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An income annuity is an annuity contract that converts all or part of a consumer’s savings into a guaranteed stream of income, either for the consumer’s lifetime or for a specified number of years. These payments can begin right away or at a later time.
Income annuities are uniquely designed to generate a stream of income in exchange for one or more premium payments. The payments from an income annuity may be received monthly, quarterly or annually depending on your preference.
Unlike other types of annuities, income annuities are annuitized immediately, regardless of when your payments actually begin. This differentiates them from accumulation annuities, which some people never annuitize.
What Are the Benefits of Income Annuities?
Income annuities — specifically lifetime income annuities — provide insurance against outliving your assets. They will continue to pay income even after you’ve recovered your principal and received all of your earnings.
Longevity Risk Protection
Insurance companies can provide longevity insurance thanks to “mortality credits” — a unique characteristic of lifetime income annuities.
Here’s how mortality credits work:
When you buy an income annuity, the insurance company adds your premium to the pool of premiums it has collected from other annuity owners. The insurance company bases lifetime income annuity payments, in part, on the average life expectancy of the annuitants in the pool.
Some annuity owners will live longer than the number of years expected, but some will die earlier, leaving behind their share of income payments. These remaining payments are the mortality credits, and they are distributed to the surviving annuity holders from the pool.
If you die before you receive all your income annuity payments and you haven’t purchased a rider to allow for beneficiaries, then your remaining payments will go to annuitants who live beyond their life expectancy.
Are Income Annuities Beneficial to Everyone?
Because the key benefit of lifetime income annuities — protection against longevity risk — results from risk pooling and mortality credits, income annuities are best suited to people who are in good health and whose family members tend to live long lives.
This is why income annuities are often referred to as “longevity insurance.”
- Single Premium Immediate Annuity (SPIA)
- Deferred Income Annuity (DIA)
- Payout Annuity
You may also specify a payout period instead of opting for a lifetime income annuity. Doing so, however, negates the longevity insurance benefit of an income annuity.
According to a white paper by the Alliance for Lifetime Income, retirement plans that rely only on investments and do not include annuity strategies fail to fully account for all of the risks.
To ensure you’re making the right move when you purchase an income annuity, you must have a solid financial plan and a clear objective for the role of an annuity in that plan.
How Are Income Annuities Classified?
Income annuities are classified according to the income payment start dates — immediate and deferred.
Single premium immediate annuities, or SPIAs, and deferred income annuities, or DIAs, are both annuitized immediately. This means that your premium is immediately converted to a stream of payments.
SPIAs are annuitized immediately and begin paying income within a few months.
Deferred income annuities are also annuitized immediately, but they begin paying income later.
What Is the Difference Between a Deferred Income Annuity and a Deferred Annuity?
SPIAs are fairly straightforward, but it’s not uncommon for people to confuse DIAs with deferred annuities.
One trick is to think of a deferred income annuity as an immediate annuity with a delayed start date.
This may help you make the distinction between a DIA and a deferred annuity, which doesn’t convert your premium to an income stream until the annuitization date specified in your contract.
Annuity expert Dr. Wade Pfau clarifies the difference in his book “Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement.” In chapter four, he explains that the word “deferred” in a deferred income annuity refers to the postponement of the income payments, not the process of annuitization.
A deferred annuity, on the other hand, uses the word “deferred” to refer to the delay in converting the contract value into a guaranteed stream of payments. Deferred annuities are not immediately annuitized and are often used for wealth accumulation as opposed to retirement income.
And lastly, all annuities are tax-deferred, so neither deferred annuities nor deferred income annuities use the word “deferred” to refer to the tax treatment of the product.
- Premium is immediately converted to a series of payments.
- Income benefits are delayed.
- Interest is fixed.
- Contract value is converted to a series of payments if and when you choose to annuitize.
- Income may be immediate if you add a lifetime income benefit rider to your annuity contract.
- Interest can be fixed, indexed or variable.
How Are Interest and Payment Amounts Calculated?
According to the National Association of Insurance Commissioners, “For immediate fixed annuity contracts, annuitants receive a fixed income stream based, in part, on the interest rate guarantee at the time of purchase.
But income annuities allow for increased income benefits over time as the pool of individuals collecting payments shrinks.
As Michael Kitces explains, “the potential for mortality credits means that, for any given maximum potential life span, annuities can actually pay out significantly more than what any individual could enjoy on his/her own, as the contribution of principal and interest and mortality credits will always be greater than the underlying principal and interest alone.”
When Do Income Annuity Benefits Begin?
One of the most attractive features of income annuities is their ability to provide guaranteed income at a time when retirees are increasingly required to live off their savings, the future of Social Security is in question and traditional pensions are practically nonexistent.
- Your income payments will begin within a year of purchasing the annuity.
- Your income payments will begin at least one year after your purchase.
Annuity contracts are legal documents. If you have questions about the terms of your contract, make sure you get answers before you sign. Ask about commissions and fees, surrender charges and the free-look period.
Furthermore, if you need assistance with any aspect of your retirement planning, talk to a credible financial advisor. If you’re not sure how to find a legitimate expert, refer to The Financial Industry Regulatory Authority’s free background-research tool or consult your state securities regulator for more information.
More Questions About Income Annuities
3 Cited Research Articles
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- Cruz, H. (2005, July 24). Lifetime income benefit rider vs. annuitization. Retrieved from https://www.chicagotribune.com/news/ct-xpm-2005-07-24-0507240025-story.html
- Kitces, M. (2015, April 1). Understanding The Role Of Mortality Credits – Why Immediate Annuities Beat Bond Ladders For Retirement Income. Retrieved from https://www.kitces.com/blog/understanding-the-role-of-mortality-credits-why-immediate-annuities-beat-bond-ladders-for-retirement-income/
- Pfau, W. (n.d.). What Is a Safety-First Retirement Plan? Retrieved from https://retirementresearcher.com/what-is-a-safety-first-retirement-plan/