An annuity is, simply, a promise to make a series of regular payments over a period of time. The annuity contract spells out the terms of this promise.
There are various types of annuities, but this discussion centers on those used for retirement or income planning. An annuity can be a great way for someone to guarantee an income for himself and prevent himself from blowing his savings too early.
An immediate annuity is created when someone uses a lump sum of cash, such as accumulated retirement savings, to purchase an annuity. The annuity will consist of payments usually made over the life expectancy of the retiree. A deferred annuity occurs when someone makes periodic payments into an annuity; when all of the payments are made, the annuity begins making periodic payments to the annuitant.
Annuities can be fixed, that is, they pay a fixed interest rate over the life of the payments. This is a very safe and conservative option, but deprives the annuitant (that’s the person receiving the payments) the opportunity to reinvest the annuity funds into an investment with a higher rate of return.
A variable annuity does not provide that guaranteed rate of return, but also allows the annuitant more control over the investments underlying the annuity – and therefore a greater chance at earning more money. Generally the annuitant (and probably his investment advisor) will choose an allocation of investments designed to generate the desired return. The annuity may also call for reallocation at periodic intervals, where the annuitant can change the underlying makeup of his investment portfolio. One downside of this more active management of the annuity funds is the fees involved with buying, selling, or reallocation of the investments.
The structure of your annuity depends on the initial investment, interest rate, underlying investments, your life expectancy, and the beneficiary arrangements on your annuity. Obviously, the longer your life expectancy, the smaller the regular payments must be. If your annuity provides for distributions to your heirs in the event of your premature death, this changes your payments too.
Also important is the financial health of the company who issues your annuity, often an insurance or investment company. If this company becomes defunct, your annuity could be at risk, so you should research and be satisfied with the issuing company’s financial stability prior to buying in.
While an annuity can be an excellent retirement planning tool, there are plenty of investing and tax issues you should consider before deciding if one is right for you. significant risks and tax issues associated with them. Shop around, and talk to a competent financial and tax planning professional before you choose an annuity.
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