Immediate fixed annuity

Annuities are financial contracts between you and an insurance company. You give the company money now and the company pays you an income at a later time. Immediate annuities are often designated as Single Premium Immediate Annuities (SPIA) or income annuities to differentiate them from deferred annuities.

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


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 will be 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 subject to the creditworthiness of the insurer. 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). 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

Forum discussions

 * Rates on Annuities

Industry

 * Insured Retirement Institute
 * Website
 * 2009 annuity Factbook