Unlocking the Two Mysteries behind SPIAs

Two mysteries confound planners who purchase single-premium immediate annuities (SPIAs) for their clients: Why does the present value of a SPIA often exceed its cost, and why do equity allocations appear to increase when a SPIA is purchased? Unlocking those mysteries requires advisors to use a different framework – based on the household balance sheet – for the withdrawal phase of retirement.

Building a retirement income strategy requires more than just deciding on a withdrawal rate for a client's financial assets. The client’s entire household balance sheet must be considered, matching assets (human, social and financial) to liabilities (essential and discretionary expenses). A crucial aspect is monitoring the present value of income from single-premium immediate annuities (SPIAs).

I’ll show how those mysteries are solved in the context of a household balance sheet, but first let’s look at how advisors can determine the present value of a SPIA.

Quantifying the present value of a SPIA

Innovative thinking on the topic of retirement income has come from the Retirement Income Industry Association (RIIA). The association establishes the household balance sheet as the central point from which advisors develop retirement income options for their clients. On the asset side, a client’s balance sheet includes not just financial assets, but also social and human capital, such as continued part-time employment and Social Security benefits.

Many individuals tend to shy away from purchasing SPIAs because they prefer to see assets appearing on their financial statements. This feels tangible and real to them. When they annuitize, it is as if their financial assets have been replaced by a much more abstract notion of a guaranteed income stream.

Many clients have difficulty quantifying the full value of a guaranteed income stream, and they don't think of it as part of their balance sheets. How much is a guaranteed income stream of $10,000 per year for life worth? Clients may be hard-pressed to give an answer, but actuaries can. Their answers provide a basis for valuing SPIAs.

As a refresher for how this works, Table 1 provides a set of calculations for a guaranteed income for life owned by a 65-year-old male. We need two key pieces of information to calculate its present value. First, we require a reasonable discount rate with similar risk characteristics as the annuity payments. Intuitively, the payments received in the future are worth less than the payments received sooner, because if we had the income today we would be able to invest it in an asset earning the discount rate, which would grow to provide the same future income as the annuity payment. Table 1 is created using a 2% discount rate and shows the discounted values of the future income stream.