Single Premium Immediate Annuities

September 11th, 2012

Single Premium Immediate Annuities (SPIA’s) are products offered by life insurance companies. There are many flavours of annuities but in general, the client gives the insurance company a lump sum of money (i.e. a single premium) and in return the company, depending on the flavour of the annuity chosen, pays the client an income stream for the rest of her/his life.

When we analyze SPIA’s in terms of the risks of retirement we get the following.

Longevity

SPIA’s offer an effective approach to addressing longevity risk. If an individual chooses a single life annuity, the payments are guaranteed for the rest of that person’s life. If a couple chooses a joint and last survivor annuity, payments are guaranteed as long as one of the two individuals is alive.

Inflation

SPIA’s differ in the degree to which they address inflation risk. One of the flavours of annuity available includes automatic payout increases that can help offset the effects of inflation, with the proviso that the initial payout will be lower than a non-indexed annuity.

Sequence of Returns

The insurance company takes all of the investment risks. The client is completely protected from this risk.

Liquidity in the Event of Health Issues

Once the type of annuity has been selected, the payment stream is fixed. In general, annuity products do not have a cash surrender option.

Product Allocation

This risk is eliminated by immediate annuities. The insurance company manages the investment process and takes all of the investment risks.

Withdrawal Rate

Again, when the choice of annuity flavour has been made, the income stream is fixed and the risk of an unsustainable withdrawal rate is illuminated.

In my conversations with my clients, there is often strong negative reaction to the idea of purchasing an annuity. This reaction is of great interest to academics in the field of financial behaviour where it is called the “Annuity Puzzle” because common sense would indicate that annuities should be far more popular than is the case.

In future articles, I will be discussing annuities in greater detail including questions such as:

  • If I give a sizable chunk of my retirement savings to an insurance company, how can I be certain that the insurance company will be around 15 or 20 years later?
  • Why is the internal rate of return on an annuity higher than the rate of return on other guaranteed products?

Immediate annuities should be considered in the situation where clients are not members of a defined benefit pension plan. In to-day’s low interest-rate environment, immediate annuities are not an attractive alternative in most circumstances, but the interest rate environment will change and long-term interest rates will eventually reach levels that will make it attractive to invest a portion of your savings in an immediate annuity.