Pros and Cons of 2 Key Annuity Types

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Retirees and pre-retirees may have heard that they should consider annuities, but they may be put off by a bewildering array of options. Joining me to discuss two of the key ones is David Blanchett. He is head of retirement research for [Morningstar Investment Management].

David, thank you so much for being here.

David Blanchett: Thanks for having me.

Benz: You recently conducted some research where you looked at two of the key annuity types: the single premium immediate annuity and deferred income annuities. You looked at under what scenarios which type would be most appropriate. Let's start by just outlining what these products are. Let's start with the single premium immediate annuity. What do those products aim to do?

Blanchett: A single premium immediate annuity, or SPIA, is one where you effectively give an insurance company some sum of money--say, $100,000--and then they guarantee you income for life. They've been around for thousands of years, and so what they allow someone to do is to instantly receive income for life when you trade that sum of wealth today for that income.

A deferred income annuity, or DIA, is different in that it's also called longevity insurance where, in most instances, you would give the money to the insurance company today. And, say, you're age 65 today; if you survive until age 85, they will then start paying you income for life as long as you live. So, the difference is that you have to survive to that point in time, and then you receive payments for as long as you live, after you see that income start date.

Benz: Let's take a look at what you see as the key pros and cons, starting with the SPIA--the single premium immediate annuity. What are the key benefits and what do you view as the key drawbacks?

Blanchett: I think one of the key benefits of the immediate annuity, the SPIA, is that it's a very large marketplace today. There are probably hundreds of companies offering some form of SPIA benefit out there, so it's very deep. There are a lot of options out there.

Another benefit that's also possibly a cost is that you have this instant trade of wealth for income. And I think that some individuals like that, but I think where the DIAs, the deferred income annuities, come into play is this idea that "I don't need a guarantee today." I think the people who buy annuities are concerned about outliving their resources. So, if you have a pool of money saved at retirement, your concern is that you live to, say, age 85 and you can't fund retirement for the next 10 or 20 years if you live past age 100. And so, DIA is allowed for that. So, I think the DIAs are a cheaper form of insurance because they only provide a benefit if you live to a certain age [rather than an annuity based on] how long you live.

Benz: Another benefit that has been touted in the DIA space is that your initial outlay is smaller than might be the case with a SPIA.

Blanchett: Correct. The cost of a DIA, for example, that would provide $10,000 a year of income, if you buy it at age 65, it would cost about 20% of what it would cost to have a SPIA starting today at age 65 to provide that same level of income. So, they are cheaper but, again, that's kind of actuarial equivalent. The idea is that the payout is based upon the fact that the odds of you living to age 85 are about 50-50, and even if you live that long, you won't survive long enough to receive a lot of benefits.

Benz: And how does the current interest-rate environment factor into all of this? I know that that's been a concern for a lot of people looking certainly at the SPIAs today--that they're essentially locking in what are quite low rates relative to historic norms.

Blanchett: It is. If you buy an annuity, it is priced based upon your mortality and interest rates, effectively. So, where rates are today makes it relatively expensive; even though a DIA costs less than a SPIA, you're still buying effectively a bond with a 10 or 20 year duration. If you look up interest rates online, you can see that the rates there are quite low; so, it really is kind of hurting your payment to some extent.

Benz: So, your recent research attempted to help retirees figure out which of these product types would make sense under which scenarios. Let's walk through the general conclusions to try to give people some help in making these decisions about whether to [choose] an annuity--and if so, what type.

Blanchett: When I did this analysis, I was kind of rooting for the DIAs. I know I shouldn't have a bias when I do research. But I think that they really are an attractive way to guarantee income for life. It makes more sense academically to create income where you have this kind of ceiling where, if you live past a certain age, you have guaranteed income. But I what I found was actually quite surprising, where SPIAs actually were more efficient on average. They do cost more; there are new considerations there. But I found the pricing for SPIA to be much more competitive than pricing for DIAs. There are a lot more providers in the SPIA space. And so, I think that today, at least currently, a lot of people could be better off buying a SPIA versus a DIA.

Benz: So, one thing that we've seen is a recent Treasury Department ruling that will make the DIAs an allowable option within 401(k)s. You have said that you expect that to transform the landscape for DIAs. Let's talk about that.

Blanchett: Effectively, long story short, the regulation will make buying insurance policies easier in your 401(k) plan. There are limits on how much you can purchase in the riders issued with the policy. But I do think we will see an increase in demand in these types of products in the future because a lot of folks have recognized that these DIAs, also called longevity insurance, are a really efficient way to create guaranteed income for someone if they survive past, say, age 85 or something.

Benz: So, we've talked about when such products might be appropriate. Are there any individuals, any situations where you would say they don't need to bother with any sort of annuity at all?

Blanchett: Sure. So, there's a whole host of factors that someone could look at to say, "What would affect my decision to buy an annuity?" And I'd say the number one factor in my research is how much you have in existing guaranteed income that's covering your need. So, if you want $80,000 per year and you have $50,000 from Social Security and pensions, you probably don't need a DIA or a SPIA as much as someone who has, say, much less coverage. So, again, you want $80,000 a year: You've got $20,000 from Social Security; that's someone who should really consider buying an annuity to guarantee that if their portfolio does poorly, they still have income for life.

Benz: David, thank you so much for being here. It's a big important topic. It's great to hear about your research.

Blanchett: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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