Annuity

What is an Annuity?

Definition: An annuity is a series of equal payments made at equal intervals during a period of time. In other words, it’s a system of making or receiving payments where the payment amount and time period between payments is equal.

An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.

What Does Annuity Mean?

What is the definition of annuity? Most investment and loans are set up as annuities to keep the terms simple. An annuity is a series of payments made at equal intervals. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments, monthly insurance payments and pension payments. Annuities can be classified by the frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other regular interval of time.

An annuity which provides for payments for the remainder of a person’s lifetime is a life annuity.

Types of Annuities

Annuities may be classified in several ways.

Timing of payments

Payments of an annuity-immediate are made at the end of payment periods, so that interest accrues between the issue of the annuity and the first payment. Payments of an annuity-due are made at the beginning of payment periods, so a payment is made immediately on issueter.

Contingency of payments

Annuities that provide payments that will be paid over a period known in advance are annuities certain or guaranteed annuities. Annuities paid only under certain circumstances are contingent annuities. A common example is a life annuity, which is paid over the remaining lifetime of the annuitant. Certain and life annuities are guaranteed to be paid for a number of years and then become contingent on the annuitant being alive.

Variability of payments

  • Fixed annuities – These are annuities with fixed payments. If provided by an insurance company, the company guarantees a fixed return on the initial investment. Fixed annuities are not regulated by the Securities and Exchange Commission.
  • Variable annuities – Registered products that are regulated by the SEC in the United States of America. They allow direct investment into various funds that are specially created for Variable annuities. Typically, the insurance company guarantees a certain death benefit or lifetime withdrawal benefits.
  • Equity-indexed annuities – Annuities with payments linked to an index. Typically, the minimum payment will be 0% and the maximum will be predetermined. The performance of an index determines whether the minimum, the maximum or something in between is credited to the customer.

Deferral of payments

An annuity which begins payments only after a period is a deferred annuity. An annuity which begins payments without a deferral period is an immediate annuity.

How Annuities Work?

An annuity is similar to a life insurance product, but there are important differences between the two.

Under the terms of a life insurance policy, the insurer will generally make a payment upon the death of the insured. Under the terms of an annuity, however, the company makes its payments during the lifetime of the individual. In addition, unless the annuity contract specifies a beneficiary, most annuity payments cease upon the death of the recipient.

There are several types of annuities:

  • Immediate Annuities are usually purchased at retirement age, with benefits that begin immediately (within one year of purchase).
  • Deferred Annuities offer benefit payments that begin at some future date. Interest usually accrues on a tax-deferred basis in the interim.
  • Qualified Annuities are annuities that an investor funds with either pre-tax dollars or tax-deductible contributions.
  • Non-Qualified Annuities are those contracts funded with after-tax dollars.
  • A Fixed Annuity is a personal retirement account in which the earnings are based on a fixed rate set by the insurance company. Fixed annuities are susceptible to inflation risk due to the fact that there is no adjustment provided for runaway inflation.
  • A Variable Annuity is a personal retirement account in which the investment grows tax-deferred until the investor is ready to withdraw the assets. Another important feature of the variable annuity is the family protection, or death benefit, that often comes along with such contracts. This guarantees that, should the investor die during the accumulation phase of the variable annuity, the account owner’s beneficiary will receive at least the amount of the investor’s contributions minus withdrawals or the current market value of the account.

Why Annuities Are Important?

Unlike an IRA, with an annuity there are no restrictions on the amount of the annual investment. In addition, variable annuities offer the potential for greater returns and the opportunity for the investor to make his/her own decisions regarding how the assets are invested.

Annuities are often obtained from a structured settlement of a personal injury lawsuit.

Example

Many people play the lottery in hopes to cash in on the big jackpot. Unfortunately, most people don’t win it big, but an extremely small percentage of people do. After they win, they often have to make the choice whether to be paid in a lump sum or in an annuity. For example, a million dollar jackpot could be paid out immediately in one lump sum of $600,000 or in $5,000 monthly installments for 15 years.

This option takes the time value of money into consideration. Notice that neither option actually pays out a full $1,000,000. This is because over time money should earn interest. Thus, $600,000 today will equal $1,000,000 in the future after interest is added up over the years. The same is true for the annuity payments.

Loans are also set up as annuities. Sometimes people don’t think of them as annuities because they are not receiving the payments. Remember annuities are just agreements with equal payments and time intervals. When a business signs a loan with a bank, it agrees to make a payment each month for specific amount. The payments are due each month until the loan principle is paid off.

The bank determines the interest rate and the time value of money needed to recoup their principle and generate the adequate return on the loan.

Accounting for annuities can be simple or complicated depending on the agreement, payment terms, and compounding interest arrangement. The key thing to remember is that prevent value and future value tables are often needed to calculate terms without a financial calculator.

Summary

Define Annuities: Annuity means a regular payment stream of equal amounts over a stated period.

  • Annuities are insurance contracts that promise to pay you regular income either immediately or in the future.
  • You can buy an annuity with a lump sum or a series of payments.
  • The income you receive from an annuity is taxed at regular income tax rates, not capital gains rates, which are usually lower.

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