When the stock market gets rocky people look for alternatives. And one option that captures many people’s attention is the income annuity. Let’s take a look at what this financial contraption is and if it makes any sense for you or not.
Income Annuity Defined
An income annuity is a series of equal payments you receive over a long period of time. You give an insurance company a big pile of money and they’ll send you a check every month. It’s as simple as that.
How Much Income Will You Receive?
The amount you receive depends on four elements:
- How old you are.
- Prevailing interest rates.
- How long you want the payments to last.
- If you want the payments to continue after you die.
Let’s break this down and take each element one at a time in reverse order.
Will The Payments Continue After You Pass Away?
When you buy an income annuity, you can elect to have other people receive your payments after you die.
If you go this route, the insurance company knows it is on the hook for much longer than if the payments stop when you do. That being the case, the payments you and your survivor receive are much lower if you elect to have a beneficiary.
Think about it. Let’s say your sister offers to give you $10,000 now if you promise to pay her $100 a month for the rest of her life. Now, if she wants to give you that same $10,000 but asks you to pay her $100 each month as long as she or your young nephew is alive, you might not agree. That’s because you are obligated to make those payments for a far greater period of time. You might agree to only pay $50 a month in cases like these. Make sense? That’s exactly how the insurance company sees things and it’s why payments from income annuities decrease as the potential length of time increases.
How Long Will The Payments Last?
This is very much related to the point above. Let’s say you buy an income annuity and don’t name any survivor beneficiaries. You still have the option of buying the annuity for your life only or you can stipulate that if you die within 5, 10 or 20 years, the payments will continue at least that period of time. Most annuities offer a variety of choices which of course is good.
People like these guarantees. Those who take the life only option take on a lot of risk. Theoretically such a person could buy a big income annuity and get almost nothing in return. That happens if they die shortly after the contract begins. People who buy a “life with 5, 10 or 20 year certain” income annuity at least have the certainty that their loved ones will receive a fixed amount of money no matter what. If you buy a “life with X years certain” the checks stop when you die or the period is over – whichever comes last.
Prevailing Interest Rates
In order to generate the payments to you over many years, the insurance company takes the lump sum you fork over and they invest it. Because they have a long-term obligation to you (to make those payments to you over many years) they make long-term investments. And the amount they pay you depends in part on how much they can earn on those long-term investments.
As I said, if interest rates are high, they can commit to making higher payments to you. When interest rates are very low it’s very hard for the company to pay out very much.
Let’s consider an example. If you invest $100,000 and earn 2%, you can annuitize this investment over 20 years and receive a monthly amount of $509. If you take that same $100,000 and earn 6% your monthly payment jumps to $726. It just stands to reason that if interest rates are low, the return is lower and therefore the income you receive is lower too.
As we discussed earlier, the insurance company can pay you more each month if they feel pretty confident that they won’t have to make those payments for too long. In other words, the older you are the less the insurance company has to worry about and the more they’ll pay.
Bottom line on income annuity payments
If you are young, name beneficiaries and interest rates are low, you aren’t going to earn much with an income annuity. If you wait until you are older, don’t name beneficiaries and interest rates rise, this might be a great idea.
Is An Income Annuity For You?
Income annuities provide a reliable income stream provided you buy one from a reputable company. That income stability is music to anyone’s ears. But while there are clear benefits to this idea, I believe the drawbacks are far greater.
I’ve discussed this at length in a prior post but there are two major problems with this investment at the present time:
- With the income annuity you give up random access to your capital. Once you sign the bottom line, kiss that capital goodbye – for good.
- Interest rates are very low right now. Why tie up your money in fixed investments right now?
I believe there are far better retirement income investment ideas that provide greater upside, more income and a lot of flexibility. The income annuity provides certainty but at a very high cost.
Despite it all, are you still interested in an income annuity? Why or why not? What’s most important to you when it comes to investing for retirement income?