Low interest rates may be good news for those, like Fed Reserve Chairman Ben Bernanke, who want to refinance their homes. But for anyone who owns a single premium immediate annuity (SPIA), the result has been a hefty cut in monthly payouts.

Last week, it was reported that Bernanke refinanced his Washington, D.C. home in 2011, cutting the interest rate from 5.375% to 4.25%.

From all indications, the Fed plans to keep short-term interest rates near historic lows until 2014. While that can lighten the borrowing costs of homeowners, like Bernanke, it is bad news for anyone who purchased a SPIA.

Comparative Annuity Reports does a monthly analysis of SPIA performance. The firm used to follow deferred annuities, but stopped several years ago, says Hersh Stern, publisher at the Englishtown, N.J.-based firm.

Its most recent results illustrate the plunge in monthly payouts for a 10-year certain, $100,000 premium SPIA (see chart). For example, a 60-year-old female who purchased a SPIA in 2009 received a monthly payout of nearly $600. If purchased in 2012, the payout would be less than $500.

Viewed through a shorter timeframe, the average monthly SPIA payout (10- and 25-year period certain) of $600 in September of last year has dropped nearly 6% to $568 in September of this year.

Souce: Comparative Annuity Reports.

To illustrate further, in 2004, a 60-year-old woman would have paid $100,000 to purchase an annuity that locked in an income of $575 a month for the remainder of her lifetime, regardless of where interest rates moved to in the following years. Whereas, in 2012, a 60-year-old woman who paid $100,000 locked in an income of $450 a month for her lifetime, Stern says. “The amount of monthly income that can be purchased by an annuity declines or rises in direct correlation to the general level of interest rates at the time of purchase.  That income amount does not change once locked in,” he says.

That variation, Stern explains, is a direct result of persistent low interest rates that have cut insurer revenues, leaving them fewer dollars to put in those monthly checks to SPIA owners.

It boils down to economics. Insurers put the lion’s share of their investments — some 85% — into interest rate-sensitive instruments like corporate bonds and mortgages, Stern notes. Since rates have steadfastly remained low, an insurer has only so much wiggle room between paying out on those SPIAs and maintaining their internal administrative costs.

“It’s almost like an annuity represents a pass-through to the consumer of the average corporate bond rates minus the spread to cover the company’s operating costs,” says Stern.

He estimates that at least 50% of an immediate annuity’s price is dependent on interest rates, along with an insurer’s assumptions about mortality. “If the Fed is intent on keeping Treasury rates low, it has a very important impact on the rates for corporate bonds, and insurance companies are at the mercy of whatever corporate bonds are paying,” Stern says.

What do advisors do?

So what does that mean for advisors who sell annuities? How should they advise their clients on what is admittedly a difficult and emotional decision?

Stern recommends first getting a feel of what direction the potential buyer envisions interest rates going. Do they think interest rates will go up, stay the same or sink further?

Based on their outlook, a client can either wait for interest rates to rise before making an annuity purchase, or buy now because they anticipate rates staying low or even going lower, Stern says.

If the client is uncertain — as many are — a middle road approach would be to ladder annuity purchases over time. Take, say, $500,000 and buy $100,000 worth of annuities each year in the hope that rates don’t go too much lower. That way, the buyer is positioned get a “better bang for their buck if rates go up,” Stern says.

However, Stern warns that anyone who bets on rising interest rates is not only betting against the Fed’s stated intention, but about 30 years of history that have seen a steady decline in interest rates.

“When you have an entrenched drop in long-term interest rates, waiting for rates to go up is essentially taking a bet that what has been going on for the last 30 years is about to change,” Stern says. “Anybody who took that bet was sorely disappointed, because it was the wrong decision.”

Interestingly, it was further disclosed that Bernanke owns two annuities: one fixed and the other variable, each with an estimated value of between $500,000 and $1 million.

One wonders what he would think of low interest rates if he owned a SPIA.

Do most advisors think SPIAs are still a good purchase? Will interest rates eventually rise?

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