A beginner’s guide to annuity! Considering investing in an annuity? Here is what you need to know

Beginner's Guide to Annuities

What is an annuity?

An annuity is a financial product offered by insurance companies or other financial institutions in the form of a contract between the annuitant and the financial institution. In an annuity contract, the investor makes either a lump-sum payment or instalments to receive a regular income stream after a certain period of time. Annuities are predominantly used for retirement purposes and help the investors support their living when they don’t have any income from their regular job or business. The holding institution can either start paying the annuity immediately after the lump-sum payment or, upon completion of a predetermined cooling period.

Key features of annuities

  • Annuitization is a binding contract between two parties, i.e., the investor and the financial institution.
  • Annuities guarantees a fixed income stream for the policyholder after the accumulation phase has passed.
  • Investors can fund their annuities during the accumulation period either by a lump-sum payment or instalments.
  • An annuity contract is freely tradable in the secondary market, which means the annuity holder can sell annuity payment for a discounted cash amount now.
  • Different types of annuities give the annuitant some options to choose from. The major types of annuities are variable, fixed, deferred and immediate.

How does Annuity Work?

Now we know what annuity is and what are the main features of the annuity. Let’s explain how do the annuities work.

  • To be entitled to receive a fixed income stream of an annuity, the investor needs to advance their money into an annuity plan. The investment could be made either as a one-off or in instalments.
  • There might be an accumulation period before the investor starts receiving their payout. Once the payout starts, it continues for a predetermined span of time. In the absence of the annuitant, the money is paid to the nominee.
  • Annuity payouts are always made in a series of payments, i.e., weekly, monthly, quarterly or, yearly.
  • The amount of the payment is calculated based on factors like the length of the accumulation period, the size of the contract etc.
  • The exact amount that the annuitant will receive is determined by the nature of the contract. If the investor took a guaranteed payout, they would receive a fixed annuity. In case the investor picked a performance-based annuity, the payout amount will vary depending on the performance of the investment.

Why do people buy annuities?

People have always been concerned about their financial security, especially when they will go to retirement. They agree to advance money now in order to secure their financial position in future so that their income flow is not disrupted once they leave their professional life.

Annuities provide three things:

  1. Guaranteed period payment: Annuities offer guaranteed Periodic payment for a specific amount of time that may cover the rest of your life or the life of someone you nominate.
  2. Benefits after death: If the annuitant expires before the payout date, the nominated beneficiary will receive the remaining amount of the annuity. Thus, the investor can secure the financial life of their dependents by investing in annuities.
  3. Deferred tax benefits: Investors into annuity products don’t have to pay taxes on interest income or capital gain until they withdraw the money. If their income falls below the taxable income limit, the investor gets full exemption; otherwise, they pay a lower tax since their income after retirement is bound to reduce. 

What are the different types of annuities?

Insurance companies have different types of annuity plans. The plans can vary depending on factors like the frequency and timing of the payments. Here are some major types of annuities:

Immediate Annuity plans: An immediate annuity plan doesn’t have an accumulation or, vesting phase. The investor invests in a lump sum instead of instalments and starts receiving the payout immediately for a lifetime or an agreed span of time.

Deferred Annuity Plans: The deferred annuity plans are, as the name suggests, start payout after a certain period of time. The investment can also be made either in a lump sum or as instalments. The deferred annuities have two phases:

Accumulation period – accumulation period is the timeline when the annuitant takes to make his investment. It starts when the investor makes the first premium and continues until the investment matures and starts receiving the payout.

Vesting Period – Vesting periods are the period throughout which the investor keeps receiving the payout in the form of an annuity as the policy benefits.

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