On my commute to work, I normally listen to financial podcasts. And recently, many of my favorites – Suze Orman, Money Girl, Vanguard Plain Talk on Investing – all talked about annuities.
If you don’t remember, I despise annuities. My mother’s ex-financial advisor tied up the majority of her wealth into annuities, and she has been paying the steep price ever since.
However, the type of product my mom was sold was a variable annuity – a retirement product that allows you to invest in mutual funds and pays you a level of income based on the performance of the investments. The contracts are usually pretty complicated, and the products also have high surrender charges, administrative costs, and expense ratios.
The type of annuity that I’ve come across recently has been the Single Premium Immediate Annuity (SPIA). It’s touted as the one type of annuity that may be worth the cost.
What is a Single Premium Immediate Annuity?
Unlike most variable annuities, the SPIA is just what it appears to be. You take a lump sum of money (a single premium), give it to an insurance company, and in exchange, they promise to pay you a certain amount of money (either fixed or inflation adjusted) for the rest of your life. No matter what happens to the financial markets, you will get the rate of return specified in your contract, as long as the insurance company is financially stable enough to keep its promise.
(The SPIA also has a variable payment version that seems just as bad as other variable annuities.)
Now, if I were forced to pick an annuity, I guess I would choose this one. It’s straight-forward, and you know what you’re getting into when you make your purchase. I’m a big believer in diversifying your income streams in retirement and finding a way to transfer some of the risk that you may outlive your money.
What are the drawbacks?
Obviously, this type of insurance comes with drawbacks.
First and foremost, they have higher fees, commissions, and administrative charges than you would incur in most other investments These expenses cut into the rate of return you supposedly get under your contract.
Secondly, you loose the liquidity of the money that you give the insurance company. That lump sum you gave now belongs to them, and you can no longer use the principal if an emergency arises.
Thirdly, with a fixed interest rate, you could lose money if the rate or return on your annuity doesn’t keep pace with inflation. Inflation adjusted annuities do exist, but obviously, they are more expensive (see point number 1).
Lastly, the income stops when you die. Thus you are gambling with how long you will live. Live until you’re 110, and you’ve made a good investment. Die the next month after you’ve given your money to the company, you’ve just thrown away a boat load of cash that your beneficiaries will never see.
Should you buy one?
As with any investment choice, whether you should purchase a SPIA depends on your specific financial situation. If you’re looking for a way to insure against running out of money in retirement, transferring the risk to an insurance company through a SPIA may be a good way to do that. You just have to be cognizant of the costs of this transfer and make sure you have a diversified retirement portfolio to supplement your expenses.