May 1, 2012
I determined that the cost of the annuity to provide the income need that is not met by Social Security (at and after 85 years of age) is $240,000 in today's dollars. Effectively, the income need beyond age 85 is funded from Social Security and the SPIA. Since an inflation-linked SPIA is being used, the desired income need can be closely matched from these two sources. Small shortages in the desired income, if any, from these two sources will be covered by making the withdrawal from the SWP. The table below presents the results of two strategies with the same set of scenario paths. (A scenario path is a sequence of inflation and asset class returns for future years. Two strategies can be effectively compared when simulated on the same set of scenario paths.)
|
Strategy 1 |
Strategy 2: |
Probability of Success |
74% |
81% |
Average Legacy |
$759K |
$997K |
Purchasing a SPIA in the future increases the probability of success and increases the average bequest, because funding the last phase of income with an SPIA frees up the SWP assets to grow. This strategy also gives affluent retirees flexibility to structure their estate transfer, since the income need has been squared away.
Conclusion
Funding the last phase of retirement – during which the year-to-year survival probability is relatively low – using a SPIA is the most efficient strategy, increasing both the probability of success (or expected income for the same probability of success) and the average bequest.
Specifically, purchasing the SPIA in future is a more flexible and superior strategy than buying longevity insurance, wherein the assets are handed over to the insurance company at the time of purchase. A DIA faces inflation risk, since there are no products with perfect CPI-U-based payments. Nominal payouts 20 years in future are vulnerable to high inflation. Purchasing a SPIA at a future date, moreover, will only be necessary if the retiree is still alive in his or her 80s. And in case of couples, if only one spouse is alive, the purchase would be of a single-life SPIA with a higher payout than a joint-life SPIA.
The psychological concerns that retirees have regarding ceding control over their capital with a SPIA at that point can be easily addressed by showing that they just need to live seven additional years to get their capital back.
There is always a risk, of course, that a SWP designed to fund the annuity purchase in future will deplete in less than 20 years. In that case – if the SWP is dwindling fast in value – the advisor and the retiree retain the option to purchase the annuity any time during those 20 years, in one or more installments.
There is a practical concern, however: It can be difficult to find an underwriter for an 85-year old investor, as insurance companies fear getting sued by the family. So, from a practical perspective, the advisor may have to make a multi-installment purchase of SPIAs over several years, beginning in the retiree’s late 70s.
Purchasing SPIAs in one’s 60s and early 70s is still useful. In majority of the cases, that will increase the probability of success of the plan. But whatever your view of the use of SPIAs during the early- and the middle-phase of retirement, all advisors who take their fiduciary responsibilities seriously should consider funding the last phase of retirement exclusively through SPIAs.
Author Bio: Manish Malhotra is the founder and CEO of Income Discovery, a firm focusing on building new approaches for generating retirement income and new tools to help planners build an appropriate income strategy for their clients. He published two papers in Advisor Perspectives: “A New Framework for Retirement Income Planning” (http://bit.ly/beNhA4), which introduced new thoughts on how to evaluate different retirement income strategies, and “The Random Walk Spoiled,” a paper on flaws in making the random walk assumption (http://bitly.com/9Te8Aq). He can be reached at .
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