What Is An Annuity?
- Annuities are financial instruments that provide a stream of guaranteed income, typically for retirees.
- An annuity's accumulation phase is its first stage. Investors fund the product either with a lump-sum payment or regular payments.
- After the annuitization period, the annuitant receives payments for a set period of time or the rest of their lives.
- Investors have flexibility with annuities, as they can be structured in different ways.
- The products are classified as immediate or deferred and can be fixed indexed or fixed.
Annuity: How It Works
Annuities are designed to help people avoid the fear of outliving their money and assets during retirement. Some investors purchase annuities because their assets might not be sufficient to maintain their level of living.
The financial products are available in two forms: immediate and deferred. People of all ages often purchase immediate annuities when they receive a large sum of money in the form of a settlement, lottery winnings, or other lump sum. They want to convert it into future cash flow. Deferred annuities grow on a tax-deferred base and provide the annuitant with a guaranteed income starting at a specified date.
Annuity products fall under the jurisdiction of the Securities and Exchange Commission and the Financial Industry Regulatory Authority. Annuity agents or brokers must hold a life insurance license issued by the state, as well as a securities license if they are selling variable annuities. The commission that these agents or brokers earn is usually based on notional value.
Special Considerations
Annuities have a period of surrender. Annuitants are not allowed to withdraw money during this period, which can last several years. They must pay a surrender fee or charge. If a large event, like a wedding, requires a lot of money, it may be wise to consider whether or not the investor is able to afford annuity payments.
There is also an income rider in contracts that guarantees a fixed income once the annuity kicks-in. Investors should consider two things when evaluating income riders.
- When do they require the income? The payment terms, rates and duration of an annuity may differ.
- What fees are associated with income riders? Some organizations offer income riders for free, but most charge a fee.
Defined Benefit Pensions, and The Social Security both offer lifetime guaranteed annuities. They pay retirees steady cash flows until their death.
Most insurance companies allow their customers to withdraw 10% of the account value, without having to pay a surrender charge. If you withdraw more, you could end up paying a fee, even though the surrender period is already over. Withdrawals made before the age of 59-and-a-half can also have tax implications.
Some annuitants who are in financial difficulty may choose to sell their annuity payment instead. It is the same as borrowing against another income stream. The annuitant gets a lump-sum and gives up some or all of their future payments in exchange.
Annuities are a hedge against risk of longevity. As long as the buyer understands they are exchanging a lump sum of liquid cash for a series of guaranteed cash flows, then the product is suitable. Annuities are not intended to be cashed out at a future profit.
Annuities Types
Immediate Annuities And Deferred Annuities
Annuities can start immediately after a lump-sum deposit, or as deferred payments. immediate annuity pays out immediately after annuitant deposits lump sum.
Deferred Income Annuities, on the contrary, do not begin paying after the initial investment. The client instead specifies the age when they want to start receiving payments from the insurer.
The annuity will recover some or all of the principal in your account depending on which type you select. If you choose a lifetime payout with no refund, the payments will continue until the beneficiary passes away. The recipient of an annuity that is fixed for a certain period of time may be entitled to receive a refund if any principal remains. Or their heirs if the annuitant died.
Deferred Annuity
Deferred annuities are better defined as a group of annuities than a specific type. All annuities are either immediate or deferred. An annuity’s category is determined by when the income payments will begin. The deferred category includes many types of annuities.
The deferred income annuity is divided into two phases. During the accumulation phase, your money is tax-deferred, until you decide to withdraw it in a lump-sum or a series. You choose when you want to withdraw income from your annuity, and pay any taxes due. Deferred annuities give you greater control over taxes.
The longer you defer the payment of income tax, on your compounded earnings, the more you will gain compared to a fully-taxable account such as a certificate of deposit or money market account.
Fixed Annuity
Payment Phase
When you decide to withdraw income from your annuity, the payout phase begins. This is usually during retirement. You can choose to take partial withdrawals or cash out (surrender your annuity) according to your requirements. Or, you can convert your deferred income annuity (annuitization) into a guaranteed stream of payments. This option is similar to buying an immediate income annuity. It will be automatically triggered on the maturity date if you do not take any action in advance.
Maturity Date
Safety
MYGA
Fixed Index Annuities
Fixed index annuities (formerly equity indexed) are a type of deferred annuity which credits interest based upon changes in a market indicator, such as S&P 500, Dow Jones Industrial Average, or the Dow Jones Industrial Average. The index increases in value, and interest is credited. However, the rate of interest is guaranteed to never be lower than zero even if the stock market falls. You will never lose your principal or any interest earned previously.
This short video provides an overview of indexed annuities, and explains how they can be used to avoid market volatility. They also have a positive effect on your retirement savings.
Insurance companies use different formulas depending on how an annuity is designed to determine the correlation between changes in the index and the amount of interest credited to each annuity at the end of the index term. (Most commonly, this is done on an annual basis). The formula usually has two parts: the crediting method, and a limiting element.
Crediting Methods Frequently Used
Annual Point-to Point
Multi-Year point-to-point
Monthly Point-toPoint
Monthly Averaging
Daily Averaging
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Common Limiting Factors
In all fixed index annuity crediting formulas, a limiting factor is used to limit the interest earnings to a fraction of the changes in the index during the index term. You will not get 100% of index gains in exchange for additional guarantees and principal protection.
Cap Rate: A maximum interest rate linked to an index that can be applied to an annuity. The cap rate is a maximum interest rate that the annuity may earn during the index period.
Index-Linked Interest Credits are calculated by calculating the percentage increase of the index linked interest credit based on the underlying index.
Spread rate or margin – A percentage deducted from total calculated changes in the index value underlying the annuity to determine the amount of index linked interest credited.
Indexed Annuities provide growth, income for life, and long-term care funding. We can assist you in achieving your indexed annuity goals. We have access to over 30 companies and can run a customized proposal for you based on what you need.