Understanding Immediate Annuities
Immediate annuities are the simplest type of annuities. You give the insurance company a sum of money, the premium, and they give you a payout each month for the rest of your life. The amount of the payout is calculated by the insurance company based on your age, your life expectancy, and the amount of the premium. It is also common to select a fixed payout period of say 10 to 15 years. It could be said that the insurance company is betting that you will die soon since at that time the payouts stop. While you, on the other hand, are betting you will receive payments over the entire payout period or over a very long life if you have purchased a lifetime policy.
These annuities are generally sold to retired people who will have sufficient assets remaining after purchasing the annuity to cover unexpected emergencies. Immediate annuities provide a guaranteed lifetime income stream but there is no provision for a lump-sum payout to cover emergencies. People in the workforce generally have a sufficient income stream to cover living expenses so immediate annuities are not usually purchased. Immediate annuities do offer income for those at any age not willing or able to manage their own investments.
To see how they work and to determine if they are a good option, look at a real life example. If you are a male, 65 years old in 2013 living in Texas then for a $100,000 premium you can purchase an immediate annuity providing a lifetime monthly income payment of $585. You would be told by the broker that this is a payout of 7.02% determined by the yearly payout of $7020 for the $100000 premium. Not bad until you consider that most of the monthly payout is your money that the insurance company is giving back to you.
So what interest rate are you really earning on your investment? Well that depends on when you die. If you live about 14 more years until you are 79 then you will have just received back your entire $100000 premium, that is to say, you will have realized a 0% interest rate. Your life expectancy if you are 65 is about 19 years so on average you should live until you are 84. If you make it that far you will have received $133,380 which is equivalent to having received an annual interest rate of 3.182% on your investment for the 19 years.
You can think about this return in more familiar terms. Assume you borrowed $100000 and had to payback $585 per month. If the contract called for 14 years of payment then you would just pay back the original amount so the loan would have had zero annual interest. If it took longer to pay off the loan then that would mean interest was applied. If the annual interest rate was 3.182% then it would take 19 years to pay off the loan and the total payments would be $133,380. Now just reverse the thinking and realize that the insurance company has effectively borrowed the $100000 from you and are paying it back with an effective interest based on how long you live.
The table below shows this effective annual interest rate versus when you die and the payments stop. Clearly if you die before you reach 80 you never get back all your investment so the effective interest rate is negative. To get the 7.02% annual interest advertised you have to live a very long time, more than another 100 years.
But let’s say you made it to your life expectancy of 84 years old and realized an annual return of 3.2%. Was that a good option for you? Maybe, but there was no inflation protection, interest rates on CDs may have increased well beyond that number in the interim, the earning from the effective interest rate were taxed as ordinary income each year, you could not have canceled the contract at any time and received the undistributed portion of your premium, and when you do die there is no estate for your heirs.
There are plans that can continue payments if you die early. One example is a policy that pays for a period of 20 years either to you if alive or to a beneficiary after you die. The payments instead of being $585 would be reduced to $508 per month. At the end of the 20 years when payments stop, the effective annual interest rate would be 2.0% instead of 3.6% (from the table). There are many other plans with fixed payout periods or continuing payments to spouses but all will have effective interest rates similar to the examples given.
The tax treatment for the payouts of immediate annuities can be a problem. The insurance company claims that about 30% of each payout is earned interest subject to being taxed as ordinary income. The problem occurs if you used after tax money to buy the annuity and you happen to die before you have received a total payout equal to your original premium (14 years in the above example). If this happens you are paying taxes on each payout even though you are still just getting back your original investment which was already taxed before you bought the annuity.
Immediate annuities have not sold well, falling 14% from 2011 to 2012 and totaling only $1.8B per quarter. Indexed annuities on the other hand grew 6% in the same time period and totaled $6.8B per quarter. The performance advantages of indexed annuities are discussed in companion articles.