What is an Income Annuity?
An income annuity is an annuity contract that is designed to start paying income as soon as the policy is initiated. Once funded, an income annuity is activated immediately, although the underlying income units may be in either fixed or variable investments. Consequently, income payments may fluctuate over time.
Also known as an immediate annuity, single-premium immediate annuity (SPIA), or an immediate payment annuity, it is typically purchased with a lump sum payment (premium), often by individuals who are retired or approaching retirement. These annuities contrast deferred annuities, which begin paying out years later.
Key Takeaways
- An income annuity is a financial product designed to convert a lump sum amount into guaranteed periodic cash flow (e.g., monthly or annual payments).
- An income or immediate annuity generally starts paying one month after the premium is paid and may continue for as long as the buyer is alive.
- Such annuities are particularly suitable for retirees who are concerned about outliving their retirement savings.
Understanding Income Annuities
Investors seeking income annuities should have a clear understanding of how much income they will receive and for how long. Many annuities pay out until the death of the annuitant, and some continue until the death of a spouse.
Although the insurance product may be activated immediately, variable investments can allow for some principal protection by participating in equity markets. Even if all income units are in fixed investments, there may be provisions for a higher return if a specific benchmark index performs exceptionally well.
The return an annuity buyer receives from their income annuity is based on their lifespan—greater longevity results in more payments and a better return. Payments may begin as soon as one month after a contract is signed and a premium is paid. Income annuity payments can be made monthly, quarterly, semi-annually, or annually. Many income annuities also offer a death benefit.
If a cash refund option is chosen, the designated beneficiary of an annuitant who dies before receiving payments equal to their initial premium would get the balance. Therefore, an annuitant’s age, life expectancy, and health are significant factors in deciding whether such an annuity is suitable.
Income annuities may be purchased for as little as a few thousand dollars. More significant income annuities might require special vetting. Some income annuities can be deferred to build income for later life.
Who Benefits Most From Income Annuities
The strategy behind an income annuity is to create a steady stream of income for a retiree that cannot be outlived, effectively acting as longevity insurance. A prudent rule of thumb is that payments secured by an income annuity should replace a retiree’s wage payments until they pass away.
Another strategy leveraging income annuities is using them to cover ongoing expenses—such as rent or mortgage, food, and utilities—assisted living facility fees, insurance premiums, or any other recurring payment needs.
One disadvantage of income annuities is that once initiated, they cannot be stopped or modified. Additionally, payments may be fixed and not indexed to inflation, meaning the purchasing power of each payment will diminish over time as inflation takes hold.
Related Terms: deferred annuities, fixed annuities, variable annuities, longevity insurance, pension.
References
- U.S. Securities and Exchange Commission. “Annuities”.
