What to Know Before You Buy an Immediate Annuity
An immediate annuity is a risk management tool
An immediate annuity is a tool for ensuring a regular income. It's most often used to provide a consistent income for retirees. Whether it is a good choice for your particular needs, however, depends upon your circumstances.
What Is an Immediate Annuity?
An annuity is a contractual financial product. In most cases, it accepts and grows funds from an individual and then pays out an agreed-upon amount each year. In some cases, annuities are funded over the course of years before it starts to pay out. An immediate payment annuity, however, is purchased with just one lump-sum payment and then starts paying out right away.
Imagine, for example, selling your home and putting the entire amount into an immediate annuity. You would then have an agreed-upon income for a set number of years or even for the rest of your life. You would not, however, have the option of investing or spending your money in any other way.
What Immediate Annuities Do and Don't Offer
Annuities are a form of insurance, and insurance is a risk management tool—not an investment. When you buy an immediate annuity, you are insuring a particular outcome, not making an investment. The outcome you are purchasing is life-long income. The key to using an immediate annuity properly is to understand what you are insuring and how to value the benefit being provided.
When you purchase an immediate annuity you enter into a contract with an insurance company to purchase a guaranteed stream of income. The insurance company calculates the amount of monthly income they can provide based on several factors such as:
- the type of annuity (fixed, variable or inflation-indexed)
- the term of the annuity that you choose (life-only, joint life, term certain)
- your age and gender (so they can estimate your life expectancy)
Calculating Risk and Opportunity: Types of Immediate Annuities
You will have several choices when you buy an immediate annuity. Do you want to maximize income now, or would you accept a lower payout for income that would rise with inflation? If you want the most income today, a fixed payout option is best. If you want income that goes up with inflation you'll have to take less monthly income now.
Do you want a fixed, guaranteed payout, or would you prefer a variable payout that has the potential to go up if markets rise? With a variable payout, the monthly amount may have a minimum guaranteed amount with a portion of the payout tied to a stock market index, or the entire payout amount may be based on the underlying performance of stock and bond funds.
Explore the various types of annuity payouts before you buy. As the purpose of an annuity is managing risk, the fixed guaranteed payout is what I prefer.
When you buy an immediate annuity you will have to choose the term of the annuity, which will determine how long your guaranteed income stream will last. A term certain annuity will have an income stream that lasts for a specific number of years, whereas a life annuity provides guaranteed income for as long as you are alive. There are joint-life options, which pay out as long as at least one annuity owner is alive. There are also options that provide a return of principal, so if you die before the total amount you put in the product has been paid back out, then any remaining balance will go to your heirs.
The older you are the higher the monthly income you get. Insurance carriers use actuarial tables to calculate your life expectancy. The older you are, the fewer years they expect you to live. Payouts, therefore, are higher if you wait longer to buy your annuity. Women tend to live longer than men, so payout rates on females are lower than on males.
Immediate Annuity Rates
Many annuity websites showcase immediate annuity rates often called a payout rate. This is not the same as rate of return or yield. You should not use an immediate annuity payout rate, or a calculated rate of return to compare it to other investments. You buy annuities for the guarantees, not for the returns. The longer you live the higher the return the annuity will provide. You can compare an annuity rate from one company to that offered by another company.
When used as part of a holistic retirement income plan, the monthly income from an immediate annuity means other capital you may have can be invested for the long-term. Over time an immediate annuity can create more total wealth. It also creates security. Those items have value that can't be measured by strictly looking at a rate of return.
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Is an Annuity Right for You?
Here are four questions you can use to decide if this product is right for you.
- Do you prefer safety and guarantees over less certain options?
- Are less than 50% of your projected retirement expenses covered by guaranteed sources of income such as Social Security and pensions?
- Are you healthy and do you think there is a fair chance you may live longer than average life expectancy?
- Are you concerned about over-spending early in retirement, running out of money later, and protecting your future self from any poor decisions due to cognitive decline?
If you have a yes answer to any of the questions above, an immediate annuity may have a place in your retirement income plan. Be sure you look at diversifying your annuity purchase across insurance carriers and over time.
What if I No Longer Want the Annuity?
With most immediate annuities, you cannot change your mind once the contract is purchased. For example, if you have been receiving your stream of income for two years, and you suddenly change your mind, you cannot cancel the income stream and get your remaining lump sum of money back. If you decided you absolutely had to have a lump sum of money, you may be able to find an outside company, such as J.D. Wentworth, to purchase your income stream from you at a discounted price. Or you can try a website like QuoteMeAPrice which will collect bids on your annuity.