Waiting Game

Dennis Ho

HOW DO DEFERRED income annuities work and how do they fit into a retirement portfolio? I’m a fan of DIAs—sometimes also called longevity insurance—because of their simplicity and range of benefits. Indeed, I sell them through the insurance website I run. But I also realize they aren’t for everyone.

With a DIA, you hand over a lump sum to an insurer in exchange for regular income payments. Like a standard lifetime income annuity, the payments are guaranteed, no matter what happens in the markets or how long you live. With a DIA, however, the start date for your payments is deferred at least a year and often far longer.

By delaying the payment starting date, DIA buyers can receive higher income, because insurers get to invest the funds for longer, plus buyers collect “mortality credits.” What are mortality credits? That refers to the fact that some DIA buyers will die young and their funds can then be used to make higher payments to those who live longer.

For example, a 65-year-old man investing $100,000 in a DIA could receive some $24,000 a year in guaranteed lifetime income starting at age 80, compared to $6,300 a year if he bought an annuity that starts paying immediately. Obviously, by the time the DIA starts at age 80, the immediate annuity would’ve already paid out a heap of money—$94,500. But in terms of total dollars collected, our 65-year-old DIA buyer makes up that lost ground by age 86. If he lives longer than that, the DIA starts pulling far ahead of the immediate annuity in terms of total income. (One nerdy point: If you figure in the time value of money—the fact that the immediate annuity pays you back sooner—the breakeven would be somewhat later.)

In effect, a DIA lets you maximize your income for your later years, while providing protection against both a financial market downturn and the risk that you run through your other retirement savings. A DIA can also help simplify the management of your remaining assets, because you have more certainty about your future income.

One possibility: A 65-year-old couple could purchase a DIA to cover all the income they’ll need starting at age 85 and then spend down their remaining assets over the intervening 20-year period. Alternatively, let’s say you have some other sources of guaranteed income, such as Social Security and a defined benefit pension. You might buy a smaller DIA to supplement this income in later years, thus helping to offset the corrosive impact of inflation on your pension’s fixed payments, while also ensuring you have extra income if you face higher medical expenses later in life.

Another way to use DIAs: Help with the transition to retirement. Imagine a 55-year-old woman who invests $10,000 a year in a deferred annuity, with payments starting at 65. Based on today’s rates, her $100,000 investment over 10 years would generate income of $7,500 a year starting at 65. By contrast, if she’d invested the full $100,000 at 65, she’d receive $5,950. Once again, the purchaser benefits from the mortality credits collected during the deferral period and she gets rewarded for letting the insurer use her money for longer. Other benefits of this strategy: It allows you to dollar-cost average into an immediate annuity, potentially protecting part of your portfolio from a severe market downturn prior to retirement.

DIAs have many uses and benefits—but they aren’t perfect. During the deferral period, you forgo the returns you could have earned with other investments, plus the promised payments will have less spending power, thanks to the intervening inflation. Also, there’s the risk you die young—and you’re the one who ends up subsidizing the mortality credits collected by others. If you pass away before a DIA starts paying, you lose your entire principal. DIAs are available with return-of-premium features, but that heavily diminishes the value of the product and means you should probably consider other strategies instead.

In addition, DIAs can make tax planning more complicated. With income annuities, a portion of each payment is considered interest and hence it’s taxable. Because DIAs have a higher interest component, a larger percentage of your payment will be taxable. When evaluating immediate and deferred income annuities, be sure to look at both the gross and taxable income. Both are available with any quote.

One final consideration: There’s the so-called counter-party risk—the risk that the insurer won’t be around to make your annuity payments. To limit this risk, buy from large insurers with a high rating for financial strength, and consider purchasing DIAs from multiple insurers.

Dennis Ho is a life actuary who has spent 20 years in the insurance industry in a variety of actuarial, finance and business roles. His previous articles include End GamePolicy Decisions and Works If You Can’t. Dennis can be reached via LinkedIn.

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