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 begin withdrawing from it immediately.
Immediate annuities are sometimes referred to as single premium immediate annuities (SPIA). There are several ways immediate annuities work, but the three primary types are fixed payout, inflation-indexed, and variable.
Understanding the differences can help you determine which one is best for you.
Fixed Immediate Annuity
In a fixed annuity, you place funds into an account with an insurance company, which determines the amount of income you receive each month. The payment they decide on stays the same throughout the term of your annuity contract.
Using a fixed immediate annuity as part of your retirement income plan can increase the probability that your retirement income lasts throughout your lifetime. Since your money is controlled by a third party—the insurance company—you are assured of retirement funds because you cannot withdraw from the account.
Fixed annuities guarantee payments through the rest of your lifetime.
Fixed payout annuities are an excellent longevity hedge—the insurance company guarantees to continue making payments no matter how long you live. For example, if you keep your retirement savings in an individual retirement account (IRA), it can run out of funds. With a fixed annuity, the insurance company pays you until your last day.
Also called an inflation-protected annuity, an inflation-indexed immediate annuity is similar to a fixed annuity. You receive a guaranteed stream of income from the insurance company for the rest of your life. The difference is that the payments increase or decrease each year, keeping pace with the rate of inflation.
An inflation-indexed annuity tracks standard measures of inflation—usually the consumer price index (CPI). The monthly income gradually changes with the CPI. Since money loses purchasing power with inflation, inflation index-tracking theoretically allows your money to retain that power as inflation fluctuates.
The consumer price index is a measure of the rate of change of the cost of a selected basket of goods. It reflects the rate of inflation.
Inflation-adjusted annuities have one drawback: They initially begin with smaller payments than a fixed payment plan. The effect of this is that it might take decades for the inflation-adjusted income to catch up to the fixed payment, which means there is a distinct possibility of reduced payouts for life if you die before they catch up.
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 might change at least once a year, depending on how 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 reliability because the payments vary.
A popular stock index that is tracked is the Standard & Poor's (S&P) 500 index. The S&P 500 index is approximately 500 stocks that are hand-selected by the financial professionals and analysts at Standard & Poor's for their financial performance.
Which Is Best for You?
Immediate annuities are an option for people who have enough money set aside to place into an account. Choosing the right one depends upon your retirement goals and financial circumstances.
The fixed payout of an immediate annuity makes the most sense if you want to add to your retirement income plan. It creates a floor of guaranteed income that you can't outlive. If you're concerned about rising inflation later in life, the inflation-adjusted product can protect your money, but there is a risk of reduced payouts compared to other annuity types.
If you want the annuity's value to increase, a variable annuity that tracks a stock index is an excellent choice because your income can increase over time if the underlying stocks perform well. The risk you take is that the stock prices might drop, causing your payments to decrease.