Annuity Essentials: Understanding Financial Stability

An annuity is a financial product that requires a periodic or a lumpsum investment which then offers pay-outs in the future in the form of a regular cash flow. Annuities are usually for those who want a steady flow of income after retirement. Annuities can be structured to suit the needs of the investor, making them very flexible investment options. 

An annuity is a financial term that is usually associated with insurance contracts that offer payments at regular intervals as income for the contract holders. Let’s look at what the term means and how it works in detail. 

What is an annuity? 

An annuity in the financial world is used in connection with insurance contracts that are issued by financial institutions. Typically, investors buy the annuities by paying a lump sum amount or premiums every month. In return, the financial institution that issued the insurance contract will give the investors pay-outs from the funds invested. This acts as a stream of periodic income for the investors for the rest of their lives. Investors usually look to invest money in annuities as a way of protecting their retirement income. 

How does an annuity work? 

An annuity helps retirees have a steady flow of income. Investors who buy insurance contracts like these are annuitants. Most people are afraid that they will live longer than their assets can sustain them. To prevent this from happening, they buy annuities from an insurance company or a financial organization that offers this product. 

An annuity typically goes through two phases. These are: 

• The accumulation phase – This is the frame of time when you make the payments to invest in the annuity. There are no pay-outs during this period. The money you invest grows tax-deferred. 
• The annuitization phase – This is the period when your pay-outs start. 

Investing in annuities is usually for older folks and not for young people since the amount invested cannot be withdrawn without incurring penalties. Since young people are more in need of liquid funds, it is better to start investing in annuities when you start getting closer to retirement. 

The Financial Industry Regulatory Authority and Securities and Exchange Commission oversee the regulatory aspects of annuities investments. Entities that sell these financial products need to life insurance licenses issued by the state and a securities license as well if the annuities are variable. 

Types of annuities – How to invest 

Investing in an annuity depends on the type of annuity you choose. Annuities can be created as needed based on a number of factors including the period of time for which the pay-outs have to continue or if the spouse of the investor gets to enjoy the benefits if the spouse passes away before the pay-out period is over. 

Deferred and immediate annuity 

There are two ways you can invest in an annuity – either deferred or immediate. Deferred annuities give the investors a guaranteed stream of regular income from the date of maturity. Till this date, the contributions grow on a tax-deferred basis. Anyone who wants to invest a large sum of money in immediate annuities can go for them. This is typically for people who win the lottery or inherit money or receive money through a settlement. 

Fixed and variable annuities 

In a fixed annuity, the annuitant will get regular income from their investment periodically. The cash flow is steady and assured. 

In a variable annuity, the annuitant will get a varying amount every time based on how well the investments perform in the market. If the investment does well, the investor will get higher income and if it does poorly, the income will be less. The advantage of this annuity type is that the investor stands to gain more income in the future if the investment does well. But the cash flows can be unsure and unsteady. 

Annuity riders for added protection 

The variable type of annuity has some inherent risks since it depends on the investments’ performance in the market to generate regular income. Investors may lose principal as well. In order to prevent this from happening, you can add a few features and riders. This may cost you a little more but it’s worth it if you are able to reduce your risk. 

By adding certain riders to your contract, your variable annuity essentially becomes a hybrid fixed-variable one. Through such an annuity, you can have the advantage of getting higher incomes when the investments do well and also have a minimum guaranteed pay-out even if the investments don’t perform well.

You can have other riders added to your contract as well. These can include a death benefit or even accelerating the pay-outs in case you get diagnosed as being terminally ill. You can also add a rider to cover the costs of living. This way, your basic cash flows will be adjusted to compensate for increased costs due to inflation. 

Difference between life insurance and annuity

The biggest difference between life insurance and annuities is the reason for which people invest in them. Life insurance companies and companies that offer investment services both offer annuity products. 

Life insurance protects the investor’s family in the event they die prematurely. If the person who holds the life insurance policy dies prematurely, the insurer pays the assured amount to the family. So, life insurance deals with death risks. 

An annuity, on the other hand, covers longevity risk. That is if the investor outlives their assets. It covers the costs of living and more till the death of the annuitant. 

FAQ on annuities