When someone offers to send you an income check for as long as you live, it sounds like a pretty good deal – right? Who wouldn’t want perpetual income? Well…as you’ll see, an income annuity might be good for some people but not everyone.
What is an Income Annuity?
An income annuity (aka immediate annuity) is a contract between an investor and a life insurance company. The investor gives the life insurance company a lump sum payment and in exchange, the insurance company sends the investor a check for a period of time. Simple as that.
How Long Do The Payments Last?
Your payout depends on the contract you sign. If you buy what is called a “life only” the payments stop once you kick the bucket. So if you buy the annuity today and pass away tomorrow, the money is gone. Pretty drastic.
If you buy a “life with 5 (or 10 or 20) years certain” it means even if you die prematurely, the payments continue for 5, 10 or 20 years. The money goes to your beneficiaries in this case.
If you buy a “joint life” the payments continue for two lives. So if you buy a “joint life” policy for you and your spouse, the payments continue as long as either one is living.
As you might guess, the longer the term that the insurance company is on the hook for, the lower the payments are. So, for example, a “life only” would give you the most monthly income – but the most risk. A “joint life” lowers the risk to you because even if one of the spouses die, the other continues to receive the monthly check. But since the risk is higher for the insurance company, this payment would be lower than the “life only”. Capishe?
Three Major Drawbacks
There are three big risks that people take when they purchase immediate annuities:
1. You can never have access to this capital. If an emergency arises and you need cash, the money you plunked down for the annuity is gone. That capital isn’t yours anymore. You traded it for the monthly check. If you want to trade back, there are companies who will buy it from you in exchange for a lump sum. But they’ll skin you alive by offering you a lot less than you paid for the contract. Ouch.
2. Interest rates are low right now. That means, all things being equal, the income you will be offered these days (and are stuck with for the rest of your life) is really paltry. In many cases, you could invest the money yourself, receive the same or close to the same income, yet maintain control over the capital.
3. Your income will never go up. Even though your cost of living will continue to rise, your income won’t. That’s a bad tone in my book.
BONUS PROBLEM – If the insurance company goes belly up, you might find it very difficult to collect what you are owed. Disappointing.
Who Should Consider Annuities?
With all their drawbacks there are a few cases where these investments could make sense.
#1 You are concerned about your retirement income plan. Since annuity payments are 100% guaranteed, this buys you buy peace of mind throughout retirement as long as the insurance company stays solvent. This doesn’t maximize your income necessarily. But it does give you some sleep at night.
#2 You are concerned about longevity. One of the main risks at retirement is the possibility of outliving your savings. You might be able to avoid this risk with an income annuity.
#3 You tend to be risk-averse moving towards your retirement years. If you do not want to invest in equities, the fixed income options are not offering interesting rates of return right now. An annuity could be an attractive alternative.
Neal’s notes: The income cash flow might be decent on an immediate income, but the cash flow you get includes a return of your own capital friend. The actual return you earn is often ridiculously low.
#4 You are in a high tax bracket. A part of the annuity payment is considered a return of capital. Therefore, the payment received is not fully taxable.
#5 You are a Woman! It is well known that women’s life expectancy exceeds men’s life expectancy by a few years. Therefore, if you are a healthy woman, your annuity income could well be worth the investment.
#6 You are advanced in years. The older you are, the lower the risk for insurance companies. As a result, you can squeeze more money out of them.
#7 Interest rates go up significantly. As I said before, the rates the company pays you depend on what they can earn at the time you sign the contract. If you sign up at a time when rates are attractive, this could work out well for you.
#8 You don’t really care about leaving money for your heirs. In that case, your main goal is likely to maximize your monthly income and the annuity could a fit.
Final Thoughts on Annuities
As you can see, this product was designed for risk adverse people who seek a stable source of income. It is true that you might make a lot more money investing in the stock market, but you could also lose. This would not happen with a fixed income annuity. Financially, the annuity doesn’t make sense for many people because it’s so expensive, you lock in low rates; you give up random access to your money and many other reasons. But as I said, for certain people, it might be a smart move despite these drawbacks.
This guest post was written by Mike, a passionate investor and personal finance enthusiast. He writes about complex financial topics to make them easy to understand. He is the author of Annuity Rates HQ.