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Uncle Sam will 'sell' you a single-premium immediate annuity (SPIA) for 50% off the insurance company price?

Uncle Sam will 'sell' you a single-premium immediate annuity (SPIA) for 50% off the insurance company price?

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This article was posted September 1, 2014.

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Last November Retire Early noted that single-premium immediate annuities (SPIA) are a bad deal for most people. Several readers asked "How can this be?" It seems that every day there's another article from a financial "expert" extolling the virtues of using an SPIA to provide a pension-like gauranteed income in retirement. But you never hear anyone talk about the hidden costs of these insurance products and the fact that Social Security will essentially 'sell' you an annuity for 50% less than an insurance company charges.

To understand why immediate annuities are a bad deal, you have to look at life insurance.

If you shop for life insurance, you'll find that prices vary wildly based on your health. A 40-year-old nonsmoker in good health pays considerably less than than a smoker with a chronic disease like diabetes or hypertension.

Life insurers typically classify applicants into four rating categories; Preferred Plus, Preferred, Standard, and Substandard. The table below shows the range of monthly premiums for a 40-year-old male. A standard risk applicant would pay a premium that is 39% higher than a Preferred Plus risk (i.e., $106/month versus $76/month.)

Monthly Life Insurance Premium
40-year-old male, $1 million death benefit, 20-year term
Source: MetLife online quote

Percent of
Rating Class Monthly Premium
15% Preferred Plus
35% Preferred
35% Standard
4% Substandard
10% Standard
1% Substandard

The highest rating class, Preferred Plus, would typically require the applicant to meet the following criteria:

--------Figure One. Preferred Plus Underwriting Criteria---------

1) Body Mass Index (BMI) of 25 or less.
2) Excellent health history with no serious or chronic illnesses or ailments.
3) Immediate family has no history of cardiovascular disease or internal cancer
before the age of 60.
4) Never smoked, or quit more than five years ago.
5) Doesn't participate in high-risk recreational or occupational activities such as hang
gliding, rock climbing, motorized racing, offshore oil drilling, underground mining, etc.
6) Excellent credit score with no bankruptcy in the last few years.
7) LDL cholesterol level 220 or less and LDL/HDL ratio 5.0 or less.
8) Blood pressure less than 140/85.
9) Clean driving record with no more than one or two moving violations in the last
three years and no DUIs or reckless-driving convictions in the last 5 years.
10) Never required treatment for drug or alcohol abuse.

There is no medical underwriting for single premium immediate annuities.

While insurers charge female annuitants about 10% more than men since they tend to live longer, there is no variation in pricing based on one's health. Life annuities pose a mirror image risk for insurers when compared to life insurance. An insurer wants his life insurance policyholders to live as long as possible and keep paying premiums. That's why the healthiest people pay the lowest rates.

In contrast, the insurer collects the full lifetime premium for an annuity up front, so it's in their financial interest for the annuitant to die sooner rather than later. It's the people that live to a ripe old age and collect the monthly benefit for decades that cost the insurer the most money. To protect against this risk, insurers price annuities with the assumption that their annuitants are going to look something like the Preferred Plus risk described in Figure One above. If you're not that healthy, you have no business buying an annuity from a commercial insurance company. Otherwise you'll be paying far more for it than it's worth.

Uncle Sam will "sell" you an annuity for 50% less than what an insurance company would charge?

It's true. It's fairly common today to see articles advocating that retirees delay taking Social Security as long as possible. If you wait until age 70 for your first monthly check, it will be about 72% larger than if you start benefits at age 62.

But what these articles don't tell you is that by delaying taking Social Security until age 70, you are essentally "buying" an inflation-adjusted life annuity from the US Gov't at a 50% discount to what an insurance company would charge. How can it be 50% less? The biggest reason is that Social Security administration bases their mortality calculation on the average Social Security beneficiary rather the longer-lived, 'Preferred Plus' risk used by commercial insurers. That makes a big difference in the price. If you are heathier than the average person and likely to live longer, it's an even better deal.

The table below illustrates this result for a 62-year-old (born in 1944) who retired in 2006 with the maximum benefit. It's interesting to note that "buying" an annuity from the Social Security Administration costs a 70-year-old female 53% less than purchasing the same benefit from a private insurer (e.g. Principal Life). For a 70-year-old male, it's 48% less.

Take Social Security Benefits From Age 62 to Age 69, Cumulative After-Tax Value at Age 70
Social Security Benefits ----- Save & Invest the SS Benefits
Year Age COLA Monthly
Amount of
SS Benefit
subject to tax
Tax Paid at
tax rate
After tax
----- Jan 01 Bal After-tax
@ 2.00%
Tax on
@ 25.00%
Dec 31 Bal
2006 62 4.10% $1,530 $18,360 $15,606 $3,902 $14,459 ----- $0 $14,459 $217 -$54 $14,621
2007 63 3.30% $1,580 $18,966 $16,121 $4,030 $14,936 ----- $14,621 $14,936 $516 -$129 $29,944
2008 64 2.30% $1,617 $19,402 $16,492 $4,123 $15,279 ----- $29,944 $15,279 $828 -$207 $45,844
2009 65 5.80% $1,711 $20,527 $17,488 $4,362 $16,165 ----- $45,844 $16,165 $1,159 -$290 $62,879
2010 66 0.00% $1,711 $20,527 $17,488 $4,362 $16,165 ----- $62,879 $16,165 $1,500 -$375 $80,170
2011 67 0.00% $1,711 $20,527 $17,488 $4,362 $16,165 ----- $80,170 $16,165 $1,846 -$461 $97,719
2012 68 3.60% $1,772 $21,266 $18,076 $4,519 $16,747 ----- $97,719 $16,747 $2,206 -$551 $116,121
2013 69 1.70% $1,802 $21,628 $18,076 $4,596 $17,032 ----- $116,121 $17,032 $2,578 -$644 $135,086
Total SS benefits $161,205 . $34,256 . ----- Total Earnings $10,850 $2,713 .
Federal Taxes Paid -$34,256 . . . ----- Tax @ 25% -$2,713 . .
After-tax Interest Earned $8,138 . . . ----- After-Tax Total $8,138 . .
Net Value of SS Benefit $135,086 . . . ----- . . . .
Monthly Social Security
Benefit @ Age 70
$3,114 . . . ----- . . . .
Increase in Monthly SS Benefit
($3,114 - $1,802) =
$1,312 . . . ----- . . . .
Cost of inflation-adjusted life
annuity @ age 70 with a $1,312/month benefit
purchased from insurance company
$259,645 for Male $284,966 for Female ----- . . . .
Savings: Soc. Security @ age 70 vs. life annuity = $124,559 for Male $149,880 for Female ----- . . . .

If you want to run your own numbers, you can download a copy of the Excel spreadsheet, click here. (file size= 30 KB)

What conclusions should you draw from this analysis?

If there is any chance you'll want to buy an annuity in retirement, the cheapest way to do so is to delay taking Social Security until age 70. If you need a $1 million annuity, it still makes sense to delay Social Security until age 70 and get the 50% discount on your first $250,000 or so in premiums, and then pay the inflated insurance company price for the remaining value up to the $1 million you want.

I don't know about you, but if I found $125,000 scattered on my kitchen floor, I'd pick it up. You should too.

Resources for more information

Optimal Annuitization with Stochastic Mortality Probabilities: Working Paper 2013-05 , By Felix Reichling and Kent Smetters

IS ADVERSE SELECTION IN THE ANNUITY MARKET A BIG PROBLEM? , Anthony Webb, 2006, Boston College, Center for Retirement Research

The Annuity Puzzle and Negative Framing by Jeffrey R. Gerlach,Julie Agnew,Lisa R. Anderson and Lisa R. Szykman, 2008, Boston College, Center for Retirement Research

The Principal Financial Group annuity quotes a listing of their current annuity payouts.

Berkshire Hathaway annuity quotes online calculator gives you an immediate quote.

Forbes magazine Guaranteeing Lifetime Income.

Assessing Investment and Longevity Risks within Immediate Annuities, Daniel Bauer, Frederik Weber, 2007, Munich School of Management.

Immediate Annuity Pricing in the Presence of Unobserved Heterogeneity , Kim G. Balls, 2004, Managing Retirement Assets Symposium - Society of Actuaries

Hewitt Associates - 401(k) index some interesting information on how people allocate their retirement acounts.

Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, by R.G. Ibbotson, M.A. Milevsky, P. Chen and K.X.Zhu

Social Security Handbook -- information on your Social Security benefits.

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Copyright 2014 John P. Greaney, All rights reserved.

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