Annuity

What is an Annuity ?


An annuity is a financial product that provides a series of payments made at equal intervals. Typically used as a form of retirement income, annuities are contracts between an individual and an insurance company, where the individual pays either a lump sum or a series of premium payments to the insurer. In return, the insurer agrees to make periodic payments to the individual, either immediately or at a predetermined future date. Annuities serve as a means of ensuring a steady income stream, offering a degree of financial security for the annuitant, especially during their retirement years.

There are various types of annuities, each with its own features. Fixed annuities guarantee a fixed interest rate for a specified period, providing a predictable income stream, while variable annuities allow individuals to invest their premiums in a range of sub-accounts, exposing them to market fluctuations. Another common type is the immediate annuity, which begins making payments shortly after the initial premium is paid, as opposed to deferred annuities, where payments start at a later date.

Annuities can be tailored to meet different financial goals, such as long-term growth, guaranteed income, or a combination of both. While they offer advantages like tax-deferred growth and a steady income stream, potential drawbacks include fees, surrender charges, and the complexity of the products. It's crucial for individuals considering annuities to carefully assess their financial needs, risk tolerance, and the specific terms of the annuity contract before making any commitments. Overall, annuities play a significant role in retirement planning, offering a structured approach to managing financial resources and ensuring a reliable income during post-employment years.

Annuity Definition


Here are definitions from various authors and sources:

1) Dictionary of Finance and Banking (Oxford Reference):
"An annuity is a contract under which an individual pays a lump sum to a life assurance company and, in return, receives regular payments for the rest of his or her life."

2) Investments: An Introduction by Herbert B. Mayo:
"An annuity is a financial arrangement that provides a series of cash payments at regular intervals."

3) The Pension Answer Book by Stephen J. Krass:
"An annuity is a contract in which an insurance company agrees to make a series of periodic payments to an individual in return for a premium or premiums paid by that individual."

4) Personal Finance by E. Thomas Garman and Raymond E. Forgue:
"An annuity is a contract sold by an insurance company that provides a series of payments made at equal intervals. The annuitant makes either a lump-sum payment or a series of payments."

5) Introduction to Risk Management and Insurance by Mark S. Dorfman:
"An annuity is a series of payments made at equal intervals. The payments continue for the life of a designated person or for a specified number of years."
Fundamentals of Corporate Finance by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. 

6) Jordan:
"An annuity is a series of equal payments made at regular intervals."
The Complete Idiot's Guide to Personal Finance in Your 40s and 50s by Sarah Young Fisher and Susan 

7) Shelly:
"An annuity is a contract between an individual and an insurance company. The individual pays the insurance company money, and, in return, the insurance company pays the individual a stream of payments."

How Do Annuities Work ?


Annuities are financial products designed to provide a steady stream of income over a specified period or for the rest of an individual's life. They are typically offered by insurance companies. The basic concept of how annuities work involves three phases: the accumulation phase, the annuitization phase, and the payout phase.

1) Accumulation Phase:
  • Initial Investment: The annuitant (the person who owns the annuity) makes an initial payment or a series of payments to the insurance company. This can be a lump sum or a series of contributions.
  • Accumulation of Funds: During the accumulation phase, the funds grow on a tax-deferred basis. For fixed annuities, the insurance company guarantees a minimum interest rate. In variable annuities, the returns are tied to the performance of underlying investment options.

2) Annuitization Phase:
  • Choosing a Payout Option: At a certain point, the annuitant decides to convert the accumulated value into a stream of income. This is known as the annuitization phase.
  • Payout Options: The annuitant can choose from various payout options, such as receiving regular payments for a fixed period, for their lifetime, or a combination of both. The choice of payout option determines the structure and duration of the income payments.

3) Payout Phase:
  • Regular Income Payments: The insurance company begins making regular income payments to the annuitant according to the chosen payout option.
  • Tax Implications: The taxation of annuity payments depends on whether the annuity is funded with pre-tax (qualified) or after-tax (non-qualified) dollars. For qualified annuities, taxes are deferred until withdrawals begin.

4) Death Benefits:
  • Beneficiary Designation: Annuities often allow the annuitant to designate beneficiaries who will receive the remaining value of the annuity upon the annuitant's death.
  • Types of Death Benefits: The nature of the death benefit can vary. For example, some annuities provide a refund to beneficiaries equal to the remaining premium or the accumulated value.

5) Surrender Period and Charges:
  • Surrender Period: Some annuities have a surrender period during the early years, during which withdrawing funds may result in surrender charges.
  • Fees and Charges: Annuities may have fees and charges, including administrative fees, mortality and expense fees, and charges associated with optional riders or features.

Types of Annuities


Here's an exhaustive list that encompasses various types of annuities:

1) Fixed Annuities:
These annuities provide a guaranteed, fixed rate of return over a specific period. The insurance company assumes the investment risk, and the annuitant receives regular, predetermined payments.

2) Variable Annuities:
The returns on variable annuities are tied to the performance of underlying investment options, such as mutual funds. The annuitant assumes the investment risk, and the payments can vary based on the performance of the chosen investments.

3) Immediate Annuities:
With immediate annuities, the annuitant starts receiving payments shortly after making a lump-sum payment. Payments can be for a fixed period or for the rest of the annuitant's life.

4) Deferred Annuities:
Deferred annuities have an accumulation phase where the annuitant makes payments or a single lump sum, but the payout phase is delayed until a later date. This type allows for the growth of the invested funds before annuitization.

5) Fixed-Indexed Annuities:
These annuities offer a fixed interest rate but may also provide returns linked to the performance of a stock market index. The returns are often subject to a cap or participation rate, offering a potential for higher returns with some downside protection.

6) Lifetime Annuities:
Lifetime annuities guarantee payments for the entire life of the annuitant, providing financial security during retirement. There are variations, such as single-life annuities (payments for one person's lifetime) and joint-life annuities (payments for the lifetimes of two individuals).

7) Guaranteed Annuities:
These annuities come with certain guarantees, such as a minimum interest rate or a minimum number of payments. They provide a level of security for the annuitant.

8) Qualified Annuities:
Qualified annuities are purchased with pre-tax dollars (e.g., from an individual retirement account or 401(k)), and taxes are paid upon withdrawal.

9) Non-Qualified Annuities:
Non-qualified annuities are funded with after-tax dollars, and taxes are paid only on the earnings when withdrawn.

10) Single-Life Annuities:
Payments are made for the lifetime of a single individual.

11) Joint-Life Annuities:
Payments are made for the lifetimes of two individuals, typically a married couple.

12) Period Certain Annuities:
Guarantee payments for a specific period, even if the annuitant dies before the period ends.

13) Life with Period Certain Annuities:
Combines lifetime payments with a guaranteed period, providing income for life or a certain period, whichever is longer.

14) Fixed Period Annuities:
Payments are made for a fixed number of years, providing a guaranteed income for a specified duration.

15) Installment Refund Annuities:
Payments continue until the annuitant's death, and if they die before receiving the full premium, the remaining amount is paid to beneficiaries.

16) Cash Refund Annuities:
Similar to installment refund annuities, but if the annuitant dies before receiving the full premium, a lump sum is paid to beneficiaries.

17) Variable Immediate Annuities:
Immediate annuities with payments tied to the performance of underlying investments.

18) Variable Deferred Annuities:
Accumulation phase involves investments in variable subaccounts, with payouts linked to market performance during the payout phase.

19) Market Value Adjusted Annuities:
Interest rates can be adjusted based on changes in interest rates in the broader financial markets.

20) Multi-Year Guarantee Annuities (MYGAs):
Fixed annuities with a guaranteed interest rate for a specific period.

Examples of Annuity


Here are a few examples illustrating how annuities might work in different scenarios:

1) Fixed Immediate Annuity:
  • Scenario: John, a retiree, receives a lump sum of money from his pension. He purchases a fixed immediate annuity with this sum.
  • Outcome: The insurance company guarantees John a fixed monthly income for the rest of his life.

2) Variable Deferred Annuity:
  • Scenario: Sarah, a middle-aged investor, purchases a variable deferred annuity.
  • Outcome: Over the years, Sarah contributes to the annuity, and the funds are invested in various subaccounts tied to the stock market. The annuity value fluctuates based on the performance of these investments. When Sarah retires, she annuitizes the contract to receive variable income payments.

3) Lifetime Annuity with Period Certain:
  • Scenario: Mark wants a guaranteed income for life but also wants to ensure that if he passes away within the first 20 years, his beneficiary receives payments.
  • Outcome: Mark purchases a lifetime annuity with a 20-year period certain. If he lives beyond 20 years, he continues to receive income. If he dies within the first 20 years, his beneficiary receives the remaining payments.

4) Fixed-Indexed Annuity:
  • Scenario: Emily is concerned about market volatility but wants potential for higher returns than a fixed annuity.
  • Outcome: She chooses a fixed-indexed annuity, where the interest rate is linked to the performance of a stock market index. Emily benefits from market gains up to a certain cap, but her principal is protected from market losses.

5) Joint-Life Annuity:
  • Scenario: Tom and Lisa, a married couple, want a guaranteed income for as long as either of them lives.
  • Outcome: They purchase a joint-life annuity, ensuring that income payments continue until the death of the last surviving spouse.

6) Deferred Income Annuity (DIAs):
  • Scenario: Jane is in her 50s and wants to secure a guaranteed income stream for her retirement starting at age 70.
  • Outcome: Jane purchases a deferred income annuity, making payments for a certain period. The annuity starts providing regular income when she reaches age 70.

7) Qualified Longevity Annuity Contract (QLAC):
  • Scenario: Mike, who has a 401(k), is concerned about outliving his savings.
  • Outcome: He invests a portion of his 401(k) in a QLAC, a type of deferred income annuity that delays income payments until a later age (e.g., 85). This helps ensure he has a guaranteed income later in life.

Annuity Formula


The formula for calculating the periodic payment (PMT) in an annuity depends on the type of annuity. There are different formulas for ordinary annuities and annuities due. Here are the formulas:

1) Ordinary Annuity:
The formula for the periodic payment (PMT) in an ordinary annuity is given by:

���=�×(�(1+�)�(1+�)�−1)

Where:
  • ��� is the periodic payment,
  • � is the principal amount (present value),
  • � is the interest rate per period (expressed as a decimal),
  • � is the total number of periods.
2) Annuity Due:
For an annuity due, where payments are made at the beginning of each period, the formula is modified as follows:
PMTdue​=PMTordinary​×(1+r)
Where:
  • ���due is the periodic payment for an annuity due,
  • ���ordinary is the periodic payment for an ordinary annuity,
  • � is the interest rate per period (expressed as a decimal).
3) Future Value of an Annuity:

The formula to calculate the future value (FV) of an annuity is given by:

��=���×((1+�)�−1�)

Where:
  • �� is the future value,
  • ��� is the periodic payment,
  • � is the interest rate per period (expressed as a decimal),
  • � is the total number of periods.
These formulas are fundamental for understanding and calculating payments, present values, and future values in the context of annuities. Keep in mind that the exact formula may vary based on specific assumptions and financial instruments. Additionally, the timing of payments (end of the period or beginning of the period) is crucial when applying these formulas.

Advantages of Annuities


  1. Guaranteed Income: Provides a steady and guaranteed stream of income, ensuring financial stability during retirement.
  2. Tax Deferral: Earnings within the annuity grow tax-deferred until withdrawal, potentially resulting in lower taxes during retirement.
  3. Diversification: Variable annuities allow for investment in a range of subaccounts, providing diversification and potential for higher returns.
  4. Death Benefits: Many annuities offer death benefits, ensuring that beneficiaries receive the remaining value if the annuitant passes away.
  5. Lifetime Income: Lifetime annuities offer income for as long as the annuitant lives, protecting against the risk of outliving one's savings.
  6. Flexibility: Annuities can be customized with various features and riders to meet specific financial goals and needs.
  7. Estate Planning: Annuities can be used as part of an estate planning strategy, providing for heirs and minimizing probate.

Disadvantages of Annuities


  1. Fees and Charges: Annuities often come with fees, including surrender charges, administrative fees, and expenses, which can erode returns.
  2. Complexity: The features and terms of annuities can be complex, making it essential for investors to fully understand the product before purchasing.
  3. Lack of Liquidity: Annuities may have restrictions on withdrawals, especially during the surrender period, limiting liquidity.
  4. Inflation Risk: Fixed annuities may not keep pace with inflation, potentially reducing the real value of income over time.
  5. Opportunity Cost: Money invested in an annuity may miss out on potentially higher returns in more aggressive investment vehicles.
  6. Long-Term Commitment: Annuities often involve a long-term commitment, and early withdrawals may result in penalties.
  7. Tax Implications: Withdrawals from annuities may be subject to ordinary income tax, and withdrawals before age 59½ may incur additional penalties.