Originally, annuities had one purpose: to convert a lump sum of capital into a stream of income for life, or for a certain time period. They were designed for people who were retiring or otherwise needed a fixed, guaranteed monthly income.

Today, there are various types of annuities that can be used to accumulate capital through investment, in addition to providing a guaranteed income.

Key Takeaways

  • Annuities provide a fixed monthly income either for a set period of time or for the rest of your life.
  • The amount of monthly lifetime payments is determined by your age at purchase and your life expectancy.
  • An annuity should not be your sole source of retirement income, as over the years inflation reduces its value.

A Secure Income Stream

For most retirees, the overriding concern is for a secure income stream for the future.

The best age at which to get an annuity depends on a number of factors, including a person’s current circumstances and investments, risk tolerance, longevity prospects, and expected income needs in retirement. Given these factors, the best age to get an annuity is when you are able to optimize its benefits for your individual needs.

As people live longer and rely more heavily on their own capital, the notion of converting a portion of that capital into a guaranteed income stream has its appeal.

Income annuities, also known as immediate annuities or immediate payment annuities, were designed for that purpose. When you buy an income annuity, you enter into a contract with a life insurance company in which the insurer agrees to make fixed monthly income payments in exchange for a lump sum of money. This type of annuity starts paying income as soon as the policy has been initiated, in contrast with a deferred annuity, which doesn't start to pay out until years later.

Income annuity payments are guaranteed for your lifetime or for a specified number of years. The payout is a bit less for a lifetime annuity because it adds a degree of uncertainty.

Fixed vs. variable annuities

Fixed annuities guarantee a specific interest rate on money invested in the contract, with the insurance company choosing and managing the investments. The interest on variable annuities, by contrast, can fluctuate because it is based on the performance of the owner's investment portfolio for the annuity. Thus, fixed annuities have more predictable returns than variable ones.

How an Income Annuity Works

The monthly payout amount is based on a number of factors, including your age and gender, interest rates, and the amount of capital invested.

Annuities are designed to pay out the full amount of principal and interest by the end of a certain period. If you want payments made for a 10-year period, the payment amount is based on the principal and total interest to be earned during the period, divided into 120 monthly payments.

If you want a lifetime income, the payment amount is calculated based on the number of months between your current age and your life expectancy age. If you are 65 and your life expectancy age is 80, the payment amount is based on 180 months. Even if you live beyond your life expectancy, the monthly payments continue.

In general, the longer you wait to annuitize your capital, the larger your monthly payment will be.

The Wait Can Be Worth It

Based on this formula, a shorter annuity payout period results in a higher monthly payment. If you want to maximize the guaranteed monthly payment, your best option is to wait as long as possible to annuitize your capital.

Consider a person who invests $250,000 in an income annuity at age 65. If the interest rate is 2.5% and the annuitant's life expectancy is 15 years, the monthly annuity payout would be $1,663.66. If they wait five more years to annuitize, the monthly payout amount rises to $2,353.54. Wait until age 75, and it becomes $4,433.75—guaranteed for life.

Factors to consider

For someone with a reasonably healthy lifestyle and good family genes, starting an annuity at a later age is clearly the best option.

Waiting until a later age, of course, assumes that you're continuing to work or have other sources of income, such as a 401(k) plan or a pension as well as Social Security.

It is generally not advisable to tie up all—or even most—of your assets in an income annuity, because once the capital is converted to income, it belongs to the insurance company. That makes it less liquid.

Also, while a guaranteed income may be highly desirable as insurance protection against longevity, it is a fixed income, which means it will lose purchasing power to inflation over time. Investing in an income annuity should be considered as part of an overall strategy that includes growth assets that can help offset inflation throughout your lifetime.

Most financial advisors will tell you that the best age for starting an income annuity is between 70 and 75, which allows for the maximum payout. However, only you can decide when it's time for a secure, guaranteed stream of income.