The Lifecycle of an Annuity: From Accumulation to Payout

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Sun Feb 11 2024

The Lifecycle of an Annuity: From Accumulation to Payout

An annuity is a contract between a person and an insurance company, where the insurer makes payments to the person either as a lump sum or in a series of payments. This can be done immediately or at an agreed-upon date in the future.

The way an annuity works is you buy it from an insurance company, bank or brokerage firm, and, when you are ready, you receive steady, guaranteed income for the rest of your life.

An example is a 40-year-old man who invests his life savings, say $50,000 into a fixed annuity and opts to begin receiving payments after he turns 60. When he turns 60, he will begin to receive over $900 every month for the rest of his life.

Aside from the fact that they offer guaranteed income throughout your retirement, annuities also help alleviate the potential risk of outlasting your savings. They can be a good option when planning for retirement; saving towards the lifestyle you want before you reach retirement age. As the ultimate option is to ensure financial freedom during your retirement, an annuity is one of the smartest ways you can save for the future.

Why Buy an Annuity?

Annuity are very flexible; you can invest your money according to your own financial situation and future retirement plan. From the original investment down to the frequency of the payouts, there are a lot of options to choose from. You can invest small amounts over a long period of time, if for example you start saving from a young age. You can also make a significant investment with a larger sum of money and opt to receive payouts after a certain period.

Immediate vs Deferred Annuities

Immediate annuities begin making payments to you as soon as you deposit a lumpsum into the accounts, while deferred annuities begin paying out at the date and age of your choosing. With the latter, your investment has time to grow, tax-free, while you wait for the payments to begin.

Fixed vs Variable Annuities

Fixed annuities pay out based on a specific rate of interest. The insurance company provides the principal and a minimum rate of interest. This offers lower risk in terms of returns but less potential for high growth.

With variable annuities, your premiums are invested in a fund like a mutual fund. The accumulation and payouts are therefore dependent on how the fund performs, although your insurer may offer minimum guarantees.

To understand how these differences impact the present value of your annuity and to explore insights into the risk and return profile of each type, see our detailed discussion in the Calculation of Present Value in Annuities section of our companion article.

 

The Annuity Journey

Planning Phase

Planning is important to help you understand your options in terms of investment variables and goals, based on individual needs. Once you have decided on your retirement plan and are considering annuities, there are some simple steps to get you started:

Timing: You need to decide when you will need your retirement income. This will determine what time of annuity to invest in, which will in turn help you decide when to start receiving payments.

Choosing the right plan: Research the various annuities and find a product that aligns with your specific investment needs.

Customize your plan: Most plans have add-on benefits; figure out which ones will work best towards achieving your savings goals.

Accumulation Phase

This is the longest phase in the annuity life cycle. This is the phase when the person investing works to grow the value of their annuity through saving.

It begins when you start saving money for your investment. It is always advisable to start saving as early as possible in order to amass as much money as possible. Most experts believe that the age at which one starts saving can be the difference-maker in the journey to financial freedom. Starting early, ideally in your 20s, will increase the yields when you finally cash in after retirement. You can take advantage of compound interest to gradually maximize your savings. Starting early also insulates you from potentially harmful business cycles.

Distribution Phase

The distribution phase begins at the discretion of the annuitant, when they begin receiving payments from the investor. This could be when they retire, or in the years leading up to their retirement. The frequency of the payouts and the amount vary depending on the type of annuity invested in, and the specific terms of the signed contract.

Most annuities have a minimum age at which one can request the payouts to begin, otherwise they risk incurring an early withdrawal penalty. There are annuities that allow for payments to continue to be made until or after the annuitant is deceased.

Income withdrawn from an annuity is taxable, meaning the payouts are taxed just like ordinary income.

 

Types of distribution:

  1. Life Annuity: With this option, payouts are spread out over the life of the annuitant.

  2. Life Annuity with period certain: In this option, payments continue to be made after the annuitant dies, for a certain period. The payments are made to a beneficiary.

  3. Joint life with survivor: This covers two or more people, usually a husband and wife. It covers the survivor after the death of the annuitant.

  4. Life contingency: This annuity has an attached death benefit, similar to a life insurance policy.

Conclusion

Retirement planning is a complicated and daunting process. Studies have shown that most Americans rarely plan for life after retirement, so they don’t often educate themselves on the necessity of financial preparedness from as early an age as possible.

An annuity is one of the best options for anyone looking to channel their savings into a retirement plan that will then provide regular payouts to them for the rest of their life once they retire. It may seem too complicated, like brushing up on the theory of relativity before space travel. But a basic understanding of how annuities work will be invaluable to someone hoping to secure their financial future, just as a foundation in relativity can make the difference for the voyager floating around in space.