The amount you collect from an annuity depends on when you invest, the return your specific annuity offers and the details of your particular contract. As a result, it’s difficult to provide a specific answer to what any single person should expect from this financial product. However, we can give some ballpark figures to help with your financial planning. For example, if you buy a $1 million annuity at 65 years old and begin taking payments immediately, you can expect to receive anywhere from $4,700 to $6,000 per month for the rest of your life. You may want to consult with a financial advisor to determine if an annuity is a good option for your retirement plan.
What Is an Annuity?
Annuities are contracts that you make with a financial institution or an insurance company where you agree to purchase the contract and its terms in either a lump-sum payment or series of payments. In exchange, you receive a series of payments made each month for a period of at least one year. While some annuities pay you for a fixed number of years, such as 10 or 20 years, others are what’s called a “lifetime annuity.” This is an annuity that pays you during retirement and continues paying each month for the rest of your life.
The idea here is similar to the interest payments you receive from a bank. The company that issues your annuity holds, uses and invests your money. In exchange, it gives you a rate of return and guaranteed payments. For annuities that pay on a fixed term (instead of lifetime annuities), this is specifically structured like a loan. You receive back your full initial investment (the principal) plus the interest that accrues over the lifetime of the contract, typically compounded annually.
How an Annuity Works
To get a better idea of how a specific annuity works, let’s look at an example of a $1 million annuity. Your annuity purchase would look like this:
In this case, you would buy the annuity for a single payment of $1 million. In exchange, the insurance company would start issuing you payments at age 65 and continue issuing payments each month for your lifetime.
Retail investors’ annuities are primarily retirement products, so most of them are structured to start repaying you at or around retirement age. Most people who use this product to save for retirement buy lifetime annuities since these provide guaranteed income throughout retirement.
Every annuity will offer rates of return that differ based on companies and their individual products. In particular, companies calculate lifetime annuities and fixed-term annuities very differently. Lifetime annuities work differently because the company doesn’t know how long it will make payments, so the value of the annuity is based on interest rates and life expectancy.
Common Types of Annuities
There are several different types of annuities that vary based on when you pay for the annuity, when you receive payments or even who is making the payments on the annuity. Let’s take a look at the most common, or well-known, types of annuities:
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Lump-Sum Annuity: You purchase your annuity with a single payment up front.
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Regular Payment Annuity: You purchase your annuity with regular payments over time.
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Period Certain Annuity: Otherwise known as a fixed-term annuity. You receive fixed payments for a defined period of time.
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Variable Annuity: You receive variable payments for either a defined period of time or for the rest of your life. The payments are determined by your contracts, such as a variable interest rate or an indexed payment system.
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Single Life Annuities: You receive fixed payments for the rest of your life.
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Joint/Survivor Annuities: You receive fixed payments for the rest of your life. After you die, a named partner continues to receive fixed payments for the rest of their life (although this second set of payments may be a different amount than the first).
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Qualified Employee Annuities: You receive payments through an annuity purchased by your employer.
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Tax-Sheltered Annuities: You receive payments through an annuity purchased by your employer if your employer is a tax-exempt organization.
How Much Would a $1 Million Annuity Pay?
If you buy a $1 million annuity, you will receive monthly payments for a period of time. How much you receive, and for how long, depends entirely on the individual contract you buy, when you buy it and who you buy it from. For example, say you buy a lifetime annuity that will start to pay you at age 65. This annuity will pay you more per month if you buy it at age 40 than at age 60.
At the time of writing, annuities offered an average rate of return between 3% and 4%. This means that the annuity provider would add, for example, 3% compounded interest to your annuity every year starting when you bought it. Your annuity would continue to collect interest while you collect payments, and would end once you have received back the full value of the principal and the interest.
If you purchase your $1,000,000 annuity between the ages of 60 – 70 and start taking payments immediately then you can expect to receive between $4,000 and $5,500 per month for the rest of your life or for the time period of your annuity payout. That’s the best ballpark estimate you can receive without knowing the specific terms and riders in your contract.
Calculating the Rate of Return on a Lifetime Annuity
Calculating the rate of return on a lifetime annuity is far more difficult since, again, these products are not built around a fixed period of time. It’s also important to note that, while many institutions advertise lifetime annuity interest rates as high as 10%, those high-interest accounts are usually what’s called an “income rider.” With an income rider annuity, you receive the interest payments only. You don’t necessarily receive back the principal on the account. This functions more like a return on a traditional investment product rather than the debt-style structure of an annuity.
For example, you could buy a lifetime annuity for $1 million and begin collecting payments on it at age 65. If you buy that annuity at age 65 and begin collecting payments immediately, you might expect to receive around $4,700 per month for the rest of your life ($56,400 per year), which comes to a repayment rate of around 5% annually.
On the other hand, say you buy that same annuity at age 35. By purchasing the contract further in advance you will lock in a much higher rate of payment. In this case, you could find some institutions which offer you repayments as high as $23,000 per month ($276,000 per year).
Drawbacks of Annuities
The biggest problem with an annuity is that it locks up your money for a very long time. These products can offer financial security, given that they guarantee payments for the rest of your life (assuming that the insurance company doesn’t go out of business), but they tend to offer comparatively low returns relative to other investments.
For example, take our annuity purchased 30 years in advance. It would give you a $276,000 per year payout in retirement. Over 30 years, you would collect more than $8 million from this contract. On the other hand, the S&P 500 generates an average return of around 10.5%. If you took that same $1 million and put it in an S&P 500 index fund for 30 years, with a 10.5% annual return, you would have $19.9 million in the bank.
The annuity would have paid you $8 million by the time you turned 95. The S&P 500 index fund would have returned $19.9 million with which to start your retirement. Sometimes the guarantee isn’t always the right play, but the answer is always going to depend on your specific financial situation.
Bottom Line
An annuity is a contract that issues you a regular payment over a fixed period of years. They’re most often used in retirement, as products that give you money each month for the rest of your life. If you buy an annuity worth $1 million, you can make a significant amount of money back on this investment, but exactly how much can range widely. The total amount you can earn depends on the factors in your annuity contract.
Tips for Investing in Annuities
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Annuities can be a great investment option, for the right person. It really depends on what your overall retirement plan is. If you’re unsure, it might help to speak with a financial advisor who can work to achieve the right investments for you. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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How can you calculate annuity rates of return for yourself? Fortunately, we’ve put together a helpful cheat sheet right here that you can use to help plan out your investment options.
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Source: finance.yahoo.com