An annuity is a contract between an insurer or annuity provider and the policy-owner, whereby the insurer promises to issue periodic payments- after a specified date- in return for a single premium or a series of premiums.
An annuity can be a flexible financial instrument that is used primarily as a retirement savings vehicle. Sometimes it is utilised as a tax-deferred savings plan or as an income option in a diversified portfolio.
Types of annuities
The question “What is an annuity?” can be answered by referencing the types of annuities available. A basic annuity matrix can be developed to represent the types. Annuities can be fixed or variable and immediate or deferred. In the annuity matrix, you can have a fixed immediate annuity or a deferred variable annuity. Also, annuities can either exist as unqualified plans or qualified plans (referring to their registration with the relevant tax authority).
Annuities are the only type of financial instrument that promise to make fully-guaranteed or partially-guaranteed payments to a policy-owner. The payments are determined by various factors, namely:
a) Size of the single premium or accumulated premiums
b) The existence and length of the accumulation period
c) Accumulation rate
d) Age and gender of the annuitant at maturity date
e) The settlement options selected
Parties to an annuity contract
An annuity contract involves the insurer or annuity provider, the contract owner (policy owner), the annuitant (who may or may not be the policy owner) and beneficiaries (if not the estate).
Upon maturity, the policy owner must choose among settlement options. The settlement option chosen will directly impact the size of the annuity payout. The straight life option yields the highest payout because it frees the insurer of any liability towards beneficiaries upon the death of the annuitant. The ‘period certain’ option is an addition to the ‘straight life option’ whereby the insurer will have an obligation to a designated beneficiary if the annuitant dies within the guaranteed period or ‘period certain’.
Annuities are often referred to as the opposite of life insurance. This is because of the different structure and function of the two products. Life insurance is concerned with creating and maintaining an estate. An annuity is designed to create and liquidate the estate, through a single payment or series of payments to the annuity contract owner.
Annuities are viewed as retirement plans because their role is to prevent the risk of outliving your life savings- also a goal of retirement planning. The major merits of an annuity are protection from longevity risk and creditors. Therefore, security is the main benefit provided by an annuity.
Annuities normally provide higher interest rates than can be obtained on the market. However, they are more conservative than growth options in a diversified portfolio. Variable annuities- which resemble mutual funds- are the most risky type of annuities that can offer the worst of both worlds (low security and underperforming funds).
Annuities bear an ample number of merits and demerits. Most annuities offer stability as opposed to growth. That is a double-edged sword, for while security is a benefit, it suggests lower returns and less protection against inflation risk. Some other disadvantages include loss of ownership of your premiums, high charges and penalties for withdrawal. Purchase of an annuity should only be made after careful consideration of its purpose and utility where your financial plan is concerned.