As people grapple with finding an optimum retirement strategy, one particular financial instrument often gets brought up: annuities.
Simply put, an annuity is a contract that pays out a stream of payments to its owner; two great examples of annuities that you are most likely funding right now are defined benefit pensions and Social Security.
However, many investors wish to allocate a higher portion of their portfolio into annuities outside of pensions and Social Security, and two types of annuities that are commonly discussed in this context are Single Premium Immediate Annuities (“SPIA”) and Secondary Market Annuities (“SMA”).
In this article, we will break down the similarities and differences between these two types of annuities so that you may best determine which product is more suitable for your needs.
The first thing you should know is that SPIAs are a primary market instrument, while SMAs as the name implies are a secondary market instrument. SPIAs can be purchased directly from your insurance company who will structure the entire annuity for you from scratch while in the case of SMAs the original annuity owner sells the annuity to a factoring company in exchange for a lump sum payment and the factoring company, with the help of an annuity broker then resells it to you.
In most cases, SMAs are generated from people who have received annuities in the form of lottery winnings or structured settlements (such as awards from personal injury and wrongful death lawsuits). These payments are also underwritten by a financial institution or insurance company however as SMAs involve a transfer of the payee rights, a court order will also need to be obtained for the reassignment.
In most cases, SPIAs are structured to maintain a continuous stream of payments until death. SPIAs are basically a bet you make with the insurance company as to how long it will take for you to die; essentially, people who purchase SPIAs and expire early are funding those who are still living.
This is because SPIA payments stop upon death and cannot be transferred to beneficiaries. On the other hand, the duration of an SMA would depend on the original terms of the settlement and payments can be transferred to beneficiaries however generally SMAs have an average duration of 5 to 20 years.
Both SPIAs and SMAs are underwritten by insurance companies therefore in terms of counterparty risk, there is always the risk of the insurance company going underwater, however that risk is very small, particularly if you do your research and only purchase from highly-rated insurance companies.
In the case of SMAs however, because there is a court order involved, there is always a bit of process risk; the risk that the proper legal documentation for the sale of the annuity was not in proper order. This risk can be mitigated by selecting reputable annuity brokers with a proven track record.
Of course, as both SPIAs and SMAs are generally fixed-income instruments, there is always interest rate risk in the sense that if interest rates rise, your fixed yields on the SPIAs and SMAs would be lower by comparison. This is no different with other fixed-income instruments such as bonds. However there are some SMAs that come with Cost of Living Adjustment increases, and it is possible to negotiate such increases with your insurance company for SPIAs as well, although that will definitely result in higher upfront costs or lower initial payments.
Liquidity risk is also something to consider for both SPIAs and SMAs. Typically, once you have paid for your SMA and the payee rights have been transferred to you, you cannot undo the transaction and you yourself will not be able to take a lump sum withdrawal. In the case of SPIAs, certain ones come with a ‘Liquidity Rider’ which will allow you to take one-off withdrawal if needed although that will undoubtedly come with a higher cost.
When it comes to comparing yields between SPIAs and SMAs, it can be difficult to make a true apples-to-apples comparison. This is because SPIAs are primarily ‘life annuities’, paid until you die which means like many insurance products, the yield would primarily depend on your risk factors, with the primary one being your age.
As we mentioned earlier, an SPIA is a bet you take with your insurance company on when you will expire. On the other hand, the yield you will receive on an SMA has absolutely nothing to do with you personally and is entirely dependent on the original terms of the structured settlement and the deal the original owner brokered with the factoring company.
That said, the yields on SMAs are typically significantly higher compared to most fixed-income instruments because the owner of the original annuity is willing to sell his or her income stream at a steep discount for a lump sum upfront cash payment. The most common reason for this is that the person needs the cash immediately to settle a large bill such as housing or student loans, meaning that an annuity seller may be in a cash-poor situation, which can lead to a steep discount and higher yields.
SMA yields are generally in the 4 – 5% range.
Typical Investor Profile
The typical SPIA investor is looking at it from the perspective of retirement planning; guaranteed cashflow up till death. When it comes to SMAs however, the investor profile becomes a bit more diverse. While investors looking for retirement income should definitely look into SMAs, SMA investors also comprise investors who simply want higher yielding alternatives to Certificates of Deposits and other fixed-income instruments such as bonds with lower default risk.
And, because SMAs are illiquid investments, the investor should be in a robust financial position with sufficient liquidity to be able to invest a significant portion of his or her net worth into an illiquid investment.
SPIAs are a primary market instrument and can be purchased on demand from your insurance company; there is no limit on their supply.
On the other hand, the supply of SMAs is limited; there are only so many structured settlements out there, even in such a lawsuit-friendly country such as ours.
Both SPIAs and SMAs are great fixed-income instruments with low risk that would make a great addition to an investor looking to acquire a constant stream of future cashflow.
However, because of the varied nature of SMAs there is a higher chance of you getting a ‘better deal’ if you shop around and find a trusted annuity broker. Now that you’ve understood the similarities and differences between SPIAs and SMAs, we hope that you are now better able to choose the type of annuity that best meets your financial needs.