How an Immediate Annuity Payout Really Works
By Neal Frankle
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:
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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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?
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.
“And that’s why immediate annuities are sold rather than bought.”
Oh come on now!
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.
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.
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.
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.
Al,
You are correct of course. There would be no tax on return of principle. Thanks for pointing that out.
Neal
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.
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
Mike,
I always learn from our exchanges. Thanks buddy.
Is an immediate payout annuity a good idea for someone planning on living in a foreign country?
I believe the same considerations apply. You have added currency risk and transaction costs but that doesn’t really change the equation.
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
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?
Once you “annuitize” the payments are fixed and can’t be changed. You can’t select a variable payout as you’ve asked about.
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.
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/