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August 18, 2014 at 11:45 AM
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).
