An annuity is a contract in the form of an insurance product, in which the seller makes future payments to a buyer in exchange for a single lump sum payment (single-payment annuity) before the annuity begins. The payments continue until the death of the annuity purchaser. There are two possible phases for an annuity: the accumulation phase, in which the customer deposits and accumulates money, and the distribution phase, in which the income payments are made. An annuity has been described by some as “buying your own person.”
There are both benefits and disadvantages to an annuity. The annuity guarantees regular payments for the rest of a person’s life. The disadvantages can be fees, the inability to bequeath money to heirs, and the potential for low return on investment. For example, there is always the risk that a person could meet an untimely end shortly after purchasing an annuity, therefore spoiling the investment. Effective returns are described as being “just a shade above certificates of deposit,” and do not take inflation or cost of living increases into account. An annuity becomes more and more worthwhile based on longevity. However, if the goal is to ensure steady, reliable cash flow, no matter how long you continue to live, and annuity may prove to be an excellent choice.
While once disfavored in estate planning, annuities are now considered a reliable part of retirement planning. Certain financial planners say that an annuity should consist of 1/3 of the capital an individual holds for retirement. With the baby boomer generation aging, social security having an uncertain future, and fewer corporate pensions, annuities can be an excellent way to ensure reliable income to retied persons.
What types of annuities are available?
There are many different groups and types of annuity available.
An annuity contract that only has distribution phase is called an immediate annuity.”
“Fixed and Variable Annuities”
Annuities that make payments in fixed amounts, or that increase at a fixed annuities. An example is the Immediate Fixed Lifetime annuity, which guarantees regular payments for life, starting immediately, in exchange for a lump sum payment upfront. In contrast, a variable annuity will pay amounts that vary, based on investment. These are typically based on bonds and mutual funds. Variable annuities allow for deferral of recognition of taxable gains. Money that is deposited into a variable annuity grows on a tax-deferred basis, so that taxes on investments are not due until a withdrawal is made.
Guaranteed annuities offer a “period certain” feature, meaning that if an individual passes away before a certain cutoff date, then the person’s heirs will receive the remaining annuity payments until the cutoff date at the end of the period. This protects against the chance that the holder of an annuity may die before recovering the value of the original investment. If the annuity holder outlasts this period, the annuity payments will continue as normal. But, in the unfortunate event where the annuity holder passed before the cutoff date of the period, the holder’s estate of beneficiaries are entitled to collect the remaining payments up to the end of the period. An example is the Immediate Fixed 10-year Certain Annuity. This annuity is similar to the Immediate Fixed Lifetime Annuity, but includes a guaranteed ten year period in which payments are guaranteed, regardless of death of the annuity holder.
An annuity can be structured in such a way to make payments to a married couple, with such payments ceasing on the death of the second spouse.
“Impaired Life Annuities”
These annuities involved improving the terms offered, due to a medical diagnosis, which is, sever enough to reduce the life expectancy. This involves medical underwriting and has a range of qualifying conditions.
Annuities that involve both, an accumulation and a distribution phase, are called deferred annuities. Some examples of deferred annuities:
Deferred Fixed Annuity with Five-Year Guarantee: annuity begins paying out in the future at a fixed interest rate for five years. After five years, the rate fluctuates with investments.
Capped S&P 500 Indexed Annuity: allows participation in the stick market, with guaranteed downside protection. Payments begin at a later time.
Deferred Variable Annuity: assets grow tax-deferred based on underlying stocks and bonds. Payouts are based on value at a certain future date.