Deferred income annuities, the hottest slice of today’s annuity market, are of growing importance to advisors and clients focusing on guaranteed retirement income.

Last month, the Your Money section of The New York Times devoted prime space to DIAs, including a detailed illustration called The Cost of Building Your Own Pension.

The Times illustrated side-by-side the DIA single premiums required to purchase $1,000 per month of lifetime income for male and female annuitants (single life) and joint lives on the basis of: 10-year income deferral; 20-year income deferral; and immediate income (from a single premium immediate annuity) starting in 10 years. All quotes were current and from New York Life, a highly rated company.

It’s as good an illustration, for planning purposes, as you’re likely to get. Yet, it did not contain the key numbers you need to help clients make DIA decisions. The Times also contained this interesting observation about DIAs:

“The pricing for this type of product, while it is interest-rate sensitive, it is much more aboutthe power of mortality pooling,” says Elizabeth Forget, a senior vice president at MetLife, referring to the fact that some people die before their life expectancy.” (Emphasis added)

Unfortunately, the article didn’t tell you how to find the “mortality sweet spots” in the DIA market. In this article, I’ll show you how to create a simple Excel spreadsheet that will help your clients see the real interest rates built into DIA payouts, and then find the sweet spots. You may be surprised to learn which clients are the best candidates for DIAs.

The Bogey: 30-Year Treasury Bonds

Professional retirement income planners don’t sell DIAs in a vacuum. They compare DIAs to other high-quality sources of predictable retirement income. Since most DIAs are long-term or lifetime commitments, the best starting point comparison is with a 30-year U.S. Treasury bond. For example, a 58-year-old client who wants to defer income for the next 10 years and then begin receiving $1,000 per month could: 1) buy 30-year U.S. Treasury bonds now; 2) reinvest interest payments into new 30-year bonds over the next 10 years; and then 3) begin taking $1,000 per month through a combination of interest payments and bond sales.

Here is the full illustration of deferred-income options as published by The Times

Lifetime Payout Only (No Cash Refund) Single-premium cost of a self-purchased annuity paying $1,000 a month for life

Age   at Purchase

Income Beginning

Men

Women

Joint

58

10 years later

$99,962

$112,392

$131,349

20 years later

$39,540

$48,510

$61,677

68

Immediately

$170,305

$181,625

$207,074

Example: A 58-year-old man wishes to buy a DIA that will pay $1,000 per month for his lifetime, starting in 10 years, at age 68. He will pay today a single premium of $99,962. If he waits 10 years and then buys a single premium immediate annuity (based on today’s rates), it will cost $170,305.

One big fear in DIAs is that death will occur during the deferral period, in which case the premium is lost. The Times noted that adding a “cash refund” feature to a DIA is a popular choice because it guarantees that the beneficiary will receive no less than premiums less payouts. Here is the comparable costs to buy the same programs with a cash refund feature.

Lifetime Payout with Cash Refund Single-premium cost of a self-purchased annuity paying $1,000 a month for life

Age   at Purchase

Income   Beginning

Men

Women

Joint

58

10 years later

$112,320

$121,523

$132,988

20 years later

$48,473

$55,742

$63,952

68

Immediately

$189,158

$200,136

$210,517

 

Example: To add the cash refund feature on a lifetime payout starting in 10 years, the 58-year old male will pay a single premium of $112,320. The cost of the add-on guarantee (cash refund) is $12,358 above that of the lifetime payout only.

You can array all such numbers for your clients – and yet it’s still hard to see where value lies, especially in comparison to the bogey, buying 30-year Treasury bonds. The T-bond is a viable choice for retirement income because it has two advantages over a DIA: 1) If death occurs before income begins, the bond’s full market value plus accrued interest will be available to the beneficiary without the extra cost of the cash refund feature; and 2) The client always has access to principal by cashing in the T-bonds, while the DIA payout may lack comparable liquidity.

The 30-year T-bond also has one main disadvantage vs. DIAs – money could run out or be depleted at the end of 30 years, while the DIA can provide a lifetime income guarantee. For many clients, these pros and cons often balance out, so advisors should not take the bogey off the table unless it’s clear the DIA offers a better tradeoff, based on a client’s personal needs.

But how do you compare T-bond yields with the premium dollars shown in the Times’illustration, which mirrors illustration methods of most insurance companies? The answer isXIRR. This Excel function converts a stream of cash flows or periodic payments into an internal rate of return (i.e., an interest rate). When you know the interest rate on all the values shown in the two tables above, clients can quickly see: 1) whether the DIA beats the bogey; and 2) where the real sweet spots in the DIA market are. For example: Is it better for a couple seeking guaranteed income to write the DIA on the male (as annuitant), the female, or joint lives? XIRR holds the answer.

All values can be manually entered (or copied and pasted) except for the XIRR formulas in row 37. The formula in cell E37, for example, is: =XIRR(E4:E36,$B4:$B36,2%)

XIRR has three arguments separated by commas: 1) a series of cash flows (column E); 2) a series of payment dates (column B); and 3) a guess at the interest rate (2%). Premiums are entered as negative numbers, and income payments are entered as positive numbers.

Based on these quotes, the interest rate represented by NY Life’s payments are 5.24% for a male single-life, 4.59% for a female single-life and 3.74% for a joint payout over the lives of both spouses (one male, one female).

The table below shows interest rates for all quotes illustrated by The Times through age 90.

 

Lifetime Payout Only (No Cash Refund) Interest rate for an annuity paying $1,000 a month through age 90.

Age at Purchase

Income   Beginning

Men

Women

Joint

58

10 years later

5.24%

4.59%

3.74%

20 years later

5.50%

4.65%

3.67%

68

Immediately

4.97%

4.23%

2.80%

 

Lifetime Payout with Cash Refund Interest rate for an annuity paying $1,000 a month through age 90.

Age   at Purchase

Income   Beginning

Men

Women

Joint

58

10 years later

4.59%

4.16%

3.68%

20 years later

4.65%

4.08%

3.52%

68

Immediately

3.77%

3.16%

2.63%

 

The other key number to know is the current yield on 30-year Treasury bonds, which was3.44% when the article was published. The tables below show the DIA rate in excess of the T-bond yield.

 

Lifetime Payout Only (No Cash Refund) Interest rate for an annuity paying $1,000 a month through age 90, in excess of T-bond yield

Age   at Purchase

Income   Beginning

Men

Women

Joint

58

10 years later

1.80%

1.15%

0.30%

20 years later

2.06%

1.21%

0.23%

68

Immediately

1.53%

0.79%

-0.64%

 

Lifetime Payout With Cash Refund Interest rate for an annuity paying $1,000 a month through age 90, in excess of T-bond yield

Age at Purchase

Income Beginning

Men

Women

Joint

58

10 years later

1.15%

0.72%

0.24%

20 years later

1.21%

0.64%

0.08%

68

Immediately

0.33%

-0.28%

-0.81%

 

Recall The NY Times quote from Elizabeth Forget of MetLife at the top of this article: “The pricing for this type of product, while it is interest-rate sensitive, it is much more about the power of mortality pooling.”

This analysis shows where the sweet spots in the mortality pool are. Remember: Mortality pools are based on large numbers of annuity buyers with a variety of health issues and longevity profiles. But few income annuities are underwritten to identify or penalize the healthiest, most longevity-prone applicants.

The sweet spot in the market works to the advantage of the healthiest male applicants, who can earn a DIA rate (without cash refund) of about 2% above Treasuries. Whenever clients face choices about whom to name as annuitant on a DIA, the advisor’s first question should focus on the health and longevity prospects of the male.  If you have a 60-year-old male client with parents still living, who doesn’t smoke and works out at the gym several times a week, he is possibly your best annuitant.

As the analysis above shows, many couples would do better to use Treasury bonds to fund their retirement incomes than DIAs with joint life payouts. However, as The Times observed, the joint annuity payout seems an intuitive choice, and thus it is very popular.

So, what about taking the cash refund option? For single-life payouts, the option actually costs quite a bit for both males and females in terms of rates. (It is relatively inexpensive for joint payouts.) You can use another set of data to help your clients see if the probability of early death justifies the option’s cost. It is the largest online mortality data base in the U.S., the Social Security Actuarial Life Table, published here:http://www.ssa.gov/oact/STATS/table4c6.html

There is just a 12.9% chance that an average U.S. man will die between 58 and 68. But the probability of a man’s dying from 58 to 78 increases to 37.3% — more than three times as much! For women, the respective mortality probabilities are 8.3% and 26.6%.

As this analysis shows, the sweet spot in DIAs often is to: 1) choose a single-life payout on the male, especially if he is healthy and has good longevity prospects; 2) choose a 10-year income deferral period; 3) and decline the cash refund option. To insure against the loss of premium if he dies early, life insurance on his life, payable to her, often can fill the gap cost-effectively.

Summary

You can illustrate any company’s DIA and SPIA payouts on a rate-equivalent basis and then compare the rates to 30-year Treasury yields. The sweet spots may vary a bit among companies and annuity contacts. But in an increasingly competitive industry, you may see a similar pattern. The main leverage your clients have in this market is to exploit the lack of underwriting and receive payouts based on above-average health and longevity prospects, compared to the pool average.

Your analysis can help your clients see and compare all DIA choices more clearly in relation to retirement investment options. Clients will continue to thank you for this service as they enjoy the extra income over long retirements.