An annuity can be best defined as a financial product which is exclusively designed and offered by insurance companies to help individuals grow funds. In other words, it is developed to offer or pay out individuals a stream of steady cash payments over time. It provides individuals a reliable channel of securing a stable cash flow, especially when they retire. It serves as a source of income in later years. Simply stated, an annuity is a contract between an individual and the insurance company.
Annuity – How it Works?
The working mechanics of an annuity are simple and very easy to understand. For example, if you buy an annuity from an insurance company, you will either agree to pay it a lump sum of money up front or make deposits on a monthly basis as agreed.
The insurance company, on the other hand, agrees to pay you the invested money in the form of distributions, starting out on a particular date and continues to make payments for a fixed period or until you or your spouse dies.
Here, it is important to understand that the money you pay to the insurance company is invested by them, which allows the company to grow that money until the distributions are scheduled. Some good examples of life time guaranteed annuities can be social security and pensions. They offer retirees a steady stream of cash as long as they are alive.
Annuities – Fixed or Variable
Annuities can easily be structured as both fixed and variable. As the name suggests, fixed annuities pay out regular payments, as scheduled to the annuitant. However, variable annuities offer the annuitant bigger payments if the investments from the annuity fund perform well and smaller payments if they do poorly. And for this reason, many individuals opt for fixed annuities as these are less risky and offer steady cash flows.
As an annuitant, you should know that annuities are illiquid. This means they cannot be converted into cash in less than a year. Deposits that you make under the annuity contract will be locked-up for a certain time period (the surrender period). This period may last for 2 years and sometimes, even 10 years.
Further Reading
- Financial education and annuities – www.oecd-ilibrary.org [PDF]
- The fair value of guaranteed annuity options – www.tandfonline.com [PDF]
- Asset allocation and annuity‐purchase strategies to minimize the probability of financial ruin – onlinelibrary.wiley.com [PDF]
- Who chooses annuities? An experimental investigation of the role of gender, framing, and defaults – pubs.aeaweb.org [PDF]
- Annuities and individual welfare – www.aeaweb.org [PDF]
- Annuities, financial literacy and information overload – books.google.com [PDF]
