How an Immediate Annuity Payout Really Works

by Neal Frankle, CFP ®

An annuity payout might be very attractive to you if you are looking for retirement income, but you should really think twice. Even though I’m not a big fan of this idea, I have to admit it has some attractive benefits:

 

annuity payout

 

Immediate Annuity Payout Pros:

1. High Payout

Let’s say you invest $100,000 and request an immediate payout. Depending on your situation and the choices you make, you might receive as much as $700 a month. That’s better than an 8% return. Very attractive in the current market environment. (More on this “high payout” in a minute…)

2. Security

Your income isn’t FDIC-insured, but it is backed by the insurance company you bought the annuity from. (Today, that’s not saying as much as it used to, but it’s still something.) At least your income is “guaranteed” by the insurance company and not subject to the ups and downs of the stock market.

High payout and security are the major benefits. Now let’s consider the flip side of the coin.

Immediate Annuity Payout Cons:

1. No Access to Capital

Once you invest in an immediate annuity, that’s it. Say goodbye to your capital. And don’t think of this as emergency funds. You’ll receive the income (assuming the company stays in business), but you can never change the monthly amount or get more money if an emergency comes up.

2. Your Payout Isn’t the Return Your Money Earns

It’s a combination of principal and interest. So, in the example above, while this person might be receiving a payout of 8%, most of it could be the investor’s own money.

Let’s take a look at our example. Assume you could invest $100,000 in an immediate annuity and receive $700 a month for the next 15 years. Your annual cash flow is $8,400 ($700 x 12 months). That’s 8.4% – but it’s not your investment return because a big part of that $8,400 is your own money. It turns out that the return is about 3.2%.

Now 3.2% isn’t bad in today’s market – but it sure isn’t 8.4%. And remember, you tie your money up for the next 15 years if you go this route. Interest rates might be much higher much sooner. Why take the risk?

In summary, an immediate annuity payout might look really attractive (and it might actually work if all you care about is maximizing your retirement income and you don’t need your capital.) But for most of us, it’s another investment that looks great but really isn’t.

 

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{ 21 comments… read them below or add one }

Debra January 16, 2013 at 5:11 PM

I just wanted to thank you for this article. Immediate annuities were misrepresented to me recently and we almost bought one. They are grossly inappropriate for our situation and this is the clearest explanation of how they actually work that I’ve found. Thank you!

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Neal Frankle January 16, 2013 at 6:46 PM

Glad this was helpful…and I’m even more delighted you didn’t get suckered into that annuity! Yea Debra!

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BJ September 17, 2012 at 7:54 PM

Neal, what are the risks of purchasing a hybrid fixed annuity with an income rider? I was forced by a physical disability to take an early retirement last year and I still have savings in the Federal Government TSP plan. I want to make sure this money is safe and so I have been researching hybrid annuities. My desire is to receive monthly income at the age of 65 to supplement my retirement pension.

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Neal Frankle September 18, 2012 at 12:37 AM

I will have to do a bit more research on this one. It is broad enough to bear having a post on it. Bear with me…..

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clay white September 17, 2011 at 11:01 AM

If I invest 1 million dollars in a annunity with a 10 year payout, what type of a monthly payment could I expect and what are the tax liabilities, if any. Is an annunity risk free, guaranteed !! By whom?

Thank you.

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Neal Frankle September 17, 2011 at 1:40 PM

If you invest $1 million with a ten year payout, the amount would depend on the interest rate prevailing at the time. The tax would only be levied on the amount above your principle. So, if you receive $140,000 a year, $40k would be interest and reported by the IRS. Nothing is risk-free. Your money is guaranteed by the insurance company. If you’d like actual quotes, contact me and I can get you real numbers. http://wealthpilgrim.com/ask-neal-a-question/

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mike olson July 30, 2011 at 11:26 AM

If I have a 100,000 annunity once I begin the payout and I choose say 15 years, do I have the choice of payment plan, say 15000 first 5 years 10000 thereafter or must I chose a time frame with exact amounts?

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Neal Frankle July 30, 2011 at 11:27 PM

Once you “annuitize” the payments are fixed and can’t be changed. You can’t select a variable payout as you’ve asked about.

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George kennedy March 10, 2011 at 9:08 AM

My dad is 84 and we had to put him in a skilled nursing facility. He resides in FL. where he owns a home and has a tax deferred annuity. We are trying to get him on Medicaid because he can no longer be on his own he has Parkision and Dementia. He needs 24hr care. In Fl the house is exempt from Medicaid. We were advised to turn the tax deferred annuity into an immediate annuity and to set up a personal care account to pay the bills on the residence because we can’t sell it its included in a family trust. Any advice would be greatly appreciated

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Mike September 17, 2010 at 10:10 AM

Is an immediate payout annuity a good idea for someone planning on living in a foreign country?

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Neal@Wealth Pilgrim September 17, 2010 at 10:22 AM

I believe the same considerations apply. You have added currency risk and transaction costs but that doesn’t really change the equation.

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Neal@Wealth Pilgrim July 15, 2010 at 7:46 AM

Mike,

I always learn from our exchanges. Thanks buddy.

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Neal@Wealth Pilgrim July 15, 2010 at 7:45 AM

Evolution,

You make strong points as well. The big issue is certainly the really really bad losses that throw retirement into a tailspin.

I agree that it’s not black and white but w/today’s low rates, the annuity is really tough to make a case for unless the investor is older and doesn’t need the capital….imo

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Evolution Of Wealth July 14, 2010 at 9:25 PM

For financial advisors that charge a fee to manage assets, the incentive would to be not to use an immediate annuity. That’s just less money that the advisor is getting his/her fee on. Is that any better or worse than selling the annuity? I’ve seen a few studies that show that people can maximize liquidity and legacy dollars by utilizing an immediate annuity as a part of their portfolio so as to reduce portfolio withdrawals in a down market.

Let’s be honest, the thing that is most detrimental with retirement income is not the average rate of return but it is that one or more down years where their portfolio losses of 20%, 30% or more and they still have to withdraw money to live on.

Why does it have to be all or nothing with an immediate annuity?

Also today’s immediate annuities do allow excess withdrawals if there is a period certain selected. Obviously, these withdrawals could reduce future payouts.

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Spokane Al July 14, 2010 at 6:39 AM

Perhaps an upside of your example of the actual interest earned on an immediate annuity which includes a return of principle is that the tax implications will be smaller. One, assuming this is a non-IRA annuity, would only be taxed on the actual interest earned.

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Neal July 14, 2010 at 7:00 AM

Al,

You are correct of course. There would be no tax on return of principle. Thanks for pointing that out.

Neal

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Mike Piper July 14, 2010 at 3:45 AM

Two follow-up questions, because as you know, I think annuities are underutilized by most investors.

a) Over what period of time would you be comfortable using an 8.4% withdrawal rate from a non-annuitized portfolio?

b) What if the investor lives longer than that?

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Neal July 14, 2010 at 6:59 AM

Mike, Thanks. Great question.

I would never be “comfortable” using an 8.4% w/drawal rate for an equity portfolio. If an investor only cares about income, the immediate annuity might be smart as I said. It’s just that very few people only care about income in my experience.

From a financial standpoint, if I thought the market is going to average 5% over the next 20 years, the equity portfolio provides the same income for 18 years and it provides other benefits like random access to capital.

However, as you say, what if the client lives longer? This is longevity risk and clearly, if you only want to max your income, the immediate annuity is a better choice.

But, as I said, while folks want to maximize their income, they usually want other benefits as well. That’s why it may work for a few people but not many.

And that’s why immediate annuities are sold rather than bought.

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Mike Piper July 14, 2010 at 7:23 AM

And that’s why immediate annuities are sold rather than bought.

Oh come on now! :P

Annuities solve a problem: They allow for a higher withdrawal rate than you can safely get from a non-annuitized portfolio. There’s value in that.

You’re on target when you say that annuities have drawbacks (illiquidity, for instance). They absolutely do. And they’re certainly not for every situation.

But they are appropriate for (many, though not all) investors who have under-saved.

It’s not only commission-paid salespeople who see their usefulness.

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Neal@Wealth Pilgrim July 14, 2010 at 6:03 PM

I agree Mike. But out of 100 people who own them, 90 were sold a bill of goods they didn’t understand. At least that’s my experience.

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Mike Piper July 14, 2010 at 6:09 PM

Fair enough. I think we more or less agree on when they are and aren’t useful. We’re just coming from different past experiences.

In my experience, out of 100 people who’d benefit from an immediate annuity, 90 have never heard of such a thing.

Thanks for yet another civil disagreement. :)

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