Risk And Return From Single Premium Annuities

by: John Walton

Risk and return from a suite of single premium annuity options are compared and explained.

Individuals with high longevity will benefit from moving some bond investments into single premium annuities.

Asymmetric knowledge between the investor and the insurance company is a potential source of alpha.

Editor's note: Seeking Alpha is proud to welcome John Walton as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »

Investments require an exchange of funds between two parties. Single premium annuities are where the investor gives a lump sum to an insurance company in exchange for lifetime income. This steady income is intended to supplement Social Security (in the U.S.) and replace a portion of the bonds in a portfolio.

Consider a portfolio with a mixture of bonds and equities related to risk tolerance. The retirement challenge is to convert the portfolio into an income stream that will last a lifetime (or two if married) and perhaps to leave remaining funds to charity or children. If the lifetime of the individual or couple were known the retirement income problem would be easier to solve, but that is not the case. If spending is too rapid, the money can run out prior to death and if spending is too low, lifestyle opportunities may be missed. If the portfolio has a high proportion of equities, a market downturn can destroy the portfolio, but if the portfolio consists mostly of bonds, inflation and lack of real return can be equally as destructive.

Single premium annuities deal with these problems and represent a potentially useful retirement income tool for some of the funds in a portfolio. David Blanchett and Michael Finke examined the beneficial role of annuities in a retirement portfolio. They conclude that annuities allow a greater fraction of equities in the remaining portfolio at the same risk level and the opportunity to provide a higher secure retirement income with fewer assets. Wade Pfau demonstrates how annuities outperform bonds in retirement portfolios.

The downsides of annuities are the loss of flexibility with the funds and the risk at dying during a time period subsequent to annuity purchase when the annuity investment will lose money. Usually, but not always, the greatest loss occurs when death occurs shortly after purchase. Annuities are essentially a bet with an insurance company on personal longevity.

The goal of this contribution is to illustrate and explain the different characteristics of some of the options available in single premium annuities. Single premium annuities come in a variety of options. Each option has a different risk/reward mixture and the tradeoffs between them are not obvious. It is important to understand these differences and have an overall perspective of when gains or loses money with an annuity.

A few calculations will help to put this in perspective. Quotes were obtained in August 2018 from ImmediateAnnuities.com. The site returns individual quotes from a set of participating insurance companies. In each situation below, the highest quote was taken irrespective of insurance company. The annuitant was assumed to be a 65-year-old male. The annuities are as follows:

  • Plain - the payout stops at death
  • Guarantee 10 - the first 10 years of payments are guaranteed and go to the beneficiary if the annuitant dies before 10 years
  • Defer 5, Defer 10 - The annuity is deferred 5 or 10 years from the date of the payment. If the annuitant dies prior to that time, all the money is lost.
  • 3% COLA - a 3%/year cost of living increase is built into the annuity. Initial payments are lower but increase with time
  • Refund - If the initial payment has not been fully paid back when the annuitant dies, the remainder is paid to the beneficiary

Source: Author's calculations

Source: Author's calculations

In each case the annuity is compared with the logical portfolio option, a bond fund with the same monthly payment. The bond fund is assumed to return 3% annual interest. When capital gains and losses are reinvested, bond funds return close the initial interest rate, about 3% at present. The profit/loss for the annuity purchase is scored relative to the hypothetical bond fund.

Investment losses occur any time the lines are less than zero; break-even is the age when the lines cross zero. Positive numbers mean the annuity made money relative to the bond fund (i.e., the bond fund went broke). The second graph expands the age when the annuity investments pass the break-even point. The numbers in the two figures are identical.

At age 70, the lowest risk (potential loss of 16% of initial principal) is with the refundable principal annuity, where all the remaining principal is refunded to the beneficiary upon death of the annuitant. The loss relative to the competing bond fund, is that the principal is not refunded with interest. An interest free loan to the insurance company costs money. Notice that, although the maximum potential loss is lower with the refundable option, the break-even age (line crosses zero) is the highest of any option at about age 87. This means that, of the options considered, the refundable annuity has the greatest probability of losing money, but the lowest probability of losing a lot of money.

The second lowest risk, at age 70, is the 10-year guaranteed annuity. The cost of this low early risk is that the break-even age advances to age 86, meaning greater probability of some loss relative to the plain annuity.

The plain annuity is third lowest in risk at age 70 and breaks even at age 84-85. It has the lowest loss from age 80-84 but is mostly bracketed between other options.

The 3% COLA annuity if fourth lowest in risk at age 70 and reaches break even around age 86. It never dominates risk or return in the figures but does become dominant around age 100 (not shown). It is only cost effective is longevity is very high (>100), a small proportion of the population. For this reason the COLA is not recommended.

The two deferred annuities provide very clear risk/return tradeoffs. If death occurs before age ~80 they have the greatest losses since no payouts occurred for the first 5 or 10 years. However, if one lives beyond age 85, they have the greatest returns until after age 100, when the 3% COLA finally passes them.

For any investor whose parents and/or grandparents lived into the mid 80's or beyond, or perhaps died at earlier age of now treatable health problems, replacing bonds in the retirement portfolio with annuities is attractive. The annuities have another benefit in that, when a high baseline income is guaranteed, the remaining portfolio can more safely be invested in higher risk/return assets such as stocks.

Another manner of looking at the return from annuities is to calculate the rate of return obtained based on the age of death. The third figure has the rate of return at death for the plain annuity (purple line) and the annuity that is deferred 10 years into the future (orange dots). For long lived individuals, the return from annuities is in the 5-7% nominal return range. For perspective, analyses of the CAPE ratio and P/B ratio suggest long term U.S. stock market returns of 4.5% real. With 2% inflation that would be 6.5% nominal return; the same return available as a secure income stream from an annuity.

Source: Author's calculations

Alpha (increased return at the same level of risk) occurs when one party in the economic exchange has more knowledge than the other. For most investments the investor is competing with a large number of highly talented, experienced, and motivated professional investors from around the world. This is why most individual investors have better success by sticking to low cost index funds with no trading.

Single premium annuities are different from most investments in this regard. When a single premium annuity is purchased, the investor makes a bet with the insurance company on longevity. No health information is provided to the insurance company when an investor purchases an immediate annuity. How long will the investor (or investor and spouse) live in relation to the average annuitant mortality tables used by the insurance company? The potential for alpha comes from this information asymmetry: The insurance company only has only conservative mortality statistics whereas the investor has family history, personal history, and personal behavior. This information asymmetry is a potential source of alpha.

More complex, seemingly attractive annuity options such as guaranteed return of principle, and inflation adjustment lower the risk of losing a larger sum of money for beneficiaries but counterintuitively increase the probability of loss by extending the break-even age. Deferred annuities, especially longer than 10 years, provide the opportunity for guaranteed equity-like returns.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.