Learn How to Compare Immediate Annuity Rates

Financial figures in a newspaper.
••• An annuity payout rate is not the same as a rate of return. Steve Casimiro/The Image Bank/Getty Images

Many people get an immediate annuity quote, see the annuity's rate, and assume that it equates to a rate of return. An annuity payout rate does not mean the same thing as a rate of return or yield.

For example, an immediate annuity website might list an annuity rate as 7 percent. This means that for a $100,000 immediate annuity purchase, you would receive $7,000 a year. This does not equal a 7-percent rate, nor is it the same as a yield of 7 percent because with each annuity payment received, you receive part of your principal back.

Resist the urge to take this 7-percent payout rate and compare it to another investment like a CD, bond fund, or retirement income fund, because you would be comparing two different animals.

Immediate annuities serve as risk management products, not investments, so it doesn't make sense to compare the rate of return to other investments, although you might want to know the annuity's rate of return for other reasons. Calculating the actual rate of return on an immediate annuity involves a bit of work, as the rate of return an immediate annuity offers depends entirely upon your life expectancy.

Calculating the Return on an Annuity

The example below explains the calculation, using the following assumptions:

  • Male, age 65, purchases a single life income immediate annuity
  • Annuity purchase amount: $100,000
  • Guaranteed income: $700 per month, or $8,400 per year

At first glance, a guaranteed income of $8,400 per year appears to be equivalent to an 8.4 percent return. The annuity's marketing material would refer to the 8.4 percent as the payout rate. Yes, the annuity pays you out 8.4 percent of your investment amount each year, but each payment consists of a partial return of your principal in addition to interest.

If you live long enough that the annuity returns all your principal to you, the annuity company has guaranteed it will continue to pay you $8,400 per year as long as you live.

Long Life Expectancy Equals Increased Return

With a single life annuity, the income stops when you die, and your initial investment belongs to the insurance company. You would have to know your life expectancy to calculate an estimated internal rate of return.

In the example above, let’s assume this 65-year-old male has a life expectancy of 18 years. At $700 per month, after 18 years, the annuity would have paid out a total of $151,200.

To calculate the internal rate of return, you can plug the numbers into a financial calculator, or use an Excel spreadsheet.

Use $100,000 as the present value, $8,400 as the annual payment ($700 monthly payment), 18 years as the term, or 216 months if you are calculating on a monthly basis, and solve for the rate of return, which works out to about 5 percent in this case.

While a 5-percent guaranteed rate of return doesn't sound very high, the guaranteed payments for life become a valuable benefit if you outlive the life expectancy used to calculate your payments.

For example, if the same person lived 30 years, the rate of return goes up to 7.50 percent, as now the initial $100,000 investment has provided $252,000 of income.

Short Life Expectancy Equals Lower Return

How does the rate of return change if you don't meet your life expectancy? Based on the earlier assumptions, if you buy a life annuity and only live 5 more years, you will actually receive a negative rate of return.

At $700 per month over 5 years, the annuity pays out a total of $42,000. In this case, your annuity investment actually lost $58,000.

The longer you live, the greater the return you can receive from a fixed payout immediate annuity. For this reason, this type of annuity works as a risk-management tool. You don't buy it for the rate of return; you buy it to protect your income over a potentially longer-than-expected life.

You can use an immediate annuity rate to compare one immediate annuity to another, but because of the partial return of principle with each payment, the return is not directly comparable to the pure-interest return provided by other investments.