Annuities – The Basics
An annuity is a product, offered by financial institutions, generally insurance and investment companies, to the annuitants, who receive a guaranteed amount of payments in the future in exchange for a lump sum or other type of investment made today or during a certain time period.
The period during which a lump sum or periodical investments are made is called an accumulation phase.
This is followed by the annualization phase when the financial institution starts providing periodic payments to beneficiaries.
Annuities can be categorized based on several criteria. The most popular categorizations are described below:
- Annuity contracts can guarantee payments to beneficiaries for the rest of their lives, similar to life insurance products, or during a specified period of time.
- The financial institution can start paying predetermined amounts upon receiving investment from the beneficiary (Immediate annuities) or the periodic payment can be deferred to some future date. Immediate annuities are generally purchased by the ones who possess a large amount of money and want to exchange it for future stable cash flows. For example, many lottery winners prefer to invest the large lump sum into an annuity contract in order to not spend all the money in a short period of time.
- The annuitant can choose either fixed periodic cash flows in the future or variable cash stream pattern that is based on the performance of the fund.
Annuities generally are attractive to retiring people who want a stable income until their death or for a predetermined time horizon.
One of the most popular products in the US, the life annuity, is similar a loan granted by the purchaser (beneficiary) to the financial institution, which pays back the principal amount and interests and/or gains to the beneficiary. The period of the loan is based on the life expectancy of the beneficiary.
Many wealthy individuals or above-average income earners invest in life annuities because of these products’ tax-preferred nature, which gives the investors the opportunity to transfer large amounts of money or to ease the effects of taxes on their annual earnings.
One of the major drawbacks of annuities is that they are illiquid, as the deposits made by the annuitant are generally locked up for a certain period (surrender period), ranging from 2 to 10 years.
The penalties on withdrawing any money from the deposit typically start from 10% and gradually declines over the surrender period.
It is also important to note, that annuities are not a useful product for everyone. For example, if a person receives Social Security or has a pension, he/she already have a fixed annuity for the rest of his/her life.