Annuities can be an important part of any financial planning strategy. Many people are familiar with the concept of life insurance, which protects an individual’s loved ones in the event of death, and to pay the upkeep or taxes on one’s estate. Annuities were designed to protect against the opposite: living beyond one’s working years.
Annuities trace their history to ancient Rome. The name “annuity” is based ont the word “annual.” Specifically it referred to contracts wherein Roman citizens would contribute payments, in return for lifetime payments once a year. Today the frequency of payments of annuities is generally very flexible, but most pay monthly.
The most basic form of annuity is an immediate annuity. An immediate annuity is purchased in full and immediately begins making payments. Some immediate annuities may offer interest to help preserve the value of the annuity against inflation by investing in relatively save liquid investments like commercial paper or government guaranteed bonds.
A common use for immediate annuities is to ensure that a beneficiary does not spend the funds immediately, but rather uses it over time. For instance, if one has a large life insurance policy it is possible to stipulate in the policy that the proceeds from the death benefit be placed in an annuity so that one’s survivor has monthly income. Lottery winners also sometimes opt for annuities both to ensure the longevity of winning proceeds, as well as for tax planning reasons.
The other type of annuity is a deferred annuity. Deferred annuities can be purchased either with one payment, or several payments spread over a period of time. In either case, the annuity contract stipulates the date when the annuity will mature. Once the annuity has matured the issuer begins making payments. Once payments have started there is usually no way to contribute further to the annuity, however there may be terms in an annuity contract that provide for interest to help maintain or increase the payout amounts.
Deferred annuities form most retirement plans. They allow for individuals to regularly contribute funds over their working career and to use these to fund their living expenses during retirement. These annuities can seek either to preserve the capital one saves, such as fixed annuities which offer very conservative guaranteed annuity rates, or to increase one’s contributions to compensate for inflation.
Fixed annuities provide a nominal fixed interest rate, and typically guarantee the return of contributions once the annuity contract annuitizes as well as a specific rate of return. These annuities invest in conservative investments like commercial paper, or government secured bonds.
Another type of annuity is a variable annuity. There are several different types of variable annuities but the concept is basically the same. Participants in such annuities contribute money and it is placed in an investment account. In some cases a portion of the investment may be placed in a safe account, with only some of the money being invested, so as to guarantee at least a minimum amount of funds to pay ones the annuity matures. Variable annuities can result in higher rates of return than do fixed annuities, which invest in secure, low-risk investments.
While there are many laws governing variable annuities, it is still important that the investor properly understand what is guaranteed in a variable annuity. Typically variable annuities will guarantee a certain minimum rate of growth on premium. The rest is invested in a separate account that is managed by a professional who selects various types of investments for the portfolio of the annuity. These investments can take many forms but frequently include a variety of stocks, bonds, commercial paper, and other investments.
Financial Planning With Annuities
There are many reasons to choose both fixed and variable annuities. On the one hand one certainly wants to ensure that any contributions made to one’s retirement be protected from market downturns.With variable annuities one can take advantage of potential stock makret gains.
Additionally, when planning for the long-term implications of an annuity one should consider the tax advantages and disadvantages of specific annuity products, and consider the tax implications both at the time one expects to retire, as well as the ability for the annuity to provide income if one lives longer than average during.
The Annuity Formula is used to help with financial planning but is somewhat obscure even with financial professionals. The formula is as follows:
FV=PMT(1+i)((1+i)^N – 1)/i
The Following provide Further Information on Annuity Terms
Written by Phil Danforth