Income Annuities, or Immediate Annuities as they are often termed, are financial tools designed to provide an ongoing income stream during retirement, making them essential for individuals concerned about outliving their savings. Today, we will dissect this financial instrument, revealing its inner workings, key features, and potential benefits.
What is an Income Annuity?
In simple terms, an income annuity is a contract initiated with a life insurance company to ensure a steady and reliable stream of income until death. Its purpose is to transform a lump sum amount into guaranteed periodic cash flows, typically monthly or annual payments. The beauty of an income annuity is that the income payments start almost immediately, usually within one month of premium payment.
Essentially, an income annuity is a type of longevity insurance, a financial safeguard designed to ensure people do not outlive their savings. This product is primarily funded through lump-sum payments often from retirement savings, such as a 401(k).
The Mechanism Behind Income Annuity
This financial product operates on a straightforward principle. An individual saves or invests a sum of money into an income annuity. Around retirement age, the person then opts to start the income payments from the annuity. Once these payments begin, they generally can't be stopped or altered.
While these financial products historically have shown inflexibility, many insurance companies now offer hybrid-type annuities that combine the features of income annuities with other forms, such as indexed or variable annuities.
Income Annuity Rates and Payouts
For an income annuity, the insurance company will establish an annual payout rate based on the amount to be annuitized and the age of the individual(s). Companies utilize actuaries and mortality tables to calculate the amount of annual or monthly payments that can be disbursed to an annuitant according to their age and life expectancy.
The Mortality Pool Concept
In the annuity context, the "mortality pool" refers to the collected money and interest available to provide an annuitant's income where their own funds may have depleted. This system works in a way that those who die earlier than their average life expectancy may still have a remaining principal balance, which will be paid out to their beneficiaries. Conversely, those who surpass their life expectancy will benefit from the mortality pool.
Considerations for Income Annuity
While income annuities can offer financial security, they should be approached with care. It is generally inadvisable to invest more than 50% of a person's retirement assets in an income annuity, primarily because they may need to sacrifice liquidity and access to the capital more than the income stream allows for.
Additionally, individuals often become joint annuitants with their spouse to ensure the money continues for as long as either one is alive.
An income annuity offers a dependable solution for retirement income, reducing the financial risk associated with longevity. By understanding this tool better, individuals can make informed decisions on integrating it into their retirement plan.
Summary
Income annuities are used by people in retirement to give them a steady, dependable stream of income until they die.
It is a financial product sold by a life insurance company, which serves as a kind of longevity insurance, so that people cannot outlive their money. People often roll lump sums from 401(k)s into these plans. Though inflexible, the income payout rate is designed to be appealing when compared to most retirement investments.
Life insurance is designed to hedge the financial risk to a family of one of their family members dying early. Income annuities are designed to hedge the financial risk of living too long. There are other kinds of annuities, but income annuities are perhaps the simplest.
A person takes a sum of money, or perhaps save it up inside of a type of income annuity, and at some point around retirement age the person will choose to commence the income payments from the annuity. Once they are begun, they generally cannot be stopped or modified.
These products have historically been very rigid but some companies are now making tweaks and hybrid-type annuities that blend features of income annuities and other kinds, such as indexed or variable annuities. For an income annuity, the company will have a stated rate of annual payout based on the amount to be annuitized (turned into an annuity income stream) and the age of the person(s).
They use actuaries and mortality tables (found here) to determine the amount of annual or monthly payments that can be made to an annuitant based on their age and life expectancy. 50% of the annuitants will die before the average life expectancy, and 50% of the annuitants will die beyond their life expectancy.
The ones who die before may still have a remaining principal balance left which will be paid to beneficiaries. The ones who die after will benefit from what’s called a mortality pool, which is the pooled money and interest that is available to pay the annuitant income where their own money would have likely failed.
It is generally not advisable to tie up more than 50% of a person’s retirement assets in an income annuity, because they would give up liquidity and access to the more than the income stream allows for. People often become joint annuitants with their spouse to ensure that the money will last as long as either of them is alive.