One of the great things about annuities is their ability to provide you with income for the rest of your days — in effect, a lifetime stream of income that you can never outlive. Even if you live to a ripe old age of 110, you're still guaranteed to be paid from the insurance company if you chose to receive annuity payments for life. (Other payout options are available as well, known as "period certains.")
There are two phases in an annuity: the accumulation phase and the payout (or annuitization) phase. Annuity proceeds accumulate on a tax-deferred basis. The payout phase provides a monthly income to you for as long as you choose. You can opt to receive lifetime income or payment over a certain period (10 years certain, 20 years certain, and so on), regardless of whether you have a lump-sum annuity or have been contributing into it for years.
The payout process works the same for a fixed, variable, or immediate annuity. Immediate annuities, which are often purchased with a lump sum, are commonly bought when you're ready to liquidate your other investments to start receiving regular monthly income.
When you're ready to annuitize (start receiving payments), it's time for the actuaries at your insurance company to get to work. Actuarial tables tell them what your life expectancy is at the time you initiate your payout phase. Insurers must ascertain how long you can reasonably expect to live.
For illustration purposes, we're going to focus on a 70-year-old male with $50,000 in one lump sum to spend, although you can pay into an annuity for many years before you decide to annuitize. He makes one large premium payment to the insurance company in exchange for monthly payments for as long as he lives. The insurer would then provide $387.24 a month for the rest of his life. (This is not meant to reflect any one company's rates.)
To arrive at this amount, the insurance company has considered how much return on investment they can get from his $50,000 and how long annuity payments might have to be made. This example assumes the insurance company can get a 5 percent return on the money that it will be investing and that the annuitant will live for another 17½ years.
If our 70-year-old lives to 103, he beats the life-expectancy odds and the insurer loses money because it will have made payments far longer than it expected. But if our annuitant dies two years after his payout phase begins, the insurance company keeps the rest of the annuity proceeds. To avoid such wide losses (or gains), insurance companies spread the investment risk among as many annuity buyers as possible. In the end, if everything has gone according to plan, the insurer should be statistically even on payouts to annuitants, reaping the benefits of annuitants who died early and paying through the nose on those who outlived their life expectancy.
Monthly payments will vary not only on your premium payment(s) but also on the insurer's expected investment returns on that money. If the insurer can expect to receive a 7 percent return on its $50,000, the monthly payout would rise to $449.96. At a 3 percent return, the payout would drop to $327.05. Insurers base their anticipated return on the performance of their often-conservative investment portfolios. In a fixed-payment arrangement such as this, you're at the mercy of their investment expertise, so to speak. If you're not comfortable with this, you might look into a variable payment. If you have chosen to receive fixed payments, your monthly payout will not change, which means the insurer takes on all the investment risk. (For simplicity sake, we've chosen to use a fixed payment for our example. You can, however, choose the variable payout, which is tied more directly to investment performance.)
As you've seen, interest rates have a direct impact on how your payout is calculated. Now, say our man is 80 years old instead of 70 and decides to buy an annuity with his $50,000. Because of his shorter life expectancy at age 80, his monthly payment would be $550.42 — 40 percent more than he'd get at 70. This change has nothing to do with investment performance; it's merely because the insurance company expects to make payments for only 11 years. The insurer can make higher payments since it expects to make them for a shorter period of time.
Women won't receive as high a payment as their male, same-age counterparts simply because women generally live longer than men. It's not discrimination at work, just differences in mortality. In our example, a 70-year-old female can expect a monthly payout of $353.41; an 80-year-old female can expect $503.83. (A 70-year-old woman is expected to live for about another 20 years.)
Instead of a lifetime payout, you can opt for guaranteed monthly payouts for defined periods of time, such as 10 years. If you die during these 10 years, your beneficiary receives the rest of your payouts. This choice would yield $361.38 instead of $387.24 for our 70-year-old male. You'll always get lower payments for "certain periods" because the insurer expects to make more payments. While it may sound confusing, a "payment certain period" completely eliminates the chance that the insurance company could pay out for less than 10 years.
You may want to make sure that your retirement income is passed along to your spouse if you die. This is called a survivorship annuity payout, an option commonly chosen. If a husband and wife are both 70 and they want a lifetime income from the annuity, the monthly payout would be $306.37. This is about $80 less per month than without the survivorship benefit. You can see that the insurance company is taking into account that it will be making more payments than it would if just one life were factored into the mortality rate.
As we've said, the life expectancy of a 70-year-old male is 17½ years; and it's extended to almost 20 years for the same-age female. When you want a survivorship option, the mortality calculations become more complicated. The insurance company has to figure out how long at least one life will live, which extends the payout period past the mortality rate of just the 70-year-old male. The insurer calculates a lower benefit payment to make sure it doesn't run out of money.
This example uses just $50,000 to show the difference in calculating monthly annuity payouts for lifetime, certain periods, and survivorship benefits. Your payouts will differ considerably when your annuity has a larger or smaller balance.
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