To evaluate your investment in immediate annuities you need to understand their rate of return.
Single premium immediate annuities provide you with a fixed monthly payment for the term you have selected. This duration can be a fixed number of years or for the rest of your life. The annuity company fixes the amount to be paid by factoring in the premium you are willing to pay, current interest rates, operational expenses, and life expectancy in the case of a lifetime payout.
All companies will quote the monthly payout and not the annuity rate of interest. However, since the company's earnings depend on interest-based investments (e.g. bonds, mortgage securities), the higher the prevailing interest rates, the greater the monthly payments.
Earnings and taxation of immediate annuities
The earnings are what you get over and above your initial premium. In the case of immediate annuities, each payment comprises both earnings and return of premium. The taxable part of each payment is the earnings. This can also be used to calculate the effective interest rate of your investment.
To elucidate, let us take a hypothetical payout over 10 years to illustrate both taxation and the effective interest or earnings. Let us use the average monthly payout quote from 16 insurance companies for a premium of $50,000 for a 10-year payout to a 70-year-old man. The average quote is $515 per month. Prevailing interest rates when this was quoted were 3.30%, 3.48%, and 4.06% for Treasuries of one-year, five-year, and 10-year, respectively.
The total sum paid out over ten years is $61,800 (10 years x 12 months x $515). This means the earnings on the invested premium is $11,800. This is the difference between the premium paid and the sum received. This translates in to earnings in ten years of $11,800 on the $50,000 investment. Moreover, only 19% of each payout is taxed ($11,800 total interest divided by the total payout of $61,800) because of the annuity tax rules for immediate annuities.
The illustration given earlier is strictly hypothetical, is based on the assumptions made, and is not a representation of actual earnings or taxes due.
Effective interest rate on Immediate annuities
The annuity company's fixed payout schedule means that your annuity payment contains both earnings and premium. This means that the company can only earn interest on the remaining premium. Initially, the company has most of the premium to reinvest. However, this premium decreases linearly to zero when the term of the annuity ends. By averaging the premium from $50,000 down to zero at the end of the term, one can say that the annuity company has only half the premium for the entire term to earn, with the other half going back to the buyer without earning any returns.
As such, one can calculate the 'effective interest' by assuming that only $25,000 (half the premium) earned $11,800 over 10 years. A 3.72% rate of interest compounded annually will give an interest of $11,800 on an investment of $25,000 in ten years (the exact rate of return is 3.03% which requires a financial calculator or spreadsheet to compute) . Though the interest rate might appear low, one has to keep in mind that the payments are for life with the insurance company committed to make the payments as long as you live. In other words, if one looks just at the effective yield on immediate annuities, they will miss the major advantage. The big benefit is that immediate annuities provide a type of valuable insurance--an income you cannot outlive.