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Is a Single Premium Immediate Annuity or a Deferred Income Annuity Best?

Think Advisor’s Gil Weinreich recently researched whether single premium immediate annuities or deferred income annuities are better.  In “Which Annuity Is Optimal? SPIAs vs. DIAs,” he looked at Morningstar study results that were published in the Journal of Financial Planning.  SPIAs have been popular for a long time because they offer a higher return and income guarantees that you don’t see with many other annuity products.  DIAs are a much newer product, but seem poised to overtake the popular SPIAs in the not so distant future.  In David Blanchett’s Morningstar study, he compared eight different types of fixed income annuities.  He used a multitude of different variables to compare more than 6,500 scenarios.  His goal was to determine which of the annuities had the best performance in the most scenarios.

Single premium immediate annuities took the top spot because of their simplicity and returns.  Immediately upon purchasing a SPIA, your lump sum payment is converted to a consistent stream of income with returns based on current interest rates.  SPIAs have long been praised for their efficiency, which has remained unmatched until recently.  Deferred income annuities should be more efficient than their immediate counterparts in theory.  Your insurance costs are cheaper when you delay your income payments until later in your life.  Some deferred income annuities don’t start paying you income until you are 85, which is a huge difference from the average age the SPIAs start paying you around 65.  Many people don’t live until age 85 and if they do, the insurance company is typically paying them income for a shorter number of years.  This makes your costs lower and your payouts higher.

Using a deferred income annuity in your financial planning helps you eliminate longevity risk.  It is relatively inexpensive to purchase such an annuity that will start paying you income late in life.  This income will last as long as you live.  You still need to finance your earlier years of retirement of course.  But the knowledge of an end date makes it much easier to plan for your retirement from age 65 or so until your deferred income annuity is set to begin.

In the study, Mr. Blanchett compared SPIAs and DIAs that are nominal vs. inflation adjusted, period certain vs. lifetime payouts, and those with and without death benefits.  Some of these variables have a much bigger effect on how the annuities ranked.  How the money was allocated within the annuity didn’t matter too much.  Death benefits made a big difference.  When the desire to leave money to heirs is ranked important, DIAs have the upper hand,  but SPIAs take the top spot when there is no need for death benefits.  During high inflation, an inflation-adjusted SPIA does well, but not during a period of low inflation.  Overall, the top ranking went to a SPIA that has a 20-year, period-certain guarantee.  The second spot went to a nominal SPIA.  A nominal DIA held the third spot in the rankings.

There is another important thing to consider.  Deferred income annuities are relatively new and the market for them isn’t nearly as competitive as it is for single premium immediate annuities.  Assuming that the DIA market increases to a level of competition closer to the SPIA market and the SPIA market continues on the same path it has, results are different.  It is likely that deferred income annuities will hold more value than single premium immediate annuities as competition in the DIA market increases.  They are cheaper and more liquid, so they can add a lot of value to your financial plan.  Although SPIAs appear to be the most optimal of the annuities currently, it might not be long before DIAs surpass them.

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