Annuities are long-term investment vehicles used for protecting your financial assets and securing your financial future with a steady stream of income during retirement. They’re often sold by insurance companies, financial intermediaries, banks or independent brokers.
When you purchase an annuity, you’re essentially buying an insurance contract. You pay the insurer a set amount of money over a specific period of time and in return, the insurance company pays you a regular income during retirement.
Those payments can either be deferred, meaning they begin at a specific date in the future after you retire or they can be immediate, meaning they can begin right away. You can choose to receive these payments for a fixed period of time or for a lifetime.
Annuities can be sold for cash or you can pass on to someone you choose to inherit it. You can also set up an annuity which can continue to make regular payments to your spouse or joint annuitant once you pass away.
After you purchase an annuity, your money is combined with the money from other annuity holders and much like a mutual fund, it is invested in order to generate the returns that are used to make annuity payments.
However, a substantial amount of money is required to generate a meaningful monthly income during your retirement. Before purchasing an annuity, it is important that you consult with your financial advisor to ensure that you are making smart money decisions.
How do annuities work? Annuities have two phases, the first one is accumulation phase and the next one is annuitization phase. During the accumulation phase, annuity holders regularly invest their pre-tax or after-tax money in annuity.
At a certain point, the annuitant decides to convert this account into a regular stream of income or a lump sum payment. This is known as annuitization phase. The amount of monthly installment can be calculated using actuarial tables.
Annuities can be attractive to individuals interested in accumulating retirement assets, because annuities are not subjected to any contribution limits. They are also useful to individuals with structured settlement or lottery recipients looking to secure their retirement.
Different Types Of Annuities For Fixed And Regular Retirement Income
- Ordinary Annuity
- Annuity Due
- Qualified Annuity
- Non-Qualified Annuity
- Fixed Annuity
- Variable Annuity
- Immediate Annuity
- Deferred Annuity
- Tax Sheltered Annuity
- Equity Indexed Annuity
- Life Annuity
- Contingent Annuity
- Joint And Survivor Annuity
- Straight Life Annuity
- Split Funded Annuity
- Bonus Annuity
- Charitable Gift Annuity
- Compulsory Purchase Annuity
- Voluntary Purchase Annuity
Ordinary annuity is a series of payments where all the payments are of equal amount, all the payments are made at the same intervals of time and all the payments are made at the end of each period.
Payments under ordinary annuity are made at the end of each month or quarter or year. Examples of ordinary annuities include half yearly interest payments on bonds or quarterly dividend payments to shareholders.
Present value of an ordinary annuity depends upon prevailing interest rates. Rising interest rate reduces the present value of an ordinary annuity where as falling interest rate increases its present value.
Annuities due is opposite of ordinary annuities where the payments are made at the beginning of each period. Similar to ordinary annuity payments are of equal amount and they are made at the same intervals of time.
Because payments are made at the beginning of each period, an annuity due has higher present value than ordinary annuity. A common example of annuity due is when landlords ask for the rent at the beginning of each month.
Most of the insurance companies have a product known as whole life annuity due where the payments are required to be made at the beginning of each month or quarter by the annuitant.
Qualified annuities are bought with pre-tax dollars and taxes are paid only when the distributions are received. This type of annuity is usually set up through an employer like simplified pension plans or tax exempt saving plans.
If the annuitant dies before receiving all the benefits, the qualified annuity funds can be transferred to the beneficiary. As qualified annuity is purchased with pre tax dollars, all the withdrawals are taxable.
Annuities that are purchased with after tax dollars are referred to as non-qualified annuities. Some of the examples of non-qualified annuities include different types of mutual funds, savings accounts, inheritance accounts, certificates of deposit, etc.
Non-qualified annuity investments allow the initial investment to accumulate interest without any tax liability. However, during withdrawals only the earnings are taxed. There is no tax on initial investment.
Fixed annuities pay a fixed rate of return. With these types of annuities your monthly retirement income is fixed and guaranteed. The returns are not very spectacular but the guarantee of a steady rate of return makes them one of the safest types of investments.
Fixed annuities invest the money in government bonds and top rated corporate bonds. The downside of fixed annuities is that even if the bonds give higher returns your monthly income remains the same.
Fixed annuities are good for conservative investors who have low tolerance for risk and value safety, stability and a secure income. They are also a good choice for investors who are nearing retirement and want to stay away from the volatility of stock and bond market.
Variable annuities do not guarantee a fixed retirement income as the money is invested in a variety of securities including stock funds and bond funds. The monthly payments can increase or decrease depending upon the performance of the investments.
Variable annuities are best suited for experienced investors who can bear some risk and are comfortable with the fluctuations of the stock market and want their investments to keep pace with inflation over a long period of time.
Variable annuities are also preferred by young investors who want to financially secure their retirement by taking advantage of the superior returns from stock market or bond market over a longer period of time.
Immediate annuities allow you to convert a lump sum amount of cash into a regular income stream. You can handover the cash to insurance company and in exchange, the insurance company will start paying you a monthly income immediately.
Immediate annuities are a good option for people who have retirement savings and want to immediately convert those savings into regular monthly income but are not comfortable managing their own investments.
By exchanging your retirement savings for an annuity contract, the insurance company takes the responsibility of managing your investments and paying you a regular monthly income specified in the annuity contract irrespective of how your investments perform.
Unlike immediate annuities, deferred annuities allow you to make a lump sum payment or series of payments in the accumulation period and defer the payout until sometime in the future during your retirement.
Deferred annuities give you several options for withdrawing your money like lump sum withdrawal where you can withdraw your entire payment at once or systematic withdrawal where you can withdraw the funds at regular intervals or annuitization where you can secure a regular monthly income over a period of time.
Deferred annuities give you an opportunity to build your retirement savings over a period of years. The ability to invest periodically can give you an added flexibility in building a larger retirement resource.
Tax Sheltered Annuity
Tax sheltered annuity also known as tax deferred annuity is a retirement savings plan available for the employees of nonprofit and tax exempt organizations who invest their pre-tax dollars to secure a consistent retirement income.
Tax sheltered annuities are designed to provide a reliable source of income during retirement. As the contributions are pre-tax, investment grows without being taxed. Taxes are paid once the employee starts withdrawing the amount during retirement.
Tax sheltered annuities provide flexibility in contributions. However, they might have high administrative costs and investment options are limited as chosen by the employer.
Equity Indexed Annuity
Equity indexed annuity, also known as fixed indexed annuity or indexed annuity is a contract with an insurance or annuity company which usually generates higher returns than bonds or other fixed income instruments but not as high as stock market returns.
Equity indexed annuity is a combination of fixed and variable annuity. As with the fixed annuity, you will get a guaranteed monthly income during retirement. But like variable annuity, the returns are tied to a stock market index and there is a possibility of earning higher returns if the stock market rises.
Equity indexed annuity follows the principle of indexed investing which is similar to exchange traded funds and is popular among conservative investors. It is less risky than other types of annuities as it offers a protection against any crash in the stock market.
Life annuity is an insurance product issued by insurance companies which can provide you with a paycheck for the rest of your life. You don’t have to worry about outliving your retirement money. It is also known as longevity annuity.
Life annuities are commonly used to generate a secure income during retirement. An annuitant can pay into the annuity with a series of periodic payments or he can purchase the annuity with a lump sum amount, usually at retirement.
Contingent annuity is a contract that does not begin making payments to the beneficiary or joint annuitant until the named contingency occurs like retirement or death. The beneficiary is known as contingent annuitant.
Joint And Survivor Annuity
Joint and survivor annuities are purchased to benefit more than one person during retirement. Under this annuity, you or your spouse or the joint annuitant can receive monthly benefits for life.
Joint and survivor annuities are suitable for couples because it guarantees coverage for both the spouses. If you pass away, your spouse would continue to receive monthly income during their retirement.
The monthly payment from a joint and survivor annuity will be less than the payment from a single life annuity. With a 50% joint and survivor annuity, the payment will be reduced by 50% when the first person dies.
Straight Life Annuity
Like all the annuities, straight life annuity also provides guaranteed monthly income to the annuitant during his retirement but does not provide any death benefits or beneficiary payments to the survivor. It is also known as pure life annuity.
Once the annuitant dies, the monthly income stops and no more beneficiary payments or death benefits can be claimed by their spouse or heirs. Hence, such annuities may not be a good choice for couples who live off the retirement income.
Straight life annuities can provide you with a higher retirement income as they do not have any survivor or death benefits. This makes straight life annuity less expensive than other types of annuities.
Split Funded Annuity
Split funded annuity is also known as combination annuity as it splits your fund to invest in an immediate annuity and a deferred annuity. This strategy helps the annuity holder to receive immediate monthly income and simultaneously save for his retirement.
Split funded annuities are more appealing to people who are nearing retirement. The funds can be split unevenly with more money going to the deferred portion of the annuity to secure a regular income during retirement.
Bonus annuities are fixed or variable annuities that provide the annuity holder with a bonus rate on the top of a regular rate of return. This bonus can either be an upfront premium bonus or a first year interest rate bonus.
Upfront payment bonus is typically found with fixed indexed annuities where the insurance company will credit your account with a lump sum amount which is the percentage of premium deposit made while purchasing the annuity.
On the other hand, first year interest rate bonus is found with traditional fixed annuities where the insurance company will add an additional percentage of interest to the base interest rate of an annuity during the first year.
Charitable Gift Annuity
Many large non-profit organizations offer charitable gift annuities where you can make a donation to the charity. In return, you become eligible for a tax deduction on donation, plus you can secure a regular stream of income for the rest of your retirement life.
Advantages of charitable gift annuities include supporting an organization you care about, possibility of donating various types of financial assets and generating a fixed stream of income for the rest of your life.
Compulsory Purchase Annuity
A compulsory purchase annuity can be purchased with your retirement savings from a pension, provident fund or a retirement annuity fund. A compulsory purchase annuity will provide you with a pension during retirement for the rest of your life.
Voluntary Purchase Annuity
Voluntary purchase annuity can be purchased at any time with your voluntary or discretionary savings. You can invest a lump sum amount in any type of annuity of your choice.
The advantage of voluntary purchase annuity is that it ensures regular monthly income during retirement, often at a higher rate, for a fixed period of time or until you die.