Guide To Annuities
The term “annuity” refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. Investors invest in or purchase annuities with monthly premiums or lump-sum payments. The holding institution issues a stream of payments in the future for a specified period of time or for the remainder of the annuitant’s life. Annuities are mainly used for retirement purposes and help individuals address the risk of outliving their savings.
Key Takeaways
Annuities are financial products that offer a guaranteed income stream, usually for retirees.
The accumulation phase is the first stage of an annuity, whereby investors fund the product with either a lump sum or periodic payments.
The annuitant begins receiving payments after the annuitization period for a fixed period or for the rest of their life.
Annuities can be structured into different kinds of instruments, which gives investors flexibility.
These products can be categorized into immediate and deferred annuities and may be structured as fixed or variable.
How Annuities Work
The assets individuals have when they reach retirement may not be enough to sustain their standard of living, some investors may turn to an insurance company or other financial institution to purchase an annuity contract. As such, these financial products are appropriate for investors, who are referred to as annuitants, who want stable, guaranteed retirement income. Because invested cash is non-liquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs to use this financial product.
An annuity goes through several different phases and periods. These are called:
- The accumulation phase, the period of time when an annuity is being funded and before payouts begin. Any money invested in the annuity grows on a tax-deferred basis during this stage.
- The annuitization phase, which kicks in once payments commence.
These financial products can be immediate or deferred. Immediate annuities are often purchased by people of any age who have received a large lump sum of money, such as a settlement or lottery win, and who prefer to exchange it for cash flows into the future. Deferred annuities are structured to grow on a tax-deferred basis and provide annuitants with guaranteed income that begins on a date they specify
Types of Annuities
Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. As mentioned above, annuities can be created so that payments continue so long as either the annuitant or their spouse (if survivorship benefit is elected) is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.
Immediate and Deferred Annuities
Annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits. The immediate payment annuity begins paying immediately after the annuitant deposits a lump sum. Deferred income annuities, on the other hand, don’t begin paying out after the initial investment. Instead, the client specifies an age at which they would like to begin receiving payments from the insurance company.
Depending on the type of annuity you choose, the annuity may or may not be able to recover some of the principal invested in the account. In the case of a straight, lifetime payout, there is no refund of the principal–the payments simply continue until the beneficiary dies. If the annuity is set for a fixed period of time, the recipient may be entitled to a refund of any remaining principal–or their heirs, if the annuitant has deceased.
Fixed and Variable Annuities
Annuities can be structured generally as either fixed or variable:
- Fixed annuities provide regular periodic payments to the annuitant.
- Variable annuities allow the owner to receive larger future payments if investments of the annuity fund do well and smaller payments if its investments do poorly, which provides for less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns from their fund’s investments.
While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts—usually for an extra cost. This allows them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value.
Other riders may be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. The cost of living rider is another common rider that will adjust the annual base cash flows for inflation based on changes in the consumer price index (CPI).