Is an Immediate Annuity Right for You?

An income stream that you'll never outlive sounds pretty attractive. We'll see if they're right for you.

Immediate Annuity

Americans are living longer than ever. The idea of living a longer, healthier life appeals to all of us, but for many of us, the tradeoff is outliving our retirement savings. The crippling costs of healthcare and the constant rise of inflation continue to compound this financial predicament. A single premium immediate annuity (SPIA) may help with this dilemma, providing you with an income stream that you will never outlive. We’ll take a look at the pros and the cons.

Here’s how they work

While many annuities are designed to build value for retirement, immediate annuities are designed to provide income immediately in retirement. A fixed immediate annuity is a contract between you and the insurance company. They are usually purchased with large lump sums of money by conservative investors in order to pay for expenses over a long period of time. In exchange for this lump sum premium the insurance company pays you a monthly income for as long as you live.

Let’s take a look at a hypothetical example. We’ll assume we have a 75 year old male purchasing a $100,000 SPIA policy. Based on current interest rates and his life expectancy he’ll receive approximately $725 dollars a month, every month for the rest of his life.1 Now, if the unexpected happens, and he dies early, his beneficiaries receive the remaining value, less payments received. This is called a “life income with lump sum refund” option and provides the assurance that you or your heirs will get at least the balance out of the policy.

If the cash refund option is not of great importance and maximum income is more of a priority, he could have chosen the “life only” payout option, which would pay a monthly payment of even more, at $900 per month. This is a common choice for the investor who’s not overly concerned with the endowment of these particular funds, rather capturing the income derived from these funds.

Tax treatment

Thanks to the “exclusion ratio” immediate annuities offer very favorable tax treatment; in fact a large percentage of the fixed immediate annuity income is tax-free. Based on the above example, the income would be 74.02% covered by the “exclusion ratio”.2 This would mean that about only 4 cents on the dollar of income would be lost to taxes, and 96 cents would be kept.3 This is because a large portion of income is considered a return of principal. Keep in mind that this represents new money, qualified funds such as IRA’s and 401k’s are generally taxable because these products represent pre-tax dollars.

Asset Protection – Medicaid

Utilizing Immediate annuities to shelter assets has become one of the latest “en vogue” planning techniques. Immediate annuities are often purchased for Medicaid planning purposes. By purchasing an immediate annuity you’re essentially removing the funds from your estate (for Medicaid purposes), thereby meeting the Medicaid minimal requirements, and qualifying for Medicaid. These minimal requirements are very low and vary depending on your specific state; for most individuals a “Medicaid annuity” is not the answer.
If qualifying for Medicaid is your intent, I suggest you work with a qualified advisor or attorney—proper planning is a must.

Creditor protection is another sought-after benefit of these policies. In most states your fixed immediate annuity cash value is exempt from attachment by creditors. This is especially relevant if things like disability were to loom on the horizon. Florida and New York offer some of the most favorable laws.

What are the drawbacks of purchasing a fixed immediate annuity?

All of the above information sounds promising but it doesn’t mean that immediate annuities are for everyone. Purchasing a single premium immediate annuity is a permanent decision that will last for the rest of your life. So you should seriously consider the following before selecting an immediate annuity product.

It’s important to remember that these products are purchased for a reliable stream of income with an emphasis on security. They are not designed for maximum return. You can typically expect fairly conservative returns that don’t often exceed the returns we see in the bond markets, but they’ll do so with considerably more security.

The fact that the income derived from SPIA’s will never change can be viewed as a double-edged sword. While the steady stream of payments is often welcomed the downside is the loss of purchasing power to inflation. This is the inherent problem with fixed income investments, in general, and for the most part can’t be avoided without delving into equity type investments.

Investors concerned with passing their assets on to heirs should take a close look at the payout options within a given policy. This may sound obvious, but when you select the “life only” income option within an immediate annuity policy the insurance company is only obligated to make payments to you for the rest of your life. If you die a month into the contract the insurance company gets all your money—nothing goes to your heirs. On the other hand if you outlive the actuarial tables you’ve won. So, it can work both ways, but
the important thing to understand is you won’t be bequeathing these funds to your heirs.

Generally speaking, immediate annuities are irrevocable contracts. Once you purchase the immediate annuity it is non-refundable, you lose the liquidity and no longer have access to these funds, save for the introductory “free-look” period. This restriction of principle is by far the number one disadvantage with these products. The tradeoff for this loss of liquidity is a lifetime of income. SPIA’s are NOT suitable for individual investors with liquidity needs.

Should you wait?

We know that the older we get the more our income needs increase. So, if you’re in no rush and have no immediate need for income it often pays to wait. Remember that the payment amount is based on life expectancy, so the shorter the life expectancy and the older you get, the larger your income payments become. Also, keep in mind that payment amounts are based on current interest rates, which are still relatively low. Waiting just a few years can make a significant difference.

Right for you?

Depending on your specific financial needs/goals a fixed immediate annuity may be the right choice for you. They’re not the end-all, do-all investment product (nothing ever is), but for certain income seeking investors, SPIA’s are a highly tax favored way of achieving a guaranteed income which will not change due to outside forces like a declining economy. To those individuals an income that can’t be outlived can be particularly comforting in these uncertain times.

1 Fidelity and Guarantee Life Insurance Company, SPIA, 10/18/06. California State premium taxes of 2.35% are included in calculating the above payments. Many other states don’t charge this fee. If you reside in a non-premium tax state you can expect even
more income than stated above.
2 Fidelity and Guarantee Life Insurance Company, SPIA, 10/18/06
3 Based on 15% tax bracket. Guarantees are based on the claims paying ability of the issuer.

One final note: If you’re looking for the best immediate annuity quote I recommend utilizing an independent financial advisor. They’re not tied to any one specific company, they can search a number of quality “A” rated companies without bias, and find you the most competitive immediate annuity rate that will meet your needs.