Understanding Immediate Annuities
Immediate annuities are the simplest type of annuities. You give the insurance company a sum of money, this is called the premium, and they give you a payout each month for the rest of your life. The insurance company calculates the amount of the payout based on your age, your life expectancy, and the amount of the premium. It is also common to select a fixed payout period of say 10 to 15 years. It could be said that the insurance company is betting that you will die sooner since, at that time, the payouts stop. While you, on the other hand, are betting, you will receive payments over the entire payout period or live out a very long life if you have purchased a lifetime policy.
These annuities are mostly sold to retired people who will have sufficient assets remaining after purchasing the annuity to cover unexpected emergencies. Immediate annuities provide a guaranteed lifetime income stream, and there is no provision for a lump-sum payout to cover emergencies. Immediate annuities do offer income for those at any age but are typically used during retirement years. (This is only an example, and does not represent an actual scenario). To see how they work and to determine if they are a good option, look at a real-life example. If you are a male, 65 years old in 2013 living in Texas, then for a $100,000 premium, you can purchase an immediate annuity providing a lifetime monthly income payment of $585. The payout of 7.02% determined by the yearly payout of $7020 for the $100000 premium.
Therefore, what interest rate are you earning on your investment? Well, that depends on when you die. If you live about 14 more years until you are 79, then you will have just received back your entire $100000 premium, that is to say, you will have realized a 0% interest rate. Your life expectancy, if you are 65, is about 19 years, so on average, you should live until you are 84 if you make it that far you will have received $133,380, which is equivalent to having received an annual interest rate of 3.182% on your investment for the 19 years.
You can think about this return in more familiar terms. Assume you borrowed $100000 and had to pay back $585 per month. If the contract called for 14 years of payment, then you would pay back the original amount so that the loan would have had zero annual interest. If it took longer to pay off the loan, then that would mean interest was applied. If the yearly interest rate were 3.182%, then it would take 19 years to pay off the loan, and the total payments would be $133,380. Now reverse the thinking and realize that the insurance company has effectively borrowed the $100000 from you and are paying it back with an effective interest based on how long you live.
To get the 7.02% annual interest advertised you have to live a very long time, more than another 100 years. However, let us say you made it to your life expectancy of 84 years old and realized an annual return of 3.2%. Some plans can continue payments if you die early. One example is a policy that pays for 20 years either to you if alive or to a beneficiary after you die. The payments, instead of being $585, would be reduced to $508 per month. At the end of the 20 years when payments stop, the effective annual interest rate would be 2.0% instead of 3.6% (from the table).