The use of annuities dates back to ancient times when the government of the Roman Empire would offer its citizens and soldiers an annual stipend, or “annua,” in exchange for a lump sum of money. Similar exchanges continued to occur throughout Europe as a way for governments to raise capital to fund wars and other government activities. Today the lineage of annuities has branched out into several different variations used for accumulating, preserving, and distributing retirement capital. The most direct descendant of annua is the immediate, or income, annuity, widely used to provide a guaranteed lifetime income.
What is an Annuity Payout Rate?
When evaluating and comparing annuities, it’s essential to consider the annuity payout rate, which determines how much you can expect to receive each month. The payment amount, or payout factor, is derived by dividing the lump sum of capital by the number of payment periods and then factoring in interest accumulation and expenses over the total payment periods. Once determined, the payout factor is fixed for life (fixed annuity).
The annuity payout factor is calculated to deplete the original principal and interest credited by the end of the payment period, which signifies the end of the life insurer’s obligation to the annuitant. The exception is when a lifetime income option is selected, which means that the income payments will continue beyond life expectancy for as long as the recipient lives. In that instance, the life insurer assumes the risk of life longevity. It is that aspect of annuities that make them so compelling to retirees – no more fear of outliving one’s income, as long as the insurance company remains solvent.
The longer you wait to start receiving income from an annuity, generally, the higher your payout rate will be. That’s because the same amount of principal is returned over a shorter period of time.
What’s the Difference Between an Annuity Payout Rate and its Rate of Return?
But the payout rate is different than the annuity return rate, which is the annualized earning rate of your investment. If the payout rate of $100,000 immediate annuity is 6%, generating $6,000 a year, a portion of that income is a return of principal, so it cannot represent the real rate of return on the investment. For this reason, a more useful comparison of immediate annuities is to consider the internal rate of return (IRR) of your investment.
Consider the following example:
David, 65-years old, purchases a $100,000 single-life immediate annuity that pays him $700 per month, or $8,400 per year. On the surface, it appears that David’s annuity is generating an 8.4% rate of return. But remember, the monthly payment includes a portion of his principal in addition to interest earned. If David lives to age 83, the annuity will pay him a total of $151,200.
Calculating the IRR of an immediate annuity is more complex than determining the payout rate because it accounts for all cash flows, including interest earned less the percentage of principal returned with each payment. This would require a spreadsheet to calculate the IRR on every payment over the payment period. The easiest way to calculate the IRR is to use an online IRR calculator for annuities.
In this example, the length of the annuity payment period is 18 years, and the final value of his annuity is zero (assuming he died at his life expectancy of 83 years). Using the $8,400 he receives each year as the annual annuity payment, the calculator arrives at 4.77% as the IRR.
While 4.77% is not as impressive as the 8.42% payout rate, if David lives another 12 years, the IRR of his annuity increases to 7.42%. That is what makes the guaranteed lifetime payments a valuable feature of an immediate annuity. Conversely, if David lives to only 72, the IRR would be -23%. He would have only received $42,000 of payments while the insurer keeps the balance of his principal.
Key Takeaway: The longer you live, the greater the return on your investment. But the primary objective of an immediate annuity is to ensure you don’t outlive your income.
Factors that Influence Annuity Rates
Annuity rates are primarily determined by the investment performance of life insurers in their general account, which is invested in a wide range of investment-grade short-term, intermediate-term, and long-term bonds and other fixed-income vehicles. But other factors can influence the rate earned in annuity accounts.
Annuity rates can be affected by increases and decreases in interest rates.
The more money you deposit, the higher the income payment you can expect.
The shorter your life expectancy, the higher your annual or monthly income payments because there is less time to pay back all your principal.
Insurance companies charge many different types of fees to cover the cost of insuring your income. These fees are charged to your principal, which can reduce the amount available to be paid out.
If you choose a single-life annuity, your payout will be higher than a joint-life annuity where a spouse beneficiary continues lifetime payments after the primary spouse dies.
The annuity marketplace is highly competitive, leading annuity providers to compete on price or rates. Some annuity providers can be very aggressive, offering high initial rates but lower minimum rate guarantees. Because an insurer’s promise to guarantee your income is only as good as its financial strength, annuity investors may want to consider only those insurers with the highest financial ratings from A.M. Best.
Types of Annuities
There are two main types of annuities: immediate annuities and deferred annuities. The latter being annuities that will payout in the future, and the former being annuities that begin immediate payouts. Within these types of annuities are many variations of annuities for different scenarios.
The premise of an immediate annuity is straightforward. In exchange for a lump sum deposit, a life insurance company promises to make income payments for a certain period of time or the life of the annuitant. The annuity payout rate is calculated based on the annuitant’s age, the length of the payment period, and an assumed rate of interest to be credited to the annuity balance.
The length of the payment period can either be a period certain (i.e., ten years) or the life expectancy of the annuitant. The total payout is calculated to deplete the annuity balance (including accumulated interest) by the end of the payment period. For a period certain payout, that is the end of the life insurer’s obligation. For a lifetime payout, the insurer’s obligation continues as long as the annuitant is living, even if it is beyond life expectancy. That is the risk the life insurer assumes, which is what makes immediate annuities so unique. There is minimal risk of outliving your income. The risk is that the insurance company goes out of business.
In the early 20th century, life insurers recognized that many people didn’t have lump sums of money to commit towards an immediate annuity or had a lump sum to invest but no immediate need for retirement income. So, they added an accumulation component to annuities that allowed investors to “defer” income distributions into the future while the insurer guaranteed the annuity principal.
A fixed deferred annuity is a contract with a life insurer that promises to guarantee the principal investment while providing a minimum fixed rate of return. Withdrawals are limited to 10% of the principal value during the surrender period, which can last between seven and 15 years. Withdrawals exceeding the 10% limit will be subject to a surrender charge that can start as high as 15% in the early years and gradually decline to zero in the final year of the surrender period. After the surrender period, withdrawals of any amount can be made, but they are taxed as ordinary income. Once all the interest earnings have been withdrawn, the principal can be withdrawn with no tax consequences.
Comparing Different Types of Annuities
We’ve described what an immediate and deferred annuity is and how they work. In many cases, investors aren’t ready to start taking income from an annuity, so they might invest in a deferred annuity to accumulate their capital before converting it to an immediate annuity. Here are the different types of annuities.
Deferred Income Annuity
A deferred income annuity (DIA) is similar to an immediate annuity in that it exchanges a lump-sum premium for guaranteed lifetime payments. The difference is, with an immediate annuity, the payments start immediately (within one year of deposit). In contrast, the payments for a DIA are deferred until some time in the future, up to 40 years. A DIA appeals to retirees who have no immediate need for income and anticipate a bigger need for income in the future.
A DIA acts as longevity insurance. Because the payout amount is based on your life expectancy, the longer you wait to start taking income from a DIA, the higher your monthly payout amount will be. For example, if you deposit $50,000 into a DIA at age 65 with payments to begin in 15 years at age 80, your monthly payout will be about $1,300 a month. If you wait until age 85 to start receiving income, the monthly payout jumps to $2,475. Because the life insurer guarantees your monthly payout for life, you will continue to receive it if you live beyond your life expectancy. That is the real value of longevity insurance.
Qualified Longevity Annuity Contract
As with the DIA, qualified longevity annuity contracts were designed to address longevity risk. They are similar to DIAs in that the income payments are deferred for a period of time, up to 20 years or age 85, whichever comes first. The critical difference is that a QLAC may be purchased inside a qualified retirement plan. They can be particularly appealing to retirees who want to avoid required minimum distributions (RMDs) from the retirement plans starting at age 72. When a retiree purchases a QLAC inside their 401(k) or traditional IRA using accumulated retirement funds, the year-end balance in the account is reduced by the amount invested in the QLAC. Because the annual RMD amount is based on the year-end account balance, the effect of the investment in a QLAC will reduce the RMD.
The amount that can be invested in a QLAC is restricted to 25 % of the retirement account’s balance or $125,000, whichever is less.
Multi-Year Guaranteed Annuities
A multi-year guaranteed annuity (MYGA) is similar to a fixed deferred annuity in every way, except they offer a multi-year rate guarantee. Whereas a fixed deferred annuity typically offers a one-year guarantee, with a MYGA, you can lock in an attractive rate for a certain number of years ranging from two to 10 years—the longer the rate lock, the higher the return.
Variable annuities are deferred annuities that offer the opportunity to earn stock and bond market returns instead of a fixed rate. That means the annuity owner assumes the market risk, which could produce negative returns. However, some variable annuities offer minimum rate and principal guarantees for an additional fee.
Fixed Index Annuities
For annuity investors who want to earn higher returns than a fixed deferred annuity but without the risks associated with variable annuities, fixed index annuities offer a happy medium. Fixed index annuities are similar to fixed deferred annuities except in the way the fixed yield is determined. With a fixed deferred annuity, the life insurer determines the yield based on the performance of its general account, which is invested primarily in high-quality bonds.
The yield for an index annuity is based on the percentage gain of a stock index, such as the S&P 500. If the index experiences an increase from one year to the next, the annuity account is credited with a portion of the gain. The life insurer retains the other portion as a “premium” for providing downside protection because, even if the index experiences a decline, the annuity account is still credited with a minimum rate of return.
Participation rate: The participation rate determines how much of the index’s gain is credited to the account. If an index annuity has a participation rate of 80%, that is the percentage applied to the gain to determine the gross yield to be credited. If the year-to-year gain is 20%, 16% would be credited to the account.
Rate cap: But that is before the rate cap is applied. Each contract specifies a maximum rate that can be credited, so if the rate is capped at 8%, then, using the same example, 8% is credited to the account instead of 16%.
Essentially, the market protection provided by the life insurer costs, in this case, 12% of the gain, which may seem like a hefty price, except to those investors who have incurred the wrath of significant market declines.
Participation rates and rate caps vary widely from one product to the next, so it would be essential to compare them to see which product can generate optimal yields from gains in the stock index. Just as fixed annuities offer a rate guarantee for a specific period of time, indexed annuities offer a guaranteed participation rate for a period of time. A high participation rate may turn out to be a way to lure you in, only to have it drop significantly in a subsequent year.
Indexed annuities provide an extra layer of protection by ratcheting up the principal, or basis, each year to include the prior year’s gain. This annual reset ensures that the annuity account will never lose value.
Why Choose an Annuity
The unique investment and tax properties of annuities can appeal to different investors with varying investment objectives.
Investors who are Risk Averse
Some people prefer to put their money in vehicles that have no exposure to risk. While that really isn’t possible, people associate savings accounts, T-Bills, and bank CDs with safety of principal. There are many different types of risk, which could have a detrimental effect on your long-term savings if not accounted for in your savings or investment strategy. But annuities provide many layers of protection for preserving principle. In addition to principal guarantees offered in many annuities, they also include minimum-rate guarantees to protect against steep declines in interest rates.
Investors who Dislike Taxes
Nobody likes to pay taxes, but for those investors in the higher tax brackets, annuities offer the benefit of tax deferral on earnings that accumulate inside the contract. However, they will have to pay taxes on their earnings when they are withdrawn. But assuming they are in a lower combined tax bracket at retirement, they will save on the amount of taxes they would have otherwise paid.
Investors who want a Competitive Edge
Even risk-averse people like to get that extra edge of half a percent or more interest credited to their accounts. The yields on annuities tend to be higher than those available on equivalent savings vehicles. Additionally, many annuity contracts will pay a bonus rate on initial deposits that exceed a certain amount. And, for CD-Type annuities, the rates go up even further when the deposits are committed to a minimum guarantee period (i.e., five to 10 years).
Investors who Think Long Term
Investors who have done a good job of establishing other savings or investment accounts available to meet short-term or emergency needs can turn toward annuities for their longer-term needs. In return for the guarantees, the tax deferral, the competitive interest rates, and the extra layer of protection that annuities provide, the annuity provider asks that you commit your funds for a minimum period of time.
Investors who don’t Like Surprises
Even risk-tolerant investors would like to build some stability and predictability into their retirement portfolios. With their minimum rate guarantees and minimum income guarantees, Annuities can accomplish that. When combined with other investments that fluctuate in value due to market swings, annuities can level out the downside returns with their steady rates and predictable income streams.
People Concerned with Outliving Their Income
If you are one of these people, you are not alone. Nearly 80% of Baby Boomers lay awake at night wondering if their assets are sufficient to generate the income they need for their lifetimes.
The Bottom Line
Annuities can play a vital role in securing your financial future, but they can be somewhat complex products to understand. This guide can help with a foundational understanding of how annuities work and how to choose the right one for your circumstances. However, it would be essential to consult with an independent financial advisor who is best positioned to help you find the perfect match for your needs, objectives, and financial situation.
Annuities are not free lunches. They can be very complicated for an investor to understand. Most annuities have very high fees, lock-up periods, and limited investment options. You need to make sure you research any product you’re considering very carefully.
You can find more information on buying annuities here on the Dechtman Wealth Management website. Or feel free to schedule a free consultation with one of our advisors.
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