What Is a Lifetime Annuity and How Does It Work?

When planning for retirement, one of the biggest fears people face is outliving their money.

What is a lifetime annuity? Simply put, it’s a financial contract that guarantees you’ll receive income payments for the rest of your life, regardless of how long you live.

By popular demand, we will be continuing our conversations from last week on annuity strategies! This time, we are joined by special guest Joseph DeFazio! Joe is a seasoned financial educator and will bring a fresh perspective on lifetime annuity income and how annuities can benefit your financial life!

If you’re interested in guaranteed lifetime income, then this video is for you! We’ll discuss the different types of annuities and explain the basics of lifetime annuity income.

Podcast: Play in new window | Download (Duration: 1:06:48 — 76.5MB)

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Annuities as a Form of Risk Transfer

[11:10] “An annuity is a private contract that completely transfers the risk of outliving your money to the insurance company in exchange for a premium payment. The insurance company uses bonds and [then] layers on actuarial calculations, actuarial science, that pools the risk so they can guarantee an income stream for as long as your contract specifies.”

When you buy a lifetime annuity, you’re basically handing over your biggest retirement worries to the insurance company. They take on the risk, and in return, they promise to pay you for life.

In other words, an annuity is the inverse of whole life insurance, which transfers the risk of not living long enough to the insurance company (in exchange for a premium). Because insurance companies manage the risk of living too long AND not long enough, they’ve created balance.

So what risks are you actually transferring when you purchase a lifetime annuity? There are three big ones that keep retirees up at night:

• Outliving retirement savings – What if you live to 95 and your 401(k) runs dry at 85? With a lifetime annuity, that’s the insurance company’s problem, not yours.
• Market volatility impacting income – Market crashes don’t care if you’re 75 and need your monthly income to pay for groceries. Your annuity payments stay the same regardless.
• Inflation erosion – This one’s trickier with fixed annuities since your payments won’t increase, but some annuity options do include inflation adjustments. 

How to Structure Your Annuity

There are two phases to an annuity: the accumulation phase and the annuitization phase. During the accumulation phase, you’re funding the annuity, and you can choose either a fixed rate or variable rate, both of which have their pros and cons.

When you’re looking at a life income annuity, you’ll find there are several ways to set it up depending on your situation. Here are the main choices you’ll face.

Immediate vs. Deferred Start

In the annuitization phase, one of the choices you must make is whether you want your benefit now or later. If you choose to start receiving your benefit within 13 months, that’s called an immediate annuity. Any time after that is considered a deferred annuity.

Think of this as the “when” decision. Need income right away because you’re already retired? An immediate annuity starts paying you within a year. Still working and want to let your money grow? A deferred annuity lets you wait and potentially get larger payments down the road.

Payment Structure Options

Then, you choose how you want to receive your benefit. You can get a level payment, and increasing payment, or even a variable payment stream that would be tied to an index. The choice will likely depend on how long you expect to take income, compared to how large your annuity is.

Here’s where you decide what your payments will look like:

• Fixed payments – Same amount every month, simple and predictable
• Inflation-adjusted payments – Payments that increase over time to help keep up with rising costs
• Variable payments – Tied to market performance, which can mean higher upside but less predictability

Single-Life vs. Joint-Life Coverage

And finally, you can choose what types of guarantees you want on that benefit. If you choose to have no guarantees, then the income benefit stops as soon as you pass on. You can also tie an annuity to someone else with a survivorship rider, which would continue to pay the income to a spouse or partner for the remainder of the annuity term.

This is a big one if you’re married. A single-life annuity pays higher monthly amounts but stops when you die. A joint-life annuity pays less each month but continues paying your spouse after you’re gone.

Additional Guarantee Options

Another way to structure it is placing a guarantee on the term, like 10 years, where it pays to someone for that term no matter what. You can also choose to simply guarantee a return of premium, so if you pass on before you’ve earned back your initial premium, it will pay a beneficiary until that benchmark.

Real-World Example: Single Retiree vs. Couple

Let’s say John, a 65-year-old single retiree, has $500,000 to put into an annuity. He might choose a single-life immediate annuity with level payments, getting around $2,500 per month for life.

Now consider Bob and Mary, both 65, with the same $500,000. They might opt for a joint-life annuity that pays $2,200 per month while both are alive, then continues at $1,650 per month to the survivor. Less money each month, but protection for whoever lives longer.

What is a SPIA? (Single Premium Immediate Annuity)

[15:01] “A person’s idea of an annuity is often tied to a SPIA because this is the description that most people have of an annuity.”

SPIA stands for a single premium immediate annuity. In other words, you pay for the annuity in one lump sum and begin receiving an income within the first 13 months. Since it has its own acronym, it’s what many people are familiar with when the topic of annuities comes up.

The Appeal of Simplicity

That being said, a SPIA isn’t for everyone. As you can see above, there are many ways to structure an annuity to work for your particular set of needs and goals.

The main appeal of an SPIA is its simplicity. You know exactly what you’re getting – no market risk, no investment decisions, no surprises. Once you buy it, you’re done making choices. The insurance company handles everything, and your checks show up like clockwork.

While the immediate nature of the SPIA may be beneficial to some, there are some things to consider. One of the major benefits of the SPIA is that you’re going to get a much higher rate of return on this than any other annuity.

The Trade-Off: No Liquidity

However, these annuities are designed to be more short-term, and any remainder goes to the life insurance company, not a beneficiary.

But here’s the trade-off: once you buy an SPIA, that money is locked up. Unlike other investments where you might be able to get some of your principal back, an SPIA is all-or-nothing. You can’t change your mind or access a lump sum if you need it later.

Who Should Consider a SPIA?

Generally, the best candidate is someone who is running out of money, is over 85, and wants to create the best possible end-of-life income. It’s certainly not right for everyone, nor is it the only option when it comes to annuities. 

Who Should Consider Annuities?

Almost anyone can benefit from looking into annuities, even if they don’t choose to buy them. That’s because most people will find themselves wanting to protect against either longevity risk (living longer than your money) or sequence of returns risk (when you have to take an income, even in a bad market). Annuities can solve both issues by creating guaranteed income without the fear of loss.

Additionally, if you have CDs or bond funds, you should consider annuities. This is because, with bond funds in particular, things can get a bit bumpy. As we’ve seen in the last few years, bonds have dipped as much as equities in some cases. Annuities won’t do this, because they’re designed to support your lifestyle.

When Annuities Don’t Make Sense

But lifetime annuities aren’t right for everyone. 

If you need access to your money, annuities probably aren’t for you. Once you hand over that lump sum, it’s gone. You can’t get it back if you need cash for an emergency or unexpected expense.

Also, if you’re still chasing high growth potential and willing to accept the ups and downs that come with it, the steady but modest returns of an annuity might feel too conservative. You’re essentially trading potential upside for guaranteed income.

Lifetime Annuity Income

When you choose to purchase an annuity, one thing to remember is that there’s an account balance, and there’s a balance that the insurance company calculates the income on.

This can get confusing. However, think of your account balance as your actual money. On the other hand, the income account value or benefit-based account value is a phantom number that the insurance company has calculated to guarantee you income off of. 

If you choose to have a lifetime benefit income rider, then you really are guaranteed income for the remainder of your life, no matter what. So this phantom number the insurance companies create is based on actuarial science and your personal longevity.

Real-World Example: Kathy’s Annuity

When you buy an annuity, it’s not unusual for the insurance company to offer bonuses. In the example Bruce shares in the podcast, Kathy got an immediate 10% bonus on her $1 million premium. This was a free $100,000 just for signing up.

Then, she’s guaranteed to earn a fixed 7% for each year she delays income, up to 15 years. Based on an 8-year deferral and an income factor of 7.25%, she’s looking to get $137,025 of annual income for the rest of her life, starting at age 70.

Moreover, if she continues to defer past the 8-year mark her account will continue to grow. If Kathy deferred for the full 15 years, she would be looking at $211,667 of annual income from age 77 onward.

So if Kathy was feeling good through her early to mid-70s, she could keep deferring and let her future income grow. But it would also be available at any point she wanted to start distributions. It’s an incredibly flexible product. 

[50:30] “Believe me, insurance companies are experts at risk management.”

Lifetime Income Annuity Pros and Cons

Before you decide whether a lifetime annuity makes sense for your situation, it helps to see both sides of the coin.

The Upside

Guaranteed lifetime income – This is the big one. No matter how long you live or what happens in the markets, your payments keep coming. You could live to 105, and those checks will still show up.

Removes investment management burden – Tired of watching your portfolio and making investment decisions? An annuity takes that stress off your plate. The insurance company handles all the investment management.

Protection from outliving assets – This is what keeps a lot of retirees up at night. With a lifetime annuity, you never have to worry about your money running out before you do.

The Downside

Irreversible decision – Once you buy a lifetime annuity, that’s it. You can’t get your lump sum back if you change your mind or need cash for something else.

May not keep up with inflation – Unless you specifically buy an inflation-adjusted annuity, your payments stay the same while everything else gets more expensive. That $3,000 monthly payment won’t buy as much in 20 years.

Potentially lower returns – You’re trading growth potential for security. Your money might have done better in the stock market, but there’s no guarantee of that either.

Lifetime Annuity Income — How Payments Work

Once you’ve got a lifetime annuity set up, you’ll need to decide how often you want to get paid. Most people go with monthly payments since that matches how they’re used to receiving income, but you can also choose quarterly or annual payments if that works better for your situation.

Tax Treatment
Not every dollar of your annuity payment is taxable. A portion of each payment is treated as a return of your original premium (your own money coming back to you), and that part isn’t taxed. The remaining portion is considered earnings and is taxed as ordinary income.

The insurance company will send you a Form 1099 each year that clearly shows how much of your annuity income is taxable.

• If the annuity is qualified (funded with pre-tax money like an IRA or 401(k) rollover), then the entire payout is taxable.
  
• If it’s non-qualified (funded with after-tax money), only the earnings portion is taxable, while your original contributions come back to you tax-free.

How a Lifetime Annuity Fits into Your Retirement Plan

A lifetime annuity shouldn’t be your entire retirement strategy. It gives you that solid base of guaranteed income, and then you can build the rest of your retirement plan on top of it.

Most people already have some guaranteed income from Social Security. If you’re lucky enough to have a pension, that’s another piece of guaranteed income. A lifetime annuity can fill in the gaps, especially if Social Security and your pension don’t cover all your basic living expenses.

Let’s say your monthly expenses in retirement are $6,000. Social Security gives you $2,500, and you don’t have a pension. That leaves you $3,500 short each month. You could buy a lifetime annuity to cover that gap.

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