Evaluating SPIAs can be difficult because a SPIA quote is stated as a payout rate that looks attractive if compared to the yields or expected returns on other financial products, but this payout rate is not equivalent to the yields on other financial products. A SPIA's payout rate includes the following components:
- Investment returns
- Return of principal
- Mortality credits
That means that every SPIA has an implied investment return figure, a period over which principal is returned, and a mortality/actuarial component.
Now, if we knew the time period of payments, the payment amount, and the starting balance, we could figure out the investment return implicit in the SPIA quote. But you don't know how long you live, and the insurance company is using an actuarial estimate. Or, given the payment amount, starting balance, and an interest rate, we could estimate the insurance company's estimate of your life expectancy. But we can't derive a fair life expectancy figure (the payment period) AND interest rate just from a SPIA payout rate.
Hence, the way to evaluate a SPIA payout rate is to get some independent estimate of one figure (the interest rate or life expectancy) and then solve for the other figure, then do vice versa. I'll work out an example.
I begin with a SPIA quote from immediateannuities.com for a 70-year-old female in Iowa paying $100,000. With no cash refund or period certain, the payout is $657 per month, or an annual payout rate of 7.884%.
Estimating Return Given Life Expectancy
To estimate the implied return, I could use an estimated life expectancy like the Social Security Administration's actuarial life table. Per that table, a 70-year-old female has a life expectancy of 15.82 years. So I can plug in the following Excel formula to get a close estimate of the implied investment return in the SPIA: =RATE(15.82,7884,-100000,0).
EDIT: The first term in the formula above is the life expectancy (nper), the second is an annualized measure of the payment (pmt), the third term is the contract premium (pv, a negative number), and the last number is zero for the amount remaining when the annuitant passes away (fv).
In this case, the rate is 2.76%. Now, there are many people who believe the SSA actuarial table is not useful for this purpose because it covers the entire population, while those who purchase SPIAs tend to be wealthier, healthier, and longer-lived. So, I consulted the Bankrate Life Expectancy Calculator, answering various questions for my hypothetical 70-year-old woman in a reasonably healthy but not active way, resulting in a life expectancy of 18.5 more years. Using that for the formula, =RATE(18.5,7884,-100000,0), results in an implied return of 4.2%. So you can see health and life expectancy matter for evaluating the rate.
Estimating Life Expectancy Using Interest Rate Proxy
To gauge the insurance company's life expectancy estimate, we can use a proxy interest rate like the 20-year Treasury bond, which is currently yielding 4.06% (at the time of writing). We plug that into the following Excel formula: =NPER(0.0406,7884,-100000,0).
EDIT: The first term in the formula is the proxy interest rate entered as a decimal (rate), the second are the annualized payments (pmt), the third is the contract premium (pv, a negative number), and the last number is zero for the amount remaining when the annuitant passes away (fv).
The result is 18.18 years. So, this is saying that if the insurance company starts with a rate of 4.06%, its quote is assuming a life expectancy of 18.18 years. As a purchaser, the hypothetical 70-year-old female in Iowa could evaluate whether she believes this figure is reasonable.
Estimating Return with COLA Given Life Expectancy
EDIT: Now, another wrinkle is that many BH would consider getting a SPIA with a COLA. We have a very good approximation to the interest rate estimate above by adding a simple multiple. In this case, I have gotten a quote for a 70-year-old woman in Iowa putting in $100,000 but also getting 2% annual increases. The monthly payments for her would start at $554, or $6648 annually. The formula would be =(1+RATE(18.5,6648,-100000,0))*(1+.02).
The first value 18.5 is the life expectancy (nper), the second value 6648 is the starting annualized payment (pmt), the third value -100000 is the contract premium (pv, a negative number), and the fourth value is the remaining amount after the annuitant passes away, or zero (fv). Note also that the specific COLA is added at the end as .02.
Unsurprisingly, this formula shows a discount rate or implied rate of return of 4.26%, pretty close to the quotes on the non-COLA annuity.
Kudos to #Cruncher for suggesting this approximation.