3 Types of Immediate Annuities to Compare
What type of immediate annuity is best for you?
An annuity is a contract between an insurance company and a client. The client contributes to the annuity, and the insurance company agrees to provide a guaranteed stream of income. Immediate annuities allow you to make one lump sum contribution and then immediately begin receiving a stream of income. They are sometimes referred to as SPIAs, which stands for "single premium immediate annuities." They come in different varieties, but the three primary types are:
- Fixed payout
- Inflation-adjusted payout
- Variable payout
Here's how each option works.
Fixed Payout Annuities
With this type of annuity, the amount of income you receive each month from a fixed immediate annuity is a set amount. It will stay the same throughout the term of your annuity contract. The insurance company you're considering for your annuity can determine the approximate amount of income you would receive from an immediate annuity depending on how much you invest. You'll be asked for your age, your spouse’s age, your state of residence, and the amount you want to invest.
Research has shown that using a fixed immediate annuity as part of your retirement income plan can increase the probability that your retirement income lasts throughout your lifetime. This type of annuity tends to look more attractive over longer periods of time. This means that this type of financial product makes a great longevity hedge—it protects your income should you live longer than average.
Inflation-Adjusted Payout Annuities
An inflation-indexed immediate annuity is a form of a fixed annuity. You receive a guaranteed stream of income from the insurance company and that income will rise each year based on a predetermined formula. The increase is usually tied to changes in the consumer price index.
An inflation-indexed annuity will provide a lower initial monthly income, but the monthly income will gradually increase over time and as inflation continues. It should eventually surpass the amount you would have received from an equivalent non-indexed annuity, but it can take anywhere from 12 to 20 years for the monthly amount to grow to the point it would have been if you had taken a fixed non-inflation payout from the start.
Wade Pfau's research on the use of inflation-adjusted annuities is outstanding. As he states in "Efficient Frontiers: Inflation Assumptions, Fixed SPIAs, & Inflation-Adjusted SPIAs," "Today, one of the results that really caught me off guard was that fixed SPIAs performed so much better than inflation-adjusted SPIAs."
Inflation rates have been low over the past decade, which is another factor in deciding whether it makes sense to take an inflation-adjusted annuity payout.
Variable Payout Annuities
With a variable payout annuity, the amount of income you'll receive depends on the performance of a portfolio of underlying investments, usually stock and bond mutual funds. This means your payment will vary each month or it will at least reset once a year. It depends on the way the annuity is structured.
The purpose of an immediate annuity is guaranteed income that you can rely on, and the variable type of annuity lacks in this respect. A retirement income fund can accomplish something similar but without the loss of liquidity. The loss of liquidity is because once you start an immediate annuity, you typically can't get out of the contract. You might be able to find a company to buy the annuity, but you may take a loss on the transaction.
Which Is Best for You?
The fixed payout immediate annuity makes the most sense if you want to add guaranteed income to your retirement income plan. It creates a floor of guaranteed income that you can't outlive. But if you're concerned about high inflation later in life, the inflation-adjusted product can protect against this.
You may want to consider other investments that offer inflation protection such as TIPS and IBonds before buying an annuity. Make sure you put together a thorough financial plan first. A well-structured retirement income plan can help you see what products make the most sense for you and, of course, the advice of an expert financial planner can be invaluable.
Kitces. "Understanding The True Impact Of A Single Premium Immediate Annuity On Retirement Income Sustainability." Accessed Nov. 22, 2020.
McLean. "Efficient Frontiers: Inflation Assumptions, Fixed SPIAS, and Inflation-Adjusted SPIAs." Accessed Nov. 22, 2020.