Retirement portfolios can be constructed from a mix of asset classes, including stocks, bonds and annuities. In the past, I’ve shown that retirees achieve some of the best outcomes by allocating a portion of those assets to single-premium immediate annuities (SPIAs). In this column, I extend my analysis to show that deferred-income annuities (DIAs) work even better than SPIAs, by providing more liquidity and better longevity protection at a lower cost.

This analysis is created in the context of the efficient frontier for retirement income, looking at the case of a 65-year-old couple and finding that a combination of stocks and SPIAs optimizes a retirement-income portfolio for a robust set of circumstances. That analysis, however, did not include DIAs within the universe of available investment choices. I’ve now remedied this.

DIAs offer longevity protection through a guaranteed income beginning at a future date, which lowers their cost relative to SPIAs. DIAs may be more attractive to clients who loath the loss of principal and liquidity implied by a SPIA purchase. When adding DIAs into the mix, the retirement income frontier expands. In my analysis, DIAs have pushed aside SPIAs as the product of choice for providing longevity protection.

Fundamentals of deferred-income annuities

For both DIAs and SPIAs, a lump-sum premium is paid today in return for a guaranteed income for life. The difference is that for the DIA, the guaranteed income does not begin until a later date. Another way to look at this is that a SPIA is a DIA with no deferral period.

The basic idea of “longevity insurance” is that a 65-year-old might purchase a DIA for which income begins in 15 or 20 years. Because the income is deferred, total lifetime payouts will be less and the cost of the annuity is lower. This provides longevity protection at a lower cost.

Recent research articles have shown that DIAs support a higher withdrawal rate more safely by creating a 20-year Treasury inflation-protected securities ladder with a DIA that starts payments after the 20 years. S. Gowri Shankar wrote about this strategy in A new strategy to guarantee retirement income using TIPS and longevity insurance in a 2009 issue of Financial Services Review, and Stephen C. Sexauer, Michael W. Peskin and Danield Cassidy reconfirmed the idea with an article in the January/February 2012 issue of Financial Analysts Journal.

An important feature about DIAs, however, is that in their current form they do not provide full inflation protection. Inflation-adjusted DIAs exist, but the inflation adjustments do not begin until the date income is received, rather than the date that the premium is paid. Advisors and their clients are forced to assume a value for the future compounded inflation rate in order to try to calibrate the real value of the income the DIA will provide. Small differences between actual inflation and what is assumed can compound into big differences over a long deferral period.

Figure 1 illustrates this with an example of a 20-year deferral to the income start date. In this example, the advisor and client try to purchase a DIA that will meet the spending goal 20 years from now in inflation-adjusted terms. They assume inflation will compound at 2.1%. If actual inflation matches this, then the real value of the income will be exactly what the client desired. If inflation is less than assumed, then the real value of the income is even greater. For instance, if inflation averages 1.6%, the DIA provides about 10% more than planned, and the client annuitizes 10% more assets than necessary. On the other hand, higher inflation reduces the real value of income. For instance, if inflation averages 3.3%, then the real value of the income provided by the DIA is about 20% less than the client’s goal. Advisors must be aware of this inflation risk when planning a DIA purchase.

Impact of Inflation on Real Income

One other risk for a DIA is the possibility that financial assets could deplete before the date that income begins, which would leave clients with a hole in their finances midway through retirement.