Immediate fixed annuity

An immediate fixed annuity is a financial contract between you and an insurance company. You give the company money now and the company pays you an income at a later time. An immediate annuity is often designated as a Single Premium Immediate Annuity (SPIA) or an income annuity to differentiate it from a deferred annuity.

Income annuities can be fixed or variable. The payments from fixed income annuities discussed here, unless they are graded, or inflation-indexed, will remain fixed over the distribution period. Inflation risk should be a major consideration when evaluating a fixed annuity income option, since inflation will reduce the purchasing power of a fixed income stream over time. Figure 1. shows the eroding purchasing power effect of a 3% inflation rate over time. If one is thinking of using a fixed annuity payout to cover two to four decades of retirement income one should consider using inflation indexed income annuities or a graded income annuity with a higher (3% or 4%) annual income adjustment.



Annuity basics
Income annuities are designed to insure an individual against the risk of outliving an income stream during the withdrawal phase of the life cycle. The payout from the annuity will reflect the following factors.

Insurance company pricing factors

 * Investment income. The level of interest income derived from the investments funding the annuity pool. This will generally reflect the interest rate level available at the time of purchase.
 *  Life expectancy. Insurer's use life expectancy tables for estimating mortality and pricing payouts. The tables insurers use reflect higher life expectancies than general population mortality tables by assuming life expectancies for healthy individuals with a continuing year by year improvement in mortality during the payout period. Life expectancy is lower for men than it is for women, and is higher for joint annuitants than it is for single annuitants.


 * Mortality credits. The income annuity payout is comprised of both interest and principal. As members of the insurance pool die, their principal remains in the annuity pool to used to pay longer lived annuitants.
 * Expenses. While costs from fixed immediate annuities are not revealed, an annuity with lower costs will provide an annuitant with higher income.

Individual annuitant factors affecting income payouts

 *  The age of the annuitant. The initial income payout will also be determined in part by the age of the individual(s) purchasing the annuity. Payouts are higher for older annuitants; lower for younger annuitants. Income payouts are higher for single annuitants than for joint annuitants. Income payments are higher for male annuitants (lower life expectancy) than for female annuitants (higher life expectancy).
 * The income option chosen. While fixed immediate annuities are the most commonly chosen fixed payout option, graded options and inflation indexed options can also be chosen. While the income stream from graded and inflation indexed income annuities offer increasing income payments over the life of the annuitant, the initial payment will be higher for a fixed payment: lower for a graded or inflation indexed payment.
 *  Adding a period certain. Payments for a straight single or straight joint annuitization end with the death of the annuitant(s). Individuals can guarantee payments for a set period for an added cost. For example, adding a 20 year guarantee period certain option to a straight life annuity at age 65 (assuming a 6% annuity pool return) would reduce the initial payment by an estimated 9% for a single life annuity and an estimated 2% reduction for a joint annuitization.

Fixed income options
It is important to understand that the payment streams from an income annuity consist of both income and principal, so the payout percentages are not comparable to the yields of fixed income securities or dividend yields from stocks. The payout is comparable to the percentage withdrawal rates of a systemic withdrawal. You can determine the actual yield of the annuity payout by using the google spreadsheet included in the external links below. The yield of the income annuity investment will increase as the term of payout increases.

In the U.S. annuitization of retirement assets is quite low. According to 2010 TIAA-CREF surveys, only 11% of U.S. citizens had annuitized nest eggs. Among college and university employees investing in TIAA-CREF retirement plans, some 34% planned on annuitizing or partially annuitizing their contributory retirement plan accumulations at retirement.

Fixed payment method
In the U.S. fixed payment income annuities have existed since 1759, although the market was quite small until the Great Depression. TIAA introduced fixed annuities in 1918. According to research from TIAA-CREF, the fixed payment option is the most frequently chosen life annuity option chosen by the firm's retirement plan owners.

Since a fixed payment annuity does not provide for an escalating future income stream, its initial income payout will be higher than a similar graded payment or inflation indexed payment. The necessary tradeoff for the higher initial payment is that the income stream will be eroded by inflation over time. This lack of inflation hedging should be a major concern for younger annuitants, since long expected payouts can be seriously eroded by inflation The lack of inflation hedging may not be as much an issue for investors making an annuitization late in the life cycle (circa age 80) with shorter life expectancies. For these annuitants, inflation is expected to have less time to compound, and there would be less time for a rising graded or inflation index payment stream to match or exceed the higher fixed income payment.

Figure 3. shows the fluctuation of fixed income annuity rates from 1987 to 2009. The data tracks income annuity payout rates for both 65 year old males and 65 year old females in comparison to interest rates on corporate and treasury bonds. While the direction of payout rates tends to track interest rates it is important to note that SPIA payouts rise and fall less, proportionately, because SPIA pricing is based in part on mortality which is unaffected by interest rates. Thus even when the interest rate is low it can be advantageous to go ahead with an SPIA purchase, because the lowness of interest rate hurts investment opportunity for money held out of SPIA more than it hurts payments received from the SPIA.

Graded payment method
With a graded payment method, an annuitant receives an initial annual income payment which is subsequently increased by either a preselected set amount, or by an amount in excess of a targeted investment rate. Graded payment methods for fixed income annuity payouts were introduced by TIAA-CREF in 1982. TIAA bases the initial income on a 4% payout rate. TIAA reinvests excess earnings to buy additional future income. Increases to the annuity income occur as long as the TIAA total total interest return exceeds 4%. Vanguard's Annuity Access program offers graded income payments providing for 1%, 2%, 3%,or 4% annual rates of increase. The higher the selected payment increase percentage, the lower the initial income payment.

Graded payment methods allow for an income stream that will increase over time. As long as the increases match or exceed the inflation rate the annuitant will have achieved some protection of purchasing power.

Inflation Indexed
For U.S. investors, the payout from an inflation indexed SPIA will provide an income that will match the CPI-U inflation rate, thus offering a hedge against inflation which a fixed income annuity can not provide. Inflation indexed income annuities have been in existence for a longer time, and are more prevalent, in the U.K.

As table 4. indicates, the initial payout from an inflation indexed annuity will track the level of real interest rates at the time of purchase.

Inflation indexed annuities are priced to produce lower initial levels of income than those provided by fixed income annuities. According to research provided by Schirripa (2009), this reduction results in a 26% lower initial income for a 65 year old male, and a 28% reduction for a 65 year old female (the reductions are somewhat higher at age 60; somewhat lower at age 70). The point at which the lower inflation indexed initial payment will match and exceed the nominal fixed payment will depend on the ensuing inflation rate. At a 4% inflation rate, the inflection point is approximately 8 years; at a lower 2% inflation, the inflection point is much later, circa 17 years.

Huang and Milevsky point to an additional consideration about inflation indexed income annuities. Retiree costs tend to track the health care and housing cost components of the CPI-U. These costs often rise faster than the CPI-U, so the annuity income stream may not offset an individual's personal inflation rate. As a possible means of offsetting higher inflation, Milevsky and Chen (2003) and Walsh (2002) advise adding an allocation of a low-cost, immediate variable annuity to an individual's product allocation plan.

Annuitization options
In addition to the first four common annuitization options available to an immediate variable annuitization, immediate fixed annuities offer a large number of additional options :
 * Single life only. As the annuitant, you receive regular income payments for your lifetime, ending at your death. (Payments are largest with this option.)
 * Single life with a guaranteed number of years. As the annuitant, you receive payments as long as you live, but not less than a guaranteed period. If you die before the period ends, your beneficiaries receive the remaining payments. The guaranteed period covers 5 to 50 years for nonqualified (after-tax) assets and up to your life expectancy for qualified (pre-tax) assets.
 * Joint and survivor life only. Payments are made as long as you (the annuitant) or another person (the joint annuitant), such as your spouse, are living. Often you can choose the amount of the remaining annuity payments as a percentage (50%, 66.67%, 75% or 100%) of the amount that was payable while the annuitant was alive.
 * Joint and survivor with a guaranteed number of years. Payments are made as long as you (the annuitant) or another person (the joint annuitant) are living, but not less than a guaranteed period. If both you and the joint annuitant die before the period ends, your beneficiaries receive the remaining payments. The guaranteed period covers 5 to 50 years for nonqualified (after-tax) assets and up to your life expectancy for qualified (pre-tax) assets.
 * Single life with installment refund. As the annuitant, you receive fixed payments for your lifetime. If you die and the sum of the income payments you’ve received is less than your purchase premium, your beneficiaries will receive the difference through monthly payments.
 * Single life with full cash refund. As the annuitant,you receive fixed payments for your lifetime. If you die and the sum of the income payments you've received is less than your purchase premium, your beneficiaries receive a lump-sum refund of the difference.
 * Joint & survivor with installment refund. Payments are made as long as you (the annuitant) or another person (the joint annuitant) are living. If both you and the joint annuitant die and the sum of the income payments you’ve received is less than your purchase premium, your beneficiaries will receive the difference through monthly payments.
 * Joint & survivor with full cash refund. Payments are made as long as you (the annuitant) or another person (the joint annuitant) are living. If both you and the joint annuitant die and the sum of the income payments you’ve received is less than your purchase premium, your beneficiaries receive a lump-sum refund of the difference.
 * Guaranteed number of years only. As the annuitant, you receive fixed payments for a guaranteed number of years (5 to 50 years for nonqualified (after-tax) assets and up to your life expectancy for qualified (pre-tax) assets). If you die before this period ends, your beneficiaries receive the remaining payments. Payments end when the guaranteed period ends, whether or not you or your beneficiaries are still living.

Exclusion ratio
Fixed immediate annuities receive a degree of tax relief (for non-qualified dollars) due to the income exclusion rules. The IRS allows the investment in the contract to be recovered over the annuitant's life expectancy. The calculation of the Exclusion Ratio is made according to the General Rule (found in IRS Publication 939 General Rule for Pensions and Annuities. The annuity payments will be partially taxable due to the exclusion over the recipient's life expectancy. After this term. the full income payment will be taxed. If the owner dies before the total investment in the contract is recovered, and annuity payments cease as a result of his death, the un-recovered amount is allowed as a deduction to the owner on the final tax return.

Credit ratings and State Guarantee Funds
The income from an immediate fixed annuity is derived from an insurance company's general account and is subject to the creditworthiness of the insurer. To lessen the risk of default you should purchase immediate fixed annuities from insurer's gaining the highest credit worthiness ratings from the five insurance rating firms.


 * A.M. Best
 * Fitch Ratings
 * Standard & Poor's
 * Moody's
 * Weiss Ratings

In case of insurer default, your State Guarantee Fund will attempt to find a replacement insurer for your contract, and will offer insurance on a given amount of annuity investment (usually up to $100,000, but greater in some states). Keep in mind that the State Guarantee Funds are not obligations of the federal or state governments but are funded by assessments placed on insurance companies that sell policies in your state. The following links provide information on state guarantee limits, as well as what happens as a consequence of an insurance company failure.


 * State Guarantee Funds
 * NOLHGA:What Happens When An Insurance Company Fails

Pros and cons
The question of whether or not to annuitize a nest egg will depend on individual circumstances. The following factors will help show under what circumstances an annuitization will be more or less suitable or unsuitable.


 * Irrevocable. The decision to convert a lump sum into an income annuity is an irrevocable decision. One losses the flexibility of managing the lump sum in exchange for a series of payments over time. For many investors this irrevocable loss of control is a profound negative.
 * Default risk. While an income annuity offers a guarantee of a lifelong income stream, that guarantee is contingent on the insurance company remaining solvent over the investor's lifetime. Default rates for insurance companies have historically been low, but defaults are not impossible. Default risk can be reduced by dividing income annuities among several highly rated insurers, and by keeping income annuity payouts from a given insurer below the NOLHGA insurance limits offered by one's state.
 * Health. A primary advantage of an income annuity is that it is designed to pay an income for life. Obviously, one's health is a major determinant in one's life expectancy. So if one enters the retirement cycle in good health and has a family history of long life, an income annuity is a suitable option to consider. Even if one is not in perfect health an income annuity may be suitable since many companies offer medical underwriting rates for such annuitants. For the terminally ill an income annuity is unsuitable.
 * Hedging later life capacity impairments. In addition to one's health at the beginning of retirement, one needs to consider the possibility of cognitive impairment should one live a long life. An income annuity provides an ongoing income stream that remains intact should one become mentally incapacitated later in life when making financial decisions is no longer possible.
 * Wealth accumulation. The suitability of adding an income annuity to the investment product mix is also highly dependent of one's wealth accumulation. For the large segments of American society who enter the retirement period with no, or very limited financial assets, an income annuity offers no solution. On the other end of the wealth distribution, for those having very large financial assets allowing them to self insure a retirement income, income annuities are not usually needed. For the large segment of the population in the middle ranges of the wealth distribution spectrum, income annuities are suitable for consideration. A number of additional wealth factors can influence the decision of whether or not to annuitize.
 * Existing annuities. Traditionally, retirement income security was based on what was called a "tripod stool" which consisted of three legs: social security; a lifetime income stream from a defined benefit pension; and personal savings. With defined benefit pension plans no longer offered to a large segment of imminent and future retirees, these individuals will have only social security and personal savings as funding mechanisms for retirement income. For these individuals adding an income annuity to the retirement product allocation is a suitable option to consider. For individuals who enter retirement with living expenses sufficiently covered with lifetime income from a defined benefit pension and social security, adding an income annuity is often not needed.
 * Legacy bequests. The desire to provide an inheritance to family or charitable interests varies with individual preference. Once again there is a spectrum between having no desire to leave an inheritance and a maximum desire to provide a legacy. The lower the concern for providing a legacy, the more suitable an income annuity becomes. However, individuals who do place a value on providing a legacy should consider the following points.
 * One can assure that the funds one annuitizes will be paid out by adding to the income annuity a guarantee period roughly matching one's life expectancy. This option will, however reduce the income one receives from the annuity.
 * Ameriks and Ren (2008) point out that although an early death soon after a partial annuitization will leave beneficiaries with less of an inheritance, the situation changes as a lifetime lengthens. They find that the life annuity tends to stabilize the inheritance values left to beneficiaries. For example, for [males] establishing an income annuity at age 65, the "bequest" breakeven point occurs between 80 and 85 years of age, essentially at the point of the individual's life expectancy at 65.)
 * If a charitable interest is paramount one should consider utilizing a charitable gift annuity or  charitable remainder trust as means for providing lifetime income streams.
 * Sequence of returns hedging. Income annuity can protect against poor returns occurring in the early phase of retirement.
 * When to annuitize. At retirement or deferred.
 * Partial annuitization. Very suitable.
 * Taxes. An income annuity distributing income from a pre-tax contributory plan, such as a 401-k, 403-b, or traditional IRA will, aside from the differentiation in withdrawal schedules, bear similar tax burdens, since withdrawals from these plans are taxed at marginal rates. For high income retirees, a non-qualifed income annuity (funded with after-tax dollars) can be tax inefficient since once the invested capital is paid back, the full income stream from the income annuity becomes taxable at marginal tax rates.

Industry

 * Insured Retirement Institute
 * Website
 * 2009 annuity Factbook
 * 2011 IRI Factbook

Forum discussions

 * Rates on Annuities

Articles

 * The Role of Inflation-Indexed Annuities, Paula Hogan, AAII Journal
 * Annuity Analytics: How Much to Allocate to Annuities?, Moshe Milevsky, (September 1,2009)
 * Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them, by Mike Piper
 * A Forbes.com tutorial series by forum member Mel Lindauer:
 * Annuities: Good, Bad Or Ugly?
 * How To Cut The Cost Of A Variable Annuity
 * For Some Retirees, This Annuity Makes Sense
 * The Truth About Equity-Indexed Annuities
 * Variable Annuities Don't Belong In Retirement Plans
 * Fixed Deferred Annuities: CDs With Gotchas