How to Compare Immediate Annuity Rates
Here's the right way to interpret current immediate annuity rates
Immediate annuities are insurance contracts that offer income that starts immediately or up to one year after you buy them. They're a good option for individuals who want a steady income in retirement that lasts a lifetime or for a set period of time. But the unique calculation of annuity rates means that even products with the best annuity rates may not be on par with the rates of return on other investments. Understanding immediate annuity rates can help you choose a product that affords sustained income in retirement.
Annuity Rate Versus Rate of Return
When you obtain an immediate annuity quote, you might assume that the annuity rate (also known as the annuity payout rate) equates to the rate of return you get on a deposit account (for example, a certificate of deposit) or a retirement income fund.
As annuities are insurance products, immediate annuity rates are calculated differently from the rates of return on traditional investments. The annuity payout rate amounts to the annual payout amount divided by the principal (initial investment) in the annuity. In other words, the rate is the percentage of the principal that you annually get back in payments. An annuity payout rate is not the same as the pure-interest rate of return on a deposit account or the rate of return on a retirement fund.
The annuity rate is not equivalent to the rate of return on other investments.
For example, an insurance company website might list a current immediate annuity rate of an annuity as 7%. This means that for a $100,000 immediate annuity purchase, you would receive $7,000 a year. But this does not equal a 7% rate of return because with each annuity payment received, you get back part of your principal.
For this reason, resist the urge to take the immediate annuity rates and compare them directly to the rate of return on other investments; it would not be an apples-to-apples comparison. While you can compare the current immediate annuity rates of one annuity with that of another, a more useful indicator of the investment potential of an immediate annuity is to calculate the internal rate of return—the annualized earnings rate of your investment.
Figuring the Return on an Annuity
The example below explains how to calculate the internal rate of return, which depends on your life expectancy:
- Investor: Tom, age 65
- Annuity type: 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% rate of return. The annuity's marketing material would likely refer to the 8.4% as the current immediate annuity rate or the annuity payout rate. Yes, the annuity pays out 8.4% of your investment amount each year, but each payment consists of a partial return of your principal in addition to interest. If Tom lives long enough that the annuity returns all his principal to him, the annuity company will continue to pay him $8,400 per year for as long as he lives.
With single-life immediate annuities like the one Tom selected, the income stops when you die, and your initial investment belongs to the insurance company. In the example above, assume that Tom is expected to live for another 18 years. At $700 per month, after 18 years, the annuity would have paid him a total of $151,200.
The actual formula for internal rate of return is complex, taking into account all cash flows from the investment. The most practical way to calculate it is to plug the numbers into an online internal rate-of-return (IRR) calculator such as CalculateStuff's IRR Calculator, or use the built-in IRR formulas in Excel spreadsheet. If using an online calculator, use $100,000 as the present value, $8,400 as the annual payment ($700 monthly payment), and 18 years as the term (or 216 months if you are calculating on a monthly basis). Solve for the rate of return, which works out to about 5% in this case.
How Life Expectancy Affects Returns
You might think that the 5% rate of return in the example sounds low. But the guaranteed payments for life become a valuable benefit if you outlive the life expectancy used to calculate your annuity payments.
For example, if Tom lived 30 more years, the rate of return goes up to about 7.5%, as now the initial $100,000 investment has provided $252,000 of income.
In contrast, a lower life expectancy diminishes your return. Based on the earlier assumptions, if Tom only lives for five more years, he would receive a negative rate of return. At $700 per month over five years, the annuity pays out a total of $42,000. In this case, Tom actually lost $58,000 of the principal.
The chart below illustrates how your return on annuity is directly related to how long you live.
The longer you live, the greater the return you can receive from an immediate annuity. For this reason, an immediate annuity works as a risk-management tool. The main goal of this type of investment isn't to maximize your rate of return, but rather to guarantee your income over a potentially above-average life expectancy.
Final Thoughts on Annuity Rates
When comparing different annuities or determining the investment potential of annuities versus that of other investments, avoid comparing immediate annuity rates with the rate of return on other investments. Annuities are insurance products, and current immediate annuity rates do not equal the rate of return on traditional investments.
Moreover, annuities that offer the best annuity rates don't necessarily offer the greatest growth potential. Calculating the internal rate of return can give you a better sense of the potential appreciation of your investment.
But remember: Immediate annuities are primarily risk-management products, not investments used for capital appreciation. Your objective when investing in these products should be to achieve income protection over the long term rather than growth of the principal. If income is your priority in retirement, long-term income protection may be more important than a high rate of return.