Annuities Explained

You need annuity advice because for some reason the word "annuity" sounds very forbidding. But in fact, the concept is pretty simple. To prove this to you, consider the word "life insurance" and "pension". Much easier to understand? Well, it turns out that annuities, life insurance and pensions are all different facets of the same thing.

To put bluntly, before going into any details, an annuity is defined as a contract where a company agrees to pay a person a regular income for some length of time, if that person deposits some money into an account at the company initially. Not so hard, was it? In fact, it should be very familiar to you: it's just like a savings account, or a certificate of deposit, or any financial instrument in which one party agrees to deposit money in exchange for small recurring interest payments.

Life insurance is a financial contract in which the insured person exchanges a monthly payment for receiving a benefit in the event of sudden loss of life. A pension is a private company or government financial contract in which the worker pays regularly into a fund, which at the terminal point of a career (retirement) starts paying back to the worker. Both of these contracts involve regular payments that result in a return payment, either one time (life insurance) or periodically (a pension). Take a look at our section on the mathematics where we introduce you to formulas like the one below for calculating present value for any given income stream.

An annuity is almost like a pension. In fact, a deferred annuity is structured exactly like a pension. There are two phases In a deferred annuity just like the pension: a savings phase and an income phase. During the savings phase, you make a series of payments over several years into a fund. After this is the income phase during which regular payments from the fund are made out to you. The idea is akin to saving for retirement. A company (usually an insurance company) manages the fund.

But why would anyone go through the trouble of setting up an annuity rather than saving his or her money simply in the bank? There are three main advantages. The first is legislative: annuities are financial products that have tax deferral properties. Income that is placed into the fund is tax deductible, and only taxed during the dispersement phase. The second advantage is interest: annuities accrue interest so that the payout at the end is more than what you put into the fund. The third is the benefit of a guaranteed payout at a certain interest rate. Think of an IRA invested in mutual funds or a 401K invested in the stock market. The latter retirement vehicles fluctuate strongly depending on the state of the stock market. On the other hand, an annuity is a contract between you and an insurance company. The insurance company has gone through the trouble of calculating how to transform your savings into a regular, interest-bearing, stable income stream.

Actually, there is a type of annuity that is not so regular and stable and that is a variable annuity. The variability comes from the fact that the funds have been invested in securities which fluctuate in value, such as federal and municipal bonds, stocks, and mutual funds. The reason for investing in such securities is to take advantage of the general trend that stocks have shown an upward trend for many decades. The payoff is, occasionally, higher returns. Unfortunately, there is still the risk that stocks fall, meaning that the payout of a variable annuity will be reduced when there is capital loss. Capital loss is simply the reduction in value of your main funds due to the falling stock market. There you have it, annuities explained! Do you need more annuity advice?

There are several professionals who deal with personal finance and are in a position to give you annuity advice. Seek out a certified financial planner to ensure you are speaking to someone who is up-to-date and competent. To reduce conflicts of interest, look for one who is fee-only so that you are not competing against a hidden interest by the advisor in peddling products off which he or she gets incentives and bonuses. Finally, a good financial lawyer or an accountant has knowledge about these matters.