In this article, we will take a look at what annuities are, why they are important, and the variations of them.
Understanding this kind of contract
An annuity is a contract between two parties: the individual and the insurance company. The individual conducts either a lump-sum payment or a series of payments. They will, in return, acquire regular disbursements, which start either immediately or at some point later on.
An annuity’s main goal is to provide a stream of income that is consistent, typically during the retirement period. Funds accumulate on a tax-deferred basis and – similar to 401(k) contributions – someone can withdraw them without penalty after age 59. 59½ to be exact.
Numerous facets of an annuity are customizable to fit the buyer’s specific needs. It goes beyond choosing between a series of payments to the insurer or a lump-sum payment. The individual can choose when they want to annuitize their contributions. That is to say, start receiving payments. An annuity that starts to immediately payout is an ‘immediate annuity’. Meanwhile, one that starts at a predetermined date is a ‘deferred annuity’.
The period in which an annuity receives funding and before payouts commence is the ‘accumulation phase’. As soon as payments begin, the contract is officially in the annuitization phase. Social security and defined-benefit pensions are two notable examples of lifetime annuities that pay retirees a steady cash flow until they die.
What is their appeal?
Annuities are the ideal financial products for those who seek stable retirement income. The lump sum put into the annuity is illiquid and is frequently a victim of withdrawal penalties. Therefore, younger individuals or those with liquidity needs should not use this specific financial product.
Annuity holders cannot outlive their stream of income, which hedges risk to longevity. The purchaser needs to understand that they are trading a liquid lump sum for a guaranteed cash flow. As long as this understanding persists, the product will remain appropriate. Certain purchasers wish to cash out an annuity in the future at a profit. However, this is not the product’s intended use.
How do they work?
This contract works by transporting risk from the owner (the ‘annuitant’) to the insurance company. Much like other insurance variants, people pay the annuity company premiums in order to bear this risk. Premiums are often a single lump sum or a series of payments. Whichever it is ultimately depends on the type of annuity. The premium-paying period is the ‘accumulation phase’.
Unlike other insurance types, there is no requirement for you to indefinitely pay annuity premiums. Eventually, the individual will stop paying the annuity and the annuity will start to pay you. Once this happens, their contract will officially enter the payout phase.
The handling of annuity payments contains great flexibility. Their structure has the capacity to generate payments for a specific number of years to you or your heirs. This can apply to a person’s lifetime or until they and their spouse are gone. Another alternative is a combination of both lifetime income with a guarantee in “period certain” payout.
A “life with period certain annuity” will pay income for life. However, suppose someone dies during a specific time frame (i.e. the period certain years). In this case, the annuity will pay their beneficiary the rest of their payments for the contractual period they chose when applying.
Life Insurance: what’s the difference?
Life insurance and annuities are both distributed by insurance companies, but they serve completely different purposes. The design of life insurance allows those you love to obtain certain benefits after you die. Annuities, on the other hand, provide a benefit while you are still alive. Usually, an annuity benefit guarantees a steady stream of income.
As Ken Nuss, founder and CEO of online annuity marketplace, AnnuityAdvantage, states:
“So an annuity hedges against the financial risk of living a very long life, while life insurance provides for beneficiaries in the event of a premature death.”
The main types
There are a wide variety of annuities, but they all boil down to the same thing. That being an insurance contract that guarantees income – typically for life – and sometimes offers a chance at capital appreciation. It acts as supplement income from a traditional stock and bond portfolio. Moreover, it is rarely a good idea to invest more than half of your portfolio in annuities. The reason for this being that an annuity is, fundamentally speaking, illiquid.
There are five primary categories of annuities: fixed, variable, fixed-indexed, deferred, and immediate. Whichever is best for the individual depends on certain variables like their income goals and risk orientation. Furthermore, when they want to start acquiring annuity income.
1 – Fixed
This is an annuity that pays a guaranteed minimum rate of return. Additionally, it provides a series of payments under established conditions when the individual purchases the annuity. They pay guaranteed rates of interest, often higher than bank CDs. On top of that, it is possible to immediately draw or defer income.
These are a favourite among retirees and pre-retirees. Specifically, those who opt for a fixed investment that is no-cost, modest, and made certain.
2 – Variable
This annuity draws both its performance and return from underlying investments in mutual funds. These give investors the ability to choose from a basket of subaccounts (i.e. mutual funds). The performance of the sub-accounts is what ultimately determines the account value. Moreover, a rider is buyable as a means to lock in a guaranteed income stream no matter market performance. This is a key hedge in the event of the subaccounts performing badly.
These annuities are popular among retirees and pre-retirees seeking a shot at capital appreciation. Particularly, alongside guaranteed lifetime income.
3 – Fixed-indexed
This annuity has a minimum guaranteed rate of return with total returns according to an underlying index, such as the S&P 500. Generally speaking, they offer a guaranteed minimum income benefit. Additionally, they provide the opportunity of principal upside that pegs to an index correlating with the market.
These are especially appealing to retirees and pre-retirees looking to conservatively participate in potential market appreciation. Moreover, do so without any hassle and with downside principal protection.
4 – Deferred
This is an annuity that starts paying income at a future date that the owner establishes. They allow people to boost their income stream later in life for less money. The reason being that the insurance company is not on the hook for long upon the deferring of income payments.
This is a favourite for people who want guaranteed income in the future rather than right now. Alternatively, those who want to build a ladder of income during different periods later on in life.
5 – Immediate
This is an annuitized annuity, meaning it is transformed into an income stream for the buyer. In essence, they function as a mirror image of a life insurance policy. Normally, one would pay regular premiums to an insurer that receives a lump-sum payment upon death. However, with this annuity, the investor provides a lump sum to the insurer in return for consistent income payments until death. Alternatively, for a specific period of time, which usually starts one to 12 months following the investment receipt.
These annuities are quite popular among retirees and pre-retirees. In particular, those in need of a higher-than-average stream of income. Moreover, who are comfortable with forfeiting principal in exchange for higher long-lasting income.