What the heck is an annuity? Part 1 - Single Premium Fixed Immediate Lifetime

Posted By Paul

As I try to become better at understanding the financial world, one word that pops up every now and then is 'annuity'.

I realized recently that I really don't have any idea what one is. I have this vague sense that I'm not interested in them, but that's not really based on anything rational, so I thought I'd do some research and share what I've found.

Here's what I've learned:

First of all, annuity is a REALLY broad term. To define it in terms that apply to all of the different flavors you end up with something like:

An annuity is an agreement (generally with an insurance company) to pay out money for a period of time.

Pretty general huh? Well it is, and that's probably why annuities get such a bad reputation, there are so many different flavors of annuity (not to mention many providers) that it's really easy to end up with a bad one.

So I'm going to start off with what I consider to be the simplest type of annuity: the single premium fixed immediate lifetime annuity.

Quite a long name, but the terms make sense if you take them individually:

Singe Premium - means there is one premium (essentially you buy it with a lump sum)
Fixed - means the payments don't vary
Immediate - means that the payments start immediately
Lifetime - means the payments continue for as long as you are alive

This type of annuity is essentially a policy that you buy with an insurance company that says that the insurance company will pay you a certain amount of money for the rest of your life.

A hypothetical example, if I were an insurance company, I might say that if you pay me $50,000 today then I will pay you $100 a month for the rest of your life.

I found a very simple web annuity quote calculator and asked it the question:

If I were age 40 (the calculator had 40 as the minimum age) and wanted an annuity that paid me $200 a month until I died, what would it cost me?

The answer? About $41k. So the question then is, is it worth it? If I just took my $41k and stuck it under the mattress and took out $200 a month, how long would that last? The quick math says I would run out of money in about 17 years. So from that calculation it seems like a pretty good deal since I plan on living longer than 17 years.

But of course if you didn't buy the annuity you probably wouldn't just put the money in your mattress, so how best to compare that?

That gets difficult, but luckily I found a savings calculator that you can use to see how long savings will last assuming a certain APR and monthly withdrawal.

If you're curious the savings calculator is here.

Using this calculator, if I start with $41k and take out $200 a month then the amount it will last depends on the APR, but for a few values comes to:

24 years at 3% interest
28.8 years at 4% interest
38.6 years at 5% interest

Interesting. At this point you start to see the trade off between having the annuity and keeping the money for yourself. Here are some of the pros and cons of the annuity:

Pros:
1) Takes some of the uncertainty out of retirement savings, with this sort of annuity you know exactly how much you'll having coming in for the rest of your life.
2) Low risk, assuming the insurance company stays solvent, you'll get your money.

Cons:
1) It's possible that you could meet or beat the returns by just managing the money yourself.
2) If you die an early and untimely death, no money is paid to beneficiaries the money is just gone (note that there ARE annuities that include a death benefit but they cost more).
3) Your lump sum is gone, so if something happens where you wanted that lump sum back, you're out of luck.

Overall, this type of annuity doesn't seem like a terrible thing from an investment standpoint, but remember, this is just ONE type of annuity, there are so many types of annuities out there that you REALLY need to be careful to make sure you're getting what you're expecting.

I'll close this (and probably all my annuity related posts) with a quote from Warren Buffett (he uses it to refer to investing it in a particular business, but I think it applies just as well to any investment vehicle):

"Never invest in a business you cannot understand. "