Deferred and single premium income annuities have key value propositions, but buyers should consider an array of questions before deciding they're a good fit.
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By Mark Miller | 03-13-14 | 06:00 AM | Email Article

My last column looked at the sales traction that insurance companies are getting with deferred income annuities, or DIAs. In this column, I'll consider the pros and cons of using a DIA as part of a retirement portfolio plan, and expand the conversation to include the DIA's first cousin: single premium income annuities, or SPIAs. We'll also consider questions of timing an annuity purchase and how to get unbiased guidance.

Retirement columnist Mark Miller writes about trends in retirement, aging, and the economy. He is the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living, and writes a syndicated column for Reuters. Mark blogs at RetirementRevised.com Twitter: @retirerevised.

Income annuities--whether deferred or immediate--have two key value propositions. One is certainty about income and a hedge against longevity risk--running out of money at a very advanced age. The second is the potential of higher returns via a mortality credit or yield: The premiums paid by buyers with less-than-average longevity provide higher yield to those who live longer.

But potential annuity buyers should ask themselves an array of questions before deciding this solution is a good fit.

1. First Things First: Annuity or Social Security?
Before buying a commercial annuity, consider meeting your income goals through a delayed claim of Social Security benefits. This is a way of "buying" an annuity from Social Security, if you consider the cost to be spending portfolio assets and/or income from work in the early years of retirement to fill any gap in living expenses, before claiming Social Security at a later age.

The cost of a Social Security annuity will beat anything available in the commercial market, and it comes with free inflation adjustments--the annual cost-of-living adjustment, or COLA, awarded to beneficiaries. COLAs also are factored into your benefit while you delay filing. This strategy can also stretch your portfolio's life by as much as 10 years.

A study by the Center for Retirement Research at Boston College found that a Social Security annuity beats a commercial annuity handily. The price of the Social Security annuity benefits from its unisex mortality ratings, whereas in the commercial annuity market, women pay more because of their longer life expectancy. Insurance companies also must charge more for inflation protection and spousal and survivor features, all of which are provided at no charge by Social Security.

"I would always start by optimizing Social Security," says Joe Tomlinson, principal of Tomlinson Financial Planning, who has done extensive research and writing about annuities. Tomlinson also has analyzed the rate of return from a delayed Social Security filing.

2. How Much Annuity Should I Buy?
If you've already optimized Social Security, an income annuity can be used to plug any projected gap in nondiscretionary expenses. Start with your projected total expenses for housing, food, utilities, transportation, and health care, and subtract guaranteed income you already can count on from Social Security and a defined-benefit pension (if you're lucky enough to have one). The gap between those two figures is what you might consider filling with an income annuity.

"If you start with your basic living needs and get those covered by Social Security and an annuity, your other investments can be used for discretionary spending, like vacations or gifts for your grandchildren," says Steve Vernon, a research scholar at the Stanford Center on Longevity and an actuary. "That's a general strategy that would work very well for many people."

3. When Should I Buy?
DIAs are being marketed to pre-retirees in their 50s or early 60s, with income starting at age 65 or 70. How does that approach compare with waiting to buy a SPIA at the point of retirement or later?

Market-timing is one argument in favor of using a SPIA instead of a DIA. The current low-interest-rate environment makes income annuities more expensive to purchase, and you're locking in a low rate. If you think interest rates will jump, it might be tempting to wait out the market.

The key question here, Vernon argues, is how you'll invest your money in the intervening years--and how long you're prepared to wait.

"If I'm very sure interest rates will go up, then you would probably just be in cash, earn nothing, and hope interest rates rise and your money would buy a better SPIA [later]," he says. "That would work if rates go up, but we might be waiting a long time for interest rates to rise significantly. It's a tricky challenge to know whether you'll do better by investing now and buying a SPIA five years down the road. On the other hand, if I'm in my 50s or early 60s, another argument to buy a DIA is that I can let the insurance company manage the interest rate and mortality risk.

"It's a series of trade-offs," he adds. "Buying a DIA at age 55 is like locking in a very long-term interest rate that protects you for the rest of your life. It's like buying a long-term bond with mortality pooling."

4. Where Should I Get Advice?
It's critical to get objective advice for any aspect of retirement planning, and annuities are no exception

I'm a big believer in working with registered investment advisors, or RIAs, who are required to meet the so-called "fiduciary standard," which is a legal responsibility requiring an advisor to put the best interest of a client ahead of all else. Many stockbrokers, broker/dealer representatives, and people who sell financial products for banks or insurance companies are not fiduciaries, and they are subject to a weaker "suitability" standard (though this is subject to ongoing debate and possible new rulemaking as a result of the Dodd-Frank financial-services reform law).

It's certainly possible to get balanced advice from a nonfiduciary adviser, broker, or agent, but the difference between "best interest" and "suitability" can be huge. A product might be "suitable" for you without necessarily being the best solution available in the marketplace. Compensation also is an issue; it's important to understand if the person advising you is compensated primarily on commission, and to weigh that in your decision-making and be on the lookout for conflicts of interest.

The stakes here are big; insurance companies are jostling alongside other financial-services providers for a share of the wave of rollover dollars moving out of workplace retirement plans and into IRA accounts. (A large share of DIA sales occur inside IRAs because outright withdrawals from workplace plans generate penalties for buyers younger than age 59 1/2). 
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