The following article will provide you with a thorough understanding of an immediate annuity and provide you with tips and strategies to find the best immediate annuity for your unique situation.
Immediate Annuities
You’ve worked hard all your life, and retirement time is fast approaching. You’ve been frugal and diligently saved up a respectable nest egg to support you through the golden years.
Now, you’re ready to enjoy a comfortable retirement. After all, you’ve earned it. But a nagging thought keeps popping up in the back of your mind. “What if it’s not enough?” What if you live longer than you planned for and your retirement savings dries up?
We all hope to be blessed with a long, healthy life. But the longer your retirement lasts, the greater the danger of outliving your assets. This is what financial planners refer to as “longevity risk.”
Any comprehensive retirement strategy needs to account for longevity risk, and, for many retirees, immediate annuities are the ideal means of doing so.
In general, an annuity is a contract between you and an insurance company under which the insurance company promises to make repeated payments to you over time in exchange for a large premium payment up front.
Although there are numerous types of annuities, nearly all of which are customizable, immediate annuities in their various forms are particularly well-suited for retirees seeking to protect against longevity risk.
What is an Immediate Annuity?
With an immediate annuity, you make a large premium payment at the time the annuity contract is executed, and the insurance company “immediately” starts making payments to you.
That is, the entire premium is paid in one lump sum at the time of contracting, and annuitized payments begin with the next payment term – usually the following month.
Conversely, with a deferred annuity, the insurance company holds and invests the premium for a defined period before payments begin.
Or, with a subscription annuity (a type of deferred annuity), the premium is paid in installments over a period of years rather than in one lump sum.
Guaranteed Payments
Immediate annuities offer guaranteed payments throughout the annuity’s term, which can either be a predetermined period of years or for life (or, sometimes, a combination of the two).
For immediate lifetime annuities, this means you are exchanging a chunk of your nest egg for a steady stream of reliable, predictable payments for the rest of your life. It’s essentially like buying a lifetime pension for yourself.
Along with addressing longevity risk, immediate lifetime annuities remove the risk of poor investment performance or loss of principal due to market volatility or recession.
The payments are absolutely guaranteed by the insurance company, and, in the exceedingly unlikely event that a highly-rated insurance company goes belly-up, state guaranty associations step in to cover your losses, assuming the role the FDIC fills with bank accounts.
A popular strategy with retirees is to purchase an annuity with sufficient payments, combined with Social Security and/or a private pension plan, to cover all regularly recurring expenses.
This strategy ensures that you always have adequate cash to meet basic living expenses, allowing for more flexibility in managing other assets.
One benefit is you won’t have to sell off stocks from your IRA at a loss to pay health insurance premiums if you know the money will be available from an annuity.
How Do Immediate Annuities Work?
In their purest form, immediate annuities don’t require any work on your part after the contract is in place beyond receiving the regular payments.
You can choose between monthly, quarterly, or annual payments – referred to as the “mode” of payment.
Most annuitants select monthly payments for the steady income stream, but quarterly and annual payments have the advantage of allowing interest to build up longer between payments.
Lifetime Annuities
Most retirees purchasing immediate annuities select lifetime annuities, which provide guaranteed payments for life no matter how long you live.
However, annuities are also available that guaranty payments for an agreed term of years. If you die before the term ends, the insurance company makes the payments to your estate or to a designated beneficiary.
An annuity with a defined term does not remove all longevity risk, but it does eliminate the chance that you will get back less than you put in.
Over the duration of the term, the total amount of payments will equal the amount of premium paid plus the growth earned by the annuity.
Annuity Rates
Annuity rates – meaning the amount of each payment – depend upon age and life expectancy, the amount of premium paid, and the term.
The insurance company assumes that you will live to your life expectancy and sets lifetime annuity rates accordingly, more or less calculating the payment so that you will have received all of the premium back plus interest by the time you reach your life expectancy.
Hence, the older you are when purchasing the annuity, the higher the payments will be because the insurance company doesn’t expect to be paying you for as long as it would with a younger annuitant.
Of course, if you live past your life expectancy, you will have received a greater return.
On the other hand, if you don’t make it that long, you might not receive all of the premium back, though there are insurance riders available that allow for refund of unpaid premium.
While the insurance company is holding the premium, the value of the annuity grows tax-deferred, with the rate of growth depending upon the type of annuity.
Fixed vs Variable
A fixed annuity earns a preset, unchanging rate of interest. Given the lack of any real risk, interest rates are moderate, though substantially better than you would see with a savings account.
Variable annuities tie growth to investment performance, allowing for higher payments when markets are good but also running the risk of reduced payments when markets drop. Indexed and structured annuities tie growth to a stock market index and typically guaranty no or limited loss of principal in exchange for an earnings cap.
Taxation of Annuity Payments
Annuity payments are taxed according to the source of the money used to pay the premium.
If pre-tax money is used, the annuity is “qualified,” and the entire payment is taxable income.
If the funds were already taxed, the annuity is “unqualified,” and payments are only taxable to the extent they are comprised of growth.
The portion of the annuity payments constituting growth versus return of premium is calculated according to a formula adopted by the IRS based on life expectancy and total anticipated pay-out.
What are the Downsides of Immediate Annuities?
The big downside to immediate annuities is that, once you enter into the contract and the ten-to-thirty-day “lookback period” passes, you don’t have access to the principal other than through the regular contractual payments.
This can be problematic if you have a large emergency expense come up and don’t have other assets readily available.
Some insurance companies do offer riders allowing for withdrawal of principal, usually subject to a substantial surrender fee.
And it’s also possible to sell the right to receive future annuity payments in exchange for a lump-sum cash payment, but you’re better off avoiding those arrangements except when absolutely necessary.
Inflation
Annuities are also potentially vulnerable to inflation eating away at the real value of the payments.
If you live long enough, and inflation rates are high, the purchasing power of the payments will be decreased.
Most insurance companies offer riders that adjust payments for inflation and/or cost-of-living increases.
By selecting an inflation-adjustment rider, the payment amount will either be lower early in the term or the initial premium will be higher.
What Types of Immediate Annuities are Available?
There are numerous variations of immediate annuities, and some insurance companies have different names for similar products.
There can also be some overlap, where a single annuity offers features of more than one variation.
So, for example, an annuity purchased with pre-tax money might provide lifetime payments in an unchanging amount, in which case it would be a “qualified annuity,” a “lifetime annuity,” and a “fixed annuity.”
With that said, these are some of the commonly available variations of immediate annuities:
Single-Payment Immediate Annuity (“SPIA”):
The baseline against which other annuities are usually compared, a SPIA involves a single, lump-sum premium payment up front, followed by payments starting as soon as the following month.
SPIAs can be fixed or variable and provide payments for life or over a defined period of years.
Lifetime or Single-Life Annuity:
A lifetime annuity provides for payments for the duration of the annuitant’s life and the annuitant’s life alone.
Lifetime annuities are sometimes described as “reverse life insurance” in that they are designed to insure against longevity risk, as opposed to insuring against early death.
Period Certain Annuity:
A period certain annuity provides payments over a defined period of years, commonly between ten and thirty. If the annuitant predeceases the term, the insurance company makes any remaining payments to the annuitant’s estate or a named beneficiary.
Life with Period Certain Annuity:
An annuity classified as “life with period certain” offers guaranteed payments for the longer of the annuitant’s lifetime or a defined period of years.
If the annuitant dies prior to the end of the period, the insurance company makes the remaining payments to the estate or a named beneficiary.
Joint and Survivor Annuity:
With a joint and survivor annuity, the insurance company is basically guarantying payments for the longer of two lives – typically, married spouses retiring around the same time.
If the annuitant predeceases the named beneficiary, the insurance company makes lifetime payments to the beneficiary.
If the beneficiary dies first, the payments continue until the annuitant’s death.
Joint and survivor annuities are sometimes set up so that, after the annuitant’s death, the payments to the beneficiary are reduced by half.
Because the chance that one of the two payees will outlive life expectancy is greater than the chance of the annuitant alone doing so, joint and survivor annuities have either higher premiums or lower pay-out rates than single-life annuities.
Refund Annuity:
An annuity is a “refund annuity” if it includes a rider that guarantees payments at least until the entire premium has been returned.
If the annuitant dies before all premium has been paid back, the insurance company pays the remaining premium to the estate or to a named beneficiary.
An immediate annuity with a refund rider will have a higher premium than an annuity with no refund mechanism.
Qualified Annuity:
If an annuity is purchased with pre-tax money, usually through a retirement account or employer-sponsored pension plan, it is “qualified.”
As with an IRA or 401k, contributions to a qualified annuity are deductible and subject to annual caps.
Qualified annuities are also subject to required minimum distributions beginning at age 70 and ½.
Now…
We know that we’ve covered a lot of information here is a relatively short amount of time, and we by no means expect someone to become an expert on annuities right away.
All we hope is…
That after reading this article, you now have a better understanding of a few key terms you’ll want to be familiar with prior to “narrowing down” which annuity option might be the best for you!
Either way…
What you’ll find is that when you give us a call here at I&E, we’re not going to bombard you with a ton of technical terms and just assume that you know what we’re talking about. Instead, we’ll go over all of your options with you, making sure you fully understand how each product works and be completely available to you to answer any questions that you may have.
So, what are you waiting for? Give us a call today and see what we can do for you!
