The Basics of Annuities

An annuity is a contract with insurers to convert a single contribution or series of contributions to a lifetime income upon maturity. No other financial vehicle offers a guaranteed lifetime income. Annuities are retirement vehicles that are designed to reduce longevity risk. Insurers provide several different types of annuities that are designed to satisfy different needs for savings, investing or retirement. There are even hybrid annuities that combine different annuity-types into single plans.

Fixed annuities versus variable annuities

Fixed annuities operate on the basis of declared interest rates and have minimum guaranteed interest rates. Declared interest rates imply that the rate is set yearly. While, it is stable, it is incorrect to suggest that declared interest rates never change. Variable annuities may or may not include minimum guarantees. Expenses and charges are included in some variable annuities, since they are managed like mutual funds. Often, variable annuities use high-risk capital appreciation vehicles like open-end mutual funds and common stock. Fixed-annuity investments tend to be in securities and bonds.

Immediate versus deferred annuities

An immediate annuity takes a single premium and converts it to a lifetime payment based on its annuity rates. A deferred annuity operates in a more conventional manner. Deferred annuities receive payments during the accumulation phase and issue payments after maturity. Immediate annuities skip the accumulation phase and convert a lumpsum into guaranteed payments. The tax structure between the two types is also different. Immediate annuities are tax exempt during the payout phase. The tax exemption on contributions with deferred annuities occurs during the accumulation phase. Annuity income from deferred annuities is taxed after annuitization.

Unregistered versus registered annuities

Unregistered annuities do not offer tax breaks on contributions. They can be regarded as long-term fixed deposits or savings plans. The rates of return or interest rates on unregistered annuities are generally greater than money market funds. They also do not bear severe surrender charges upon surrender. Registered annuities are registered with the tax authorities and are the ones most people are familiar with.

In order to better understand annuities, it is important to know about annuity rates. These are the set rates that insurers use to determine the amount of a payout, in conjunction with the cash value at maturity. The rates differ among insurers and between sexes. Men have higher annuity rates than women due to the difference in life expectancy.

An annuity matrix can be constructed to determine the types of plans that exist. There can be fixed immediate annuities or variable deferred annuities. Insurers sometimes offer a combination of fixed and variable deferred annuities on one plan. This adds to the flexibility of this product. Some annuities have clauses that require regular payment while others operate as flexible premium annuities.

There are several pros and cons of annuities. The merits of annuities are:

1)Tax shelter

2)No will probate- transfer of funds to beneficiaries are facilitated 3

)Protection from creditors

4)Guaranteed lifetime income

5)Generally high returns with lower risk than other financial instruments

The demerits include:

1) Liquidity risk- Money invested typically must remain for the long term

2) Deferred tax- although tax breaks are enjoyed, retirement income may be taxed

3) Returns are based on the strength of a company’s investments and the insurer’s policy.

4) Inflation risk- if the return is not much higher than the increase in the cost of living, the real rate of return from the annuity would be significantly lower.

5) Purchasing power risk- The annuity provides a fixed income payment that would continually decline in value during retirement.

It is always important to have at least a minimum understanding of financial products before you make decisions about whether to use them. Given that annuties are long term and involve locking your funds away for substantial periods, it is wise to be informed. Understanding the types of annuities available, their purpose and consequences, would lead you to make informed decisions about them.