When you hear the term annuity, you’re often left wondering what is an annuity? The simplest annuity definition is a financial product designed to ensure cash flows at equal intervals of time. Financial institutions can provide annuities as a service that works as a regular income to their clients. Primarily annuities are created by life insurance companies as a long-term insurance product to guarantee income after retirement. However, there are other ways in which an annuity can be used. As an annuity is a financial agreement between the client and the financial institution through which payments are arranged for a set period of time, they can work as retirement income, regular payments for savings accounts, or periodic payments for mortgages or other types of insurance payments.
Looking at what annuity means in general, we can see it as something between insurance and investment. You, as the client, ensure and invest in your future by funding an annuity and fixing a set stream of payments once the annuity is funded. The financial institution sells annuities as financial products to clients who want to ensure that once their traditional incomes stop or fail, they will have this nontraditional way to receive a form of income.
The reason why annuities were created was to secure a steady cash flow for any individual, especially during their retirement, while easing fears of living longer than their assets could afford. Another way to use annuities is to transform large lump sums into a steady cash flow. Benefit pensions and Social Security are the most basic forms of lifetime annuities providing a steady income to retirees.
There are two periods of an annuity’s life. The first one is the funding period. As it can be guessed, during this period, the annuity is funded through lump sums or periodic payments and is known as the Accumulation Phase. The annuity contract can either set an accumulation phase or allow that period to continue until the individual decides to withdraw funds based on their retirement timeline. Also, during the accumulation phase, an annuity can be invested or deposited, depending on the annuity’s type, but more on that later on. The second period is when payments start and is known as the Annuitization Phase. The timeline of the annuity and the date set in the contract can determine when this period begins, or, as stated above, it can start when the first withdrawal occurs.
There are different types of annuities based on several factors and details. When you choose the type of annuity, you have to factor in the kind of deposit you are making, the annuitization phase’s timeline, the beneficiaries, etc. Based on these, we have:
- a variable annuity allows the owner to invest the funds accumulated and receive payments that can either increase or decrease based on their portfolio’s performance.
- through a deferred annuity, the financial institution signs up to either pay a lump sum or generate a regular income from a future date.
- unlike deferred annuities, an immediate annuity guarantees income almost immediately.
- while variable annuities base their payments on a portfolio’s performance, indexed annuities pay an interest rate based on one specific market index performance.
- while they are similar to Individual Retirement Accounts, an individual retirement annuity limits annual contributions and has higher fees.
- this insurance product is designed for couples as regular payments continue to be made as long as one of the joint annuitant lives. It can also be used for a third beneficiary, a child if both spouses die early.
- this type of annuity can be funded from qualified retirement plans or an IRA.
While life insurance deals with the mortality risk, an annuity deals with the longevity risk. To put it simply, purchasing life insurance ensures that your beneficiaries will have the funds necessary to cover mortgage expenses, school tuitions that you would have otherwise covered from a monthly income. However, when you purchase an annuity, you make sure that however long you live, you will have an income after retirement to afford living costs.