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The high cost of a no-fee, no-commission Single Premium Immediate Annuity (SPIA).

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The high cost of a no-fee, no-commission Single Premium Immediate Annuity (SPIA).



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This article was first posted July 1, 2009, revised December 15, 2009.

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You'll sometimes hear a financial advisor or insurance agent recommend a "no-fee, no-commission" Single Premium Immediate Annuity (SPIA) as a safe way to provide lifetime retirement income. The "no-fee, no-commission" pitch is likely used to distinguish them from their disreputable cousins, the Variable Annuities (VA) and Equity-Indexed Annuities (EIA) which are often plagued by outrageously high fees and abusive sales practices. However, Single Premium Immediate Annuities actually carry very high costs themselves that can rival or exceed those of their cousins -- they just don't call them "fees" or "commissions". Because an SPIA is considered an insurance contract rather than an investment, SEC regulations don't apply. As a result, the promoters of SPIAs are not required to disclose these costs to the purchaser in a prospectus.

You can estimate the costs embedded in a single premium immediate annuity by comparing the premium quote you get from the insurance agent to the expected present discounted value (EPDV) of an immediate life annuity. The EPDV is sometimes called an "actuarially-fair annuity" or "money's worth annuity". Economists define the ratio between the EPDV and the premium quote as the Money's Worth Ratio (MWR).(Note 1.)

For individuals of average mortality, Money's Worth Ratios as low as 0.70 are not uncommon, depending on the annuitant's age. That would indicate that 30% of the purchase price of the SPIA is siphoned off in the insurer's various costs and expenses. For retirees who are aquainted with low-cost index funds where one can assemble a diversified portfolio of stocks and fixed income securities for an annual cost of 15 basis points (0.15%) in fees, the embedded costs of an SPIA seem large enough to choke a crocodile. Even if you applied a 15 basis point annual fee over the entire 50 to 60-year life of the annuity pool, it would still amount to less than 2% of the purchase price.

How do you calculate the Expected Present Discounted Value (EPDV) of an immediate life annuity?

To calculate the expected present discounted value, you'll need an appropriate mortality table and discount rate. There is tremendous adverse selection in the individual annuity market, so it's best to make the calculation two ways; 1) the value of the annuity for the average person and, 2) the value of the annuity for the much healthier segment of the population that actually buys annuities. If you're not blessed with the good health and long-lived genes of the typical annuity purchaser, you'll end up overpaying for the product relative to its value.

The Social Security Administration publishes a Mortality Table that describes the life expectancy for the population has a whole (i.e., the average person.) While every insurance company developes their own proprietary mortality table based on the specific markets they target, this information is not in the public domain. Mitchell, Poterba, et al (Note 2) have done work on estimating the affect of adverse selection in the individual annuity market. The information from Table 2 in Mitchell's article on the relative mortality between the general population and annuitants was used to adjust the 2004 Social Security mortality table for adverse selection. The adjustment places the median annuitant in the 66th percentile of the mortality distribution for the general population as described by the 2004 Social Security table. This translates to almost a 5-year spread for adverse selection for a 55-year-old and 3 years for a 70-year-old.

Comparison of the Median Life Expectancies (Years)
2004 Social Security Mortality Table vs. Annuitant Table with Adverse Selection
. Male Female
Age 2004 Soc Sec
Table
Annuitant w/
Adverse
Selection
2004 Soc Sec
Table
Annuitant w/
Adverse
Selection
55 25.4 30.0 29.2 33.1
60 21.0 25.1 24.6 28.1
65 16.9 20.7 20.2 23.6
70 13.2 16.1 16.0 19.0

For nominal annuities, the yield on AA-rated commercial bonds is a reasonable discount rate. For inflation-adjusted annuities, the current real yield on the long-term Treasury Inflation-Protected Security (TIPS) is the most appropriate benchmark. The table below compares the expected present discounted value (EPDV) with annuity premium quotes from the Principal Life Insurance Company. If you want to do your own expected present discounted value (EPDV) calculation, you can download a copy of the Retire Early spreadsheet, click here.

Comparison of the Expected Present Discounted Value (EPDV)
of an inflation-adjusted life annuity with quotes from insurer .

Based on the Social Security mortality table and the long-term TIPS coupon of 2.35%
.----- $12,000 annual benefit -----
. EPDV
($)
Insurer's
Quote
Embedded Costs
($)
Money's Worth
Ratio (MWR)
Age/Sex General
Population
Annuitants Principal
Life
General
Population
Annuitants General
Population
Annuitants
55 male $220,220 $250,028 $308,195 $87,975 $58,167 0.71 0.81
60 male $192,791 $222,087 $262,178 $69,387 $40,091 0.74 0.85
65 male $165,150 $192,609 $218,465 $53,314 $25,856 0.76 0.88
70 male $137,685 $162,030 $177,623 $39,938 $15,593 0.78 0.91
55 female $243,382 $269,111 $330,918 $87,535 $61,807 0.74 0.81
60 female $215,700 $241,627 $286,205 $70,505 $44,578 0.75 0.84
65 female $187,180 $212,257 $243,108 $55,928 $30,851 0.77 0.87
70 female $158,146 $181,296 $201,711 $43,565 $20,415 0.78 0.90


Why are immediate life annuity costs so high?

There are several identifiable costs that could explain the wide gap between the insurer's premium quote and the low Money's Worth Ratios (MWR) observed here:

    Adverse Selection and Mortality Risk. As the table above shows, between one-third to one-half of an annuity's embedded costs can be attributed to the mortality difference between the general population and much healthier annuitants (i.e., adverse selection.) This should be of special concern to annuity purchasers of average life expectancy since it greatly increases the cost of the annuity relative to the value received.

    Interest Rate and Reinvestment Risk. To the extent that the longevity of people in the annuity pool exceed the maturity of readily available fixed income securities, insurers bear some risk that they won't be able to reinvest the proceeds on maturity at an equal or higher interest rate for the portion of the annuity pool that remains. However, life insurers typically invest in instruments with higher yields than the US Treasury TIPS and AA-rated corporate bonds we've assumed here. James and Song (2001) (Note 3) found that the yield on insurance company portfolios exceeded the risk-free rate by 1.3% or more per year. Some, most, or all of the interest rate and reinvestment risk may well be covered by that spread.

    Administrative Overhead and Profit. Insurance companies typically occupy high-rent, luxury office towers, maintain fleets of well-upholstered private jets for the highest echelon of management, and sometimes even pay multi-million dollar compensation packages to failed executives. For example, angry shareholders of The Hartford (NYSE: HIG) recently forced the retirement of long-time CEO Ramani Ayer who worked his management magic to deliver a more than 50% decline in HIG's stock value over his 12-year reign. Absent any executive compensation restrictions imposed by the US Government's bailout of The Hartford, Mr. Ayer received over $4 million in compensation for 2008.

    Distribution and Marketing Costs. Sales commissions of 3% to 4% of the annuity premium, advertising costs, and incentives like this week-long retreat at the 5-star St. Regis Monarch Beach resort in California (including a $23,000 bill for massage and spa services) apparently add quite a bit to the cost of an immediate annuity. There are no happy endings for retirees underwriting this largess.

Can you provide lifetime income without incurring the high costs of a commercial insurer?

Back in September 2007, Retire Early outlined the Social Security Withdrawal of Application strategy that allows you to effectively "buy" an inflation-adjusted Single Premium Immediate Annuity at a big discount to what a commercial insurer would charge.

The Social Security Administration has a handy table you can use to determine how much the Withdrawal of Application strategy will increase your monthly Social Security benefit. For example, for a retiree who was born in 1940 and started collecting his or her Social Security benefit in 2002 at age 62, the increase is 1-(131.5/77.5) = 69.7% for someone filing a Withdrawal of Application at age 70. For an individual drawing a 2009 benefit of $1,640 per month, that would be a $1,143 per month increase. The table below details the net cost of repaying the Social Security benefits you've collected to date and the tax credit available on the reimbursement.

Social Security -- Withdrawal of Application

Maximum Monthly Benefit for a
62-year-old starting benefits in 2002
Year Age Monthly
benefit
Annual
Subtotal
2002 62 $1,325 $15,903
2003 63 $1,344 $16,126
2004 64 $1,372 $16,464
2005 65 $1,409 $16,909
2006 66 $1,467 $17,602
2007 67 $1,515 $18,183
2008 68 $1,550 $18,600
2009 69 $1,640 $19,680
Total Benefit 2002-2009 to be reimbursed $157,651
85% of benefit subject
to Federal Income Tax
$134,003
Tax credit for 15% tax bracket ($20,100)
Tax credit for 25% tax bracket ($33,501)
Net cost for Withdrawal of Application - 15% bracket $137,551
Net cost for Withdrawal of Application - 25% bracket $124,150

At the current quote, the Principal Life Insurance Company would charge a 70-year-old male $203,023 for a $1,143/month, inflation-adjusted benefit and $230,556 for a 70-year-old female. The savings for "buying" an annuity from the Social Security Administration rather than a commercial insurer is detailed in the table below.

Cost Comparison
Social Security Withdrawal of Application vs.
Buying an Inflation-Adjusted Life Annuity from a commercial insurer.
($1,143/month benefit for a 70-year-old annuitant)
Age/Tax Bracket Principal Life
Annuity Quote
Cost of Soc. Sec.
Withdrawal of
Application
Savings w/
Withdrawal of
Application
70-yr-old Male
15% tax bracket
$203,023 $137,551 $65,472
70-yr-old Male
25% tax bracket
$203,023 $124,150 $78,873
70-yr-old Female
15% tax bracket
$230,556 $137,551 $93,005
70-yr-old Female
25% tax bracket
$230,556 $124,150 $79,406

Of course, people have differing opinions on whether it's safer to get a Social Security check from the US Government or an annuity benefit from a commercial insurer. Some also complain that Social Security is socialism and that we'd all be better off with a completely private retirement system. There's no more loving a gesture that a principled conservative could make in support of the free market and unregulated executive compensation than to forgo the opportunity to do a Withdrawal of Application and pay the extra $80,000 or so for an annuity from a for-profit, private insurer. I'm sure your insurance company CEO appreciates the sacrifice on his behalf.

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Footnotes

1. The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program, Jeffrey R. Brown, Olivia S. Mitchell and James M. Poterba, 1998, The Wharton School.

2. New Evidence on the Money's Worth of Individual Annuities, Olivia S. Mitchell, James M. Poterba, Mark J. Warshawsky and Jeffrey R. Brown, December 1999, American Economic Review.

3. Annuities Markets Around the World: Money’s Worth and Risk Intermediation, Estelle James and Xue Song, October 2001, American Economic Association.

Resources for further information

The Principal Financial Group annuity quotes a listing of their current annuity payouts.

Berkshire Hathaway annuity quotes online calculator gives you an immediate quote.

Forbes magazine Guaranteeing Lifetime Income.

Assessing Investment and Longevity Risks within Immediate Annuities, Daniel Bauer, Frederik Weber, 2007, Munich School of Management.

Immediate Annuity Pricing in the Presence of Unobserved Heterogeneity , Kim G. Balls, 2004, Managing Retirement Assets Symposium - Society of Actuaries

IS ADVERSE SELECTION IN THE ANNUITY MARKET A BIG PROBLEM? , Anthony Webb, 2006, Boston College, Center for Retirement Research

Hewitt Associates - 401(k) index some interesting information on how people allocate their retirement acounts.

Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, by R.G. Ibbotson, M.A. Milevsky, P. Chen and K.X.Zhu

Social Security Handbook -- information on your Social Security benefits.

Who Benefits from the Mortgage Interest Deduction? -- as it turns out, not many.


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Copyright © 2009 John P. Greaney, All rights reserved.

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