If you’re about to retire, and want to create an immediate source of retirement income, you should investigate immediate annuities. You can set one up at the time of retirement, and it will begin providing you with income payments immediately. In addition, it can be setup to provide you with income for the rest of your life.
In that way, an immediate annuity can function like a defined benefit pension, if you’re not already covered by one through your employer. It solves the problem of how you’re going to convert your investments to an income once retirement arrives.
What are Immediate Annuities?
Sometimes referred to as a Single Premium Immediate Annuity, or simply SPIA, immediate annuities are setup to provide you with income in retirement. You you can set up the income payments so that you will receive them for the rest of your life, or you can have them run for a specific period of time, such as 20 years.
Like most annuities, immediate annuities can function like a defined benefit pension plan, that will provide you with a steady income throughout your life. But what distinguishes them from other types of annuities is that you can begin receiving payments immediately after establishing the annuity.
Other annuities require that a certain amount of time passes before you start receiving income. But with immediate annuities, you turn the money over to the insurance company, and you begin receiving income right away. Immediate annuities can be an excellent supplement to Social Security income, or other sources of retirement income that you have available. You also have the option to set an immediate annuity up as either a fixed or variable payment with regard to the income that you receive.
How Immediate Annuities Work
To set up an immediate annuity, you make a one-time lump sum annuity payment to the insurance company – which is referred to as a “premium”. The insurance company then guarantees that they will make regularly scheduled payments to you, immediately after the annuity is established.
You can choose the sequence of income payments. For example, you can select monthly income payments, or some other frequency, such as quarterly, semiannually or even annually, if that's your preference.
Your income payments are based on current interest rates. That means that the higher rates are, the higher your income payments will be. The interest rate, also called annuity rate, is set at the time that you open the annuity, and will be fixed for the life of the contract – which is the rest of your life.
When you set up the annuity, you can choose to receive income for the rest of your life. But if you want your spouse to continue receiving income even after your death, you should choose an income payment period covering a specific amount of time.
For example, if you and your spouse are each 60 years old, you may want to choose an income payout that will last for 30 years. If you were to die at, say, 80, you could arrange the annuity such that your spouse will continue receiving benefits for the remaining 10 years of the contract. You can also choose a joint annuitant option, but there will be additional fees for this.
Like all annuities, immediate income annuities do offer you an opportunity to add various riders that can enhance the benefits that they provide. One important rider is a select monthly income payments. Since annuities terminate upon your death, and any remaining proceeds revert to the life insurance company, they typically don't pay a death benefit to your heirs. But you can add a death benefit rider that will provide that benefit, while the annuity itself is providing you with a living benefit. The rider will reduce the size of the income payments that you receive on the annuity, but it will enable you to provide for your heirs upon your death.
As is the case with any annuity you may choose to invest in, you should always carefully explore all of the various options that are available with them. The addition of a single benefit could make the difference in whether or not an annuity will work for you.
The Benefits of Immediate Annuities
Immediate annuities provide certain benefits that are unique to that type of annuity, and others that are common to all annuities.
A safe, secure investment. Immediate annuities provide complete safety of your investment principal. They also guarantee the income level that you will receive, and also ensure that it will continue throughout your lifetime. These are all benefits that are critically important at the time of retirement. An immediate annuity can provide you with known benefits that can help to relieve much of the anxiety that comes with retirement. You won't spend time worrying about the performance of the stock market, and how that might impact your income or your retirement.
Income for life. We've been touching on this point throughout this article, but it's the central benefit of immediate annuities. Most other types of retirement related investments run the risk of running out. As the principal in the plan draws down, the income distributions decline as well. That is not the case with immediate annuities. You will have a fixed stream of income, and a guarantee that you will receive it for your entire life. That means that you can never outlive your retirement savings.
A completely passive investment. While some people are investment savvy, it’s likely that most people are not. Immediate annuities are perfect for people who want a completely passive investment. You won't need to worry about how or where to invest the money in the plan, since it is actually an income contract. You invest your money up front, the plan pays you a specified income level for life, and there is nothing more that you have to do.
Higher returns than CDs. Let's face it, interest rate returns on certificates of deposit and Treasury bills are pathetically low. Insurance companies generally pay higher interest rates than those other types of investments. In addition, since part of your income payment represents a return of capital invested, the income that you receive from the annuity will be higher than the interest income streams that CDs and Treasury bills earn.
No commissions or administrative fees. Your entire premium invested goes into the contract, and is used to generate and pay your monthly income. There are none of the high commissions or administrative fees that typically accompany other annuities, and even other retirement plans.
No limit on contributions. You can literally contribute as much to a deferred income annuity as you like, as there are no legal maximums. This is important if you don't have sufficient savings for retirement, or if you simply want to increase the amount of savings and income that you will have available when you retire.
Virtually all tax-sheltered retirement plans cap the amount of your annual contributions, either by a dollar amount or by a percentage of your income. Immediate annuities, and annuities in general, have no such limits. You can contribute as much as you want to a contract, to produce the level of income that you need.
Creating your own pension equivalent. Very few people today will retire with traditional employer-sponsored defined benefit pension plans. Those are the plans that are funded completely by the employer, and pay out a specific monthly benefit for the rest of your life. But you can use an immediate annuity to provide the same result. By depositing a certain amount of money with the insurance company for the annuity contract, you virtually guaranteed a constant income stream for the rest of your life.
Creating a death benefit. Though annuities typically do not have a death benefit, you can add a death benefit rider to your annuity, that will pay a specific amount of money to your heirs upon your death. Though the rider will reduce your income payments somewhat, adding it to your annuity will enable the contract to both provide you with income for life, and a death benefit for your loved ones.
The Risks of Immediate Annuities
Like all annuities, immediate annuities do come with certain risks. In taking an annuity, you have to weigh those risks against the benefits that the contract will provide.
Immediate annuities don't grow over time. The inflation that you've seen throughout your life won't end when you retire. That's a problem with immediate annuities. There is no growth provision in this type of annuity, so it's likely that the income you receive from the plan will slowly but steadily decrease in purchasing power over the years.
If you're planning to start your annuity with an investment that will not be sufficient to pay the income level you will need to retire, you may want to consider a different annuity, such as a deferred income annuity. That type of annuity will allow several years for your investment to grow before it begins paying income benefits. The larger the investment is, the higher the income payments will be.
The monthly income payments are fixed for life. This gets back to the inflation factor. A monthly payment of $2,000 per month that provides you with sufficient income to retire at age 65 (along with other retirement income sources), may no longer be enough when you are 75. Inflation may lower the real value of that income to $1,500, making it difficult for you to survive.
Immediate annuities don't have an automatic cost-of-living (COLA) built into the contract. However, you can purchase a COLA option, that will help to keep your income payments in line with inflation.
Immediate annuities are not liquid. This is true of all annuities, but particularly with immediate annuities. The only withdrawals you can make from an immediate annuity are the scheduled income payments. An immediate annuity is a contract to provide you with an income stream. As such, it is not the type of account that you can simply pull money out of when the need arises. For that reason, an immediate annuity is best supplemented with a generous emergency fund, or some other investment accounts that you can access if you need extra cash.
Not a DIY investment. Immediate annuities are much more like traditional pensions than they are like self-directed retirement accounts. If you like to do your own investing, you will not be able to do that with an immediate annuity. It’s basically a contract between you and the insurance company, in which you put up a certain amount of money upfront, in order to purchase an income stream for life. There will be no investments in the plan to manage.
Interest rate risk. This is perhaps the biggest single risk of having an immediate annuity. Given that the income you receive is fixed when you take the immediate annuity, your income will not increase if general interest rates increase. If you believe that interest rates will increase, you should delay taking an immediate annuity until rates reach a level that's satisfactory to you. In the current ultra-low interest rate environment, you may want to consider other types of annuities with better returns and higher income payments as alternatives .
Death and survivorship. If you don't add a death benefit rider to your annuity, any funds remaining in the contract at the time of your death will revert to the insurance company. This is true of all annuities, and it is a trade-off in which you are essentially giving up your investment in exchange for the guarantee of income for life.
It is only because of this provision that insurance companies are able to pay you that guaranteed income. But it means that if you die five years after taking an immediate annuity, all the money paid into the contract – which will be most of it – will revert to the insurance company, and not be paid to your heirs.
As mentioned earlier, you can get around this limitation by adding a death benefit rider to your immediate annuity.
No FDIC insurance. Annuities are not covered by FDIC insurance, the way bank investments are. They are instead guaranteed by the issuing insurance company. The incidence of insurance company failure is extremely rare. But you can lower those chances by checking the company's rating with A. M. Best. The higher the rating that they assigned to the company, the lower the chance that they will ever default.
In addition, most states have guaranty associations that provide at least some protection in the event of a default by the insurance company. You can call your state insurance commissioner to see if your state has this protection, and how much coverage they provide. The level of coverage is typically somewhere between $100,000 and $300,000.
Are Immediate Annuities Good for You?
Immediate annuities are best for people who upon reaching retirement want to create a reliable income stream, but don't know how to do it through direct investment. They are also worth considering if you are not covered by an employer sponsored defined benefit pension plan. An immediate annuity is set up specifically to be a substitute pension.
They are also good for people who are looking for complete security. Your principal value is guaranteed, as are your income payments. You can set up an immediate annuity upon reaching your desired retirement age, and began receiving income payments the following month. In this way, an immediate annuity can be an excellent way to retire before you are eligible for Social Security. You can begin taking income payments and age 59 1/2, without having to pay a 10% early withdrawal penalty.
These are also “fear-free” investments. You turn your money over to the insurance company, and you don't have to worry about anything anymore. You don't have to worry about what's going on in the financial markets, because your monthly income payments are guaranteed no matter what happens.
And like all annuities, they provide you with an opportunity to save even more money for retirement, or to play catch-up if you’re approaching retirement age with insufficient savings. Since there are no maximum contribution limits, you can contribute as much as you need to in order to provide for the type of retirement that you want.
On the flip-side, if you prefer to actively manage your own investments, you probably won't be interested in an immediate annuity, since there are no investments to manage. And if you believe that interest rates are likely rise in the coming years, you will at least want to delay taking this type of annuity.
Finally, you're concerned with the impact that inflation will have on your future income payments, you should probably avoid an immediate annuity altogether. This is especially true if you are retiring by 65 or earlier. Since your income will need to last for another 20 or 30 years, inflation will be a major factor.
Carefully evaluate all of the benefits and risks of immediate annuities before entering into one. And be sure to check out the available options – they may improve or increase the benefits enough to make an immediate annuity worth taking.
