Breakdown of terminology An immediate annuity allows you to receive payments immediately, while a deferred annuity puts off payments until a later date. A fixed rate annuity is a preset payment amount, while a variable annuity fluctuates with the success of the investment choice. The payments are determined by a number of factors, some of which include the amount of the investment, and length of payment period. To get an idea of how much you may be entitled to, try this free annuity calculator.
The immediate fixed annuity is a popular choice, and often sounds to good to be true, so we are going to look at the mechanics of this investment in greater detail. Say an older couple, aged 65, purchases as immediate annuity that guarantees a 6% annual return. If they invest $500,000 that equates to $30,000 in yearly returns. This sounds pretty good as stocks yield an average of 4.8%, and mutual funds yield even less. So whats the catch? Truthfully, that older couple will never really receive a 6% return on their money. Buying the annuity results in a full loss of the investment, as the insurance company is quite simply, giving you back your investment for the first 15 years. At this point the couple will be 81 years old and their principle investment will no longer hold any value. If the couple lives until 82 they will only see an internal rate of return at less then 1%. If they live until they are 88, their return will only be 3.5%. Furthermore there are numerous upfront fees, taxes, and penalties if you try to withdraw your money too soon.
Because an annuity is not truly an investment, it is poorly prepared to handle inflation. A fixed income of 30,000 will diminish every year in its buying power, with 4.5% as the average yearly inflation rate. In 15 years time that income will end up being a fraction of what is truly needed for a comfortable retirement, being equivalent to receiving a mere $10,000, and no principle investment to fall back on. The annuity would be better off to offer less income early in retirement, with the percentage of return growing over time to match inflation. If after 15 years your investment doubled and you had $1M, it would be a different story. However, the complete loss of principle makes this a poor investment choice for many, and a costly avenue of money management.