Three Flies in the Ointment of American Financial Planning
The following content is adapted from the book Tax-Free Income for Life by David McKnight.
In a previous article, I shared how guaranteed lifetime income in the form of a single premium immediate annuity (SPIA) is clearly adept at eliminating longevity risk in a far less capital-intensive way than the traditional stock market approach. What’s more, it confers a long list of psychological, mathematical, and longevity benefits that can smooth out an otherwise rocky road in retirement.
If ever there were a simple, effective solution to ensure you never run out of money, it’s the SPIA. All this of course begs the question: If the guaranteed- income approach to vanquishing longevity risk is so compelling, why do so few Americans take advantage of it? Market studies have shown time and again that America’s inherent aversion to annuities boils down to three principal complaints: lack of liquidity, lack of inflation hedge, and the Mack Truck Factor. Let’s examine all three.
Lack of Liquidity
The first perceived shortcoming of the SPIA is its lack of liquidity. There’s no getting around the fact that in order to receive a guaranteed stream of income for life, you have to surrender liquidity on a portion of your retirement assets.
You give an insurance company a chunk of your stock market portfolio and they, in turn, give you a stream of income that’s guaranteed to last as long as you live. Even though the myriad mathematical, psychological, and health benefits that stem from this exchange have been lauded by study after study, investors can’t seem to wrap their brains (or their hearts) around it. Let’s face it, there’s something reassuring about having a vast supply of cookies sitting in the cookie jar on the kitchen counter that can be accessed at a moment’s notice.
Lack of Inflation Hedge
The second objection investors have to the SPIA is its lack of an inflation hedge. When you purchase a SPIA, the insurance company sends you a fixed payment every month for the rest of your life. In their most common form, SPIAs are not designed to keep pace with inflation. This can be a jagged little pill for many investors who are good at math and understand the eroding effects of inflation over time.
Here’s an example to illustrate:
Let’s say you gave an insurance company $500,000 in exchange for a guaranteed lifetime stream of income of $2,500 per month, or $30,000 per year. That $30,000 payment, coupled with your Social Security payments, may be perfectly sufficient to cover your income needs in the here and now. But how about 30 years from now? If the Rule of 72 holds true, then the purchasing power of that $30,000 payment will be more than cut in half by the end of that 30-year time frame. So, what started out as a perfectly sound income plan at the beginning of retirement turns into bare-bones, subsistence-type living by the end of it.
To combat this concern, some financial experts simply suggest that you pour even more money into the SPIA in the short term, leaving a buffer for inflation over time. For example, if you need $30,000 to close your income gap today, you might purchase an annuity that gives you $50,000 of income. And while you won’t need the full $50,000 today, that inglorious day will soon arrive, thanks to the inexorable effects of inflation. And because you built this inflation buffer into your income plan at the outset, you’ll be shielded from its effects later in retirement.
While building an inflation buffer into your income annuity seems like a reasonable approach to combating inflation, it requires even more capital in the here and now. This, of course, feeds into the primary objection to SPIAs we discussed earlier: loss of liquidity. In other words, it is possible to solve the inflation conundrum with a SPIA, but only by surrendering an even larger portion of your liquid retirement assets to an insurance company at the outset.
The Mack Truck Factor
The last objection to the single premium immediate annuity is what I call the Mack Truck Factor. Here’s how it works:
Let’s say you just handed $500,000 over to an insurance company in exchange for $30,000 of annual guaranteed income for life. You did so in part because you have a Methuselah gene and have every intention of outliving everyone else in the risk pool. You are intent on beating the insurance company at their own game. And then it happens. Two years into retirement you step off the curb and get flattened by a Mack truck. Boom. Game over. Your annual payments come screeching to a halt and the balance of your $500,000 goes to subsidize the guaranteed lifetime income of everyone else in the risk pool. Not only did you lose all that future income, but your heirs got cut out of the equation as well. This possibility, however unlikely, strikes retirees as supremely unfair and discourages a huge number of Americans from ever entering into the transaction.
How Can We Overcome Perceived SPIA Deficiencies?
The three aforementioned complaints are not without merit, and insurance companies know this. In my next article, I’ll share how they have responded to the perceived deficiencies associated with the SPIA. Until then, remember you can always visit the Hanson Blog to read past articles.
If you’d like to discuss how to guarantee your own income for life and you have not yet implemented a strategic plan with Hanson Wealth Management, please reach out for a consultation to see how this wisdom could look in your world. My approach to a secure retirement includes lowering your tax burden and optimizing your income streams with the objective of achieving a tax-free retirement so you can truly live your best life.