May 12, 2008

What are annuities and how do they work?

One way to provide for you retirement is to buy an annuity. An annuity is a contract which you pay a lump sum in return for future periodic payments. There are many varieties of annuities with different options you can get. Basic definitions of some annuity terms:

Immediate or deferred

An immediate annuity will start paying regular benefits immediately. Its basically opposite to a mortgage in the respect that you pay a lump sum now to get periodic payments over the future. A deferred annuity will pay you out payments at a future time and will let you accumulate funds until then.

Fixed versus variable annuities

A fixed annuity pays a fixed or guaranteed amount over its term. A variable annuity will pay out a variable amount that may or may not have a minimum.

Period versus life

Period annuity will pay a regular sum for a specified period of time such at 5 years, 10 years, 20 years, etc. A Life annuity will pay a regular sum for the lifetime of an individual. With a life annuity the annuity will pay the person the regular sum regardless of how long they live. So a life annuity could pay more or less depending on exactly how long you live. Use of a life annuity avoids the uncertainty in your life span for your retirement planning. To plan for retirement you have to account for how long you expect to live and a life annuity will remove that variable from the planning.

Single life or Survivorship

You can buy an annuity for a single person. The annuity pays for the life of that person only. Or if you are married then it would normally make sense to have your annuity cover the life of both people. An annuity that covers a person and their spouse is called a survivorship annuity. A survivorship annuity will cost more than an annuity on a single individual because it is covering the lives of two individuals either of which may live longer.

Full or partial survivorship

With a survivorship annuity the surviving spouse will be paid benefits. A full survivorship annuity will pay 100% of the payment sum to the survivor. However one person can live for less than two people so it would make sense to plan to pay less than 100% of the value

Pure life annuity versus life-with-period-certain annuity

Normally a life annuity will pay benefits until the death of the annuitant. If the annuitant dies prematurely then the annuity would only pay for a short period. Consider if you are 65 and spend $500k on an annuity and then retire. The annuity is paying you a nice monthly sum until you die. But if you were to pass unexpectedly at age 66 then that annuity would only have paid benefits for 1 year. Your annuity would have paid out very little compared to the amount you bought it for. To account for this possibility and ensure that your annuity pays a minimum amount to your estate in the case of an early death you can buy a period with life certain annuity. A period with life certain annuity will pay for a certain period of time minimum.

Loads / Commissions and fees

Be aware that annuities are typically sold with commissions and can have relatively high fees. This is one reason why annuities might be a poor choice of investments. The commissions (or loads) on annuities can be several percent. Expenses can run you over 2% annually.

Further information about annuities:

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