An Annuity: What Is It?
An insurance contract known as an “annuity” is one that financial institutions sell to pay out invested money as a fixed income stream in the future. Investors buy or invest money in annuities using lump-sum payments or monthly premiums. The holding institution issues a future stream of payments for a certain amount of time or the length of the annuitant’s life. Generally used for retirement planning, annuities assist people in reducing the danger of outliving their assets.
How Annuities Operate
Annuities are made to give people a consistent cash flow during their retirement years and to ease their concerns about outliving their resources. Some investors may resort to an insurance company or other financial institution to acquire an annuity contract since these assets might not be sufficient to maintain their living level.
As a result, these financial instruments are suitable for investors, also known as annuitants, who need a steady, certain retirement income. It is not advised for younger people or those with liquidity demands to utilize this financial instrument due to invested cash’s illiquidity and withdrawal penalties.
An annuity passes through several distinct stages and intervals.
These are known as:
The accumulation phase is the time between when an annuity is funded and when payments start. During this phase, any funds put in the annuity grow on a tax-deferred basis. After payments start, the annuitization period begins.
These financial instruments come in delayed or immediate forms. People of any age who have received a sizable lump amount of money, such as a settlement or lottery win, and who would like to swap it for future cash flows frequently acquire immediate annuities. Deferred annuities are designed to develop tax-deferred while giving annuitants a guaranteed income that starts on a date of their choosing.
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) oversee the regulation of annuity products. Annuity salespeople must possess a securities license (for variable annuities) and a life insurance license from their respective states. These brokers or agents often receive a commission based on the annuity contract’s notional value.
Particular Considerations
Typically, annuities have a surrender term. During this period, which might last several years, annuitants cannot withdraw without incurring a surrender charge or fee. During this moment, investors must take their financial needs into account. Consider if the investor can afford the required annuity payments, for instance, if a major event like a wedding would cost considerable money.
Additionally, contracts feature an income rider that guarantees a set income once the annuity begins to pay out. When thinking about income riders, investors should ask the following two questions:
When do they require the income?
The annuity’s payment terms and interest rates may change during its lifetime. What costs are connected to the income rider? While some organizations provide the income rider without charge, most charge for this service.
Many insurance providers permit beneficiaries to take up to 10% of their account’s value without paying a surrender fee. However, even if the surrender time has already passed, you could have to pay a penalty if you withdraw more than that. There are tax repercussions for withdrawals made before the age of 59 and a half.
Some financially strapped annuitants may choose to sell their annuity payments instead due to the possibly high cost of withdrawals. The annuitant receives a lump in return for giving up the right to some (or all) of their future annuity payments, comparable to borrowing against any other income stream.
Annuities provide longevity risk mitigation since investors cannot outlive their income stream. The product is suitable as long as the buyer knows they are exchanging a liquid lump payment for a series of assured cash flows. Although it is not the product’s intended usage, some buyers aim to sell their annuities for a profit in the future.
Various Annuity Types
The time that annuity payments may be guaranteed to continue is one of many different features and considerations that can be considered while structuring an annuity. As was noted, annuities can be designed to provide payments as long as the annuitant or their spouse (if survivorship benefit is chosen) are still living. As an alternative, annuities may be set up to provide payments for a certain period, such as 20 years, independent of the annuitant’s life expectancy.
Deferred and Immediate Annuities
Upon depositing a lump payment, annuities may start immediately or be set up as delayed benefits. After the annuitant deposits a lump sum, the instant payment annuity starts paying. On the other hand, deferred income annuities do not start paying out after the first deposit. Instead, the customer sets a starting age for receiving payments from the insurance provider.
The annuity may or may not be able to recover any of the principal put in the account, depending on the kind you select. A lifetime payout involves no principal repayment; payments continue until the recipient dies. The beneficiary, or their heirs if the annuitant has passed away, may be entitled to a return of any remaining principle if the annuity is set for a defined amount of time.
Variable and Fixed Annuities
Annuities can typically be fixed or variable structured: Regular recurring payments are made to the annuitant through fixed annuities.
In contrast to fixed annuities, variable annuities allow the owner to receive larger future payments if the annuity fund’s investments perform well and smaller payments if they perform poorly. This allows the annuitant to benefit from the fund’s strong returns while providing less stable cash flow than a fixed annuity.
Although riders and features can be added to annuity contracts, generally at an additional cost, variable annuities can include some market risk and the possibility of losing capital. As a result, they can serve as hybrid fixed-variable annuities. If the portfolio’s value declines, contract owners will still be protected by a guaranteed lifetime minimum withdrawal benefit.
A death benefit or an acceleration of payments in the event of a terminal illness for the annuity holder are two additional riders that can be added to the contract. Another typical rider that will modify the yearly base cash flows for inflation depending on changes in the consumer price index (CPI) is the cost of living rider.
Objections to Annuities
Annuities have been criticized for being illiquid. Deposits made into annuity contracts are normally locked up for a period known as the surrender period, during which the annuitant would be penalized if they touched all or a portion of those funds.
Depending on the specific product, these durations might extend anywhere from two to more than ten years. Over the surrender term, the penalty usually decreases annually and might start at 10% or more.
Life insurance versus annuities
The two main categories of financial entities that sell annuity products are life insurance companies and investment firms. Annuities are a natural hedge for the insurance products of life insurance firms. Life insurance protects against mortality risk or the possibility of passing away too soon. Policyholders pay an annual premium to the insurance company to pay out a lump sum upon their death.
If the policyholder dies prematurely, the insurer pays the death benefit at a net loss to the company. Actuarial science and claims experience allow these insurance companies to price their policies so that, on average, insurance purchasers will live long enough so that the insurer earns a profit. In many cases, the cash value of permanent life insurance policies can be exchanged via a 1035 exchange for an annuity product without any tax implications. On the other hand, annuities deal with longevity risk or the risk of outliving one’s assets. The risk to the annuity issuer is that annuity holders will survive to outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.
Example of an Annuity
A life insurance policy is an example of a fixed annuity in which an individual pays a fixed amount each month for a predetermined period (typically 59.5 years) and receives a fixed income stream during retirement.
An example of an immediate annuity is when an individual pays a single premium, say $200,000, to an insurance company and receives monthly payments, say $5,000, for a fixed period afterward. The payout amount for immediate annuities depends on market conditions and interest rates.
Annuities can be a beneficial part of a retirement plan, but annuities are complex financial vehicles. Because of their complexity, many employers don’t offer them as part of an employee’s retirement portfolio.
However, the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law by President Donald Trump in late December 2019, loosens the rules on how employers can select annuity providers and include annuity options within 401(k) or 403(b) investment plans.
The easement of these rules may trigger more annuity options open to qualified employees shortly.
Who Buys Annuities?
Annuities are appropriate financial products for individuals seeking stable, guaranteed retirement income. Because the lump sum put into the annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or those with liquidity needs to use this financial product. Annuity holders cannot outlive their income stream, which hedges longevity risk.
What Is a Non-Qualified Annuity?
Annuities can be purchased with either pre-tax or after-tax dollars. A non-qualified annuity has been purchased with after-tax dollars. The qualified annuity has been purchased with pre-tax dollars. Qualified plans include 401(k) and 403(b) plans. Only the earnings of a non-qualified annuity are taxed at the time of withdrawal, not the contributions, as they are after-tax money.
What Is an Annuity Fund?
An annuity fund is the investment portfolio in which an annuity holder’s funds are invested. The annuity fund earns returns, which correlate to an annuity holder’s payout. When an individual buys an annuity from an insurance company, they pay a premium. The insurance company invests the premium into an investment vehicle containing stocks, bonds, and other securities, the annuity fund.
What Is the Surrender Period?
The surrender period is the time an investor must wait before withdrawing funds from an annuity without facing a penalty. Withdrawals made before the end of the surrender period can result in a surrender charge, essentially a deferred sales fee. This period generally spans several years. Investors can incur a significant penalty if they withdraw the invested amount before the surrender period ends.
What Are Common Types of Annuities?
Annuities are generally structured as either fixed or variable instruments. Fixed annuities provide regular periodic payments to the annuitant and are often used in retirement planning. Variable annuities allow the owner to receive larger future payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns from their fund’s investments.
Conclusion
- Financial products called annuities provide a guaranteed income stream, often to retirees.
- An annuity’s accumulation phase is its first stage when investors finance the product with either a lump sum payment or recurring payments.
- After the annuitization period, the annuitant starts receiving payments for a predetermined time or the remainder of their life.
- Investors have flexibility since annuities may be formed into many types of securities. These goods can be divided into immediate and deferred annuities and have fixed or variable structures.
