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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, as is the case with an immediate annuity, or at a later time, as with deferred annuities.
Income annuities provide the contract holders with a stream of income in exchange for one or more premium payments. The income schedule can be monthly, quarterly or annual, as a form of guaranteed, periodic income.
Although many annuity holders choose to withdraw their money as a lump sum after a period of accumulation, income annuities are intended to provide regular income that lasts for an extended period of time, whether payments begin immediately or at a later date.
To illustrate the income-generating strategy behind buying an annuity, consider Webster’s New World College Dictionary’s definition of the word “annuity.”
- a payment of a fixed sum of money at regular intervals of time, esp. yearly
- an investment yielding periodic payments during the annuitant's lifetime, for a stated number of years, or in perpetuity
The origin of the term is from the Latin word for “annual.” Hence, annuity contracts were originally intended to guarantee steady, regular income.
Income Annuities Protect Against Risk
Income annuities provide insurance against outliving your assets. So no matter how much your principal has grown, and even if you have received all your principal and earnings as income payments, you will continue to receive income payments for the remainder of your life.
Mortality credits generated from lifetime income annuities are a unique benefit of these products. They essentially allow the insurance company to use the remainder of the premiums paid by annuitants who die earlier than expected to subsidize people who live longer.
If you die before you receive all your payments and you haven’t purchased a rider to allow for beneficiaries, then your remaining funds are used to pay people who live beyond their life expectancy.
According to a white paper by the Alliance for Lifetime Income, retirement financial strategies that rely only on investments and do not include annuities fail to fully account for all of the risks.
By providing guaranteed income, annuities protect retirees from common retirement risks, including longevity, market volatility, and possibly inflation, as well as the uncertainty of Social Security and their own mismanagement of their finances.
To ensure you’re making the right move when you purchase an annuity, you must have a solid financial plan and a clear objective for the role of an annuity in that plan.
The Insurance Information Institute notes that income annuities can be classified according to several features.
Carefully and thoroughly evaluate these — from the duration of your payments to the tax status of the money you use to purchase the annuity — before you buy.
How Are Interest and Payment Amounts Calculated?
The insurance company sets the interest rate and payment amount. These will be specified in the annuity contract. Annuities are available as fixed, indexed or variable products.
- Fixed annuities pay an interest rate that is set in the annuity contract and not dependent on other investments.
- The growth rate of an indexed annuity is determined by the performance of an outside index, such as the S&P 500.
- A variable annuity is riskier in that the insurance company invests its principal in a portfolio that contains a variety of investment vehicles, including stocks, bonds and mutual funds. The value of a variable annuity may grow or shrink, depending on its underlying investments.
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. For fixed deferred annuity contracts, the insurer credits a fixed interest rate to contributions in the accumulation phase and pays a fixed income payment in the annuitization phase.”
When Do Income Benefits Begin?
One of the most attractive qualities of most 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.
- If the annuitant begins receiving the income within a year of purchasing the annuity, it’s known as an immediate income annuity, also called a single premium immediate annuity or SPIA. Typically, immediate annuities are purchased with a single lump sum payment.
- If the payout, or distribution, phase begins a year or more later, the income annuity falls into the category of deferred income annuity, or DIA. Deferred annuities purchased with a lump sum are called single premium deferred annuities, or SPDAs. Deferred annuities purchased with multiple payments are known as flexible premium deferred annuities, FPDAs.
The income payments from a deferred annuity are typically higher than payments from an immediate annuity for two reasons.
First, with a deferred annuity, your principal has time to accumulate before you start taking payments. The second reason is specific to life annuities, which pay income for the remainder of the annuitant’s life. In these cases, the longer the annuitant waits to receive payments, the fewer payments he or she will receive. Fewer payments mean larger payments.
Some annuities are treated more like certificates of deposit, with the annuitant allowing the money to grow over time and withdrawing the full amount at the end of the contract. These types of annuities are called multi-year guaranteed annuities, or MYGAs.
Premiums, Tax Status & Payment Duration
In addition to classifying annuities by the start date of the income stream and the interest rate and payment amount, annuities can also be categorized according to the following features.
- Period certain
- Fixed amount
- Single premium
- Flexible premium
These classifications amount to a variety of product offerings designed to ensure a guaranteed income stream in retirement. The product you choose will depend on your lifestyle and personal goals.
For example, you could purchase a fixed deferred annuity, which would allow your principal to grow at a guaranteed minimum interest rate. Your income payments would begin some years later.
Or you may opt for a single premium immediate variable annuity, or SPIVA. You would purchase this income annuity with a lump sum, and your income benefits, which would vary according to the performance of investments in your underlying portfolio, would begin within a year.
Remember: 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.
12 Cited Research Articles
- Bell, A. (2019, April 12). Demand for Income Annuities Is Out There: Idea File. Retrieved from https://www.thinkadvisor.com/2019/04/12/demand-for-income-annuities-is-out-there-idea-file/
- Chen, James. (2019, May 7). Immediate Variable Annuity. Retrieved from https://www.investopedia.com/terms/i/immediate-variable-annuity.asp
- Insurance Information Insititue. (n.d.). Annuities Basics. Retrieved from https://www.iii.org/publications/insurance-handbook/insurance-basics/annuities-basics
- Insurance Information Insititue. (n.d.). What are the different types of annuities? Retrieved from https://www.iii.org/article/what-are-different-types-annuities
- Kagan, J. (2018, December 18). Sequence Risk. Retrieved from https://www.investopedia.com/terms/s/sequence-risk.asp
- Klein, R. (2014, May 12). 8 reasons fixed-income annuities belong in your IRA. Retrieved from https://www.marketwatch.com/story/8-reasons-fixed-income-annuities-belong-in-your-ira-2014-05-12
- Langone, A. (2019, May 1). Income Annuities Are Gaining Popularity as a Way to Make Your Money Last in Retirement. Here Are all the Pros and Cons About This Controversial Product. Retrieved from https://money.com/what-are-income-annuities-money/
- National Association of Insurance Commissioners. (2007). Buyer’s Guide to Fixed Deferred Annuities. Retrieved from https://www.naic.org/documents/prod_serv_consumer_anb_lp.pdf
- National Association of Insurance Commissioners. (2019, October 4). Annuities. Retrieved from https://content.naic.org/cipr_topics/topic_annuities.htm
- Pfau, Wade. (n.d.). Protected Lifetime Income A New Formula and Category for Today’s Modern Retirement Plan. Retrieved from https://fb53c249d56cbdc517b3-a0041c3964186a9714763246bc825d85.ssl.cf1.rackcdn.com/Pfau-Pardo-Alliance-Risk-Pooling-Research-Paper21_181015_181207.pdf
- Pfau, W. (n.d.). Taking a Closer Look at Deferred Income Annuities. Retrieved from https://www.onefpa.org/journal/Pages/DEC14-Taking-a-Closer-Look-at-Deferred-Income-Annuities.aspx
- Webster's New World College Dictionary, Fifth Edition (n.d.). Annuity dictionary definition. https://www.yourdictionary.com/annuity