A single premium immediate annuity (SPIA) is a contract between an insurance company and an annuity owner, also known as an annuitant. The annuitant makes a lump sum deposit, and the insurance company promises to make regular income payments to the annuitant. The payments usually begin shortly after the contract is entered into (often within a month) and continue for the life or the annuitant or another period specified in the contract. The income payments usually are monthly but can be made quarterly or annually at the election of the annuitant.
Definition of Single Premium Immediate Annuity
The key features of a single premium immediate annuity are that it is a legal contract under which the payments to the annuitant are guaranteed by the insurer. Both the amount of the payments and the length of time over which they are made are guaranteed. The annuitant makes a lump sum deposit with the insurer in return for these promises. SPIAs sometimes are known simply as immediate annuities or income annuities.
The annuitant doesn’t have an account with the insurer. The annuitant doesn’t join in any investment gains made by the insurance company and doesn’t suffer any losses that are incurred. The annuitant has contractual rights to receive the guaranteed payments.
SPIAs are known as immediate annuities because the income payments usually begin within a month after the contract is entered into.
The annuitant determines the period over which the payments will be made when the contract is purchased. Most often the payments are made for the life of the annuitant or the joint life of the annuitant and a beneficiary, usually the annuitant’s spouse.
For example, Kathleen is a 70-year-old retiree who wants to guaranteed lifetime income to begin soon. She makes a lump sum payment of $100,000 with an insurance company. Her contract specifies that Kathleen will receive a monthly payment of $480 for the rest of her life, however long that may be.
If Kathleen lives to age 88, she will have received payouts equal to her lump sum deposit. If Kathleen lives beyond 88, she will end up receiving more than $100,000 from the insurer. But if Kathleen dies before then, she will have received lifetime payments that are less than her deposit with the insurer. No additional payment would be made to Kathleen’s estate or any beneficiaries.
But Kathleen can elect to add a rider to her annuity, often known as a cash refund or return of premium option. Under this rider, if Kathleen’s lifetime payments don’t at least equal her deposit or some other benchmark set in the rider, the difference would be paid to a beneficiary named by Kathleen. This rider has a cost. Kathleen will receive a lower monthly payment than she would from an an SPIA without the rider.
How Does a Single Premium Immediate Annuity Work?
The annuitant makes several decisions about the details of the SPIA.
The annuitant decides when the payments will begin. The annuitant also decides how often the payments will be made: monthly, quarterly, or annually.
The most important decision is how long the annuity income payments will be received. As mentioned, most often the payments are made for life, the joint life of the annuitant and a beneficiary, or for a fixed period of years.
The annuitant also decides how much to invest in the annuity.
After the annuitant makes these decisions, the insurance determines the amount of the regular payments the annuitant will receive. The amount of the payments depends on assumptions the insurer makes about the life expectancy of the annuitant, the insurer’s investment return, the insurer’s expenses, and other factors.
Most often, the income payments to the annuitant are fixed for life. But the annuitant might be able to select an alternative. A variable immediate annuity allows the annuitant to select from an investment menu, and the income payments can vary according to the returns of the investments. Under these annuitant, the income payments can rise or fall with the investment returns.
The annuitant also might be able to choose an inflation-indexed annuity. In this annuity, the income payments are adjusted annually according to changes in a selected inflation benchmark, such as the Consumer Price Index. Some annuities automatically adjust the payments each year by a fixed percentage, such as 3%. With these annuities, the initial monthly payment is lower than for a standard SPIA with fixed payments for life.
Though SPIAs usually last for the life of the annuitant or the joint life of the annuitant and a beneficiary, other payment periods can be selected. Each is likely to make lower fixed payments to the annuitant than the straight life annuity. Other commonly-available annuity payouts include:
– Life with Cash Refund: This option allows a beneficiary to receive a payment when the aggregate lifetime payments made to the annuitant don’t at least equal the lump sum deposit made to purchase the annuity or some other threshold.
– Life and Period Certain: The annuitant receives payments for the longer of life or a minimum number of years. If the annuitant passes away before the minimum number of years, payments will continue to one or more beneficiaries named by the annuitant for however many years are left in the period of years. A common form of this annuity is life and 10 years certain.
– Joint and Survivor Annuity: The payments continue for the joint life of the annuitant and a named beneficiary, usually the annuitant’s spouse. Payments are made as long as one of the two beneficiaries is alive.
– Period certain: Payments are made for a fixed number of years. If the annuitant outlives that period, payments stop at the end of the period. If the annuitant dies before the end of the period, payments continue to one or more beneficiaries named by the annuitant.
How a Single Premium Immediate Annuity is Taxed
An SPIA will be funded with either pre-tax or after-tax dollars. Pre-tax dollar as those in a traditional IRA, 401(k), or similar qualified retirement plan.
When pre-tax dollar are used to make the lump sum deposit, the annuity is known as a qualified annuity. When the annuity income payments are received, they will be taxed as ordinary income to the annuitant, just as distributions from the traditional IRA or 401(k) would have been.
An SPIA funded with after-tax dollars is known as a nonqualified annuity. In a nonqualified annuity, a portion of each income payment is prorated between after-tax dollars (which aren’t taxed again) and pre-tax dollar, which are taxed as ordinary income. Details about how to determine the non-taxable and taxable portion of each nonqualified annuity payment are in IRS Publication 575.
Pros of Buying a Single Premium Immediate Annuity
A single premium immediate annuity is for someone who wants to use a portion of his or her retirement nest egg to provide regular guaranteed lifetime income. The annuitant does not have to worry about outliving his or her income.
While few people put all or most of their retirement portfolios into SPIAs, putting a portion of the nest egg into an SPIA can increase lifetime financial security. The safety of the SPIA also allows the annuitant to be more aggressive with other investments, potentially earning a higher return.
Immediate annuities are highly customizable and can be tailored to suit the annuity owner’s specific needs and goals.
Immediate annuities are also relatively easy to understand.
Cons of Investing in an Immediate Annuity
If the annuitant doesn’t live to at least life expectancy, the aggregate income payments received by the annuitant could be less than the lump sum deposit the annuitant made to purchase the annuity. Even if the annuitant lives to life expectancy, there will be no payment to a beneficiary. Though the terms of the annuity can be modified to change these disadvantages, that would result in lower income payments to the annuitant.
In most SPIAs, the annuitant is limited to the fixed payments of the annuity. If a large unexpected cash need should arise, the annuitant won’t be able to receive additional payouts from the annuity. Some SPIAs have provisions allowing an annuitant to draw an additional amount up to 10% of the initial lump sum deposit, but those provisions reduce the regular income payments to the annuitant
These disadvantages are reasons why most individuals should not put all of their retirement funds into SPIAs. SPIAs are appropriate for a portion of the nest eggs of many retirees.
What you don’t know about your retirement finances can hurt you. Learn more about all aspects of your retirement finances, especially the most important recent changes, through Retirement Watch. The only publication to cover all the elements of retirement finance, it has been edited for more than 30 years by America’s #1 retirement expert, Bob Carlson. Carlson was trained as an attorney and accountant and has served as Chairman of the Board of Trustees of the Fairfax County Employees’ Retirement System (which has more than $5 billion in assets) since 1995.