You should be aware that because of the different ways of calculating annuity rates and rates of return on other investments, comparing the different products can be tricky. Understanding immediate annuity rates can help you choose an annuity product that is on par with other kinds of investments and will be able to provide you with sustained income.
Annuity Rate vs. Rate of Return
When you are looking to obtain an immediate annuity quote, you might assume that the annuity rate (also known as the annuity payout rate) equates to the rate of return you get on a deposit account (for example, a certificate of deposit) or a retirement income fund. Because annuities are insurance products, immediate annuity rates are calculated differently from the rates of return on traditional investments. The annuity payout rate amounts to the annual payout amount divided by the principal (initial investment) in the annuity. In other words, the rate is the percentage of the principal that you annually get back in payments. An annuity payout rate is not the same as the pure-interest rate of return on a deposit account or the rate of return on a retirement fund. For example, an insurance company website might mention a current immediate annuity rate of 7%. This means that for a $100,000 immediate annuity purchase, you would receive $7,000 a year. But that does not equal a 7% rate of return because with each annuity payment received, you get back part of your principal. For this reason, resist the urge to take the immediate annuity rates and compare them directly to the rate of return on other investments. While you can compare the current immediate annuity rate of one annuity with that of another, a more useful indicator of the investment potential of an immediate annuity is to calculate the internal rate of return (IRR)—the annualized earnings rate of your investment.
How Do You Figure Out the Return on an Annuity?
Here’s an example of how to calculate an annuity’s IRR, which depends on a person’s life expectancy.
Investor: Tom, age 65Annuity type: Single-life income immediate annuityAnnuity purchase amount: $100,000Guaranteed income: $700 per month, or $8,400 per year
If Tom lives long enough that the annuity returns all his principal to him, the insurance company will continue to pay him $8,400 a year for as long as he lives. Because his annuity is a single-life annuity, the income will not continue to be paid to someone else when Tom dies. Whatever remains of the initial investment belongs to the insurance company. At first glance, a guaranteed income of $8,400 per year appears to be equivalent to an 8.4% rate of return. The annuity’s marketing material would likely refer to 8.4% as the current immediate annuity rate or the annuity payout rate. And, yes, the annuity pays out 8.4% of his investment amount each year. But each payment consists of a partial return of the principal in addition to interest. Assume that Tom will live for another 18 years, or to age 83. At $700 per month, after 18 years, the annuity would have paid him a total of $151,200. The actual formula for IRR is complex, taking into account all cash flows from the investment. The most practical way to calculate it is to plug the numbers into an online IRR calculator for annuities. Use 18 as the length of the annuity, which is the number of years Tom will be receiving payments in this example. Enter $100,000 as the initial investment. Keep the final value of the annuity set at $0. (The final value of an annuity is usually zero unless the contract states it will be some other amount.) Use $8,400 ($700 a month x 12 months) as the annual annuity payment. The annuity rate of return is then calculated as 4.77%.
How Does Life Expectancy Affect Returns?
You might think that the less than 5% rate of return in the example sounds low. But the guaranteed payments for life become a valuable benefit if you outlive the life expectancy used to calculate your annuity payments. For example, if Tom lives 30 more years instead of 18, the rate of return goes up to 7.42%. The initial $100,000 investment has provided $252,000 of income. In contrast, a lower life expectancy diminishes the return. If Tom lives for only five more years, the rate of return would be -23.35%. At $700 per month over five years, the annuity pays out only $42,000. The insurance company gets to keep $58,000 of Tom’s principal. The chart below shows how the return on an annuity is directly related to how long a person lives. The longer you live, the greater the return you can receive from an immediate annuity. For this reason, an immediate annuity works as a risk-management tool. The main goal of this type of investment isn’t to maximize your rate of return. It is to guarantee your income over a potentially above-average life expectancy.
