Too many people get an immediate annuity quote, see the annuity rate, and assume that it is equivalent to a rate of return. An annuity payout rate is not the same as a rate of return, nor is it the same as yield.
For example, an immediate annuity website may list an annuity rate as 7%. This means for a $100,000 immediate annuity purchase you would receive $7,000 a year. This is not the same as a rate of return of 7%, nor is it the same as a yield of 7% because with each annuity payment received you are getting part of your principal back.
You should not take this 7% payout rate and compare it to another investment like a CD, bond fund, or retirement income fund. That is not a fair comparison.
Immediate annuities are risk management products, not investments, so there is not usually a compelling reason to compare the rate of return to other investments, but you may want to know the rate of return for other reasons. Calculating the actual rate of return on an immediate annuity is more difficult than it sounds as the rate of return that an immediate annuity delivers depends entirely upon your life expectancy.
The best way to explain is to look at an example. Here are the particulars:
Male, age 65, purchases a single life income immediate annuity
Annuity purchase amount: $100,000
Guaranteed income: $700 per month ($8,400 per year)
At first glance, a guaranteed income of $8,400 per year would appear to be equivalent to an 8.4% return.
In marketing material describing the annuity, it would refer to the 8.4% as the payout rate. Yes, the annuity is paying you out 8.4% of your investment amount each year, but part of each payment is a return of your principal. If you live long enough that they return all your principal to you, they have guaranteed they will continue to pay you $8,400 per year as long as you live.
Sounds great. But wait…
With a single life annuity, the income stops when you die, and the initial amount invested belongs to the insurance company. You would have to know your life expectancy to calculate an estimated internal rate of return.
Long Life Expectancy Equals Increased Return
In the example above, let’s assume this 65-year-old male has a life expectancy of 18 years. At $700 per month, after 18 years, the annuity would have paid out a total of $151,200.
To calculate the internal rate of return you need to plug the numbers into a financial calculator, or into an excel spreadsheet.
You use $100,000 as the present value, $8,400 as the annual payment ($700 monthly payment), 18 years as the term (or 216 months if you are calculating on a monthly basis), and you solve for the rate of return, which in this case is about 5%.
A 5% guaranteed rate of return isn’t bad.
If that same person lived 30 years, the rate of return goes up to 7.50%, as now the initial $100,000 investment has provided $252,000 of income.
A 7.5% guaranteed return sounds fantastic.
However, what if you only live 5 years?
Short Life Expectancy Equals Lower Return
If you buy a life annuity, and only live 5 years, your rate of return is actually negative.
At $700 per month over 5 years, a total of $42,000 is paid out. In this case, the annuity investment actually lost $58,000.
Not so great.
As you can see, the longer you live, the greater the return that a fixed payout immediate annuity provides. This is what makes this type of annuity a risk-management tool. You don't buy it for the rate of return; you buy it to protect your income over a potentially long life.
You can use an immediate annuity rate to compare one immediate annuity to another, but you should not use it when comparing the annuity to other investment options.