Of all the investment products for sale, there is probably none more misunderstood than
annuities. There are many people who don’t really understand the pros and cons of
annuities and are worried that their income won’t last. They have become a prime target
of salesmen out for the high commissions associated with annuity sales. Annuities are
not appropriate for everyone. In this first of a series of articles, we will begin to provide
a brief overview of the most common types of annuities along with some of the pros and
cons of each.
There are three basic types of annuities: immediate-fixed annuities, deferred-fixed
annuities and variable annuities. Probably the easiest to understand and the least
potentially problematic is the immediate-fixed annuity. In this article, we’ll focus on the
basics of immediate fixed annuities. In a future article we’ll discuss the other types of
annuities as well as when annuities are appropriate and when they are not.
An immediate-fixed annuity is like a life insurance policy in reverse. With a life insurance
policy, you pay premiums while you are alive and your beneficiaries receive a lump sum
when you die. When you purchase an immediate-fixed annuity, you pay a lump sum up
front in return for monthly payments for the rest of your life.
The amount you receive each month from the immediate-fixed annuity depends on your
age and current interest rates. The older you are and the higher interest rates are, the
more you will receive each month. This is due to two things. First, the company that
sells you the annuity invests your money in order to meet the future payments
promised. The higher interest rates are, the more they can make on your money and
the higher the corresponding payments will be (Competition generally keeps them
honest). Second, the older you are, the shorter your life expectancy is. It is likely,
therefore, that the annuity provider will have to make fewer payments than for someone
younger. As a result, the payments are larger.
Immediate-fixed annuities can supplement a retiree’s other income and help insure their
money will last for their lifetime. Annuitants (those who receive annuity payments) can
choose to receive payments for their life with no further payments after they die (This is
called a straight-life annuity.) Alternatively, annuitants can choose to receive payments
over both their life and their spouse (a joint and survivor annuity). Since total payments
over two lives will likely be higher than over one life, the promised monthly payments are
less than for a single-life annuity.
As an example of typical payments, we used Vanguard’s annuity calculator for a
Michigan male aged 60 years old who buys a $100,000 immediate-fixed single-life
annuity. Monthly payments would be $ 628.22 based on current interest rates. A
person aged 70 would receive $ 764.15 a month due to their shorter life expectancy.
Since the annuity payments include both principle and interest, a portion of the monthly
payments would be taxed as ordinary income. For the 70 year old payment stream,
using current interest rates on immediate annuities, 68.2% would be tax-free and 31.8%
would be taxable at the annuitant’s applicable tax rate. This assumes the annuity is an
after-tax, non-IRA annuity.
For those who worry that they may die at a young age, there are other types of annuity
distribution options that ensure beneficiaries will receive benefits. For example, a Ten-
Year Certain annuity distribution option assures payments will continue for at least ten
years to beneficiaries, should the annuitant die before ten years of payments have been
made. Such a guarantee results in lower payments than for a single-life annuity
payment stream.
Studies have shown that using 20% to 30% of your assets to purchase an immediate-
fixed annuity can increase the chances that your funds will last through life expectancy.
Pensions and Social Security payments are essentially the same thing as annuities.
Therefore, those with substantial pensions and Social Security payments have less
need for a fixed annuity than one who has neither a pension nor substantial Social
Security payments.
If you decide to purchase an immediate-fixed annuity, be sure you buy from a reputable
large firm and seek out a low-cost product.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, March, 2008,
All About Annuities - Part I
By David and Erin Patterson