An SPIA can be thought of as a backward life insurance policy. Instead of paying a series of monthly, quarterly or yearly premiums, then receiving a lump sum benefit at death, the purchaser of an SPIA pays a lump sum up-front, then receives a series of payments (monthly, quarterly or annually) until death.
As with life insurance, the purchaser of an SPIA receives a single premium quote from a life insurance company for a specific benefit. You don’t know how much of the premium is being used to fund the benefit and how much is going to the insurance company to cover expenses and sales commissions.
Fortunately, bright minds have tackled the problem of evaluating SPIAs. On the website “Retire Early” is a spreadsheet that works off age- and gender-specific mortality tables built from Social Security data. (Life insurance companies don’t make public the mortality tables they use.) You can find the SPIA calculator by going to http://www.retireearlyhomepage.com/annuity_costs.html.
Adverse selection
The typical SPIA purchaser is healthier than the average person. Why? For an SPIA to provide more benefits than the cost of the premium, the annuitant must live longer than his or her average actuarial life expectancy. Who would give, say, $100,000 to an insurance company in exchange for a lifetime stream of $750 monthly payments if that person believed he or she would survive only three more years, thus receiving back only $27,000?
In constructing the SPIA calculator for his website, Greaney relied on an academic study published in the December 1999 American Economic Review. One goal of this study, by Professor Olivia Mitchell at the Wharton School and others, was to determine the extent to which adverse selection affects premium quotes for annuity purchasers. The study, using data from the Society of Actuaries, found that mortality rates for annuity purchasers were typically about one-third lower than those for the general population. The Retire Early spreadsheet includes complete Social Security mortality tables for both the general population and for the “adversely selected” population likely to purchase SPIAs.
The Money’s Worth Ratio
The Retire Early spreadsheet calculates a statistic called the “Money’s Worth Ratio” (MWR). This statistic compares the cost of the SPIA to the present value of the stream of monthly payments the annuitant is promised. The higher the ratio, the better. The 1999 Mitchell study found that MWRs for commercial SPIAs were typically in the 75 percent to 85 percent range. It also noted that the MWRs included in the study had increased from those noted in earlier studies, which the authors attributed to more competition among insurers to attract SPIA purchasers. Expect commercial insurance firm SPIA premium quotes to produce MWRs between 80 percent and 90 percent.
How it works
To illustrate how to use the Retire Early calculator, here are a couple of examples. The first is a 65-year-old male looking to convert a $100,000 IRA to an SPIA to supplement his Social Security income. In my experience, those considering SPIAs favor guarantees, because they’re uncomfortable with the idea they could die shortly after paying a large lump-sum premium, so I looked at SPIAs with 10-year guarantees. From a commercial insurance company, I received a quote of $596 in monthly income for my subject. Here’s what I entered into the calculator:
Age…..65
Annual Benefit…..$7,152
Discount rate…..5.5%
Guarantee period…..10 years
Premium…..$100,000
I chose 5.5 percent as the discount rate, because at the time of writing, it approximates the current yield on 10-year AA-corporate bonds. The “discount rate” is a factor applied to future payments to find their economic value today. Using general population mortality data, the calculator generated an MWR of 79 percent. Using the adverse selection mortality data, the MWR was 86 percent. To me, the adverse selection data is more germane, because SPIAs make little sense for people not in good health or not genetically disposed to longevity.
The 86 percent MWR means if our subject lives to his life expectancy, he’ll receive back 86 percent of his premium in monthly payments. The 14 percent difference, or $14,000, should be viewed as the cost of insuring our subject against longevity (outliving his money).
For the second example, I obtained a quote for a 75-year-old female considering converting a variable annuity valued at $100,000 to an SPIA. The same insurance company quoted monthly benefits for her of $686 with a 10-year guarantee.
The MWR using adverse selection data for our second subject was slightly higher, at 89 percent. Is it worth it for her to pay $11,000 to ensure she won’t outlive her $686 monthly payments? That’s not an easy question, Because the answer may depend on many factors. But at least it’s the right framework in which to view the SPIA decision, and it helps quantify what, to this point, has been difficult to quantify.
Getting quotes online
You can obtain immediate SPIA quotes from Berkshire-Hathaway (http://www.brkdirect.com/spia/EZQUOTE.ASP) and from Vanguard (http://www.aigretirementgold.com/vlip/VLIPController?page=SubmitQuote). Enter into the Retire Early spreadsheet the premium and benefit amounts you receive from the insurance company, using the appropriate age and guarantee period. Then ask yourself, “Is assuring that I don’t run out of money worth the difference between the premium paid and the expected benefits?”
