Annuity Definition - What is an Annuity?
An insurance contract, issued and backed, by a life insurance company that is used to pay you a guaranteed stream of income in exchange for a one or more payments you make to the insurance company.
Chances are you have heard this term, especially in the context of retirement planning. Maybe you attended a "free" seminar on retirement planning where an annuity was pitched as the solution for your retirement. Maybe you heard your parents or grandparents talking about the annuity they just purchased. Perhaps you already have an annuity, or are considering purchasing one.
There are many types of Annuities including; Variable Annuities, Equity Indexed Annuities, Fixed Deferred Annuities, Income Annuities, Period Certain Annuities, etc.. For the purpose of this explanation we are going to dive deeper into what an income annuity is simply because all the other annuities usually contain a provision that will allow you to convert them to an income annuity. The other annuities are all designed with accumulation as the primary objective, to grow your money.
Regardless of the circumstances, it is important to know what an annuity is, and what it does.
Let's use an example to clearly illustrate what an annuity is, how it works, and the common terms you will see when considering purchasing an annuity.
Imagine you and your spouse are retiring within the next 5 years and think you may need an annuity. You ask your financial adviser:
"What is an annuity?"
They tell you that in exchange for giving an insurance company a lump sum (although it can be done with multiple payments) they will pay you a guaranteed income for the rest of your life. In other words, you are transferring your longevity risk (how long you may live) to the insurance company in exchange for guaranteed income.
"How does the annuity work?"
In exchange for taking this risk they require you to give them a certain amount of money. In doing so they will pay guaranteed income to you. They can do this since they are very good at knowing how long people are statistically going to live, pooling that risk, and investing your money in a variety of safe and secure investments that generate enough return to fulfill their income promise to you while still being able to make a profit on that money for the insurance company. Insurance companies are experts at this since they have been managing risk much longer than any of us.
The income you receive is comprised of three components:
Return of principal
The return of principal is just that, a portion of each income payment is a return of your original premium. The interest rate is a crediting rate the insurance company will pay on your money, typically locked in at the time you purchase the annuity. The mortality credit is based upon how many people, who also purchased annuities, the insurance company expects will die before you do.
So what is a mortality credit? Imagine you and three friends get together once a year to play poker. At one of these gatherings you suggest that the four of you each put $100 in a shoebox, hide it under the bed, and then whomever is alive a year from now gets to split it. A year passes. One of your friends has passed away. While playing poker you all remember the shoebox, pull it out, dust it off, and open it to see the $400. You agree to split it, each getting $133.33. You just made over 33% on your money, but all it did was collect dust for the last year. This is a mortality credit.
You and your financial adviser have projected your total retirement expenses to be $6,000 a month to maintain your lifestyle. Your guaranteed retirement income is projected to be $4,000 a month, $3,500 a month from Social Security, and $500 a month from an old pension. You are still short $2,000 a month of guaranteed income to meet your retirement expenses. Most people feel best making the transition to retirement knowing they can guarantee all or almost all of their retirement income needs. An annuity could be used to fill this income gap. It is a guaranteed stream of income payments for the rest of your life. With the income gap filled, you now know there is a very high likelihood you will be able to maintain your lifestyle indefinitely in retirement, being able to focus on the things you want to do while not having to worry about your income running out. The annuity provides peace of mind.
Common terms of an annuity:
The person or persons who's life expectancy is used to determine the income amount based upon the amount deposited
This is typically the same person as the owner but not always
Sometimes a second person is added to an annuity contract (like when a married couple buys an annuity), can be done for a variety of reasons
The person buying the annuity. They control how the annuity is first set up, who the beneficiaries are, and who is to receive the income
The insurance company (typically), institution or person paying the income to a payee
The person, or sometimes institution, that receives the annuity income from the payer
The person, persons, or institution that would receive any remaining benefits if the Annuitant where to die prematurely
Although I hope this information has given you a better understanding of what an annuity is and how they work, keep in mind that there are almost as many types of annuities as there are grains of sand on a beach. An annuity, if used correctly, can be a very powerful tool for retirement income and a key component of your financial plan. They are definitely not a one size fits all product and should be customized to fit your specific needs, if indeed you need one at all.
Already have an annuity or are you considering purchasing one?
Unfortunately there are many misconceptions about annuities, they have been known to be misrepresented or simply misunderstood by the very people selling them. Given the complexity of annuities and their many nuances, we provide a free, no obligation, objective analysis to help you learn more about what you have or are considering buying.