Real rates, sweet spots for deferred income annuities

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

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

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.