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What is an Annuity?

definition

An annuity is a financial product — in which funds accrue on a tax-deferred basis — that can be used to fund fixed payments received at a later time, such as during retirement.

🤔 Understanding an annuity

Annuities come in many different flavors, but almost all allow an individual to invest money that will later be returned to the individual as fixed payments. Most annuities have the potential to receive interest or investment gains and losses as well. They can be a way to save for retirement, typically when IRA contribution maximums are reached, to replace wages once retired. You can buy an annuity from an insurance company or through a broker. Fixed annuities, variable annuities, immediate payment annuities, and deferred income annuities are the major types. Annuity payments can be structured as lump sums, set to continue for a set number of payments, or continue for the life of the beneficiary. Although these payment types are commonly used, it is not mandatory to set up a payment plan. Some annuities have a survivor benefit (where a designated beneficiary continues to receive payments after your death), but not all do.

example

Consider the fictional couple John and Martha. John and Martha receive a large lawsuit settlement after Martha is in a car accident. To ensure themselves continuing income, since Martha can no longer work, John and Martha decide to purchase an immediate payment annuity. They fund their new annuity with a lump-sum payment of $500,000 from the lawsuit settlement. They also select a length of time for payments to continue. From that choice, such as 20 years for example, the amount they would receive a month would be calculated. The exact monthly sum could vary based on which annuity provider they select.

Takeaway

Annuities are like a freezer full of ice cream...

There are many flavors of ice cream, and each tastes different, but all is still ice cream made from milk and sugar. Annuities come in different styles with various features, just like different flavors of ice cream taste different. The freezer keeps the ice cream cold and lets you save it for another day, like annuities allow you to save your money for another day. And, depending on how long you live, you may or may not get to eat all the ice cream.

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Tell me more...

How do annuities work?
What are the different types of annuities?
What does surrender period mean?
What does income rider mean?
What is an annuity death benefit?
What is an annuity rate of return?
What is the difference between annuities and life insurance?
What are the pros and cons of annuities?
Are annuities a good investment?
How are annuities calculated?
How do I buy an annuity?

How do annuities work?

In general, annuities are a lot like squirrels hiding nuts for the winter. The buyer deposits nuts during bountiful times and withdraws the nuts later in the winter when food is needed. Annuities generally have the added benefit of not only saving, but growing over time until withdrawals begin.

Life insurance companies are the primary providers of annuities, even those sold by brokers, so much of an annuity’s structure is similar to life insurance. The annuity is paid for with scheduled payments or a lump sum. A rider to the annuity can sometimes be purchased to provide payouts to your beneficiary after your death. The time when an annuity is making payouts to the owner or beneficiary is called the annuitization phase or annuitization period.

Annuities are not FDIC insured, and the only guarantees are from the company issuing the annuity. Some annuities (such as variable annuities) also run the risk of losing value if investments do not do well.

What are the different types of annuities?

There are four main types of annuities. These are: 1. Fixed annuities 2. Variable annuities 3. Immediate payment annuities 4. Deferred income annuities

Each type of annuity often has riders available to customize its features.

Fixed annuities

Fixed annuities receive a fixed interest rate over a specific period of time and are often renewable at the then-current rates.

Variable annuities

Variable annuities offer a chance to invest your payments and current balances into stocks, bonds, and cash. These are available in what are called "sub-accounts"—that resemble mutual funds. However, they are different products. Like with any investment, there is a risk. If investments lose value, the principal (the amount you paid in) can be lost. However, if the investments do well, the annuity value could potentially grow faster and larger than a fixed-income option.

Immediate payment annuities

Immediate payment annuities begin payments almost immediately, while the remaining balance may earn interest. This is often used when someone receives a lump sum settlement from an insurance claim, lawsuit, or lottery winning. Be aware that once you start receiving income, it cannot be changed and you no longer have access to your initial investment. The choice to receive income is said to be 'irrevocable'.

Deferred income annuities

Deferred annuities can be either fixed or variable but are designed to provide payouts far into the future after purchasing the annuity.

What does surrender period mean?

The surrender period for an annuity refers to a period of time, specified in the annuity contract, during when the annuity owner cannot withdraw funds without paying a penalty. This can last 10 years or more from the signing of the agreement. During the surrender period, if the annuity owner must withdraw funds for any reason, surrender charges may apply. These are specified in the annuity contract and can be larger than 10%, with the percentage declining the longer the annuity is held. Not all annuities charge a surrender fee.

What does income rider mean?

An income rider on an annuity is an option in the contract that allows fixed payouts to be selected at a specific rate. For example, Betty wants $2,000 per month out of her annuity when she retires. If this is selected, it will affect the funding requirements of the annuity. Some companies charge for an income rider, and others simply use it as part of the funding calculations.

What is an annuity death benefit?

A death benefit is a type of safety valve for an annuity. If the owner dies, the annuity may — depending on the terms — pay a lump sum to the designated beneficiary.

What is an annuity rate of return?

The annuity rate of return is a calculation that shows how much money you will receive from an annuity compared to the amount you paid into the annuity. The number of payments, the amount of payments, the present value of money, the number of payouts, and amount of payouts are all part of calculating the rate of return.

What is the difference between annuities and life insurance?

An annuity is not the same thing as life insurance, but a death benefit or a survivor benefit can provide payouts to your selected beneficiary.

Some whole life insurance plans allow you to cash in your policy for an annuity. This will enable you to move the cash value of the life insurance into the annuity in a tax-deferred way (rather than receiving cash and being taxed immediately) thanks to a rule in the tax code called a 1035 exchange. However, if you transfer your policy in this way, you lose the death benefit from the life insurance policy.

What are the pros and cons of annuities?

ProsCons
Growth generally tax-deferredNot FDIC insured
Way to provide fixed monthly payments in retirementTax penalties for early withdrawal
Another option for saving tax-deferred once IRA contribution limits are reachedRisks of loss, especially in variable annuities
Investment option for cashed out life insuranceDifficult to access quickly and may have surrender fees

Are annuities a good investment?

Like any investment, whether an annuity is a good or bad investment depends on personal financial circumstances and the specific details of the annuity purchased. The pros and cons of annuities should be weighed against your individual situation and goals. Annuities can be a good investment but will not be a good investment option for everyone.

How are annuities calculated?

Annuity costs and returns are calculated by insurance companies using an individual’s actuarial statistics (such as your age and expected lifespan) along with interest rates and the annuity type. Many calculations are company-specific, as well. This means there is not a way for you to calculate an annuity on your own. Calculations will vary for each individual and with each company quoting the annuity. Even fixed-term annuities (where you will receive payments for a set number of years only) have company-specific calculations.

There are financial calculators available online to help you determine how much you can withdraw. These are based on investment, length of annuity, frequency of payout, and growth rate.

How do I buy an annuity?

You can buy an annuity directly from an insurance company or through a broker. Brokers can deal in annuities issued by life insurance companies if they have passed a certain level of FINRA testing (for variable annuities) and have state licensing. Your broker or life insurance agent will discuss with you the annuity types and options they have and the specifics of rates, fees, and penalties. Once you decide on an annuity with the help of your financial adviser, you sign the contract and make payments. Some companies also offer self-serve annuity options that you can buy online without consultation of an agent or broker. In those cases, it is vital you understand the ins and outs of annuities very well on your own.

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