An annuity is a financial arrangement to exchange a lump sum with a regular monthly or annual income. The annuity is generally arranged through an investment or insurance company. An annuity can take on a number of forms.
Annuities are a form of passive income resulting from efforts at an earlier time, rather than as payment for work. Annuities may be the result of investing in a retirement annuity, a pension fund or a divorce settlement. A pension or retirement income is generally a type of annuity.
Some business ventures result in the creation of a long term stream of earnings that do not require active participation. Network marketing is often promoted as having the ability to produce an annuity income. Similarly, income produced as a result of royalties can be seen as annuity income even though the amount received may vary from one month to the next.
Retirement funding is often based on an annuity type of model. Funds are accumulated over a number of years, resulting in what is hopefully a substantial lump sum at the date of retirement. The lump sum is paid to the company that quotes the highest annuity rate. In exchange, the company will provide a a fixed income over a period of time.
The first step in the life of an annuity is to purchase an annuity using a substantial sum of money.
The annuity may work in a number of ways. It may be paid for a fixed term or for life. In the case of retirement funds, the annuity is usually paid the remainder of a person’s life. Sometimes there is a guaranteed payment period, so that payment of the annuity will continue for a guaranteed period even if the annuitant dies.
Most retirement type annuities are calculated on the basis of using the capital over the remaining period based on life expectancy. Most annuities are based on depleting the capital over the period of time. Retirement annuities are usually calculated on the basis of life expectancy rates. The risk that some annuitants will live longer than expected is offset by those that die earlier.
The actual income achieved from an annuity may be fixed or variable. A fixed annuity is based on the annuity rate quoted by the insurance when the annuity is purchased. No matter what happens to the economy, the income from a fixed annuity will never change.
A variable annuity can be negotiated based on prevailing interest rates over time. The income from the annuity can increase or decrease over time based on prevailing rates of interest and the performance of various investments.
A fixed annuity may also include guaranteed increases in the amount of income receivable each year. It is still based on the interest rate at the beginning of the period.
The term of an annuity may be fixed – say for five, ten or twenty years. A fixed term annuity is easier for an insurance company to calculate. For instance, a fixed term annuity may be instituted to provide support for a child until his or her twenty-first birthday.
When purchasing an annuity, it may be possible to negotiate an annuity with a return of capital or without. The return of capital may be reducing or may include the entire lump sum. In some cases, it may even be possible to derive an income from the lump sum and to achieve capital growth. However, return of capital is generally achieved at the expense of income. If capital return is not required, the income achievable will be much higher.
Like all insurance products, it is important to know exactly what you are getting when you purchase an annuity. Wherever possible, opt for a return of capital and shop around fro the best rates. The terms that you accept are binding for a very long time.