What Are Annuities?
An annuity is a contract in which an insurance company agrees to pay out a guaranteed sum of money to an investor, called the annuitant, for a specified period. The investor hands over a sum of money, either in a lump sum or over a period of time, to the insurance company, which agrees to make payments, usually monthly or quarterly, to the investor.
Payout periods can range from a certain number of years, for example 10, or over the course of the person's entire lifetime, no matter how long they live. The amount the person receives depends on the length of the payout period, the insurance company's rate of return, and how many people are covered by the annuity contract—either one person or the investor and their spouse. Annuities are popular investments for retirement as they provide an income stream after the person has stopped working.
Annuities usually include a death benefit to the investor's beneficiaries, although the amount of the benefit can depend on how much, if any, of the annuity has already been paid out. If there are no beneficiaries and the person dies before the annuity has fully paid out, the insurance company keeps the difference, which is one of the drawbacks of an annuity. However, there are many different types of annuities that can mitigate the risk of premature death, but that often can reduce the payout.
Company pension plans and Social Security are the most common equivalents of an annuity. The worker receives monthly payments, usually until they die, which is when the payments stop. By contrast, annuities are offered by insurance companies, so the financial strength of the insurer is a key consideration in choosing an annuity provider. However, as noted, annuities can cover more than one person, plus they often pay a death benefit.
Types Of Annuities
There are several types of annuities.
1. Immediate Annuity
The most common, and the simplest to understand, is the immediate annuity. The investor gives the insurance company a lump sum, say US$100,000. Within a month or so, or almost immediately, the insurance company begins making payments to the annuitant according to a fixed, agreed upon schedule, usually once a month.
The shorter the payout period, the more money the investor will receive each month. For example, an annuity that pays out over 10 years will pay more per month than a 20-year annuity, although the 20-year annuity will pay out more over the life of the contract. Likewise, if the contract covers the annuitant until they die, the monthly payment will be less. Similarly, if the annuity covers both spouses, no matter how long each lives, the monthly payout will also be reduced.
2. Deferred Annuity
Deferred annuities are similar to immediate annuities except that the payout period doesn't begin at once but at some point in the future, as the name implies. For example, a deferred annuity may not start to pay out until 10 years or so after the annuitant first deposits the money. That gives the funds in the annuity time to grow. A deferred annuity may be a good investment for someone who is planning to retire in 10 years. Investors in deferred annuities often have the option of making an initial lump sum payment or making additional payments over time.
3. Fixed Annuity
As the name implies, a fixed annuity pays a fixed amount of money to the annuitant every month, guaranteed by the insurance company, according to a predetermined schedule. As noted above, the amount of the payment doesn't change but is based on the length of the payout period and the number of people covered by the contract. If it's a lifetime annuity covering the lives of two people, the monthly payment will be a lot smaller than if it's covering only one person for a fixed number of years.
4. Indexed Annuity
In contrast to a fixed annuity, which is based on the insurance company's rate of return, the returns—and payments—on an indexed annuity are tied to the returns on an index, such as the S&P 500. As a result, the payments on an indexed annuity can fluctuate depending on the performance of the underlying index. That could work in favour—or against—the annuitant and is therefore more risky.
Moreover, the annuitant may not receive the full amount as the index's return may imply. For example, the insurance company may deliver only a certain percentage, say 80%, of the index's return to the annuitant, or cap the return at a certain level, holding the rest to compensate it for the risk it's taking.
5. Variable Annuity
In contrast to a fixed annuity, in which the insurance company invests the money and guarantees the payment, in a variable annuity the annuitant decides how their funds will be invested and therefore the kind of return they may receive. Needless to say, this is a much riskier proposition than a fixed annuity, although it's possible that the returns can also be greater, as with an indexed annuity. Investors in variable annuities choose their investments from a menu of choices offered by the insurance company, such as stock and bond mutual funds and the like.
Advantages And Disadvantages Of Annuities
Annuities are a potential source of guaranteed retirement income. But they also come with some major drawbacks. So it's best to speak to a retirement expert or financial consultant you trust to see if annuities should be something that can benefit you.
Other than Social Security and corporate pension plans, which are becoming rarer in today's world, annuities are about the only vehicle that promises to provide guaranteed income in retirement. That can provide plenty of sleep insurance once your work paychecks stop.
However, annuity contracts are only as good as the insurance company behind them. As a result, it's best to find an annuity provider with a strong record of paying claims.
Annuities in today's market also tend to have relatively low returns compared to stocks and other investments, largely due to the historically low interest rate environment. Then again, depending on what type of annuity you get, your payments are guaranteed, possibly for as long as you live.
Like many government-sanctioned retirement accounts, money invested in annuities is tax-deferred. You don't pay income tax on the money until you start receiving payments.
Many people don't like the fact that the insurance company "wins" if you die early and then collects whatever is left in your annuity. However, not all annuities are structured that way and do pay the remainder to your beneficiaries, although sometimes that reduces the monthly payment.
As noted, annuities are a contract between you and an insurance company. If you change your mind later on or need the money immediately, breaking the contract can sometimes be difficult and expensive to do.
Some annuities, particularly the more complicated ones that promise above-market returns, also charge high fees.
Many annuities can be complicated, which is another disadvantage. That's why it's best to consult an expert you can trust.
Annuities are contracts with insurance companies that guarantee regular payments to account holders over the life of the contract, often as long as the person lives. As a result, annuities can be appropriate investments for people looking to maintain a regular income once they retire.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…