by An annuity is a financial product that provides certain cash flows at equal time intervals. Annuities are created by financial institutions, primarily life insurance companies, to provide regular income to a client.
An annuity is a reasonable alternative to some other investments as a source of income since it provides guaranteed income to an individual. However, annuities are less liquid than investments in securities because the initially deposited lump sum cannot be withdrawn without penalties.
Upon the issuance of an annuity, an individual pays a lump sum to the issuer of the annuity (financial institution). Then, the issuer holds the amount for a certain period (called an accumulation period). After the accumulation period, the issuer must make fixed payments to the individual according to predetermined time intervals.
Annuities are primarily bought by individuals who want to receive stable retirement income.
Types of Annuities
There are several types of annuities that are classified according to frequency and types of payments. For example, the cash flows of annuities can be paid at different time intervals. The payments can be made weekly, biweekly, or monthly. The primary types of annuities are:
- Fixed annuities
Annuities that provide fixed payments. The payments are guaranteed, but the rate of return is usually minimal.
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Variable annuities
Annuities that allow an individual to choose a selection of investments that will pay an income based on the performance of the selected investments. Variable annuities do not guarantee the amount of income, but the rate of return is generally higher relative to fixed annuities.
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Life annuities
Life annuities provide fixed payments to their holders until his/her death.
- Perpetuity
An annuity that provides perpetual cash flows with no end date. Examples of financial instruments that grant the perpetual cash flows to its holders are extremely rare.
The most notable example is a UK Government bond called consol. The first consols were issued in the middle of the 18th century.
Valuation of Annuities
Annuities are valued by discounting the future cash flows of the annuities and finding the present value of the cash flows. The general formula for annuity valuation is:
Uses of Annuities:
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Retirement Income:
One of the primary uses of annuities is to provide a steady stream of income during retirement. Individuals can convert their retirement savings into an annuity, ensuring they receive regular payments for a specified period or for the rest of their lives. This helps manage longevity risk and provides financial security in retirement.
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Wealth Management:
Annuities can be used as a wealth management tool, allowing investors to grow their assets on a tax-deferred basis. The accumulation phase of certain annuities lets individuals invest their funds in various financial instruments, potentially increasing their wealth over time before withdrawing it later.
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Educational Funding:
Parents can use annuities to save for their children’s education. By purchasing an annuity that provides payments when their children reach college age, parents can ensure they have the funds needed to cover tuition and other educational expenses.
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Structured Settlements:
Annuities are often used in structured settlements resulting from legal claims or personal injury cases. Instead of receiving a lump sum, individuals can opt for an annuity that pays out over time, providing financial stability and reducing the risk of mismanaging a large sum of money.
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Estate Planning:
Annuities can play a role in estate planning by providing a way to transfer wealth to heirs. Certain types of annuities allow individuals to designate beneficiaries, ensuring that funds are passed on according to their wishes while potentially avoiding probate.
