Even So-Called Simple Annuities May Be More Complex Than You Think

SPIAs. Think of a SPIA as buying a pension. Your client turns over some of their money to an insurance company which promises to pay a defined sum of money every year for the rest of the account holders’ life (or lives if it’s a joint annuity). It’s basically that simple. However, some SPIAs have more complexities, such as paying out for at least 10 years, even if the client passes away before then. This is called a “life and 10-year period certain” provision. 

As of the time of this writing, a 65-year-old woman could pay $100,000 to receive $570 a month for the rest of her life, according to ImmediateAnnuities.com. That’s a 6.84% annual payout rate from an insurer with an A-plus credit rating. That’s not all income, however, because part of that payout is return of principal. 

The case for this simple annuity is that it provides steady cash for the rest of the client’s life, thereby providing longevity protection. But advisor William Bernstein warns that this kind of annuity plays Russian roulette with inflation. For example, in 25 years with 3% annual inflation, the monthly payout will only buy 48% of what it buys today. With 6% and 10% inflation, it only buys 23% and 9% respectively. While no one knows the future rate of inflation, remember the national debt is in uncharted territory and a major risk factor for long-term inflation. Think of a SPIA as a bond with a duration of the rest of the client’s life. Last year, as inflation expectations soared, bonds had the worst year in recorded history. Ariel Stern, COO of ImmediateAnnuities.com, sent me data illustrating the tight relationship between SPIA payouts and long-term AAA corporate bonds with 20+years maturities. When interest rates increase, both newly issued bonds and annuities have higher payouts, and fixed cash streams can be bought at lower prices.

Stern calculated that a 65-year-old woman could buy a SPIA with the same payout earlier this year for nearly 25% less than she would have paid back in January 2021. (Note this is roughly the loss of a long-term bond portfolio, as illustrated by the Vanguard Long-Term Bond ETF (BLV) declining 29.0% in those two years). Simply put, with both annuities and long-term bonds, you get a much better deal if you buy when rates are high. I ran this by David Lau, CEO of DPL Financial Partners, and he responded that no one can predict interest rates. While true, advisors should take into account the risk of inflation continuing to rise, which typically would lead to higher interest rates (and annuity payouts) before recommending a SPIA for clients now. 

One way independent advisors can purchase annuities for clients is through firms like DPL Financial Partners, which offers commission-free annuities working with RIAs. While far lower than typical commissions, they do have some fees.

Though one can no longer buy an annuity that adjusts to the CPI, annuities with fixed annual increases might seem like a solution to the inflation problem. While it makes intuitive sense, it’s completely backward. Insurance companies, of course, reduce the cash payout in earlier years which increases the duration of the payout, thereby increasing inflation risk, says Stan Haithcock, an independent agent with the website StanTheAnnuityMan.com. If inflation and interest rates come in higher than anticipated, you lose less purchasing power by having more cash flow come in during the early years than after decades of compounded inflation. 

MYGAs. These even simpler than SPIAs. There is generally no life insurance part of the contract promising guaranteed income for life. They simply provide guaranteed income for several years, similar to a certificate of deposit that is backed by an insurance company rather than a bank or credit union. And rather than the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA), states provide some protection. 

There are some other differences, including the fact that MYGAs provide some tax-deferral benefits. But keep in mind that one generally cannot take cash out of an annuity before age 59.5 without a 10% IRS penalty on the gain.

I compared MYGA rates to CDs. As of the time of this writing, the highest rates from an AM Best A-plus rated insurer for 3- and 5-year MYGAs were 5.25% and 5.70% respectively, vs. 5.65% and 4.68% respectively for CDs. Haithcock had previously told me MYGAs typically pay more than CDs with terms longer than three years and this data supports it.

I’m less picky on the soundness of the bank or credit union since, within limits, they are backed by agencies of the U.S. government. But how sound are the state insurance guarantees? Haithcock says “they have never been tested.” Personally, I place little reliance on state guarantees as the funding would come from assessments on other insurance companies (rather than taxpayers) which I think might not be forthcoming in a systemic stress environment where many insurers were failing or having financial hardships.

My own experience in buying a MYGA was anything but simple and transparent. I had a large CD at a credit union earning only 3.2% for another 2.6 years with a large penalty to withdraw the funds early. The investment arm of the credit union contacted me with an offer to waive the penalty if I bought a 3-year 4.5% MYGA from an A-minus rated insurer. That was a hard no for me, due to the credit risk, but I countered with an A-plus-plus insurer paying a 4.6% rate that I found on Haithcock’s website. The credit union accepted.

I regret the purchase as the process was difficult and filled with errors. There were missing funds, multiple contracts issued with different dates and amounts, for which the credit union and agent blamed each other. It took me an estimated 23 hours over weeks to get things fixed. The only good thing was that rates rose during the period and I ended up with a rate of 4.9%. 

My take. SPIAs and MYGAs are relatively simple contracts that have some appeal. I’m not willing to take on the inflation risk of a SPIA but, with Treasury inflation-protected securities (TIPS) yielding positive returns now, it’s possible CPI-adjusted SPIAs will return since actuaries can again hedge inflation risk. 

I suspect my personal experience with MYGAs was an outlier so, for periods of four to five years, they could make sense for part of a client’s fixed income portfolio due to their high yields. However, as with any annuity product, I strongly recommend making sure the credit quality of the insurer is high. 

Allan Roth is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He is a licensed CPA and CFP, and has an M.B.A. from Northwestern University (Kellogg), but still claims he can keep investing simple.