What is Annuity? | Definition, Types, Advantages and Disadvantages

The term annuity refers to a fixed amount of payment made to a person at regular intervals, for any given period of time. It can also be seen as a kind of investment or insurance depending upon the nature of the amount, and if it is seen as an income or expenditure. This may include payments to savings accounts, or insurance, or pension payments.

It has a specific meaning with respect to insurance. Insurance companies have several policies for annuities in which the customer is to make payments of a certain amount regularly to the company. In return, the insurance company pays back the customer a regular income (starting a stipulated amount of time later in the future). This may continue for the rest of one’s life.

Key Takeaways

1. An annuity is a financial product that pays a fixed sum at regular intervals, typically for retirement income.
2. Annuities can be immediate or deferred, with the former starting payments immediately after purchase and the latter starting at a future date.
3. Annuities offer tax-deferred growth and guaranteed income for life but may also come with high fees and restrictions on accessing funds.

Types of Annuities

In practice, there are several kinds of annuities which depend on the nature of the payment and the company disbursing the funds. Broadly it may be divided into the following categories:

1. Fixed Annuity – It is a guaranteed fixed amount of payment given to the customer by an insurance company in the future.
2. Variable Annuity – This has lesser stability, but may be beneficial to the investor. This can happen if the mutual funds invested in by the buyer do well in market and grow to a larger amount.
3. Immediate Annuity – The payments in this system begin as soon as the customer invests with an insurance company.
4. Deferred Annuity – This leads to an accumulation of money as more and more payments are made by the investor, and it ultimately leads to a greater lump sum return in the future.  
5. Indexed Annuity – In this situation the payments are linked to an index in which limits are set for minimum and maximum amounts for payment.
6. Contingent Annuity – In this case the annuity is paid only on account of meeting a certain number of prerequisite conditions. A life annuity, for instance, will only be paid in the lifetime of a person.Till then however, it is a certain annuity.

Advantages of Annuities

1. It is a promising source of a regular income in fixed intervals of time. The guaranteed steady flow of money makes it a highly lucrative investment.
2. It is very advantageous as a retirement plan because of the cash flow.
3. In joint life annuities for married couples, either one is liable to receive payments despite the death of their spouse (although a reduced amount). This is beneficial to men and women who do not participate in the work force and do not have a steady income of their own.

Disadvantages of Annuities

1. There is a surrender period in which the investor cannot encash the amount deposited without the payment of a hefty fee. This can go up to several years in some cases.
2. Variable annuities bear the risk of losing the principal amount because of prevailing market conditions, whereas fixed annuities remove the scope for receiving higher payments.
3. While the balance may increase at a steady rate, any amounts disbursed by the company are subjected to income tax.

References

1. https://www.nber.org/papers/w7199
2. https://www.cambridge.org/core/journals/astin-bulletin-journal-of-the-iaa/article/guaranteed-annuity-options/55E3DAC470DFFC10E62FCF2F2A415A50