What is Annuity? - Definition and Types

What is Annuity?

Definition :

It is the method of converting an amount(usually pension sum) into an income for the rest of our life period. Annuity is one of the retirement strategies.

Factors affecting Annuities

1. Investment amount 2. Gender,age,health 3. Choice of benefit options

Annuity rate

The amount of income an annuity provides each year in return for the amount invested from your pension sum is defined as the annuity rate

Example :

If the amount invested is $50000 and amount of income provided by annuity is $5000,then annuity rate=10% that is 10% of $50000=$5000

Types of annuities

The two basic annuities are 1. Immediate Annuity 2. Deferred Annuity Each of these annuities is again classified as fixed and variable.

Immediate annuity

Immediate annuity returns payment immediately after an initial investment is made. The income starts within one year after the initial investment is made.The following factors are to be noted while choosing immediate annuity. 1. The minimum amount must be $10000 2. The monthly interest rates remain same during the investment period if it is fixed immediate annuity and interest rates may vary according to annuity progress in case of variable immediate annuity. Immediate Annuity = pi / ( 1 - ( 1 + i )-n

Where,

p = Sum to invest n = Time period(in years) i = Annual rate of return

Deferred annuity

Deferred annuity accumulates money until the investment period and the accumulated sum is withdrawn during the retirement period.Deferred annuity is suitable to those who need a steady income after their retirement period.This annuity earning is tax deferred which means that the tax need not to be paid on all gains during the investment period.There are three basic types of deferred annuity. 1. Fixed deferred annuity,where the annuity rate remains the same 2. Equity indexed annuity,where the annuity rate may increase based on the rise in the stock market 3. Variable deferred annuity,where the annuity rate depends on the progress of the annuity.This is risky because there is a chance of losing principal investment when the market does not perform as expected. If investment is made at the beginning, Future value of Deferred annuity = ai ( 1 + i )n If investment is through period of payments, Future value of Deferred annuity = a ( ( 1 + i )n-1) / i

Where,

a = Amount, i = Expected rate of return, n = Time period.

Annuity due

Annuity due refers to annuities whose payments are made at the beginning of the period

Need of Annuities

1. The payment of tax is deferred 2. Annuity provides large amount which is more helpful for retiring persons 3. The annuity income and payments are guaranteed

Disadvantages of Annuities

1. When you are starting annuity for the first type, you need to provide commission to insurance brokers(from 10%) 2. Surrender charges need to be paid when you are withdrawing annuity(from 7%)


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