To compare the purchase of an immediate annuity to other investment options, you must calculate the rate of return of the annuity. This is more difficult than it sounds as the rate of return that an immediate annuity delivers depends entirely upon your life expectancy.
The best way to explain is to look at an example. Here are the particulars:
- Male, age 65, purchases a single life income immediate annuity
- Investment amount: $100,000
- Guaranteed income: $700 per month ($8,400 per year)
At first glance, a guaranteed income of $8,400 per year would appear to be equivalent to an 8.4% return. After all, if you invest $100,000 in a certificate of deposit, it needs to pay you 8.4% to provide you with $8,400 per year of interest income.
Sounds great. But wait…
With a single life annuity, the income stops when you die, and the initial amount invested belongs to the insurance company. You would have to know your life expectancy to calculate an estimated internal rate of return.
Rate of Return For Immediate Annuity With A Long Life Expectancy
In the example above, let’s assume this 65 year old male has a life expectancy of 18 years. At $700 per month, after 18 years, the annuity would have paid out a total of $151,200.
To calculate the internal rate of return you need to plug the numbers into a financial calculator, or into an excel spreadsheet. (You can find access to such calculators from the Internal Rate Of Return article.)
You use $100,000 as the present value, $8,400 as the annual payment ($700 monthly payment), 18 years as the term (or 216 months if you are calculating on a monthly basis), and you solve for the rate of return, which in this case is about 5%.
A 5% guaranteed rate of return isn’t bad.
If that same person lived 30 years, the rate of return goes up to 7.50%, as now the initial $100,000 investment has provided $252,000 of income.
A 7.5% guaranteed return sounds fantastic.
However, what if you only live 5 years?
Rate of Return For An Immediate Annuity With A Short Life Expectancy
If you buy a life annuity, and only live 5 years, your rate of return is actually negative.
At $700 per month over 5 years, a total of $42,000 is paid out. In this case, the annuity investment actually lost $58,000.
Not so great.
As you can see, the longer you live, the greater the return that a fixed immediate annuity provides.
