An immediate annuity is a guaranteed series of payments that can continue for a set number of years or one or more lifetimes. Payments are usually guaranteed by an insurance company. As financial firms gear up marketing programs aimed at retiring baby boomers, these annuities are growing more visible and perhaps more attractive to consumers. The promise of steady, predictable income that you can't outlive is appealing, but it's not so good that you should rush to buy the first immediate annuity offered. The immediate annuity market is very competitive, and you may be able to significantly increase your retirement income just by shopping around. The analysis required to compare immediate annuities is not time-consuming or complex; this article will walk you through it. (For related reading, see Immediate Annuities: More Income and Lower Taxes.)
Three Types Of Immediate Annuities
Immediate annuities are purchased in three main ways:
- Lump-Sum Payment - A sum of money is transferred to an insurance company to buy a stream of income. Common sources include cash from a retirement plan distribution, an award in a personal injury settlement, divorce and lottery winnings.
- Annuitization of a Deferred Annuity - Most tax-deferred annuities allow the account to be converted into a guaranteed stream of payments.
- Terminal Funding of Retirement Plans - Some individuals who participate in retirement plans are offered annuity payouts at retirement. The plan terminates its liability to the participant by transferring it to an insurance company. When retirement plans pay out in this manner, a special kind of "qualified immediate" annuity is often used for tax efficiency.
A key point to understand is that all of these choices present options. For example, if you own a tax-deferred annuity and want to annuitize, you aren't limited to the payout offered by your own insurance company; you can shop among payouts offered by competing companies and then complete a tax-free (Section 1035) transfer to the company that offers the best terms. If your retirement plan offers one insurance company for terminal funding, you can shop for others and then transfer the money to the vendor you think is most suitable for you. (For more on this, see Selecting The Payout On Your Annuity.)
Always shop around and compare quotes for immediate annuity rates. The more quotes you obtain, the better. The next step is to compare annuity quotes to each other, as well as to other alternatives for earning interest on your money, such as a certificates of deposit (CD), money market funds or bonds.
Evaluating a Straight Payout Over a Fixed Period
Any annuity payout over a fixed number of years, purchased with a single sum, can be converted into an annual interest rate equivalent. For example, suppose you are quoted an annuity of $600 per month over the next 20 years, and you will pay a premium of $100,000. In Excel, you can build a quick calculator of annuity rates, and it will tell you that this payout converts into an annual interest rate of 3.96%. The boldfaced numbers are those that you input based on the annuity you're evaluating. (For more on using Excel, read Microsoft Excel Features For The Financially Literate.)
|3||Period in Years||20|
|5||Annual Interest Rate||3.96%|
- The formula in cell B4is:
The formula above uses Excel's RATE function to convert the stream of payments into a monthly interest rate.
- The formula in cell B5 is:
This converts the monthly interest rate in B4 into a compounded annual rate. This rate can then be compared to other fixed-period annuity payouts (perhaps over longer or shorter periods) and also to rates currently available on bonds, money market funds or CDs.
Evaluating a Lifetime Payout
In a lifetime annuity payout, there is no fixed period to evaluate because death could occur and payments discontinued at any time. Therefore, a good starting point is to use the annuitant's life expectancy for the payout period.
For example, suppose that a female who is age 67 is offered a straight life annuity of $600 per month in return for a premium of $100,000. According to the Period Life Table published by the Social Security Administration, her life expectancy at age 67 is 17.67 years. This factor is based on the table updated on July 9, 2007.
Note that the table includes different life expectancy factors (for each age) for men and women. According to the table, women of retirement age outlive men by three to four years, on average.
Plugging a payout period of 17.67 into the Excel calculator produces an annual interest rate of 2.87%, as shown below.
|3||Period in Years||17.67|
|5||Annual Interest Rate||2.87%|
It is fairly common for the annual interest rates on straight life annuities to be less than those on fixed-period annuities, and the reason relates to risk. Paying lower rates compensate insurance companies for bearing the longevity risk that an annuitant will live a very long time, in which case the insurance company must pay out more money.
The older a person is at the time of annuitization, the steeper this built-in life annuity payout penalty can be. In fact, it is common to see negative interest rates offered to people who buy immediate annuities in their 80s. In this case, the annuitant must outlive life expectancy by several years just to receive a return of principal. Therefore, except for the healthiest and most optimistic people, it usually does not pay to buy a lifetime payout annuity after age 75.
When to Annuitize
Anyone who shops for annuity quotes over time will see a common pattern: As prevailing interest rates go up, so do immediate annuity quotes. Therefore, to a degree, shopping for immediate annuities is akin to shopping for CDs. The best time to lock in the rate is near the top of an interest rate cycle, perhaps after the Federal Reserve has already raised interest rates several times.
Clients who make the mistake of buying CDs when rates are low can exit by paying a penalty or waiting until maturity. Annuity purchase decisions, however, usually have longer-term consequences and are irreversible. Retirees who lock in long-term annuity payouts when rates are low may keep paying a penalty for the duration of their retirement. Therefore, patience in waiting for attractive rates can be rewarding. (For related reading, see Step Up Your Income With A CD Ladder.)
Evaluating an Annuity With an Annual Increase
Some annuities offer an annual percentage increase in the payment to help offset inflation, and turning this type of payment stream into an annual interest rate can take a bit more work. For example, suppose the 67-year-old woman in the example above is offered an annuity payout over 15 years. The first payment will start at $500 per month, and the payouts will increase by 3% per year. For this stream of payments, she will pay $100,000. This stream can be converted into an annual interest rate by using Excel's Internal Rate of Return (IRR) function, as shown below.
|18||Annual Interest Rate||1.31%|
- The formula in cellB18 is:
The annual interest rate shown in cell B18 is 1.31%. Note that the first value entered is the purchase payment as a negative amount (-100,000).
What Good Is a Low Rate?
You might wonder: Why would anyone accept an annual interest rate of just 1.31% on a long-term fixed-period payout? The answer may be: Because they don't bother to perform this simple calculation.
If you do perform the calculation and then ask the insurance agent or company about it, they may tell you than in an annuity payout with an annual inflation increase, the company must be compensated for the extra risk. This answer is nonsense. All future payments in such an annuity are fixed at the time of purchase, and there is no extra risk just because payments increase. It is different if the annual increase is tied to an unknown variable, such as Consumer Price Index (CPI). Some immediate annuities have begun to offer CPI-linked payments. (For related reading, check out The Consumer Price Index: A Friend To Investors.)
The Financial Strength of Your Insurance Company
Finally, there is one other important issue to consider in evaluating immediate annuities - the financial strength of the insurance company. Immediate annuity payouts can last for decades, so it's important to choose a company that is strong enough to survive and honor guarantees across economic cycles. For each company that makes your "final cut", be sure to check the current ratings, which are usually posted on the insurance company's website. Three leading agencies - A.M. Best, Moody's and Standard & Poor's - rate most major U.S. insurance companies.
Don't grab an immediate annuity quote just because you like the idea of a guaranteed check in your mailbox every month, already do business with the same insurance company or hear a great sales pitch. In this important, irrevocable decision, it pays to shop around.
In fact, it pays to shop 'til you drop - and then use the calculation tools described in this article to convert annuity quotes into annual interest rates. If you can obtain superior interest rates in products with more flexibility such as CDs or bonds, maybe it's not such a good idea to lock up your money in annuities long term. The best reason to buy an immediate annuity is a combination of an attractive locked-in interest rate and a guarantee of income you can't outlive, even if you live to age 100 or more.