Annuity

3 key takeaways

• An annuity provides regular payments, often used as a reliable income stream during retirement.
• Annuities can be immediate or deferred and can be fixed, variable, or indexed.
• They help individuals manage longevity risk by ensuring they do not outlive their savings.

What is an annuity?

An annuity is a contract between an individual and an insurance company in which the individual makes a lump-sum payment or a series of payments in exchange for regular disbursements, beginning either immediately or at some point in the future. The primary purpose of an annuity is to provide a steady income stream, often for retirees, to ensure they have sufficient income during their retirement years.

Types of annuities

Immediate annuities: These begin payments almost immediately after a lump-sum investment is made. They are typically used by retirees who need a steady income right away.

Deferred annuities: These allow investments to grow over time before payouts begin at a later date, such as at retirement. Deferred annuities can be funded with either a lump sum or a series of payments.

Fixed annuities: Provide regular, guaranteed payments and a fixed interest rate. They offer predictable income and are considered low-risk.

Variable annuities: Payments vary based on the performance of underlying investments chosen by the annuitant, such as mutual funds. They offer potential for higher returns but come with greater risk.

Indexed annuities: Returns are linked to a specific financial index, such as the S&P 500. They offer a middle ground between fixed and variable annuities, with potential for higher returns while providing some level of protection against market downturns.

Importance of annuities

Annuities are important for retirement planning as they provide a guaranteed income stream, helping individuals manage their finances more predictably during retirement. They can be particularly useful for managing longevity risk—the risk of outliving one’s savings. By providing regular payments for life or a set period, annuities ensure that retirees have a stable income regardless of market conditions.

How annuities work

Purchase: An individual purchases an annuity from an insurance company, either with a lump sum or through a series of payments.

Accumulation phase: For deferred annuities, the money invested grows tax-deferred during the accumulation phase until the annuity payments begin.

Payout phase: When the payout phase begins, the insurance company makes regular payments to the annuitant based on the terms of the contract. Payments can be monthly, quarterly, or annually and can continue for a specified period or for the lifetime of the annuitant.

Examples of annuities

• Retirement income: A retiree invests in a fixed annuity with a lump sum of $200,000. The annuity pays out $1,000 monthly for the rest of the retiree’s life, providing a predictable income stream.
• Education funding: Parents invest in a deferred annuity when their child is young. The annuity grows tax-deferred, and when the child reaches college age, it provides regular payments to cover tuition expenses.
• Business exit strategy: A business owner sells their business and invests the proceeds in an immediate annuity to generate a steady income during retirement.

Real-world application

Consider an individual nearing retirement who wants to ensure a stable income. They purchase a deferred fixed annuity with a $100,000 lump sum. The annuity guarantees to pay them $500 per month starting at age 65 for the rest of their life. This arrangement provides peace of mind, knowing they have a reliable income stream in addition to other retirement savings.

Understanding annuities is crucial for effective retirement planning and financial management. They offer a way to convert savings into a steady income stream, helping individuals maintain their standard of living in retirement.

Related topics you might want to learn about include retirement planning, investment strategies, and risk management. These areas provide further insights into how annuities can fit into a comprehensive financial plan.