An immediate annuity is an investment that turns your current retirement savings into future income payments. When you buy an immediate annuity, you receive guaranteed income payments for a set number of years—or possibly for the rest of your life. Annuities are not for everyone, though. Here’s what you need to know to decide if immediate annuities make sense for your retirement strategy.

How Does an Immediate Annuity Work?

An immediate annuity is designed to provide you with income payments for a set period of time in exchange for an initial lump-sum investment. They’re called “immediate” annuities because you begin receiving annuity income payments almost immediately after you deposit your money .

There are many types of annuity contracts, featuring a wide range of different features and fees. Like immediate annuities, they all aim to help investors create their own retirement paycheck. You provide an upfront investment, and the annuity company guarantees regular income for the life of the contract.

This income guarantee makes annuities an attractive option for some retirement investors, but it comes with its own costs. There are fees to watch out for, and once you’ve purchased an annuity contract it can be expensive to withdraw your principal investment. If you needed to withdraw additional funds beyond your regular annuity payment for a given month or year, you could face high penalties.

This general lack of liquidity means it’s best not to invest all of your savings in an immediate annuity contract.

Immediate vs Deferred Annuity

Broadly speaking, there are two varieties of annuity contract: immediate annuities and deferred annuities. Each type comes with its own annuity income payment schedule.

With a deferred annuity, you delay income payments for at least a year or longer. This gives the annuity company more time to invest and grow your money, so your future payments will be larger than you would get with the same initial investment in an immediate annuity.
With an immediate annuity, the income payments begin within a year of purchasing the contract, and many start right after you sign up. Because there is no delay in collecting income, these products can be a good fit for people who are just entering retirement.

“Think of an immediate annuity as a do-it-yourself pension plan,” said Jonathan Howard, a certified financial planner (CFP) with SeaCure Advisors in Kentucky. “Instead of getting it from an employer, you’re getting the pension from a lump sum of money that you give to an insurance company.”

Single Premium Immediate Annuity

Besides payment schedule, immediate annuities differ from deferred annuities in one key way: the time you have to fund the contract. Immediate annuities are generally purchased with a single, lump sum deposit. Because of this funding method, this style of annuity is commonly referred to as a single premium immediate annuity (SPIA). Deferred annuities may also be purchased with a lump sum, though you can fund them incrementally over the years you have before you retire as well.

With immediate annuities, you have to put up the money in this way because in most cases you’re aiming to start collecting income right away. You can fund your SPIA by making a large deposit of cash or by transferring over money from a retirement plan, like a 401(k) or individual retirement account (IRA).

If you don’t need income right away, you might choose to build your savings through a deferred annuity, which you then convert into an immediate annuity when you’re ready to retire.

Types of Immediate Annuities

Immediate annuities companies describe their products a few different ways. It’s important to understand these distinctions because how your immediate annuity is classified ultimately determines what your future payments will be.

First and foremost, most annuities are categorized by the returns they provide. Annuity rate of return is classified one of three ways—variable, fixed and index. Annuities may be further classified by how long their payments last: either over a set term or a lifetime. This means you might have a variable lifetime immediate annuity or a fixed term immediate annuity.

Here’s what each of those classifications means and who might benefit most from each kind of immediate annuity.

Variable Immediate Annuities

You’re probably most familiar with the mechanics powering variable immediate annuities. Variable immediate annuities generally work like investment accounts, like your 401(k) or IRA: You deposit a certain amount and what you earn is based on market performance.

In a variable immediate annuity, your investments are held in subaccounts, which basically work like mutual funds: They invest in groups of assets like stocks, bonds and money market funds. If your investments do well, your monthly payout increases. But if the investments perform poorly, your income payments may decrease. Just like with normal investment accounts, this means you may actually lose money, especially in the short term.

A variable annuity can make sense if you can tolerate some short-term changes in income payouts in exchange for higher growth potential over the longer term. You might also consider a variable annuity contract for the inflation protection they can provide: Market returns have historically greatly exceeded inflation rates and returns of other safer investment vehicles, like certificates of deposit (CDs) and annuity products with more fixed rates of return. Just make sure you have other resources you can use to pay your bills in the event of short-term income drops from down markets.

Fixed Immediate Annuities

Fixed immediate annuities work a lot like CDs. In exchange for a certain upfront payment, your annuity provider agrees to pay you a set income regularly. This effectively removes risk from investing in the annuity, aside from the inherent risk of locking up a chunk of your money. Besides inflation diminishing the value of your funds, this trapping of your assets may also cause problems if you need to withdraw more than is allowed at a given time, a move that may result in penalties.

Your returns in a fixed immediate annuity will also be lower than they might be if you used an annuity whose returns were at least somewhat based on market returns. That said, if you absolutely need a set amount of income and can’t risk any losses, a fixed annuity would be a good choice.

Index Immediate Annuities

Index immediate annuities, also known as fixed index annuities, fall in the middle of variable and fixed annuities. Your payments are tied to some sort of market index, like the S&P 500. When the index does well, you receive a larger payment and when the index doesn’t do well, you receive less.

An index immediate annuity caps both your potential gains and losses, so there is less volatility in your income than you’d have with a variable annuity. As a result, you’ll earn less in good years but make more in bad years compared to a variable immediate annuity. In addition, your losses generally have a floor, meaning you won’t lose any of the initial amount you used to purchase your fixed index annuity.

Term Immediate Annuities

In a term immediate annuity, your payments only last for a set period of time called a term. Terms generally range from five to 20 years, and you can choose an interval that works for you. If you die during the term, the annuity will generally continue making those scheduled payments to your selected heir. Once the term ends, though, the payments stop, even if you’re still alive.

A term immediate annuity can make sense if you only need income for a set period of time. “I find that fixed time period immediate annuities are most commonly used to fund a life insurance policy that requires a fixed funding arraignment,” said Greg Klingler, director of wealth management at the Government Employees’ Benefit Association..

They could also be used to finish paying off your mortgage or to cover your bills until you qualify for other income, like a pension. The logic is you’re covering a temporary need that won’t last your entire life.

Lifetime Immediate Annuities

Alternatively, you could select a lifetime immediate annuity. As you can guess by the name, the payments on these contracts last for your entire life. You could also set up a joint lifetime annuity that spans the lifetimes of two people, like you and your spouse. With joint lifetime annuities, payments continue so long as at least one of you is alive. Because the payments are tied to two lifespans, which increases the likelihood at least one person will live a long time, payments may be lower with joint lifetime annuities than comparable single lifetime annuities.

Whether joint or single, a lifetime immediate annuity can be a good fit for general retirement planning because they assure you’ll always have at least some income as long as you live.

Benefits of Immediate Annuities

Start receiving money right away. As soon as you purchase an immediate annuity, you can start collecting income payments. There’s no delay between your upfront investment and the return, making it a good choice for people who need money right away.
Simplicity. Immediate annuities are easy to manage. Unlike other forms of investment income, they require no account monitoring or rebalancing—you just get paid every month, like clockwork.
Potential for lifetime income. An annuity with lifetime payments is one of the few ways to create a steam of guaranteed income you can’t outlive.
Protection against market losses. If you set up a fixed or index immediate annuity, the contract protects your income against market losses. You don’t have to worry about losing income during a downturn.
Customizable. You choose how your annuity is constructed. That goes further than just deciding how much and how long you get paid. You can also pay for additional features, called riders, to add extra benefits like protection against inflation or an inheritance for your heirs.

Disadvantages of Immediate Annuities

High upfront cost. Since you’re paying off the annuity all at once, you need to have a considerable amount saved up for immediate annuity contracts.
No control of deposit. Immediate annuities are not liquid. Once the insurance carrier has the money and starts paying you, you no longer have control over the amount you paid for the annuity. If you have an emergency and need to access the funds, it could be expensive to break the contract.
Potentially lower returns if you die early. If you select a lifetime immediate annuity, the amount you get back depends on how long you live.“This investment option will prove to be very valuable for an investor who outlives his/her peers but will not be advantageous to someone whose lifespan is below average,” said Klingler. “A life-only annuity would provide almost no benefit to an investor who dies shortly after the policy is put into place.” To get around this problem, you could purchase a lifetime annuity with a guaranteed minimum number of payments, so if you die early, your heirs would receive this remaining money
Payments could lose value from inflation. Since your annuity payments can last years and even decades, inflation could gradually decrease the buying power of your income, especially if you bought a fixed annuity. While variable and fixed index annuities have more short-term risk, they could help grow your future payments to keep up with inflation. If you’re concerned about inflation eating away the value of your annuity payments, you might consider buying a cost of living adjustment rider. With this annuity add-on, your payments start out lower than a comparable policy without the rider but then increase over time to help keep up with inflation.

How to Tell If an Immediate Annuity Is Right for You

If you’re entering retirement and are ready to start tapping into your savings, an immediate annuity could be a good fit. Not only do the payments start right away, it’s one of the few ways to turn your savings into income that you cannot outlive. An immediate annuity can be especially helpful if you do not have any other sources of guaranteed lifetime income, like a pension. “Given that more and more employers are doing away with pensions, protecting against this risk has become increasingly important to retirees,” said Klingler.

On the other hand, if you don’t need income right away, you may be better off continuing to invest your money in the market or through a deferred annuity. And if you do have a pension, you might already have your basic income needs covered so you may not need an annuity on top of it.

If you’re on the fence because you have mixed goals, needing income today as well as growth for the future, one other possibility is to set up a split-funded annuity, which divides your deposit between one account for immediate payments and the rest for deferred growth. For more information and help finding the best annuities for your situation, consider meeting with a financial advisor to discuss whether an immediate annuity is right for you.