Annuities

Understanding the earnings your money generates for you in an immediate annuity helps your evaluate your investment.

A single premium immediate fixed annuity (SPIFA) gives you a fixed monthly payment for the term of the annuity. That term may be a certain number of years or for the remainder of your life.

The amount the insurance company will pay you depends on the amount of premium you pay and prevailing interest rates in addition to expenses and your life expectancy if it’s a lifetime payout.

Companies will quote you their monthly payout to you but not the interest rate (interest rates on immediate annuities are typically 2%-4%). Nevertheless, since all earnings of the company are dependent on interest-based investments, higher prevailing rates will allow them to make higher monthly payments – and vice versa.

Earnings and taxation of your investment
What you earn is the excess of payouts over the premium you pay. Every payout is considered part earnings and part return of premium. The fraction of each payout that’s taxable is the ratio of the total excess payout to the premium.

To illustrate let’s take a hypothetical example of the payout over a 10 year term certain to illustrate both taxation and the effective interest that produces earnings. We’ll use the average monthly payout quote  based on 16 insurance companies for a $50,000 premium for a 10 year payout term for a 70 year old man. This average quote is $515 per month. Prevailing  interest rates at time of this quote are 3.30, 3.48, and 4.06 % for 1 yr, 5 yr and 10 yr US treasuries respectively.

The total payout over ten years is $61,800. So, the earnings on the premium investment is $11,800 which is the excess received over the premium paid. That’s an earnings of 23.6% (= $11,800/$50,000) –but over ten years!  Of each payment, only 19% is taxable because of the way IRS taxes immediate annuities.

The example shown above is strictly hypothetical based on the assumptions described and is not representative of an investor’s actual earnings or tax consequences.
 
Your effective interest rate
Because the annuity company’s constant payout schedule returns both earnings and premium payments back to you, it can only earn interest with the premium payments it retains. In the beginning it has most all the premium to earn interest with. But this decreases linearly to no premiums left at the term’s end.  Equivalently from an averaging point of view, we can consider the annuity company having only half your premium for the whole term to earn interest while the other half goes back without earnings to bolster the payouts – as is the annuity’s purpose.

So, we can deduce the “effective interest” the man earned by assuming only $25,000 (half his premium) did all the earning of the $11,800 excess payout over the 10 years. A compounded annual interest rate of 3.72% applied to $25,000 will increase it by $11,800. To see the numbers for your situation, use the immediate annuity calculator.
Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments.

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In retirement, a guaranteed income can reduce your stress and allow you a less-panicked approach to investing. With no pension, you may be relying on Social Security as your only assured income. Buying a life annuity can guarantee that extra income, but you lose both control of your assets and their use as your legacy. What’s a solution to this dilemma?

The fixed term SPIA solution
Use a single premium immediate annuity (SPIA). In this case we’re looking at a fixed term SPIA where you purchase the SPIA for an immediate payout, but only for a fixed term – perhaps 5, 10 or 15 years.

The idea is to buy the fixed term ingle premium immediate annuity with only 50% of your savings. The term you choose depends on how much extra assured income you need and what you plan to do with your other 50% of savings. Let’s see some examples for this approach.

New retiree – getting adjusted
Take this hypothetical example. If you’re a 66 year old man beginning retirement with $400,000 in savings but no company pension, you may want to complement your Social Security income with single premium immediate annuity income while you pursue some endeavour for the first 10 years of your retirement. But you don’t want to lose control over your assets for later alternative choices.

As an option, you could purchase a 10 year term single premium immediate annuity that would pay  you $2,084.01 per month to supplement your social security benefits for about $200,000.  This would leave you with $200,000 in savings that you can invest to grow over the next 10 years. With the assurance of the annuity income, you can invest this remainder of your savings more aggressively.

Investing at a hypothetical 7% or 8% growth rate may allow you to recover your $400,000 over those 10 years if things go as intended.  The growth you can reasonably expect will depend on your choice of investment and if that money is in a tax-deferred account. The latter would allow you tax-deferred high income investments.  Or, you could buy a deferred annuity at a guaranteed rate. But, you’re in control of those assets.

Older retiree – worrying about a legacy and living expenses
Let’s consider another hypothetical example. Let’s take an 80 year old woman with $200,000 in savings and a house with no mortgage. She’s drawing down her savings at about $2,000 per month and is worried about depleting her savings and losing her legacy for her children.

She could purchase a single premium immediate annuity for a fixed term – perhaps 10 years - with a fraction of her savings to pay the monthly drain on her savings. And, invest the remainder in a deferred annuity to grow for later use or as a legacy. Her house’s equity can also be a source of income under a reverse mortgage if necessary.

Note: Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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When you buy an immediate annuity, you pay a lump sum to an insurance company and begin receiving monthly payments right away. An immediate life annuity is attractive to retirees because it guarantees them a lifetime income. But should they choose an immediate variable annuity (IVA) or an immediate fixed annuity (IFA)?

The IFA gives you a guaranteed but fixed payment – generally monthly for your lifetime. That’s because the underlying annuity investment relies on long term bond investments purchased by the insurance company. But in twenty years the purchasing power of that fixed monthly payment may be significantly less due to inflation.
 
The IVA also offers a lifetime (monthly) payments, but those payments will vary. That’s because the underlying annuity money is invested in the subaccounts that fluctuate with the underlying securities (e.g. stocks and bonds). The attraction of the IVA is based on the hope that over time, the investment markets will rise and help offset inflation by producing larger monthly payments. The danger is that the stock market can go into a slump and reduce those payments.    

With the IVA, you can change how your annuity is invested among subaccounts associated with it. You can also opt for a guaranteed minimum payment despite how far down the market goes and your subaccount investment earnings fall. But that kind of guarantee will add to the cost of the contract.

If you’re especially concerned about future inflation, perhaps you’ve got a better option than locking yourself into an IVA. Instead of investing all that ‘annuity’ money into an IFA, just invest a portion – perhaps half of it. Then invest the remaining half in a conservative mix of bonds and stocks that’ll potentially generate both growth and earnings.

Use only the earnings of this that you need. This gives you more control of your investment money with your own guaranteed minimum from your IFA. Years later you can always opt to invest the balance into an IFA too. Your increased age alone will produce a higher monthly return for yourself because the later in life you start your annuity payments, the larger the payments.  You can see how this works with the immediate annuity calculator.
Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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Live to 100. Sounds great. But what are the downsides of longevity? “How can there be downsides?” you may ask. After all, you’d have more time to golf, go fishing, and spend with the grand-kids. Well, the risk may be that if you hadn’t planned to live that long you could end up running out of money.  Very few people have sufficient retirement savings to live to 100.  Yet, if you are already age 70, life expectancy of living to age 100 is 3% (one of every 33 people).  If you make it to age 80, then your life expectancy to 100 jumps to 4% (one out of 25 people).

So how long of a retirement should you plan for?  How can you prepare for significant longevity?

According to the IRS longevity tables, a 70-year-old person is expected to live for 17 more years to age 87. However, this is an average. Half of the 70-year-olds will live longer, and half will not. Therefore, a 70-year old individual who is basing his or her retirement plan and spending habits on living to 87 is rolling the dice. Furthermore, when you consider that there are more than 70,000 U.S. centenarians  who represent the fastest-growing segment of our population, there is reason to take notice.

However, planning too conservatively could be detrimental as well. After all, you don’t want to cut your standard of living down to the point that you’ll be miserable. And of course, you always have the option to make adjustments in your spending as time goes on.

All of this comes down to two simple facts; you can control how long your money will last, but you only have a limited ability to predict how long you will live. So what can you do to reduce the risk of running out of money too soon?

A fixed immediate annuity offers an income that will continue for a lifetime, no matter how long you live, and it will help you plan for the possibility of living to 87, 107, or beyond.  The other option is a reverse mortgage–your ace in the whole should you ever need it.

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Even the best experts can’t predict how certain investments will perform or the income that you’ll see from them.

Nevertheless, you might need a set amount of money each month to pay non-discretionary expenses like mortgage payments, auto loans, and life insurance premiums. Frequently these monthly outlays are fixed for a number of years.

To pay these predictable expenses, you may want to consider a fixed, immediate annuity to provide a steady stream of income for your lifetime, your spouse’s lifetime, or the duration of the loan.  And if you don’t like paying taxes, you may like the idea that part of that regular check from an immediate annuity is a tax-free return of your investment.  If you find comfort from social security check, having the fixed income stream from a lifetime immediate annuity is quite similar.

But what about expenses that you will always have and most likely will go up each year, such as real estate taxes, auto insurance, or homeowner’s premiums? Some immediate annuities offer several options to meet your future needs too, including an inflation protection rider that will let your income rise annually.

Ability to make payments based on claims-paying ability of Annuity Company. Not government backed or FDIC insured.  Exact provisions of inflation rider may vary among annuity companies and may not be available on many annuities. Additional riders are subject to additional fees and charges.
For a free illustration of how a fixed, immediate annuity can provide that money you need to meet your monthly obligations, use the immediate annuity calculator.

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