An annuity is a contract between a person and an insurance company. There are various types of annuities. Here we will look at the immediate annuity. It should not be confused with the deferred annuities which are commonly called the fixed annuity, the indexed annuity or the variable annuity.
With an immediate annuity a person pays the insurance company a lump sum payment called a premium. In exchange for this payment the insurance company gives the person a regular income that the person could not outlive.
This helps the person overcome two different risks. One risk it helps overcome is investment risk or market risk. The insurance company is legally obligated to pay the income no matter how the stock or bond market is performing.
The other risk which this contract helps the person with is longevity risk. That is the risk that a person will live too long, longer than the persons savings will last. It’s sort of like having reverse life insurance. Instead of transferring the risk of your premature death to the insurance company you are transferring the financial risk of a prolonged life to the company.
The amount of income a person receives is primarily based on the person’s age, but interest rates at the time of purchase are also a factor. Older people receive much higher payouts than younger people due to the unfortunate fact of life that they will not be around as long to receive payments.
The great thing about immediate annuities is that you now have a guaranteed lifetime income that you cannot outlive! Often you can even structure them so that your income payments increase each year, hopefully keeping up with inflation.
The drawback to this type of annuity is that you no longer have an investment that you can randomly draw cash out of. In a way, you have purchased a private pension from the insurance company and all sales are final. If you want to change your mind it would be like asking the government for all your social security money back because you no longer want to participate in the program. It’s not going to happen.
A second drawback to this type of arrangement is that under normal scenarios your beneficiaries are not going to receive much after your death. In fact they might not receive anything. It is possible to structure the contract so that your beneficiaries do receive money, but that’s a subject for another time. To keep it simple, don’t put money that you want your kids or beneficiaries to have into an immediate annuity.
Everybody likes the thought of guaranteed lifetime income. Most people however do not like giving up complete access to their money or the idea of the kids not getting anything upon the owner’s death. For these two reasons other types of annuities developed that provide some income benefit while still providing access to the funds as well as a death benefit.
As for immediate annuities, they can be appropriate for passive investors who feel they need another source of guaranteed income. The desire for a guarantee is important because other investments will probably produce more income over time, but they do not have the same guarantee that annuities have. Since it is a very permanent decision you should only put a portion of your money into an immediate annuity. $10,000 is a common minimum dollar amount to purchase. The more you put in initially the higher your monthly income payment will be.