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Life Health > Annuities

Annuities’ Alphabet Soup: Choosing the Best Option

By Scott Stolz

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Despite the fact that annuities are uniquely designed to provide guaranteed income for life, over the last 30 years, they have been used mostly as a means to provide tax-deferred accumulation.

The commonly held belief has been that as the baby boomers continue to age, much of the $3 trillion-plus in estimated annuity assets will eventually be used to generate income. Twenty years ago, the expectation was that much of this money would flow into immediate annuities. However, given that immediate annuities have never captured more than 3% of industry sales, insurance companies have found it necessary to develop other ways to create income.

Advisors today must choose between an alphabet soup of income options, each with its own industry-adopted acronym. So how does one decide between SPIAs (single premium immediate annuities), DIAs (deferred income annuities) and GMWBs (guaranteed minimum withdrawal benefits) — especially now that the latter can be added to fixed and indexed annuities as well as variable annuities? Let’s first look at the unique characteristics of all of these options.

Single Premium Immediate Annuities (SPIAs) can be thought of as purchasing a personal pension. A policyholder turns over a lump sum of money to an insurance company in exchange for a promise to pay a regular income — usually monthly or quarterly — for a predetermined amount of time. While that time period can be a specific number of years, it typically is guaranteed for at least one lifetime. Two important characteristics to keep in mind: (1) Each payment is partially a tax-free return of principal (unless it’s bought in a qualified plan) and (2) Immediate annuities have little if any liquidity.

Deferred Income Annuities (DIAs) are essentially immediate annuities where the guaranteed income starts at least one year after purchase. Often these are purchased to provide income at a much later age (i.e., 70, 80 or 85). They have the same tax treatment as SPIAs and offer little if any liquidity.

Guaranteed Minimum Withdrawal Benefits (GMWBs) offer much more flexibility and liquidity than either SPIAs or DIAs, and therefore have become the most popular income option for annuities. When one cuts through all of the long and sometimes complex descriptions of GMWBs, they are really nothing more than a guaranteed lifetime systematic withdrawal based on an amount that is calculated separate from the account value (commonly referred to as the income base).

Since the income base grows by a predetermined amount each year and the allowed systematic withdrawal is contractually guaranteed, if the policyholder can tell the advisor when she wants to begin receiving income, the advisor can tell her exactly how much she will be guaranteed at that time. This guarantee cannot be negatively impacted by poor performance of the account value. Since the income is considered a withdrawal from the policy, unlike with the SPIA and DIA, the income can be started and stopped and any remaining policy value can be cashed out or paid out to a beneficiary. The big tradeoff is that every income payment will be fully taxable to the extent there are earnings in the contract at the time of the withdrawal.

Before I move into general guidelines and strategies for choosing between these options, it’s important to note the biggest difference between GMWBs on variable annuities versus index annuities. Variable annuity companies tout the potential for an increase in income should the account value grow faster than the income base that generates the guaranteed income (known as a step-up). While this is certainly true, given the fees charged for this benefit combined with the investment restrictions that exist on most variable annuity GMWB designs, I would caution against over-selling this potential benefit.

Technically, index annuities could also have a step-up in income, but given today’s interest rates and current product designs, that is never going to happen. But there is one very important difference. Variable annuity companies must protect against the possibility of a significant drop in the account value. Index annuity companies do not. Therefore, at today’s pricing, an index annuity with a living benefit is always going to guarantee more income initially than a variable annuity with a living benefit. A variable annuity is always going to require at least one step-up of the income base to ultimately provide as much guaranteed income as the index annuity.

Annuities cannot escape the basic laws of finance. As investment flexibility and liquidity increase, we would expect income guarantees to decline. The case studies below provide hypothetical illustrations of some possible income options given a specific type of client’s income plan.

Case 1: 55 Year Old

Desiring Income at 65

Using CapitalRock’s Annuity Wizard Income Tool, I solved for a 55-year-old male that wants $40,000 in annual income at age 65.

Not surprisingly, the DIA required the least amount of capital ($341,536) to generate the required income. The index annuity required an additional $51,400, and the variable annuity with investment restrictions required yet an additional $57,427. And if you wanted a variable annuity without investment restrictions, then you would need to pony up a total of $470,588. Keep in mind also that if the annuity is funded with after-tax dollars, the DIA income would be 42% tax-free, while the index and variable annuity options would be 100% taxable until all of the growth is withdrawn from the account value.

In choosing between the various options, you must ask the following questions:

The DIA was quoted as life only, therefore, is the additional liquidity worth the extra $51,400 that is required to provide the same income using the index annuity?

If the answer to No. 1 is yes, then is the potential for better account value growth and possibly a step-up in income worth the additional $57,427 to choose a variable annuity over an index annuity? And if the answer to No. 2 is also yes, then in all likelihood its worth investing an additional $20,257 to get total investment flexibility, thereby significantly increasing your chances of getting a step-up in income.

Case 2: 65 Year Old

Desiring Income Now

We see similar results if the income is needed immediately rather than 10 years later. The graph above summarizes the numbers for a 65-year-old who wants $40,000 in income immediately.

In this example, the SPIA has an even greater advantage over the other annuity options. Given that index and variable annuity companies do not want immediate withdrawals from their products, it’s not surprising that they are designed to provide the most income to policyholders who defer the withdrawals. I should also note that the above example illustrates a SPIA that pays for life only. Should the client prefer a life with a cash refund option, the required investment increases to $669,744.

But what if we looked at the issue differently? Rather than focusing on the lack of liquidity and flexibility of the DIA, what if we stopped to realize that by letting the DIA generate the required lifetime income, we have more flexibility to invest the rest of the client’s portfolio? Recommended portfolio withdrawal rates of 4% (or less) and the portfolio construction itself are overly conservative in order to protect against periods like 2007–09. If the goal instead becomes to take the pressure off the total portfolio by generating the required income with as little money as possible, SPIAs and DIAs become a much more attractive option. In fact, it could lead you to conclude that rather than an either or question, the SPIA or DIA should be paired with a variable annuity (or mutual fund).

Going back to our 55-year-old looking for income at age 65, what if we take the $470,588 that the variable annuity without investment restrictions would require to provide the $40,000 in income and put $341,536 into a DIA and the balance into a variable annuity without living benefit, thereby saving the client the living benefit fees?

Case 3: 55 Year Old

Desiring Income at 70

There is one last important scenario to cover. Have you noticed how variable and index annuity companies typically illustrate income that starts no more than 10 years after the date the annuity is purchased?

There’s a real good reason for that. With just a couple of exceptions, product designs today guarantee to grow the income base and therefore the amount of guaranteed income for only 10 years.

Typically therefore, on the day the policy is issued, the policyholder is guaranteed no more income on the 15th policy anniversary than they are on the 10th policy anniversary.

With that in mind, I solved the required investment amounts for a 55-year-old who wants $40,000 in income beginning at age 70. For comparison purposes, I included an index annuity product that guarantees growth of the income base for the life of the contract.

In this particular case, a strong argument can be made for putting $290,909 into the index annuity that grows the income base for all 15 years over putting $259,045 into the DIA. A lot can change in a client’s life between ages 55 and 70.

Assuming you can find a GMWB that grows the income base for the entire deferral period, the client would likely find the extra $31,864 a small price to pay for the ability to accelerate or delay the income — or reallocate the money altogether.

However, our previous alternative solution works here as well. Rather than purchase a $400,000 variable annuity with a living benefit and without investment restrictions, why not put $259,045 in the DIA and the balance into a variable annuity (or mutual fund) without a living benefit? And if the goal is to have greater flexibility, then a possible solution would be to put $290,909 into the indexed annuity and the balance into a variable annuity.

Income Plan Needed

All of these examples assume that there is, at a minimum, an assumed and estimated income gap that must be closed. No matter which annuity income acronym you decide to utilize, it has to start with an income goal. Adding a living benefit to either a variable annuity or an index annuity simply because the benefit is available or it sounds like a sexy feature far too often leads to poor planning and unnecessary fees. Used properly, SPIAs, DIAs and/or GMWBs can help clients remain confident during times of financial uncertainty — like now.

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