Single premium immediate annuities (SPIAs) are retirement products sold by life insurance companies to provide guaranteed lifetime income in exchange for a lump-sum payment. They're considered life insurance contracts because the amount they pay out is usually tied to how long you live.
Buying an immediate annuity is like buying a pension for yourself. Learn how immediate annuities work, and how they can fit into your retirement plan.
Definition and Examples of Immediate Annuities
Defined contribution plans like 401(k)s and IRAs are what most people rely on for their retirement, but they aren't guaranteed to provide lifetime income. In fact, only 15% of private sector workers have access to a traditional pension that provides lifetime income.
Like a pension, single premium immediate annuities pay a monthly or annual income amount for the lifetime of one or more annuitants. “Annuitant” refers to the person or people receiving the income. The annuitant and the owner are often the same person, but they don't have to be. The income amount received is based on the age of the annuitant, their sex, the amount of money used to purchase the annuity, and the payment option chosen.
Immediate annuities begin to pay an income within a year of a purchase payment, or premium. They’re referred to as single premium immediate annuities because they are purchased with one lump-sum payment as opposed to a period of payments over time. Here's an example of immediate annuity lifetime income payments based on 65-year-old annuitants:
|Based on a $100,000 Purchase Payment|
|Male Age 65||Female Age 65||Joint & Survivor Male and Female Age 65|
|Monthly Income||$ 486||$ 453||$ 410|
|Annual Income||$ 5,832||$ 5,436||$ 4,920|
- Alternate name: Immediate annuity
- Acronym: SPIA
How Does a Single Premium Immediate Annuity Work?
Immediate annuities are different from other investments because you are exchanging principal for income. Once the income begins, you generally have no access to the money you purchased the annuity with.
In the earlier example, a $100,000 premium created $5,832 of income per year for a 65-year-old male. Compared to an interest-bearing investment, that might seem like a return of 5.83% per year. But the actual rate of return is considerably lower. This is because the money used to purchase the annuity is only recoverable through payouts—so part of those payouts are a return of principal. Assuming the 65-year-old received payments for 20 years, the rate of return is 1.68%.
On the other hand, the income may be higher than what you would receive from other guaranteed investments, such as CDs or government-issued bonds—especially if you live longer than expected. Here's why: Insurance companies know that a certain percentage of annuitants will die before their life expectancy. A portion of the money they would have received is used to fund higher payouts for everyone else; these are referred to as mortality credits.
For instance, if the 65-year-old male above received payments for 25 years, the rate of return increases to 3.45%. If he received payments for 30 years, the rate of return would be 4.43%.
The insurance company pays less to females and the joint and survivor options because life expectancy is longer for both.
Immediate annuities have several options for income; these can be applied to one life or two. Options applied to two lives are called “joint and survivor” and pay income until the last of two annuitants dies. Here are a few common payout options.
- Life only: A payment is guaranteed for the lifetime of the annuitant. No payments are made after the annuitant's death. Life-only options will pay out a higher monthly or annual income than the other options. Joint and survivor life only is available for the longer of two lives, usually spouses.
- Life and period certain: A payment is guaranteed for the lifetime of the annuitant. The payments are made for at least a "certain" number of years regardless of when the annuitant dies, typically 10 or 20 years. Joint and survivor options are usually available for this payout as well.
- Life with cash refund: A payment is guaranteed for the lifetime of the annuitant. At the death of the annuitant, if the payments made are less than the purchase payment, the balance is refunded.
- Fixed period: Payments are made for a specified number of years regardless of when the annuitant or annuitants die.
Income from immediate annuities are taxed at ordinary income tax rates, but only a portion of payments are taxable. This is because immediate annuity income is considered part interest and part a return of principal—only the interest portion is taxed.
The ratio of principal to interest is calculated using an IRS actuarial table. In our example of a 65-year-old male, only $832 of the $5,832 of annual income is taxable.
For fixed period, life and period certain, and life with cash refund annuities, there may be a balance remaining upon the owner’s death. In this case, the balance of any payments due are made to the named beneficiary.
Insurance Company Rating
The guarantees of the insurance company are only as good as their ability to pay. That's why it's important to purchase an immediate annuity from a financially strong insurance company. You can find financial strength ratings of insurance companies from AM Best, Moody's, Fitch, and Standard and Poor.
Types of Single Premium Immediate Annuities
There are two types of single premium immediate annuities.
Fixed Immediate Annuities
Fixed immediate annuity payments are determined when the insurance company receives the purchase payment. Your annuity payment doesn't change and is based on the payment option you select, such as life only or life with period certain, and the age and sex of the annuitant.
With some fixed immediate annuities, you may be able to select an inflation option that increases the amount of payments based on the consumer price index, or a predetermined percentage.
Variable Immediate Annuities
With a variable immediate annuity, your payments are tied to how well investments you choose perform. So income can fluctuate and be higher or lower in some years, accordingly. The assumed rate of interest (AIR) is what insurance companies use to calculate the initial variable income payments from an annuity, along with the age and sex of the annuitant.
If the investments you selected perform better than the assumed interest rate, your payment may increase. If the performance of investments you selected are lower than the assumed interest rate, your payments may be lower.
Pros and Cons of Immediate Annuities
Guaranteed lifetime income
Potentially higher cash flows
Favorable tax treatment
Low rates of return
Inflexible and illiquid
- Guaranteed lifetime income: There are three sources of guaranteed lifetime income: Social Security, pensions, and annuities. Running out of money is a top concern of retirees, and an immediate annuity is one way to address that.
- Higher cash flows: Immediate annuities often offer higher cash flow than similar low-risk investments because of mortality credits.
- Favorable tax treatment: Annuity income is considered part principal and part interest. Only the interest is taxed.
- Low rates of return: In our example above, it takes the 65-year-old male 17 years to get his money back. Consequently, the rates of return are low, or even negative, until you live past life expectancy.
- Inflexible and illiquid: Immediate annuities exchange principal for income. Once you enter into an immediate annuity, if possible, it’s difficult and costly to undo.
- No legacy: Once the minimum number of payments have been made, there is no death benefit to heirs.
Are Single Premium Immediate Annuities Worth It?
According to a 2019 survey by the Association of International Certified Professional Accountants, “going broke in retirement" is the number-one concern of retirees. Immediate annuities are intended to address the problem of outliving your money by creating a minimum amount of guaranteed income for the rest of your life.
They can be used to supplement other guaranteed sources of income such as Social Security and pensions, or to supplement non-guaranteed sources of income such as dividend-paying mutual funds. But whether they’re worth it depends on your particular situation, assets, and how you manage the rest of your portfolio. For instance, an otherwise aggressive investor might benefit from having a guaranteed income source should the market falter.
Research suggests that using an immediate annuity within a larger retirement portfolio can improve overall portfolio performance, and therefore legacy value to heirs.
It’s important to remember that in purchasing an immediate annuity, you generally give up access to the entire purchase amount. If you need liquidity—meaning you might need to access those funds in an emergency, for example—you could be better off using a different guaranteed strategy, such as a CD ladder, in which you can earn interest and draw down your capital over time or as needed.
- Immediate annuities are insurance products designed to provide a guaranteed lifetime income.
- Unless you live past life expectancy, immediate annuities have low rates of return.
- If you live well past your life expectancy, your return could be much higher than similar investments.
- To purchase an immediate annuity, you exchange a lump sum for income.
- Immediate annuities can be used to supplement Social Security and pension income.