What Is an Income Annuity?
An income annuity is a contract between an individual and an insurance company that provides a guaranteed stream of periodic payments for a specified period or for the rest of the annuitant's life. This financial product falls under the broader category of retirement planning and is designed to convert a portion of an individual's savings, often a lump sum, into a predictable income stream. The primary appeal of an income annuity is its ability to offer financial security by mitigating the risk of outliving one's assets, also known as longevity risk.
History and Origin
The concept of annuities dates back to ancient Roman times, where a guaranteed income stream was known as "annua," a Latin term for annual stipends. Roman citizens would make a one-time payment in exchange for lifetime payments each year. The Roman jurist Ulpian is credited with being one of the first to deal with annuity contracts and create actuarial life tables for this purpose. Annuities continued their evolution through the Middle Ages, with "tontines" emerging in 17th-century France, offering increasing payouts to survivors as participants passed away. In the United States, annuities gained prominence in the 18th century, with the Presbyterian Church utilizing them in 1759 to provide secure retirement for ministers and their families. The Pennsylvania Company for Insurance on Lives and Granting Annuities was established in 1812 as the first American company to offer annuities to the general public. By the early 1990s, annuity payouts constituted nearly 40% of combined payouts from life insurance and annuities in the U.S., reflecting a significant growth phase since the late 1970s.6,5
Key Takeaways
- An income annuity provides a guaranteed stream of payments, often for life, converting a lump sum into predictable income.
- It offers financial security by addressing longevity risk, ensuring funds do not run out in retirement.
- Income annuities typically bypass market volatility, providing a stable income regardless of market performance.
- The payout amount is influenced by the annuitant's age, gender, prevailing interest rates, and the specific annuity contract terms.
- Payments from an income annuity are generally taxable on the portion representing earnings, while the return of principal is tax-free.
Interpreting the Income Annuity
An income annuity is interpreted as a tool for de-risking the distribution phase of retirement. By converting a portion of an investment portfolio into an income annuity, individuals can establish a baseline of guaranteed income that covers essential living expenses, independent of market fluctuations. The interpretation of its value relies heavily on the assurance of continuous payments, especially when considering increasing lifespans. For example, a 70-year-old purchasing an income annuity receives a higher payout than a 60-year-old for the same premium, as the payments are expected to be distributed over a shorter actuarial lifespan. The amount of the periodic payments depends on various factors, including the annuitant's age, gender, current interest rates, and the chosen payout option (e.g., single life, joint life, period certain).
Hypothetical Example
Consider Maria, a 65-year-old retiree, who has accumulated a lump sum of $200,000 from her retirement savings. She wants to ensure a portion of her retirement income is guaranteed for life. Maria decides to purchase a single premium immediate income annuity (SPIA) with her $200,000.
The insurance company evaluates her age, gender, and current interest rates. Based on these factors, the insurer quotes her a guaranteed monthly payment of $1,000 for the rest of her life. This means that from the moment she initiates the annuity, Maria will receive $1,000 every month, regardless of how long she lives. If Maria lives for another 25 years (until age 90), she will have received $1,000 x 12 months/year x 25 years = $300,000 in periodic payments. This example illustrates how an income annuity provides a predictable and steady stream of income, reducing uncertainty in retirement.
Practical Applications
Income annuities are primarily applied in personal financial planning to secure a predictable source of retirement income. They are often used to cover basic living expenses, acting as a "personal pension" to supplement other guaranteed income streams like Social Security benefits. By converting a portion of their assets, retirees can create a floor of guaranteed income, freeing up the remaining investment portfolio for growth-oriented investments or discretionary spending.
These products are also relevant in estate planning scenarios where individuals wish to provide a consistent income for beneficiaries for a defined period or their lifetime. For tax purposes, the Internal Revenue Service (IRS) provides guidance on how pensions and annuity payments are taxed, generally distinguishing between the tax-free return of the cost (or basis) and the taxable portion representing earnings.4 The SEC also issues investor bulletins to educate the public about annuities, emphasizing factors such as surrender charges and potential tax penalties for early withdrawals.3
Limitations and Criticisms
While income annuities offer significant benefits, they also come with limitations. One primary criticism is the loss of access to the principal once it's converted into an income stream. Unlike other investments, the funds in an income annuity are generally illiquid. Additionally, unless specific riders are purchased, traditional income annuities do not offer protection against inflation. Over time, a fixed income stream may lose purchasing power, diminishing its real value.
The return on an income annuity is also highly dependent on prevailing interest rates at the time of purchase. If rates are low, the payout may be less attractive. Some investment philosophies, such as those espoused by the Bogleheads community, view certain types of annuities with skepticism due to their complexity, high fees, and potential for commissions that may not align with investor interests.2 Furthermore, the financial strength of the insurance company issuing the annuity is crucial, as the guaranteed payments depend on the insurer's ability to meet its long-term obligations.
Income Annuity vs. Deferred Annuity
The primary distinction between an income annuity and a deferred annuity lies in when the payments begin. An income annuity, often called an immediate annuity, starts providing payments almost immediately (typically within one year) after a lump sum premium is paid. Its purpose is to convert savings directly into a stream of income for current needs or to immediately address longevity risk.
In contrast, a deferred annuity has an accumulation phase where funds grow, often on a tax-deferral basis, before the income payments begin at a future date. During the accumulation phase, the annuity holder may have options to allocate funds to fixed accounts, variable investment options, or indexed strategies, and can typically make withdrawals subject to surrender charges and tax penalties. The income phase of a deferred annuity begins only when the annuitant chooses to "annuitize" the contract, converting the accumulated value into future periodic payments.
FAQs
What happens to the money in an income annuity if I die early?
If you die soon after purchasing a basic single-life income annuity, the remaining principal may be forfeited to the insurance company. To avoid this, you can choose payout options with a "period certain" (e.g., guaranteed payments for 10 or 20 years, even if you pass away) or a "cash refund" option, which ensures your beneficiaries receive any remaining principal if you die before receiving payments equal to your initial investment. These options typically result in lower periodic payments.
Are income annuity payments taxable?
Yes, generally, the earnings portion of income annuity payments is taxable as ordinary income. The part of each payment that represents a return of your initial principal (your investment in the contract) is tax-free. The IRS provides methods for calculating the taxable and non-taxable portions of pension and annuity income.1 If you withdraw funds from a tax-deferral annuity before age 59½, you may also be subject to a 10% federal tax penalty.
How are income annuity payouts determined?
Income annuity payouts are determined by several factors, including the amount of the initial lump sum, the annuitant's age and gender (which influence life expectancy), prevailing interest rates, and the specific payout option chosen. Insurance companies use actuarial tables to calculate the expected payout based on these variables.
Can an income annuity provide inflation protection?
Standard income annuities provide fixed periodic payments that do not adjust for inflation. However, some income annuities offer an inflation rider or cost-of-living adjustment (COLA) feature, which increases the payments over time to help maintain purchasing power. Opting for such a rider typically results in lower initial payments. A financial advisor can help evaluate these options.