Immediate Annuities Explained: Convert Assets to Income

Annuity Definition and Explanation

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Annuities come in many forms, but immediate annuities may be among the most simple to manage (and the least abused). Immediate annuities can help you plan for a wide range of finance needs and goals. You can use them to plan ahead for retirement income, to prepare for costs you know are coming, or to manage a major windfall or lump sum so that you don't deplete the funds too quickly.

What Is an Immediate Annuity?

An immediate annuity is a tool in the form of a contract that pays income over time based on assets you provide to an insurance company. Payments often begin in the month after you purchase the annuity, but the details may vary, as they depend on your contract.

How It Works

When you use a single premium immediate annuity (SPIA), you deposit a lump-sum of cash (your “premium payment”) with an insurance company. Then, that company makes steady income payments to you. For example, you might receive monthly or annual payments. Those payments might come as paper checks or electronic deposits that route straight to your bank account.

Can I Pause Payments?

Once you buy an immediate annuity and start taking income (also known as “annuitizing”), in most cases there’s no turning back. When you decide it's time to receive payments, this choice is irrevocable. There may be ways to back out, but it will depend on the terms of your contract, and it could be complex and costly. It may not suit your needs either. Recall, in return for your payment upfront, the insurer promised to pay you a steady amount over time. In most cases, you tend to receive more if you can commit to an irreversible payment stream in writing.

Can I Decide When Payments Start?

Immediate annuities differ from deferred annuities, which hold on to and invest your money in much the same way, but may be less strict with how you can use and access funds. Most deferred versions allow you to withdraw funds any time you like, transfer your assets, or cash out (though you may face tax consequences when doing so).

Just because an annuity contract allows you to take certain actions doesn't mean those actions are in your best interest. For instance, if you withdraw funds, transfer money between accounts, or cash out in full, you may incur fees and taxes.

How Much Do Annuities Pay?

The amount of income you receive each month, and over time, will depend on many factors. It may go without saying, but the more you add upfront, the more you’ll get back in the long run. You also have a number of options for how you prefer to be paid. For example, you might choose from one of the following common set-ups:

  • Lifetime: Guaranteed payments for the rest of your life, no matter how long you live
  • Period certain: Payments for 10 or 20 years, and your beneficiaries receive any payments that remain if you don’t live that long
  • Joint lifetime: Payments that last as long as you or your spouse are still alive
  • Other options: Your insurer may offer many other choices, on a case by case basis

The largest payments often come with the first choice—a single lifetime income. If you want the payments to last as long as two people remain alive, the insurance company is taking on more risk and will reduce your payments with this factor in mind.

What Happens at Death?

If you annuitize and choose lifetime payments, the payments stop upon death (or the second death, if you chose joint lifetime payments). Whether or not you come out ahead depends on a number of factors. When choosing an option for payouts, you should think about all outcomes, including how long you think you'll live. Insurance companies devote massive amounts of resources to analyzing risk, and they are highly adept with statistics. Chances are they have played out a full range of outcomes, and assigned values to each and every one. If you live a very long life, you may end up receiving more than expected. But if you die within two months of taking income and did not choose a “period certain” (such as 10 years), the insurance company keeps the principal amount that you put into the annuity when you signed up.

Unless you can predict how long you’ll live, there’s always some risk when using an immediate annuity. As a result, it’s crucial to assess the risks and compare options.

Perhaps you can just spend down your assets without going through an insurance company at all. Or you might construct your annuity with safeguards or limits, so that it invests only a portion of your assets.

Costs and Risks

In addition to the risk of living a short life, immediate annuities can be complex tools. Though a few of the more common options are listed above, the sheer number of options out there is massive. So many providers offer a dizzying array of options, such as those that protect against inflation, or custom riders of all kinds that can be added onto a basic contract. Note that there will always be a price to pay for extra features. The tricky thing is that you don’t always see a “cost” that displays as a clear dollar amount when you're in the planning and purchase stage. Instead, you may pay an opportunity cost, because you can't predict what will happen in the future, you can only guess, and the insurer is placing bets on a wide range of outcomes.

Another risk is the chance that your insurance company goes belly-up. Insurers are not backed by the government, like FDIC insured banks or credit unions. As a result, be sure to do your research and choose strong insurers (and hope that they stay secure throughout your lifetime).

The Bottom Line

Buying an immediate annuity is a big move. An annuity can provide steady income, much like the paychecks you received during your working years, but it's not for everybody. Read your contract and all insurance documents with caution, as the terms may differ from one policy to the next. Also, it's best not to assume you know how your assets will be treated, or how your income will be paid. Speak with a financial planner or trusted insurance agent if you have any doubts. It is also wise to discuss your goals and all of the options with a professional, or someone you trust, before you make a decision.