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

Annuity refers to a fixed payment made to a person regularly for any given period. 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, insurance, or pension payments.

It has a specific meaning concerning 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, 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.
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Types of Annuities

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

  1. A fixed Annuity is a guaranteed fixed payment given to the customer by an insurance company in the future.
  2. Variable Annuity – This has lesser stability but may benefit the investor. This can happen if the mutual funds invested in by the buyer do well in the 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 the investor makes more payments, ultimately leading 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 for meeting certain prerequisite conditions. A life annuity, for instance, will only be paid in a person’s lifetime. Till then, however, it is a certain annuity.

Advantages of Annuities

  1. It is a promising source of regular income in fixed intervals. 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 benefits men and women who do not participate in the workforce and do not have a steady income.

Disadvantages of Annuities

  1. There is a surrender period in which the investor cannot encash the amount deposited without paying a hefty fee. This can go up to several years in some cases.
  2. Variable annuities risk 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 steadily, any amounts disbursed by the company are subject 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
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