Single premium immediate annuity

A single premium immediate annuity (SPIA), also known as a fixed life annuity, can be used to provide regular income during retirement. The annuitant hands over a lump sum to a life insurance company (single premium). The constant (fixed) payments will start almost immediately, for example in one month, and last as long as the annuitant is alive. For a couple buying a joint annuity, payments will last as long as one annuitant is alive. There is also the option of a guaranteed minimum number of payments, but this typically reduces the annuity's regular payment.

Annuity payments are a combination of return of capital (getting your own money back), interest, and mortality credits. The latter consist of transfer of capital from annuity holders who die earlier than statistically expected to those who live beyond their life expectancy. This mutualizes the risk of dying old and potentially running out of money. In other words, SPIAs provide protection against longevity risk, and also investment risk, on the annuitized capital. Therefore, the academic literature strongly favours them as a decumulation method. A separate factor is that non-annuitized wealth is psychologically more difficult to spend than annuitized wealth (government pensions, DB pensions, annuities); Blanchett and Finke (2021) estimate that "every $1 of assets converted to guaranteed income will result in twice the equivalent spending compared to money left invested in a portfolio". Another advantage of SPIAs (over self-managed drawdown strategies) is preventing bad investment decisions later in life due to cognitive decline.

However, the vast majorities of SPIAs sold in Canada provide nominal payments, i.e. there is no protection for inflation. Another downside of SPIAs is that the capital won’t be available for emergencies and bequests. Life annuity purchases is not reversible, partly explaining why they are not more popular: only about 10% of Canadians aged 55 to 75 own one according to one survey. But complete annuitization is not generally required: instead, life annuities can be combined with an investment portfolio.

The overview article on annuities explains annuity basics, types of annuities other than SPIAs, and covers taxation issues, payout rates, how to buy annuities, and consumer protection. In contrast, the current article aims to cover SPIAs in more detail and address topics like pros and cons of using SPIAs for retirement income, how much wealth to annuitize, and when to do so. It also mentions alternatives to life annuities.

Understanding SPIAs

Comparison with life insurance

A SPIA is like life insurance in reverse. With life insurance, you make a series of payments to the life insurance company (the monthly or yearly premia) and your heirs receive a lump sump (the death benefit). With a SPIA, you supply a lump sum to the life insurance company and you receive back a series of regular payments (made monthly, quarterly, semi-annually or annually), typically for life. So SPIAs are a form of longevity insurance.

… risk pooling allows everyone to spend more because then everyone can spend like they're going to live to their life expectancy rather than being worried about well, what if I live to 95 or what if I live to 100?

Similarly, men pay more than women for life insurance at the same age because they tend to die sooner, on average. For the same reason, single life annuities cost less for males than for females of the same age, for the same periodic payment. Stated differently, for the same capital put into a SPIA, men will get higher regular payments because their life expectancy is shorter.

Comparison with bonds

Life insurance companies mostly invest the premia from SPIAs in corporate and government bonds. So it is worth comparing SPIAs with bonds and exploring how bond interest rates influence SPIA payouts.

When buying an individual bond, you get regular interest payments, and then the principal back at maturity if the issuer does not default. Calculated bond yields take only interest payments into account: they do not include the principal.

With a SPIA, you typically don't get your capital back at the end (unless you die during a guarantee period, in which case your heirs will get something; see below). This allows SPIAs to have higher payout rates than bonds: you get some of your capital back as part as each payment. The second reason that SPIAs pay more than bonds is mortality credits: those who die young subsidize those who survive longer.

The following graph illustrates the effect of bond interest rates on annuity payout rates. It plots the theoretical annuity payout rate, for a hypothetical inflation-index SPIA purchased at age 65, versus the real interest rate on an inflation-indexed US government bond at the time of purchase, based on certain assumptions about mortality probabilities and insurance company overhead charges:

At age 65, even with zero percent real (after-inflation) returns in the government bond market, hypothetical inflation-indexed SPIAs should have payouts in the 4-5% range for females versus males, based on those calculations.

Single or joint

Life annuities come in two different forms, single or joint. Single Life annuities pay a periodic income as long as the sole annuitant is alive. Joint Life annuities pay a periodic income as long as one of the two joint annuitants is alive.

Reducing or not

For joint annuities, if the forecasted cost of living is less for one person than for two, the couple may opt for a less expensive "reducing" joint annuity, which pays less after the first person dies. Most couples however select the "non-reducing" version, in which the income is constant, regardless if two or only one annuitant(s) are still alive.

Guarantee period

A typical concern of investors looking at annuities is that they might die quickly, before having gotten back a significant portion of their capital in the form of periodic payments. To alleviate this concern somewhat, providers offer guarantee periods during which periodic payments will be made whether or not the annuitant(s) is/are alive. Guarantees can last up to 20 years or more, but can't extend beyond the annuitant 90th birthday (e.g., ). Longer guarantee periods cost more, in the form of lower payout rates. If the annuitant(s) die during that period, heirs can choose a lump sum option (a "death benefit"). At the end of the guarantee period, payments continue if the annuitant(s) is/are still alive.

In the case of a Joint Life Reducing Annuity with a guarantee period, the reduction in periodic payments resulting from the death of the first annuitant would only happen after the guarantee period.

Milevsky notes that most purchasers opt for a guarantee, but that this waters down the benefits of longevity risk pooling. I.e., if you want to benefit from other people's money if you live long, you must be willing to transfer your capital to other people in the pool if you die sooner than expected. This is illustrated by the following graph showing the monthly income that could be obtained from a $100k SPIA purchase in August 2012, for males 55 to 80 year old and females 75 to 80 year old (to avoid overcrowding the plot; see for the full data), in the US:

The decline in payout rates as the guarantee period lengthens -- Milevsky's "watering down" -- is more obvious for older purchasers. At these ages, probabilities of living another 15-20 years are significantly less, and mortality credits are more important; taking a long guarantee period lowers these credits significantly. For younger purchasers, e.g. aged 55 to 65, short guarantees such as 5 years are inexpensive, because they are unlikely to apply; so a case can be made to take them, especially if this helps to overcome the annuity purchaser's reluctance.

Even if theoretically, SPIAs without a guarantee should have higher payouts (all else equal), there may be situations where the guaranteed version has a a higher payout, especially for younger annuitants, so it is potentially worth looking at those as well, even if the intent is to get a life-only SPIA.

Refund option

Another feature is designed to appeal to people concerned with potential early death: the refund option. If the annuitant dies before the total payments from the annuity equal the premium paid, then the beneficiary will get a refund. This can be a lump sum or extra payments if the annuity is non-registered. Of course, there is a price for this option.

Indexed or not

Most life annuities sold in Canada pay a fixed amount per payment, with no indexation for inflation. So over time, the purchasing power of the monthly payments decreases. This is especially problematic for non-indexed annuities purchased at a relatively young age: the annuitant may face many decades of inflation. For example, at 3% inflation, in about 24-25 years the original $10 000 of annual annuity income will only be worth about $5000 in today's dollars. Stated differently, what used to cost $10k during the first year of annuity payments will cost about $20k in nominal dollars in 24-25 years, but the annuity will still be paying the same $10k.

There are two main solutions. The first is to buy an additional non-indexed SPIA when the purchasing power of the first one has declined too much. The second is indexed annuities. Those are rare in Canada, and payments typically increase by a fixed predetermined percentage every year (e.g., 1% to 5%) rather than being indexed to the actual cost of living. One exception that some defined benefit pension plans offer inflation-indexed annuities that can be purchased using additional voluntary contributions, which themselves can be funded through RRSP transfers.

Prescribed or not

When purchasing an annuity with non-registered (post-tax) funds, there are two possibilities in terms of the tax treatment: prescribed or not. The income tax treatment is generally better for prescribed than for non-prescribed annuities (e.g., ). Details are discussed under "Taxation" in the annuity overview article.

Pros and cons

Benefits of annuitization

• Sustained income for life
• Stable income facilitates financial planning
• Protection against longevity risk, investment risk and sequence of returns risk
• Benefit from mortality risk pooling, if the annuitant lives long
• Licence to spend: because longevity risk is addressed, annuitized wealth is easier to spend, for both rational and behavioural reasons
• In the case of partial annuitization, the retiree can worry less about the performance of the remaining portfolio, which can allow higher equity allocations to be tolerated
• Peace of mind: "no need to take further investment decisions about the money you’ve deposited", including in cases of cognitive decline

Drawbacks of annuitization

• Loss of liquidity (the decision is not reversible)
• Loss of bequest (except if the annuitant dies within a guarantee period)
• Income needs may vary over time, including unforeseen expenses
• Not favored for people with short life expectancies
• The market for inflation-indexed annuities is "nearly nonexistent in Canada"

Other reasons for the lack of popularity

• Behavioral biases including decision framing, mental accounting, regret aversion, and misinformation
• Financial advisors paid a percentage of assets every year will not typically recommend them
• Ignorance: 29% of Canadian survey respondents aged 55 to 75 "were never offered one or ever thought about such products" or "do not know what annuities are"
• For some Canadians, access to employer-sponsored defined benefit pension plans which may already provide enough stable retirement income
• Some people cite "insufficient savings" as the reason for not buying an annuity, although depending on the company, minimums can range from $10k to $50k

How much to annuitize

What proportion of one's assets to annuitize, if any, depends on one's financial situation and life expectancy as seen above, but also to some extent on personal preferences and attitudes that control which retirement income style appeals to each investor.

Safety-first endmember

Investors in the "safety-first" school of retirement planning will want to ensure a certain level of guaranteed income to cover a retirement income floor, i.e. the lowest level of retirement spending that can be accepted. That income floor may cover significantly more than just the basic needs.

The guaranteed income will be provided through Old Age Security, Canada Pension Plan/Québec Pension Plan, and any workplace pensions that offer regular guaranteed payments. If those sources are not enough, then a portion of the portfolio should be "pensionized". This means using fixed income products and life annuities, perhaps with a significant portion of one's assets in some cases (if necessary): this is a liability matching process. The proportion of the portfolio to be pensionized depends on the "liability" (required guaranteed income) to be matched, not on any rules of thumb.

The remainder of the financial assets would be used to support a preferred budget (discretionary spending), with an "aspirational portfolio" invested in stocks and bonds.

Probability-based endmember

Investors in the "probability-based" (or conventional) school often like to keep full control of their financial assets, and will rely partly on stock market returns or other risky assets to fund their retirement. They manage their portfolios for "total returns". They make portfolio withdrawals to fund their retirement expenses, for example using a sustainable withdrawal rate to try to minimize the likelihood of premature portfolio depletion and maximize the odds of meeting their lifestyle goal.

Investors in this "self-managed drawdown" or total return camp are unlikely to view life annuities favorably: for them, the 'cons' listed above outweigh the 'pros'. They might be looking at the retirement income problem more with an "investment" point of view than with a "consumption" point of view.

Hybrid strategies

Hybrid strategies combine annuities with self-managed drawdown, with an attitude somewhere between the endmembers of "safety-first" (where life annuities could play a very large role) and probability-based (where life annuities typically play no role at all). As has been discussed by Milevsky and Macqueen, partial annuitization can significantly reduce the risk of running out of money.

Hybrid strategies come in many forms. Examples include:

• Using SPIAs, annuitize just enough to provide a basic income (if other sources of pension income are not sufficient)
• Delay annuitization (to a predetermined age or portfolio value) and then buy a SPIA
• Laddered annuitization, with SPIA purchases spread over time
• Buy an advanced-life deferred annuity (ALDA) and self-manage the remaining portfolio in the interim (before the ALDA starts paying at an advanced age)

When to annuitize

Effect of age and mortality credits

The cash flow one receives from an annuity is comprised of three streams: return of principal, interest on principal, and mortality credits. Mortality credits are the result of living longer than the others in the annuity pool. When one annuitizes in one's sixties, interest on principal is the main influence on the income stream. By the time one is in their late seventies, mortality credits comprise about 80% of the return.

To illustrate this, the following graph plots the theoretical annuity payout rate versus the annuity purchase age for a hypothetical inflation-indexed SPIA (remember those don’t really exist commercially in Canada), assuming a 1% real (after-inflation) interest rate, and certain assumptions on mortality probabilities and insurance company overhead charges:

Using non-indexed SPIAs typically sold in Canada, the following table illustrates the monthly income (best quote out of 6 companies) that can be obtained with a $100 000 purchase using registered funds for single females and males, with no guarantee period, as of April 2023. The bold number in the first row is the age of the annuitant upon purchase:

-	55	60	65	70	75	80
Male	$495	$538	$599	$679	$782	$968
Female	$475	$516	$565	$628	$698	$865

This increase in payouts with age, on its own, is not a sufficient reason to wait to buy a SPIA: yes, payments will be higher, but the annuitant will get fewer payments. Plus, the investor has to self-manage the funds (and probably make withdrawals) during the waiting period, which may produce better or worse results than buying a SPIA upon retirement.

So what is the optimal time to annuitize?

All-or-nothing scenario

Milevsky and Young (2007) discuss two cases. In the first hypothetical case, the person must choose to annuitize his/her entire wealth, or not, at a certain age. This could correspond to the option of converting investments from a defined contribution (DC) pension plan into an annuity for example. Since the purchase of an annuity is irreversible, and because of adverse selection (actual purchasers of life annuities tend to have longer life expectancies than the general population), Milevsky and Young (2007) write that investors have an "incentive to delay" the purchase. In this all-or-nothing scenario, as summarized by MacDonald et al. (2013), "the optimal age of purchase depends on the individual's risk preference, personal health status, the equity premium and the investment's level of volatility. For reasonable levels of risk preference, (...) it would be suboptimal to annuitize prior to age 70".

Open system scenario

In the second case presented by Milevsky and Young (2007), any amount can be annuitized at any time, an open-system scenario which corresponds to investors with assets outside of company pension plans (e.g., in RRSPs or RRIFs). The result of that analysis, again as summarized by MacDonald et al. (2013) was that retirees "were advised to annuitize some portion of their wealth immediately, where this portion depended on the same factors listed above as well as the proportion of pre-existing annuitized wealth, and then to gradually purchase additional annuities over time depending on their wealth-to-income ratio." In other words, in this open system scenario, retirees start buying annuities immediately, even before age 70, to provide a base level of income.

Another aspect in evaluating the optimal age to annuitize is: "what is the porfolio invested in meanwhile?". With a fixed income-only portfolio, in the absence of interest rate changes over time, delaying the annuity purchase while making equivalent withdrawals will likely reduce the lifetime income; however the loss is small (2-5%) for a 55 to 65 year old investor delaying 5 years, and might be considered acceptable since it preserves optionality and bequests. But "given the sharper increase in mortality rates after age 70, one can conclude that it pays to begin life annuity income no later than at age 70".

With a balanced or stock-heavy portfolio, the investor is taking somewhat of a gamble by delaying annuitization while making withdrawals: stocks markets can up up or down. The general advice is that "the funds to purchase a life annuity should be obtained from the fixed-income portion of the investor’s portfolio".

Alternatives to annuities

If you are considering a private market annuities such as a SPIA, a strong alternative (or at least first step) for many people is to defer Old Age Security and/or Canada Pension Plan/Québec Pension Plan. These income streams can be viewed as inflation-indexed annuities, which you can increase significantly by delaying them up to age 70 (for QPP, age 72). In fact, delaying government pensions and benefits is the only widely available inflation-protected life annuity in Canada.

Annuitization is one of many possible strategies to convert financial capital (including RRIFs and other accounts) into retirement income. For an overview of this topic including the non-annuity strategies, see Retirement income strategies and styles.

See also

• Retirement income strategies and styles
• Withdrawal strategies

Further reading

• Financial Wisdom Forum topic: "Single premium immediate annuity (SPIA)"
• Full list of Financial Wisdom Forum topics that include annuit* in their title

External links

• Rational Reminder podcast: Financial Economics and Annuities: Rational Planning for Retirement, August 2019 (interview with Alexandra McQueen)
• Rational Reminder podcast: Safety-First: A Sensible Approach to Retirement Income Planning with Wade Pfau, March 2020 (discusses annuities)