Understanding Immediate Annuities

With all of the attention being given to variable and indexed annuities in recent years, the patriarch of all annuities, the immediate annuity, has gotten lost in the shuffle. Yet, perhaps at no time in its long history has its importance to retirement planners been greater. With more people approaching retirement with concerns over outliving their income, immediate annuities are suddenly in demand again. Understanding immediate annuities would be important for any person who is seeking a secure retirement income that can’t be outlived.

Immediate Annuity Overview

For as long as history has been recorded, annuities have been used by governments and financial institutions to provide people with a secure income in exchange for a lump sum of money. The governments of ancient Rome, and European powers such as England and France, used the capital raised from annuities to funds wars and major construction projects. Later, annuities were institutionalized by life insurance companies in the U.S. as a financial instrument offered to the public.

Immediate annuities are so named because they provide an immediate source of income for investors who deposit a lump sum of money. Investors enter into a contract with a life insurer that obligates the insurer to make period payments for a specific period of time, or for the lifetime of the investors. The investors’ capital is irrevocably turned over to the insurer so that it can fulfill its contractual commitment.

Immediate Annuity Mechanics

When an investor deposits a lump sum of money with a life insurer, the insurer commits to making period payments for the period specified by the investor. The insurer then makes a calculation to determine the rate at which payments will be made. The key factors used in the calculation are the current age and life expectancy of the investor, as well as the projected interest rate that will credited to the annuity balance. The resulting payout rate establishes the amount of income that will be paid so that, by the end of the payment period, the entire annuity balance will have been returned to the investor plus interest.

Determining the Payment Period:

The payment period may be a specified period of time, such as 15 years, or it may be the life expectancy of the investor. If, at the time of the deposit, the insurer determines that the investor’s life expectancy is 25 years, then that becomes the payment period. The significant difference between using a specified period versus a lifetime period is that, if the investor, or annuitant, lives beyond his or her life expectancy, the life insurer is still obligated to continue the payments until the actual death of the investor. This is insurance aspect of an annuity in which the life insurer assumes the risk of the investor living too long.

How the Length of the Payment Period effects the Payout:

Since the payout rate is based on both a return of principle plus an assumed rate of interest, the rate is directly affected by the length of the payment period. The shorter the period, the higher the payout rate because more of the principle balance will need to be returned more quickly. This is one reason why some retirement planners will recommend delaying the income payments from an annuity for as long into retirement as possible.

Tax Aspects of Annuity Payments

When an annuity payment is received, it is taxed as ordinary income to the extent that it consists of earned interest. The portion of the payment that is a return of principle is not taxed.

Annuity Payments after the Death of the Annuitant

In its simplest form, the payments are made to an annuitant as a single life, so that, at the death of the annuitant, the payments simply stop and the life insurer retains the annuity balance. If the annuitant is married, and the annuity is titled as joint life, then the payments would continue until the death of the second annuitant. The payout rate is reduced by a percentage to cover the risk of the additional life. Even in that case, the insurer would retain the annuity balance unless a refund option was selected.

Refund Options:

If the annuitant would like to have the account balance proceeds paid to a beneficiary, then a refund option can be selected which would pay the proceeds in installments. Refund options can be selected for varying periods in which, if death occurs the beneficiary would receive the proceeds. For instance, if a refund option for a period certain of 10 years is selected, death must occur within that 10 year period for the refund to be paid to the beneficiary. A lifetime refund option could be selected as well, but the length of the refund period will affect the payout rate. The longer the refund period is, the lower the payout rate.

Other Payment Options

Because annuity payments are fixed at the time of annuitization, the income can eventually lose its purchasing power over time due to inflation. Many immediate annuity contracts include an option for adding an inflation rider with will link the payments to an inflation index. The charge for this rider reduced the current payout rate.

Behind the Life Insurer’s Obligation

The obligation of a life insurer to guarantee a lifetime of income is one in which investors must be able to have complete faith. For retirees, financial security is paramount and it is something that they can’t afford to risk. With immediate annuities, life insurances guarantee both the annuity balance and the stream of income payments. Life insurers have been fulfilling their annuity obligations for two centuries without an incident of principle loss for any annuity owner. This record of safety is due primarily to the way lie insurers are structured and the strict regulations by which they are required to conduct their business.

Life insurers are required by their state regulators to maintain a reserve of liquid assets that would be able cover all of their future obligations. The state’s monitor these reserve levels each year to ensure that the requirements are met. Additionally, each state has a guarantee fund that will reimburse annuity owners for the loss of their annuity account balance up to $250,000(in some states), much like the FDIC insurance covers bank deposits.