Immediate annuities have been offered since medieval times when English retirees gave land and assets to the Church in exchange for lifetime income. In the modern version, the investor makes a single deposit with a life insurance company and then receives a fixed lifetime income (or income for a period of years that you select). Many investors have been cautious about such arrangements worried that the fixed income may not keep pace with the rising cost of living. Or they worry about giving up access to their principal.
The insurance industry has addressed these concerns with the immediate variable annuity, which supplies an income based on the underlying investment accounts in the annuity. The idea is that the investment accounts will hopefully rise over time and provide an increasing income. Below is a picture of what could happen under the hypothetical scenario that our investment selection within the annuity averages 8% annually and that the base interest rate selected by the investor, on which to base their initial annuity payout, is 3.5%.
Chart Source: AAII Journal, February 1994
Note that you the investor make the investment selection from a menu of 20 or more accounts and you may change you selections at any time. Some variable annuities have over 100 choices (the choices are basically mutual funds managed by well known fund companies). So the returns are in your control.
In such a case as the graphic illustrates, the annual payment keeps increasing because the actual rate of return is beating the initial selected payout rate. Of course, the experience can go the other way. If the investment sub accounts decline in value, so does the investors annuity income. Some insurance companies do however offer a minimum income guarantee (for an extra annual fee).
The minimum income guarantees typically work in this fashion. The investor's account is charged an additional .5% annually. In return, the annuity company will guarantee a 6% account growth assuming the investor holds the account for at least 10 years and then anytime after that, begins a monthly lifetime income. Such guarantees allow the investor to proceed without worry that their investment selections will perform terribly. Each annuity company structures their guarantee and guaranteed rate differently so read the prospectus. We have written about such guarantees in detail at our blog:
The other item to consider is the tax benefit. The monthly annuity payments are partially tax free because IRS considers part of each payment a return of principal. For example, an investor with a 20 year life expectancy depositing $50,000 would receive a annual payments of which $2500 ($50,000/20 years) would be non-taxable.
As to giving up access to your principal once you start your monthly payments, some annuities will allow you to cancel the arrangement (called commutation). This often has a cost.
If you like the idea of a fixed known income, than a fixed immediate annuity is the best choice. If you believe that the stock market will rise over time and it does so, than the immediate variable annuity would be more suitable and could provide more income over time.
To be able to choose from a wide selection of such annuities, consult an independent financial planner (financial advisors working for large companies will have a limited menu dictated by their firms).
Interesting to read that the history of annuities. I have been in the industry years and didn't know such a similar mechanism was used in medieval times. I'll get an article up about it on Annuity Rater.