Very few investment vehicles can trace their lineage back to the days of the Roman Empire. Gold comes to mind, but back then it was used as a currency. Annuities are as old as some hills, and they have been providing people with financial security for centuries. They were derived from a simple financial arrangement that involved an exchange of money for a stream of annual payments, or stipends as they were known way back when. Now, annuities are a product issued by life insurers that have formalized the concept into contracts. The same type of annuities that secured the families of Roman citizens are now referred to as Single Premium Immediate Annuities (SPIA), but they are designed to achieve the same thing for people today.
The basic concept of SPIA has never really changed. Throughout history, people have been concerned with securing an income that they can’t outlive. Today, an increasing number of people are growing anxious over the capacity of their own assets to generate a stable income during ever expanding life spans. As a result sales of SPIAs have increased dramatically as have the number of products being offered in the marketplace. The vast number of choices can be perplexing, but once SPIA annuities are explained it is little easier to find the right annuity product.
The Mechanics of SPIA Annuities
It’s a straightforward transaction. In exchange for a lump sum of capital, a life insurer promises make income payments based on the amount of the lump sum, the age of the individual, the length of the payment period and an assumed amount of interest credited to the annuity balance. The length of the payment period can be based on a specific number of years or on the life expectancy of the individual. In the case of the latter, the number of payment periods is calculated by subtracting the current age from the age at expectancy, and then dividing it by 12 (for monthly payments). The amount of the payment is derived by dividing the lump sum of capital by the number of payment periods and then factoring in interest accumulation over the total payment periods.
The income payout is calculated to deplete the total capital along with interest credited by the end of the payment period at which signifies the end of the life insurer’s obligation. The exception is when a lifetime income option is selected, which means that the income payments will continue beyond life expectancy for as long as the recipient lives. In that instance, the life insurer assumes the risk of life longevity. It is that aspect of SPIAs that makes them so compelling to retirees – no more fear of outliving one’s income.
Things to Know about SPIA Annuities
Deposits are irrevocable:
Once a lump sum of capital is deposited with a life insurer, it is irrevocably retained by the insurer. This occurs because the insurer is required to commit the capital to investment so it can generate the promised payout. So, it is obviously important that the decision to invest in an SPIA is based on sound planning.
SPIAs offer several payout options
: The simplest annuity arrangement is called “life only”, which applies when an annuitant has no need to have the income continue beyond his life. So, once the annuitant dies, the income stops, and the life insurer retains the balance of the annuity account.
When there is a need for continuing income, a joint life payout option can be chosen which provides for the continuation of income to the surviving person. The initial payout on a joint life option is lower than that on a life only option to compensate the life insurer for the longevity risk of the joint annuitant.
Additionally, where there is a need or desire to have a beneficiary receive the annuity account balance (as opposed to having it retained by the life insurer), a refund payout option can be chosen. In this instance, after the death of the annuitant (or both annuitants in the cases of joint life option) any remaining annuity balance is paid to a beneficiary in installments over a specified period of time, typically five years. Again, there is an added cost for this option which Is deducted from the initial life only payout amount.
SPIAs offer inflation protection
: One of the criticisms of SPIAs has been that they only provide a fixed level of income which would become inadequate over time due to the rising cost of living. Most SPIAs offer an inflation protection option which will link the income payout to a cost-of-living index so the income will be adjusted each year.
The income guarantee is backed by the strength of the life insurer
: A distinguishing feature of SPIAs is that the income payment is guaranteed which brings a lot of comfort to retirees who are distressed over economic uncertainty. It is important to be mindful that the guarantee is only as solid as the life insurance company that backs it. While the life insurance industry as a whole is considered to be the most financially stable of all financial institutions, some companies within the industry are measured as being much stronger than others. Companies that earn the highest ratings from the ratings agencies are deemed to be strong enough to weather the worst of economic storms, while lower rated companies are viewed as suspect in their ability to pay future obligations.
SPIAs can be used in a number of situations
: While SPIAs are thought of as primarily a retirement income vehicle, they are used in a wide number of situations where a lump sum of capital needs to be converted into a fixed number of installments or payments. SPIAs are used in legal settlements, lottery payouts, and by businesses in buyout situations. Grandparents have been known to purchase an SPIA that will payout an income for a grandchild to cover college expenses.
They may be ancient, but they have never been more timely. SPIAs are bringing much needed peace-of-mind to anxious retirees who have lost confidence in the markets and their own capacity to generate enough income for their retirement security. When used in concert with other investments, SPIAs provide the stability a portfolio needs to withstand volatile markets and economic uncertainty.