Annuity

An annuity is a product sold to investors by financial institutions: a contract in which investors pay a certain amount of money over time. Then at a predetermined time, it begins to pay the money back to the investor for a specific amount of time.

To provide cash payments in the future, the company using annuities uses investor money to grow funds-an equivalent of a mutual fund, except that the returns are guaranteed.

Annuities are frequently used by investors who wish to set aside funds for retirement. In general, the investor assumes they will live long enough to pay back more than they invested, while the company is betting the investor will receive less than they invested.

In technical terms,

A series of constant cash flows occur at the end of each period for some fixed number of periods.

Key Takeaways

• In most cases, they are financial products that ensure a steady income stream for retirees.
• A lump sum or periodic payments are made to investors during the accumulation phase of an annuity.
• After annuitization, the annuitant begins receiving payments for a fixed period or the rest of their lives.
• Different kinds are available, offering investors flexibility.
• Fall into two categories: immediate or deferred, which can be fixed or variable in structure.

Type of Annuities

Annuities are available in many different types to suit different needs. You can determine which type is right for you based on your individual goals and objectives.

Fixed:

• Provides regular periodic payments to the annuitant.
• It has a set rate of interest that is guaranteed for a set period.
• Interest rates may be guaranteed for a certain period or fluctuate from anniversary to anniversary.
• It is backed by the insurance company that issued it.

Fixed Index:

• Interest is earned based on market indexes, such as the S&P 500.
• It does not participate directly in the stock market and maintains premiums.
• A minimum rate of return is guaranteed.

Variable:

• Several benefits of this type include receiving larger future payments if its fund's investments do well. However, it has smaller payments if the investments do poorly, providing less stable cash flow than a fixed one but allowing the annuitant to take advantage of solid returns from their fund's investments.
• Earns interest through investments you make within the annuity.
• The return is not guaranteed, but the growth potential is more significant.

Immediate or Deferred:

In the case of annuities, they can begin immediately upon a deposit or be in the form of deferred benefits. After the annuitant deposits a lump sum, the immediate payment begins paying.

Conversely, deferred income annuities do not begin paying after the initial investment. As an alternative, a client specifies an age at which they would like to receive payments.

How does it Work?

It means converting a lump-sum payment into an income stream the consumer cannot outlive. Providing for their daily needs is more than relying on Social Security and investment savings for retirees.

It is designed to supply this income through accumulation and annuitization. In the case of immediate annuities, lifetime payments are guaranteed by the insurance company that begins immediately following a purchase with no accumulation phase needed.

You pay the insurance company a premium when you purchase a deferred annuity. However, depending on your contract terms, your initial investment may grow tax-deferred for ten to thirty years during the accumulation phase.

Quick note

Annuity premiums represent your investment in its plan and the firm that provides it. It can be paid in full or in installments. The insurance company invests the premium into an annuity fund, which is an investment vehicle that includes stocks, bonds, and other securities.

Following the annuitization or distribution phase, you will start receiving regular payments - again, based on the terms of your contract.

A contract for annuities transfers all the risks associated with a down market to the insurance company. Therefore, a contract owner is protected from market risk and longevity risk, meaning there is no chance of outliving their money.

Insurance companies charge investment management, contract riders, and other administrative services to offset this risk. In most contracts, a surrender charge is imposed when the contract holder withdraws money from the annuity during the surrender period.

In addition, insurance companies generally impose caps, spreads, and participation rates on indexed annuities, reducing your return.

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) provide regulation of annuity products.

In the case of variable annuities, agents and brokers must also hold a securities license. An agent or broker typically earns a commission based on the notional value of the annuity contract.

Calculations

The formula to find the present value is based on the number of periods/months, the discount rate, and the payments. The same components apply to the formula of the future value. 

PVA = A [1 - (1/ (1 + r)^t)/ r]

FVA = A [(1 + r)^t - 1/ r]

Where

A = payments

r = discount rate 

t = number of periods payments are or will be made

Let's see both in an example.

Suppose you win the $10 million lottery. The money is paid in equal annual installments of $333,333.33 over 30 years. If the appropriate discount rate is 5%, how much is the sweepstakes worth today (use Present value)?

Answer:

PVA = $333,333.33[1 – 1/1.05^30] / .05 = $5,124,150.29

This means the value of the entire annuity today is $5,124,150.29.

Suppose you begin saving for retirement by depositing $2,000 per year in an RRSP. If the interest rate is 7.5%, how much will you have in 40 years (use Future value)?

Answer:

FVA = $2,000(1.075^40 – 1)/.075 = $454,513.04

By saving $2000 into my RRSP account every year, I will have $454,513.04 in 40 years.

Reasons why they are useful

Annuities provide long-term income. While they are often viewed as financial solutions for older investors nearing retirement, they can also benefit investors of all ages.

• Long-term security
• Tax-deferred growth
• Principal protection
• Adjustments for inflation
• Benefits for heirs after death

People within one year of retirement who want the security of guaranteed income should consider income annuities.

Remember that single premium immediate annuities (SPIAs) begin paying out after one year. This means that, unlike the deferred version, there is no accumulation period.

In this regard, SPIAs are also advantageous for younger people who have inherited large sums of money and wish to protect the inheritance against poor financial management.

Deferred annuities, however, are generally not recommended for short-term financial needs or younger individuals who have more aggressive investment strategies.

Please watch this video for more explanations.

Advantages & Disadvantages

The pros & cons are:

Pros:

1. Tax-Deferred Growth

• Interest is not taxed until a later date, so you save money.

2. No Contribution Limits

• In contrast to 401(k)s and IRAs, you determine your investment amount.

3. Invest in Your Retirement

• Annuitants create a steady income stream for life.

4. Take Care of Your Family

• You can transfer money to your loved ones through death benefit riders.

Cons:

1. Penalties

• They are long-term contracts with penalties for early withdrawals.

2. Inflation

• In certain types of annuities, guaranteed income may not keep up with inflation 

3. Limited Liquidity

• The liquidity is limited, and sometimes there is no liquidity at all.

4. Less control of investment

• Investing in an income annuity will require you to lose control over your investment.

Researched and authored by Michael Rahme | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Annual Percentage Rate (APR)
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• Liquidity Ratio
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