What is an Annuity?
An annuity is a contractual financial product sold by financial institutions that is designed to accept and grow funds from you and then, at a time of your choosing, pay out a stream of payments at a later point in time.
The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase.
Annuities were designed to secure a steady cash flow for you during your retirement years and to alleviate fears of longevity risk or outliving one’s assets.
Annuities can also be created to turn a substantial lump sum into a steady cash flow, which could happen if you won a large cash settlements from a lawsuit or won the lottery.
Defined benefit pensions and Social Security are two examples of lifetime guaranteed annuities that pay retirees a steady cash flow until they pass.
Annuity structure options vary. Depending on a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue the contracts can be designed so that — when annuitized – your payments will continue as long as either you or your spouse (if survivorship is elected) is alive. Alternatively, annuities can be structured to pay out funds to you for a fixed amount of time regardless of how long you live. Furthermore, annuities can begin immediately upon deposit of a lump sum or they can be structured as deferred benefits.
Annuities are most often broken down into two types — either fixed or variable. Fixed annuities provide regular periodic payments to the annuitant. Variable annuities allow you to receive greater future cash flows if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund’s investments.
Annuities provide guarantees but are illiquid. Similar to a CD, deposits into annuity contracts are typically locked up for a period of time, known as the surrender period, where the annuitant would incur a penalty if all or part of that money were touched. These surrender periods can last anywhere from 2 to more than 10 years depending on the particular product. Surrender fees can start out at 10% or more and the penalty typically declines annually over the surrender period.
Variable annuities can carry market risk. While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts (usually for some extra cost) which allow them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value. Other riders may be purchased to add a death benefit to the contract or accelerate payouts if the annuity holder is diagnosed with a terminal illness. Cost of living riders are common to adjust the annual base cash flows for inflation based on changes in the CPI.
Life insurance companies and investment companies are the two sorts of financial institutions offering annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk – that is, the risk of dying prematurely. Policyholders pay an annual premium to the insurance company who will pay out a lump sum upon their death. If policyholders die prematurely, the insurer will pay out the death benefit at a net loss to the company. Actuarial science and claims experience allows these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit. Annuities, on the other hand, deal with longevity risk, or the risk of outliving one’s assets. The risk to the issuer of the annuity is that annuity holders will live outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.
Annuities require a long term commitment. Because the lump sum put into the annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs. Annuity holders cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that he or she is trading a liquid lump sum for a guaranteed series of cash flows, the product is appropriate. Some purchasers hope to cash out an annuity in the future at a profit, however this is not the intended use of the product.
Immediate annuities are often purchased by people of any age who have received a large lump sum of money and who prefer to exchange it for cash flows in to the future. The lottery winner’s curse is the fact that many lottery winners who take the lump sum windfall often spend all of that money in a relatively short period of time.
Annuities are complex investments with multiple moving parts. As such, they are a prime example of an insurance product where utilizing an agent will ensure that the investor fully understands both upside and downside of the transaction and the agent can make certain the investor uses the right product for their situation.