This post discusses the meaning of annuity, the types of annuities and the way annuities work. In this post, you will understand the meaning of an annuity, the stages of an annuity contract, how annuities work, the features of annuities, the advantages of buying an annuity, the practical considerations of annuities, and the types of annuities.

WHAT IS AN ANNUITY?

An annuity is an insurance product designed to provide consumers with guaranteed income for life. Specifically, an annuity contract is a legally binding, written agreement between you and the insurance company that issues the contract. This contract transfers your longevity risk, the risk of you outliving your savings, to the insurance company. In exchange, you pay premiums as outlined in the agreement. 

Annuities are insurance contracts. Annuities are usually expressed in terms of the annual amount payable. They can be payable monthly, quarterly, half-yearly or yearly. The annuitant will pay a set amount of money today, or overtime, in exchange for a lump-sum payment or stream of income in the future. An annuity can be purchased with a lump sum or a series of payments, and start collecting annuity almost immediately or in the future.

STAGES OF AN ANNUITY CONTRACT

There are two stages to any annuity contract:

1. The first stage of an annuity contract is the accumulation stage, or the period where the annuitant saves and potentially grows his retirement funds and builds his annuity’s cash value. 

2. The second stage of an annuity contract is the distribution stage, when the annuitant is ready to start collecting the annuity to create an income in retirement. The process of converting the annuity into regular payments for retirement is known as annuitization.

How the annuitant builds his retirement funds and cash value (accumulation) and then converts those funds into guaranteed income (distribution) will depend on the type of annuity purchases.

HOW DO ANNUITIES WORK?

Many retirees need more than Social Security and investment savings to meet their daily needs. Annuities are designed to provide this income through accumulation and annuitization or, in the case of immediate annuities, lifetime payments guaranteed by the insurance company that begin within a month of purchase – no accumulation phase is necessary. 

Annuities work by converting a lump-sum premium into a stream of income that a person cannot outlive. When you buy a deferred annuity, you pay a premium to the insurance company. That initial investment will grow tax-deferred throughout the accumulation phase, typically anywhere from ten to 30 years, based on the terms of your contract. Once the annuitization or distribution phase begins based on the terms of your agreement, you will start receiving regular payments.

Annuity contracts transfer all the risk of a down market to the insurance company. This means you, the annuity owner, are protected from market risk and longevity risk, that is, the risk of outliving your money. Insurance companies charge fees for investment management, contract riders, and other administrative services to offset this risk. In addition, most annuity contracts include surrender periods during which the contract holder cannot withdraw money from the annuity without incurring a surrender charge.

FEATURES OF ANNUITIES

Furthermore, insurance companies generally impose caps, spreads, and participation rates on indexed annuities, each of which can reduce the return. Features of annuities include a free-look period, riders, beneficiaries, fees and commissions, and taxation.

ADVANTAGES OF BUYING AN ANNUITY

Buying an annuity can provide peace of mind by way of an additional retirement income. An annuity can provide a stream of income, in addition to pension and Social Security benefits, at retirement. Suppose the annuitant chooses an annuity that provides payments for the remainder of his life. In that case, he does not need to worry about income after retirement as long as the annuity can cover basic expenses. These guarantees can add some certainty to how much money the annuitant needs to save to retire comfortably. Annuities can be complicated and may only be for some or some situations.

TYPES OF ANNUITIES

Types of annuities include Immediate Annuity, Deferred Annuity, Annuity Certain, Guaranteed Annuity, Joint Life and Last Survivor Annuity, and Increasing Annuity. Let’s briefly describe these types of annuities.

IMMEDIATE ANNUITY

An immediate annuity is the easiest type of annuity for most people to understand because it has fundamental provisions in its most common form.

DEFERRED ANNUITY

Unlike immediate annuities, deferred income annuities do not start making payments immediately. In most other respects, though, they closely resemble immediate annuities. With a deferred income annuity, the annuitant pays a certain upfront premium. In exchange, the insurance company promises to pay a certain amount once the annuitant reaches the age specified in the annuity contract, e.g., age 65 or 70. Based on the above two types of annuities (that is, deferred and immediate), annuities can be categorised into two: 

1. Fixed annuities, and 

2. Variable annuities.

ANNUITY CERTAIN

An annuity certain is a contract that provides a fixed number of payments for a predetermined number of years, regardless of whether the annuitant survives. The payments are made regularly – monthly, quarterly, semi-annually, or annually. The policy will continue paying annuity to the annuitant or estate if the annuitant dies before the payment terms end.

GUARANTEED ANNUITY OR ANNUITY GUARANTEED

A guaranteed annuity is an immediate annuity that guarantees annuity payment for a minimum period or until the annuitant dies, whichever comes later. For instance, an annuity guaranteed for ten years will be payable for life or ten years, whichever is longer. If the annuitant dies during the guaranteed period, the balance of the guaranteed instalments will be paid to the estate. However, a commuted cash sum may be payable instead.

JOINT LIFE AND LAST SURVIVOR ANNUITY

A joint life is an annuity that makes payments to both the annuitant and the spouse or the annuitant and another beneficiary until both the annuitant and the spouse have died. A joint life with the last survivor annuity allows the annuitant to provide for the spouse continuingly, rather than giving a lump sum at death. The annuitant may also designate another party, such as an orphanage or a charity, to receive payments until the spouse’s death. If funds remain at both spouses’ deaths, the annuity pays a death benefit to the designated party or the survivor.

INCREASING ANNUITY

An increasing annuity allows instalments to increase by a fixed percentage each year. This annuity assists annuitants in cushioning the effect of inflation on the actual value of the payable annuity.

CATEGORISATION OF ANNUITIES

Meanwhile, there are generally three main categories of annuities: 

1. Fixed annuity, 

2. Variable annuity, and 

3. Indexed annuity.

See the full video on What is an Annuity and How do Annuities Work? : https://youtu.be/_IreDu6Zgxc