Annuities are often marketed as part of a smart retirement plan. The biggest selling point is guaranteed income. You pay the insurance company, and in return, they pay you for the rest of your life. You may even be able to retire early. However, there are many details about this financial instrument that you need to understand before you invest a chunk of your retirement savings. Let’s examine how annuities work and why you may want one.….Story continues…
By : Holly Humbert
Source: FinanceBuzz
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In investment, an annuity is a series of payments made at equal intervals. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments, monthly insurance payments and pension payments. Annuities can be classified by the frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other regular interval of time.
Annuities may be calculated by mathematical functions known as “annuity functions”. An annuity which provides for payments for the remainder of a person’s lifetime is a life annuity. An annuity which continues indefinitely is a perpetuity. Payments of an annuity-immediate are made at the end of payment periods, so that interest accrues between the issue of the annuity and the first payment.
Payments of an annuity-due are made at the beginning of payment periods, so a payment is made immediately on issue. Annuities that provide payments that will be paid over a period known in advance are annuities certain or guaranteed annuities. Annuities paid only under certain circumstances are contingent annuities.
A common example is a life annuity, which is paid over the remaining lifetime of the annuitant. Certain and life annuities are guaranteed to be paid for a number of years and then become contingent on the annuitant being alive.
- Fixed annuities – These are annuities with fixed payments. If provided by an insurance company, the company guarantees a fixed return on the initial investment. In the United States, fixed annuities are not regulated by the Securities and Exchange Commission.[citation needed]
- Variable annuities – Registered products that are regulated by the SEC in the United States of America. They allow direct investment into various funds that are specially created for Variable annuities. Typically, the insurance company guarantees a certain death benefit or lifetime withdrawal benefits.
- Equity-indexed annuities – Annuities with payments linked to an index. Typically, the minimum payment will be 0% and the maximum will be predetermined. The performance of an index determines whether the minimum, the maximum or something in between is credited to the customer.
An annuity that begins payments only after a period is a deferred annuity (usually after retirement). An annuity that begins payments as soon as the customer has paid, without a deferral period is an immediate annuity. Valuation of an annuity entails calculation of the present value of the future annuity payments. The valuation of an annuity entails concepts such as time value of money, interest rate, and future value.
If the number of payments is known in advance, the annuity is an annuity certain or guaranteed annuity. Valuation of annuities certain may be calculated using formulas depending on the timing of payments. If the payments are made at the end of the time periods, so that interest is accumulated before the payment, the annuity is called an annuity-immediate, or ordinary annuity.
Mortgage payments are annuity-immediate, interest is earned before being paid. Annuity due refers to a series of equal payments made at the same interval at the beginning of each period. Periods can be monthly, quarterly, semi-annually, annually, or any other defined period. Examples of annuity due payments include rentals, leases, and insurance payments, which are made to cover services provided in the period following the payment.
Valuation of life annuities may be performed by calculating the actuarial present value of the future life contingent payments. Life tables are used to calculate the probability that the annuitant lives to each future payment period. Valuation of life annuities also depends on the timing of payments just as with annuities certain, however life annuities may not be calculated with similar formulas because actuarial present value accounts for the probability of death at each age.
How to calculate the present and future value of annuities
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