Immediate Annuity Guide

An immediate annuity is a financial contract that delivers something very close to what its name suggests – regular, lifelong payments from insurance company to annuity holder that begin soon after the signing of the contract. The history of immediate annuities goes back to the origins of annuity contracts.

Immediate Annuity Origins

In the 1860s, the Equitable Life Assurance Company began issuing financial contracts called “tontines,” in which an individual paid a lump sum to the insurance company in return for the promise of guaranteed, lifetime income payments. Tontines were enormously popular and helped make The Equitable the most successful insurance company of that day.

Eventually, this financial contract became synonymous with its plan of payment, which was known as an annuity.

Immediate Annuities vs. Deferred Annuities

In the twentieth century, many annuity contracts acquired the dual aspect that they retain to this day– an initial phase of gradual, regular payments made by the annuity holder, followed by payments from company to holder. The first phase is the accumulation phase, in which the company invests the payments made by the holder. The second phase is the distribution phase, in which the company distributes the invested earnings to the holder over the remainder of his or her life.

The postponement of the distribution, or annuity, phase of the contract gives deferred annuities their name. Annuities lacking this postponement are immediate annuities. This is a slight misnomer since distribution does not commence immediately after signing of the annuity contract. Upon receipt of funds, the insurance company invests the money in order to generate the income necessary to fund the annuity. (Immediate payment would require payment in advance of investment.) The first payment in an immediate annuity contract is made in accordance with the payment-frequency terms stipulated in the contract. Possibilities include monthly, quarterly, semi-annual or annual payments; thus, the first payment on an immediate annuity might be delayed for a maximum of one year. This gives the insurance company time to invest the funds and generate a return.

Immediate Annuity Distribution

The classical distribution plan for an immediate annuity is the lifetime distribution, in which the annuity holder receives level payments for the remainder of his or her life. At the holder’s death, the insurance company claims any remaining undistributed funds. Since the annuity payout is calibrated to the holder’s life expectancy, these forfeitures will roughly counterbalance the monies lost when holders outlive their life expectancies.

Numerous variations exist in which the holder can name one or more beneficiaries of a death benefit. At a minimum, this would consist of the undistributed remainder, less any partial withdrawals. Alternatively, the annuity can elect distributions for a period certain, with the distributions continuing to the beneficiary in the event of the holder’s premature death. Joint distributions (joint life or joint-and-several, respectively) pay benefits to two people with benefits ceasing upon the second death or upon the first.

The notion of “getting back” undistributed funds is really arbitrary, since the annuitant is purchasing the right to receive lifetime payments. Varying the terms upon which those lifetime payments are made produces different purchase prices for that right. An annuity including a death benefit, for example, will feature either a lower periodic annuity distribution (for a given immediate payment) or a higher immediate payment (for given distribution payments) than will the classic lifetime immediate annuity. The annuity holder could alternatively purchase the lower-priced lifetime annuity and then use the price difference to fund a legacy, via life insurance or financial investment.

In recent years, the concept of variable annuities has extended to immediate annuities as well, with the development of the immediate variable annuity. Here, the level, regular payments are replaced with a payout geared to the performance of an equity portfolio selected by the annuity holder. Still more recently, many indexed annuities – whose portfolio values vary with returns to indexes of market performance, such as the Standard & Poor ‘s 500 stock index – are immediate annuities.

Immediate Annuity Calculator

A good program for calculating the periodic payout on an immediate annuity with a given initial lump-sum premium can be found on our Immediate Annuity Calculator page.

This calculator requires the supply of other key parameters, such as the life expectancy of the holder, the interest return expected, and the payment frequency. Allowance can be made for changes in important external economic variables, such as taxes and inflation. The latter is particularly vital for recipients of fixed income, since inflation acts as an implicit tax on holders of money, depreciating its worth. Unlike recipients of earned income, fixed-income recipients cannot expect increases in income to counterbalance this depreciation in the purchasing power of money.

Immediate Annuity Buyers

Two characteristics distinguish the purchaser of an immediate annuity: desire for regular, lifelong income payments and desire to begin those payments as soon as possible. The category of buyer that best fits this description is a retiree who wants to convert retirement savings into a regular source of income that cannot be outlived. Hence, individuals who are just retired and whose risk tolerance is heavily weighted toward security are very good candidates for immediate annuities.

These retirees may be investing personal savings or the proceeds of qualified plans or pensions. In particular, retiring employees who are heavily invested in company stock have a strong incentive to diversify upon entering retirement in order to reduce the risk to their income. Rolling over a 401(k) or company pension to an immediate annuity is one way to eliminate this risk while guaranteeing a source of retirement income.

Another source of demand for immediate annuities comes from beneficiaries of structured legal settlements, such as liability lawsuits. The terms of the settlement typically require payments to replace lost income or lost wages that would otherwise have been realized over many years; moreover, this replaced income must be provided with as much certainty as the legal system can deliver. An immediate annuity is made to fit this order. The defendant is ordered by the court to purchase the annuity in an amount sufficient to fulfill the plaintiff’s damage claim.

Business owners or corporate financial managers can purchase immediate annuities to fund pension plans. (The structure of a lifetime annuity distribution is essentially that of a pension payout.) Governments facing vast unfunded retirement-system liabilities are in an analogous, but more tenuous, position. They, too, can benefit from immediate annuities. An example is Chile, which privatized its Social Security-like system over two decades ago using annuities. As a consequence, demand for immediate annuities in Chile is extremely high. In the U.K., demand is also high because the law requires that company pensions be annuitized by the time the recipient reaches age 75.

Immediate Annuity Regulation

Regulation of annuities is divided between state insurance regulators and federal securities regulators. The latter regulate variable annuities and a few indexed annuities, which are deemed to involve investment risk to annuity holders and therefore to require the information disclosure contained in a prospectus. After January, 2011, all indexed annuities will be regulated as securities. All other annuities meet the “safe harbor” insurance exemption to the Securities Act of 1933 and are regulated by state insurance departments.