Using Fixed Income Annuities to Build Your Income Portfolio Ladder introduced two types of fixed income annuities: single premium immediate annuities, or “SPIAs,” and deferred income annuities, or “DIAs.” As stated in that blog post, while the use of SPIAs is widespread, DIAs are currently offered by only a handful of life insurance companies.
SPIAs and DIAs come in two flavors insofar as the length of time that life insurance companies are on the hook for making payments to you: life annuities and period certain annuities. While SPIAs have traditionally been favored over DIAs, life annuity payment modes have generally been chosen over period certain annuities. This is understandable since most people don’t want to run out of money, with married couples preferring income to last for the remainder of both individuals’ lifetimes.
A life, or joint life, payout, can be a great choice in certain situations, however, if your goal is to create a retirement income plan that provides for different and distinct income streams to match your expense needs associated with different stages of your retirement years, it probably won’t be the best solution. Also, a lifetime payout, due to the open-ended nature of the number of payments, is the most expensive annuitization choice. Finally, unless you purchase an appropriate amount of life insurance in conjunction with the commencement of lifetime annuitization of a fixed annuity, you could potentially lose your entire investment after receiving just one annuity payment.
Let’s take a look at the last situation first since it is potentially the most devastating. Suppose that you are 65 and the value of your fixed income annuity is $250,000 when you decide to annuitize it, choosing a life annuity payment option resulting in a $1,400 per month payment to you for the rest of your life. This seems like a good deal to you since you will be receiving $16,800 a year, or 6.7% of the current value of your investment each year for the rest of your life. After receiving your first electronic deposit (whatever happened to checks?) for $1,400, you die in a car accident. Guess what? Game over. Life insurance company passes go and retains $248,600 ($250,000 – $1,400). Your beneficiaries receive nothing.
The previous example, while it’s certainly possible, is not your typical scenario. What’s more likely to occur is that you will live for a longer period of time, say ten, twenty, or even thirty years, receiving $1,400 each and every month. While it may not end up being such a great deal if you live to 75 since you will receive a total of $168,000, or $82,000 less than the value of your investment of $250,000 when you began receiving payments, if you live twenty or thirty years, you will receive payments totaling $336,000 or $504,000, respectively.
While you may receive payments under a life payout option for an extended period of time that may meet your needs when you retire, this generally won’t be the case after five or ten years due to inflation. Assuming 3% inflation, your $1,400 per month payment will be worth $1,045 in ten years, $775 in twenty years, and $580 in thirty years. Unless your retirement income plan includes another source of income kicking in ten years into your retirement, e.g., a deferred income annuity, or DIA, you may be forced to adjust your lifestyle and/or sell your house in order to cover your expenses.
Finally, when deciding between different payment options, always keep in mind that a lifetime payout is always going to be the most expensive way to go. When you choose this option, and assuming that you are 65 when you begin receiving payments, keep in mind that the life insurance company is potentially liable for making payments for 30, 40, or more years. Due to the open-ended nature of the number of payments combined with increasing life expectancies, the monthly payment that you will receive by choosing a life, or joint life payout, will usually be much less than if you choose a term certain, e.g., twenty years, payout.