Many economists and retirement experts favor inflation-adjusted single-premium annuities (SPIAs), but advisors and the investing public have never shared their enthusiasm. Detractors contend that the product is fundamentally flawed and will never gain broad acceptance. My own view is more optimistic, but significant obstacles will, nonetheless, continue to impede wider adoption.
After all an inflation-adjusted SPIA should be a natural fit for most retirement plans. In return for an up-front premium, the buyer receives lifetime income that adjusts each year in response to actual inflation.
It's like a do-it-yourself inflation-adjusted pension or an add-on to Social Security, which, for most people, does not cover basic living expenses. With defined-benefit pensions on the wane, this product could help fill the void.
I'll discuss details of the inflation-adjusted SPIA and its pricing – including prospects for that pricing to become more affordable with time. But first, we should begin by discussing the viability of these products.
Product viability
The limited popularity of all types of SPIAs (inflation-adjusted, level-pay, those providing fixed-percentage increases) has been studied by many economists, who have tried to solve the so-called “annuity puzzle." For those who want a window into these efforts, financial planner and researcher Michael Kitces tackled the issue in a February 2011 blog post with the incisive title, “If Immediate Annuities Are Such A Great Solution, Why Doesn't Anyone Want to Buy One?” Kitces didn't offer any single answer to the question he posed, but he and his readers discuss a number of factors contributing to the unpopularity.
My own view is that the unpopularity is more a reflection of lack of advisor interest in selling the product, than SPIAs not meeting client needs. For advisors who depend on commissions, for instance, SPIA sales pay less than other types of annuity products, and, for advisors whose compensation is based on assets under management, the sale of a SPIA removes assets from investment accounts.
SPIAs are a better fit for the small minority of advisors who are paid hourly fees or retainers, but even that group typically favors systematic withdrawals over annuities of any type.
There are also competing annuity products to consider. The dominant products in the annuity market, variable annuities and fixed-index annuities, offer more sales pizzazz than the inflation-adjusted SPIA. Although inflation-adjusted SPIAs do a better job dealing directly with inflation and longevity risks, that’s not an easy message to communicate. Finally, the current low-interest-rate environment has a direct and transparent effect on SPIA prices, whereas for the more popular annuity products the effect may be hidden in product complexity.
Working with clients
Despite the impediments, there are financial planners who recognize the valuable role inflation-adjusted SPIAs can play and successfully recommend them to clients. One such planner is Paula Hogan, a thought leader in the financial planning community whose eponymous firm is based in Milwaukee, Wisconsin.
I recently spoke to Paula about inflation-adjusted SPIAs, and she offered the following recommendations, based on her experience working with clients:
- Start discussions early, when clients begin planning how to draw down retirement savings.
- Before getting into product discussions with clients, focus on the need for secure retirement income that is protected against inflation and longevity risks.
- Spread recommended purchases over a number of years, rather than trying to move a large chunk of assets all at once.
- Spread purchases over multiple carriers, while being mindful of state guarantee limits. (A previous article that I wrote for Advisor Perspectives covered this topic.)
Hogan noted that insurers charge more (or, equivalently, offer lower payout rates) for inflation-adjusted SPIAs than they charge for level-pay SPIAs or those whose payouts increase by fixed percentages. She still generally prefers the inflation-adjusted version, however, viewing it as an opportunity to obtain valuable insurance protection against the contingency of high inflation. Among all annuities, only the inflation-adjusted SPIA offers that protection.
Hogan also differs with planners who argue that wealthier clients do not need products with guarantees, including SPIAs. Given the many and varied risks that all retirees face, particularly those relying on savings, she considers clients with as much as $2 million in investable assets to be "squarely in the crosshairs for the types of perils that can threaten retirement well-being."
Hogan’s promotion of inflation-adjusted SPIAs stems from her belief that financial planning needs to expand beyond its narrow focus on investment management. Advisors, in her view, can add more value when they provide comprehensive planning to address the full array of risks that clients face. If more advisors begin to think like Hogan, then there’s plenty of reason to believe that they will give inflation-adjusted SPIAs more serious consideration.
True inflation protection?
Payouts from inflation-adjusted SPIAs are determined each year based on changes in CPI-U (the consumer price index for all urban consumers), which is the most popular measure of inflation. But seniors have a different mix of expenses than the general population, so an important question is, "How closely does CPI-U track typical retiree expenses?" To answer the question, the Congressional Research Service did a study two years ago that compared changes in the CPI-U to changes in an experimental index of inflation for Americans aged 62 and over. For the period 1982-2009, the average annual increase for the experimental index was 3.2%, compared to 3.0% for CPI-U – a difference, but not a huge one.
A different index is used for annual adjustments to Social Security, which are based on changes in CPI-W (the consumer price index for urban wage earners and clerical workers). That measure produced a 2.9% average annual increase over the test period.
The products available to the public do not put a cap or upper limit on inflation increases. (There is a customized inflation-adjusted SPIA offered to federal workers through the Thrift Savings Program that does have a 3% annual cap.) In the event of deflation, the insurers typically cushion the impact in some way. For example, one insurer holds payments level in the event of deflation and reduces future increases as an offset.
Product pricing
The companies that sell inflation-adjusted SPIAs build extra margins into their pricing for the inflation protection. How much extra margin can be inferred comparing pricing for inflation-adjusted SPIAs to products with fixed percentage step-ups in payouts.
The following example is based on rates as of early November 2012 from Income Solutions®, an online platform offering low-cost immediate annuities from multiple insurance carriers. These rates are for a 65-year-old female:
Inflation-adjusted versus step-up annuities |
|
|
Company that offers: |
Product |
Annualized Payout Rate |
Implicit Inflation Rate |
Best inflation-adjusted rate |
Inflation-adjusted |
4.07% |
2.50% |
Best inflation-adjusted rate |
2.5% step-up |
4.48% |
3.27% |
Best step-up rate |
2.5% step-up |
4.69% |
3.72% |
In early November, long-term inflation expectations, as measured by the difference between rates on 10-year Treasury bonds and Treasury Inflation-Protected Securities (TIPS), stood at 2.50%. The above chart compares pricing for an inflation-adjusted SPIA with pricing for SPIAs that have 2.50% annual step-ups (actually a 50/50 mix of 2% and 3% step-ups).
The best initial payout rate (first-year income divided by the premium deposit) for an inflation-adjusted immediate annuity for our hypothetical 65-year-old woman was from an insurer offering 4.07%. The same carrier offered a 2.5% step-up with an initial payout rate of 4.48%, which illustrates the extra margin built in for actual inflation protection. There are also insurers that offer step-ups but not inflation-adjusted SPIAs, and selecting the best initial payout rate from that wider universe produced a further increase to 4.69%. So the pricing differential reflects both insurers charging extra margin and the greater number of insurers offering step-ups.
The rightmost column of the chart translates the higher payouts into "inflation equivalents." For this particular example, one could go to the company with the best step-up rates, obtain a mix of 3% and 4% step-ups with a weighted average of 3.72%, and pay the same price as for the inflation-adjusted SPIA. If future inflation were to average less than 3.72%, the step-up choice would beat the inflation-adjusted SPIA, and with inflation expectations at 2.50%, that is a good bet. On the other hand, the step-up would not protect against higher inflation; if inflation exceeds 3.72%, the inflation-adjusted SPIA is the better choice.
That pricing difference creates a dilemma for advisors who may want to recommend SPIAs: Is it worth forgoing inflation protection in order to get those higher initial payout rates?
Is more attractive pricing feasible?
Part of what’s keeping inflation-adjusted SPIAs from gaining popularity is that they represent a small share of the already-small SPIA product line, so insurers have little incentive to offer the most competitive prices. But that leaves open the question, "If insurers wanted to market the product more aggressively, could they raise rates?"
I have taken a look at this issue by first trying to understand how insurers invest the funds that support these products. I've had to rely on indirect sources, because insurers are tight-lipped about their investment strategies.
For fixed-income products, including inflation-adjusted SPIAs, most insurers rely on the spreads they can earn on investments with credit quality in the A to BBB range. Although it might seem logical that insurers would invest in TIPS to support inflation guarantees, they wouldn't be able to earn enough margin with TIPS to build viable products. They can, however, obtain inflation protection and retain their credit spreads by combining nominal bonds with inflation swaps, which are analogous to selling Treasury bonds and buying TIPS.
Indications are that, for some insurers, inflation-adjusted SPIAs are not a big enough product line to make hedging necessary, so they simply add extra pricing margin to cover the inflation risk. That approach leaves carriers vulnerable to the risk of runaway inflation, but damage would be limited by the size of the product line. Some insurers may be more cautious than others, and at least one insurer I know of does use swaps to hedge the inflation risk.
Insurers who use swaps for inflation protection would likely have room to offer more competitive inflation-adjusted SPIA rates if they chose to do so. My estimate is that the cost of swaps affects payout rates by roughly 10 basis points, so an insurer offering a step-up rate of 4.69% would be able to offer 4.59% for an inflation-adjusted SPIA, a considerable improvement over the best rate of 4.07% currently available. Of course, getting insurers to price more aggressively would require more demand for the product, and that loops back to the product viability issues discussed earlier.
Conclusion
Given the current low interest rates, I would not expect to see many advisors jumping on the SPIA bandwagon. My own view is that interest rates may remain low for quite some time, so I am comfortable recommending SPIAs, provided the purchases are spread over time. Despite the pricing differences, I favor the inflation-adjusted SPIA over the step-up versions, because I like the protection against inflation risk. Overall, I prefer the inflation-adjusted SPIA to more complex products like variable annuities, because I like being able to be able to directly meet client needs for additional, secure lifetime income and provide inflation protection at the same time.
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