.
But in the aggregate, SPIAs with a 20-year, period-certain guarantee ranked best, followed very closely by a nominal (i.e., non-inflation-adjusted) SPIA. A nominal DIA came in a not-too-distant third.
But herein lies an important twist.
Recognizing that the DIA market is relatively new — some five years old — and thus being relatively less competitive than the SPIA market (Blanchett was able to obtain just six DIA quotes versus 17 SPIA quotes), the study re-crunched the numbers on the assumption that DIAs offered a modestly higher 5% payout.
In other words, assuming that at some point in the near future, the DIA market was as competitive as the SPIA market, Blanchett tested whether the rankings would then shift.
And, assuming SPIA rates were held constant, the rankings did indeed shift.
Nominal DIAs took the top spot, with nominal SPIAs now a close second.
Blanchett therefore concludes that the difference between DIAs and SPIAs is marginal and that DIAs hold great future promise. Their cheaper cost and greater liquidity could therefore make them a valuable tool for advisors developing income strategies for retirees seeking to hedge longevity risk.
Related on ThinkAdvisor:
- Annuity Anomaly: EIA + GLB > SPIA?
- Milevsky: Mispricing Annuities, Then and Now
- Milevsky Warns: Beware of Annuity Ignorance
- Milevsky’s Tales From Annuity History: A Most Curious Will(iam)