In our last post, we asked whether now (or actually earlier this month) might be a good time to purchase a single premium immediate annuity (SPIA) to strengthen Floor Portfolios used to fund essential expenses. In that post (and prior posts) we focused on SPIAs that provide fixed dollar payments each month for life. In this post, we will discuss SPIAs that provide lifetime payments with annual fixed rate “cost of living adjustment” (or Cola) increases, and why you might want to consider this type of annuity rather than a fixed dollar SPIA to strengthen your Floor Portfolio. We include an example.
SPIAs with fixed rate Cola increases
Instead of purchasing a SPIA with monthly fixed dollar payments for life, one can purchase lifetime payments that increase annually by a fixed rate (generally between 1% and 5% per annum). This rate is agreed upon in advance in the insurance contract, and the annual rate of increase is independent of actual inflation. Because payments are designed to increase each year, they will start out less than an equally priced fixed dollar SPIA and eventually increase above the fixed dollar SPIA if the beneficiary lives long enough. The higher the contractual fixed rate cola, the lower the initial starting payment, all things being equal. Most SPIA sales in the U.S. involve fixed dollar (non-increasing) payments and U.S. insurance companies no longer offer products that increase payments based on the actual increase in inflation (i.e., based on increases in a consumer price index).
The expected present values of insurance company premium income and the present value of payments made to beneficiaries who purchase these contracts, be they fixed dollar payment SPIAs or the various fixed rate cola SPIAs, should be roughly equal based on investment returns assumed by the insurance company actuaries (net of expenses and insurance company profit margins) and assumed life expectancies of the anticipated pool of purchasers. Of course, the actuaries at different insurance companies make different assumptions, and the prices of SPIA products can vary significantly from company to company at any given time. This is why it is important to obtain quotes from several different highly rated carriers before actually making a purchase.
Once again, we remind you that we are not insurance agents or financial advisors and have no financial interest in any annuity purchase you may (or may not) make.
Why consider a SPIA with a fixed rate cola
Let’s assume you have the following goals/objectives with respect to your plan in retirement:
- Throughout retirement you want to match the present value of your non-risky investments with the present value of your expected future essential expense spending consistent with the Safety-First Investment Strategy
- You anticipate your future essential expenses will increase each year with inflation, and
- You anticipate you will live longer than your life expectancy
The example below shows that a SPIA with a fixed rate cola can help you better accomplish your objectives than a fixed dollar SPIA and can also reduce your reinvestment risk.
Example
Let’s assume that Bill is a single 65-year-old male. He is receiving an annual Social Security benefit of $18,000 and he estimates his annual recurring essential expenses at $25,000. Bill anticipates that these expenses will increase by inflation increases of 3% per annum. Using the default assumptions in the Actuarial Financial Planner (AFP) for Single Retirees (including a lifetime planning period of 29 years and a 5% discount rate), Bill calculates the present value of his annual recurring essential expenses as $561,069.
Bill then calculates the present value of his Social Security benefit using the same default assumptions to be $403,970. To match his Floor Portfolio assets with his estimated essential expense liabilities, he calculates he will need additional non-risky investments with a present value of $157,099 ($561,069 - $403,970) to cover the remaining $7,000 of annual real dollar essential expenses.
Let’s assume that Bill can purchase $8,000 per annum of fixed dollar lifetime income payable monthly starting in one month for a premium of $100,000. Based on his recent review of CANNEX annuity pricing, our friend and fellow actuary Joe Tomlinson tells us that reasonable pricing for a comparably priced lifetime annuity increasing by 2% per annum is about 83% of the 0% cola price, or in this example, $6,640 per annum for a $100,000 premium.
Using the AFP and the default assumptions, Bill determines the present value of the $100,000 fixed dollar lifetime income contract to be $127,185, or 27% greater than the contract’s purchase price.
It is a little more complicated for Bill to determine the present value of the $100,000 2% cola contract, but Bill accomplishes this by inputting the $6,640 annual amount as an indexed life annuity and overriding the inflation assumption and entering 2% per annum to determine the present value of this contract under default assumptions at $132,135, or 32% greater that the contract’s purchase price. (He could have also used our separate Present Value Calculator spreadsheet).
He determines that if he spends $125,000 instead of $100,000 on the contract premiums, he will have sufficient present values under either contract to more than match his essential expense liabilities. In this event, then, Bill will either receive $10,000 per annum for life under the fixed dollar contract, or $7,968 per annum, under the 2% increasing contract.
Both of these contracts will provide more than Bill needs initially to satisfy his essential expense spending ($3,000 more for the fixed dollar contract and $968 more for the 2% increasing contract). In order for Bill to use either of these contracts to match his anticipated essential expense spending, he will therefore have to save and invest the excess received in the early years in order to satisfy later year real dollar spending needs. This timing issue can create reinvestment risk.
In addition to providing a higher present value based on Bill’s assumptions for the future, the 2% increasing contract involves less reinvestment risk. Perhaps Bill should also explore purchasing a 3% per annum increasing contract.
Summary
Effective retirement planning involves matching household assets with household spending liabilities. If you are going to be conservative about how long you expect to live for determining your liabilities, you should presumably use consistent assumptions for how long you expect to live for determining your assets. This is why you should look at lifetime guaranteed insurance contracts because they favor those who live longer. And, as demonstrated in the example above, you may also wish to look at fixed cola SPIAs. To quote Joe Tomlinson,
“If I was purchasing a SPIA today, and wanted match up with expected fixed expenses not covered by Social Security, I would likely choose a COLA at a rough estimate of future inflation (2.5%?) rather than trying to get a bit extra with a level SPIA.”
Happy planning!
