When to Get an Immediate Annuity

Immediate annuities are designed to do one thing and that is to convert a lump sum of money into a guaranteed stream of income for a predetermined period of time, either a fixed period or for the life expectancy of a person.  That’s it. As simple as that may sound, there are several factors that should be considered to determine when to get an immediate annuity.  The time to get one may very well be when you need the income, but it may not be the best way to optimize the benefits of an immediate annuity. With some understanding of how an immediate annuity works, you can get the most out of an immediate annuity and get the income you need.

In order for a life insurer to make the immediate annuity appear so simple, there are a few actuarial machinations that must occur along with some contractual commitments on the part of the insurer and the annuitant (the person receiving the income).  Let’s cover the contractual commitments first.

An immediate annuity is a contract which obligates the insurer to its part in providing an income stream in consideration for a lump sum deposit made by an individual. The contract requires that the individual relinquish his rights to the deposit money in return for the guaranteed income.  Once both parties enter into the contract, it is irrevocable.  The contract specifications are determined by the individual, his age, the amount of money to be deposited, and his specific need for income.  An individual may need to secure an income for the remainder of his life, or he may need the income for a specific period of time.

When the money is accepted by the insurer, its actuaries go to work to determine the amount of income that the annuitant will receive.  For a lifetime income, the annuitant’s age and the cost of money are the primary determinants. Using current life expectancy tables, the insurer determines how long the annuitant is expected to live. Factoring in interest rates that will be applied to the remaining principal, the insurer comes up with a payout rate that is based on a systematic return of the principal and the payment of interest earned.

Said differently, the income payment and annuitant receives consists of both a return of their principal and interest earned.  The number of years of remaining life expectancy is the key factor in determining how much of the income will be return of principal and how much will be interest earned. This is where it gets to the issue of when to get an immediate annuity.

For anyone to have considered a purchase of an immediate annuity, they probably have concerns about the prospect of outliving their income.  It also means that they would probably prefer not to have to concern themselves with having to manage the assets or administer any accounts.  Also, they prefer more stability and predictability in their retirement income.

It would also seem that the most appropriate time to buy an annuity is at retirement age when earned income stops.  The goal for most retirees is to be able to maintain as much of their preretirement lifestyle as possible and the supplemental income from an immediate annuity would help them fill in the gap.

Ideally, the newly retired person has at least a couple of sources of income such as a qualified retirement account and, maybe, income from a part-time job along with his Social Security.  With proper planning, it may be possible to have the existing income sources provide enough to meet his basic lifestyle needs.  Having a sum of money that can sit in cash for emergencies or near term purchases would be even more ideal.  Under these circumstances, the best time to buy an immediate annuity is as long into the future as possible.  Let’s explore the reason why.

Because of the role that life expectancy plays in determining the payout rate, the older a person is when he annuitizes, triggering the payout calculation, the higher the payout rate will be. This is because the insurer must be able to distribute all of the principal and interest in a shorter period of time.  Should the annuitant live past his life expectancy, the insurer is obligated to continue income payments at the same payout rate.

Positioning for a higher annuity payout later could allow for bigger current withdrawals from other retirement accounts. Because the future annuity payout will be based on prevailing interest rates, the actual rate cannot be accurately predicted, however, using different assumptions for the direction of interest rates in the future, one could arrive at reasonable forecast.

The key is to take the lump sum that was allocated for an immediate annuity and put it to work in a deferred annuity so it can accumulate safely at competitive rates and without current taxation of interest.  At the time the income is needed the deferred annuity can be converted to an immediate annuity without penalty or tax consequences.

The most important factor to determine when to buy an immediate annuity is when you have the need for a secure, guaranteed stream of income.  That’s why they were created, however. with some foresight and some effective planning, it’s possible to get most out of an immediate annuity and get the income you need.