Simple Explanation of Annuities
Annuity is a financial instrument that serves a wide range of purposes, from risk reduction to high-return long-term investment. Read on to learn about annuities and their usage.
Annuity is the opposite of life insurance. When you buy life insurance, the insurance company wants you to live forever because it has to pay your beneficiary a death benefit if you die before a certain age (usually 100 years). When you buy an annuity, the insurance company wants you to die immediately because annuities require an insurance company to pay you only as long as you live.
Annuities work similarly to a bank deposit, though producing a higher rate of return. When you buy an annuity, you pay a premium. In exchange, the insurance company will pay you predetermined sums of money until your death.
- Why buy an annuity?
- Annuity products:
- Fixed Annuities
- Variable Annuities
Why buy an annuity?
First, you can outlive the premium paid, in which case the insurance company will have to keep paying you as long as you live. People who purchased annuities at a young age and lived longer than the average life expectancy might collect several, if not dozen times more than their premium.
Second, buying an annuity can be very advantageous for tax purposes. If you won $1M in a lottery and cashed out at once, you would have to pay taxes on all of that money while being in a high tax bracket. If the lottery company issued you an annuity instead, the money would be distributed to you in chunks over a large period of time, thus pushing you into a lower tax bracket and allowing you to defer taxes on the portion that still hasn’t been received.
Third, after you deposit your premium, it starts accumulating a handsome interest which is also tax deferred (i.e. not taxed before withdrawal) and is taxed as ordinary income. Thus, if the insurance company pays you an annual interest of 9% on your annuity, it will take only about 8 years to double your account balance. Therefore, if you determine you need to have $1,000,000 in your account by the age 60 and purchase an annuity at the age 30, you might have to pay only a small fraction of it in premiums to get to a million.
Fourth, on some types of annuities you may select a beneficiary who will collect the remainder of your account if you die before the money is distributed in full. This, however, will not be a death benefit, meaning any money your beneficiary receives will be the money that you deposited as a premium for your annuity + any interest that money earned – the portion that has been already distributed back.
Fifth, despite being regulated under insurance laws, annuities are not insurance. They do not require a physical examination and can be purchased at any age. The premium remains the same for all ages as well, making some of their types very attractive for seniors.
In this section we will consider types of annuities and various annuity products.
Immediate annuities vs. deferred annuities
Strictly speaking, all annuities can be divided into two main types:
- immediate annuities;
- deferred annuities.
Immediate annuity starts paying back as soon as you pay the premium. The insurance company will decide the size of monthly payments to you (depending on your age, gender and the type of annuity), and you will start receiving them from the next month until you die. Deferred annuity does not distribute any money until the predetermined period, but do earn interest on the funds are held by the insurance company.
A lottery win collected through an annuity will most likely be an immediate annuity. A deferred annuity is usually used for educational and retirement purposes. A parent may elect to buy an annuity for their child’s education at their birth, so that by the time the child goes to college the original premium has collected a large interest.
A deferred annuity can be purchased either with a single premium (aka lump-sum premium, lump-sum payment or simply a lump sum) or with level premium payments. The first option is more attractive for those looking for an immediate account value and aggressive growth of interest on their annuity. The second option allows to spread payments over time, avoiding a immediate substantial decrease of liquid assets. Immediate annuities are most often purchased with a single premium.
Pure Life Annuity, or Straight Life Annuity
It will pay the annuitant a certain amount of money while s/he lives, cancelling all payments after the annuitant’s death. This option is the riskiest, but it also provides the highest monthly payments.
Life Income Annuity with Period Certain
Aka Annuity Certain or Period Certain Annuity. This option allows selecting a beneficiary who will receive the remainder of your account if you die during the Period Certain. After the end of the Period Certain the beneficiary will not be able to collect any money, but the insurance company will still pay you as long as you live.
Refund Life Annuity
Also allows selecting a beneficiary. Your beneficiary will collect the remainder of your account if there is any money left at the time of your death. A refund can be given as a lump-sum, or as a series of chunks called installments. However, while bearing little risk, this type also provides lower payments during the term of the annuity.
Multiple Life Annuity
This type of annuity is usually used by two annuitants, most often a wife and her husband. It has two sub-types: Joint and Survivor Annuity and Joint Life Annuity. The first one will continue to distribute payments to the survivor after the death of their partner, while the second stops making payments after the death of any party. Being significantly riskier, the second option also provides higher monthly payments.
A fixed annuity has a guaranteed minimum rate of return (usually about 4% annually), and the insurance company bears all the associated investment risks. This rate can be increased if the company is doing very well in a given period, but it will never fall below the minimum. Fixed annuities are backed by the Life Insurance Guarantee Fund of the state in which the annuity was purchased, making them significantly less risky than the other annuity types.
Make sure you ask questions about the Guarantee Fund: agents are not allowed to talk about it unless asked by their client.
Equity Indexed Annuity. A subtype of fixed annuity. It guarantees returning both the invested principal and the earned interest. However, any earnings in excess of the guaranteed rate may accrue depending on the market index used to gauge the annuity’s performance. S&P 500 is the most commonly used benchmark for Equity Indexed Annuities.
Not backed up by the Guarantee Fund; considered securities. The annuitant bears all the investment risks associated with variable annuities. There is no guaranteed rate of return. The funds of the annuitant are invested into the stock market and usually are used as a hedge against inflation.
Market Value Adjusted Annuity
A subtype of variable annuities requiring the annuitant to invest their money for a predetermined period of time. The final value received at the end of the annuity’s term is guaranteed, but if the funds are withdrawn earlier they may be subject to an adjustment. The adjustment can be either negative or positive and is inversely correlated with changes in the interest rate.
by Danil Rudoy