Single premium immediate annuities are advertised as a way to reduce longevity risk – the risk of outliving one’s life savings. Indeed, increased life expectancies also increase the severity of the myriad retirement risks that retirees face. The temptation to use the safety net provided by the immediate annuity is even greater. However, careful assessment of the pros and cons of Single Premium Immediate Annuities (SPIAs) is necessary.
== Pros ==
♦ Lifetime income
SPIAs take one cash (or other liquid asset) lump sum and convert it to a reliable income stream. This income stream is available to the annuitant until death. For example, if an annuitant purchases a SPIA for $200,000, and actuaries determine the life expectancy to be an additional 15 years with a rate of return of 8%, the monthly payment for life would be $1,911. Even if the annuitant lives beyond the life expectancy, he would still receive the payment until death. This is one of the major selling points of the immediate annuity.
♦ Reliable income source
The annuity provider is obligated to make the payment stipulated in the annuity contract, regardless of the state of the market. A few SPIAs are index-linked, making those payments somewhat volatile. In any event, there would be a base guaranteed payment for such annuities. Purchasing the immediate annuity reduces the retirees’ exposure to market risk and provides an income stream that can be relied on.
The “annuitization rate” of the immediate annuity (the income per thousand dollars of capital) is typically higher than would be obtained in other income options like bonds and Money Market Funds. Single Premium Immediate Annuities are typically two percentage points higher than the income from the other income options. The reason for this is that the immediate annuity is purchased in exchange for income, making it a long-term plan. When funds are committed, rates of return are higher to compensate for the loss of liquidity.
♦ Income tax advantages
A substantial part of the income from the immediate annuity is tax exempt. The percentage that is tax-exempt is based on the relationship between the interest and the principal. For example, if your annual payment from an immediate annuity is $10,000, based on the exclusion ratio (principal/principal + interest) the tax-exempt amount could be $6,000. The tax treatment depends on the state or country in which you reside; consultation on the effect of this (particularly on large sums) is advised.
♦ Estate planning
The link between annuities and estate planning are not obvious, but gift/charitable single premium immediate annuities can be used as an estate-tax reduction strategy. Since annuities seek to liquidate part of an estate, it can be used to manage estate tax thresholds – that is, to reduce or eliminate the dreaded estate tax. In addition to this, annuity settlement options give the annuitant the option of allowing beneficiaries to receive the income should they pass on. The implications for rights and benefits depend on the option selected. The main options are period certain, joint survivor and refund.
♦ Safety from creditors
Proceeds from SPIAs are protected from creditors. The immediate annuity is also a way to protect the lump sum invested, since that lump sum no longer forms part of your asset base.
== Cons ==
♦ Savings loss or reduction
The SPIA requires that the policy owner relinquish rights and ownership of the fund used to purchase the annuity. If you invest in a Money Market Fund, you can withdraw from it and benefit from the return (income) as well. With the SPIA, you benefit from the income only. You purchase lifetime income in exchange for the lump sum as part of the contract. The immediate annuity therefore significantly reduces your liquid net worth.
♦ Decision to buy is irreversible
In addition to losing liquidity, once you have received your first payment from the provider, you cannot cancel the immediate annuity. In the majority of cases, the annuity purchase is irreversible. Therefore, you have to exercise due care in making the decision to purchase and in selecting the amount that you are willing to part with.
♦ Annuity guarantees are only as good as the annuity provider
While immediate annuities provide safety and guarantees to the annuitant, the promise is only as strong as the provider making it. In times of recession, it is possible for annuity providers to become insolvent or illiquid. While these annuity providers are regulated and must show that they can meet liabilities by maintaining a stipulated level of liquidity, the guarantee is not typically 100% certain.
Other demerits of single premium immediate annuities are the inflation risk posed when the payments are fixed and the increased opportunity cost incurred by the loss of liquidity. The immediate annuity can benefit many persons and can serve the purpose for which they were created. However, this is not a given. Before purchasing a SPIA, critically analyze the effect of the pros and cons on your financial circumstances.