Annuity: Financial Concept - Principles

Understanding Annuity ; A Comprehensive Guide

Annuity is a form of capital which is deposited by an individual at regular intervals. Gain interesting perspectives on the two basic principles of Annuity, its purpose, types, relevant examples and other meaningful resources when you go through this post.

What Is an Annuity?

An annuity is the timely deposit of capital by an investor at regular intervals of time. The investments made in annuity includes regular deposits to a savings account, monthly insurance payments, and monthly home mortgage or pension payments. The idea of annuity gained popularity as it helps the investors to credit capital in return. The deposits made by an investor extensively depends on the frequency of its payment dates. Therefore, the deposits or payments can be initiated weekly, monthly, quarterly, yearly, or any other regular interval of time.

Authorities like financial institutions and other economic organisations are responsible for generating annuities which accept funds from various individuals. Later, the received fund from the individuals is invested and left until annuitisation. An annuitisation phase is a phase when the processing of the payments begin. Once the investment reaches the point of annuitisation, it issues a stream of payments benefitting the investors. Thus, the time duration between the funding of an annuity and payouts generation is known as the accumulation phase.

The purpose of the annuity is to allow an individual to invest or deposit payments in return to obtain benefits from that investment. Moreover, to achieve a flow of payments and to enjoy the benefits of the investment, it is imperative to follow the annuity calculations. The annuity also plays a significant role in benefitting an individual at the time of his retirement or other plans. Therefore, the primary factor on which the method of the annuity depends is the period of the payment time. The period of this payment time is considered from the point annuity guarantees to continue.

The Basic Principles of Annuities

2 Basic Principles Incorporating the Working of Annuities

To achieve a better understanding of the working of annuities, you need to learn the following principles:

The accumulation phase: The accumulation phase is also known as the investment phase as it is the period when money is invested in the annuity. If you are willing to go with the accumulation phase, you need to purchase a postponed annuity. Now, it depends on you that whether you want to buy a single premium annuity or buy at instalments (EMI).
The distribution phase: The distribution phase comes into play when you start earning distributions from the money invested earlier in an annuity. After you begin receiving the deliveries, you get to choose between two options for receiving distributions from your investment. If you go with the first option, you can withdraw all your money at once without leaving anything behind. Now, if you go with the second option, you get a guarantee to enjoy the income from your investment for the rest of your life. It depends on you whether you want to enjoy the comprehensive income for your lifetime or wish to receive the amount for a specific period. The best part about this phase is that it can be selected any time by your deferred annuity. Moreover, you can purchase an immediate annuity to receive payments within the first year.

What is the primary purpose of an annuity?

Initially, annuities possessed a great significance in the working of life insurance companies. The reason for this being is the benefits these companies enjoyed under the annuities, i.e., it allowed the companies to outnumber the risk of a policyholder regarding their income source. So, it had permitted annuities to work as an excellent tool for the retirement and investment of an individual. Thus, an annuity is the term of economics contributing significantly to the development of market investment in a way that benefits the investor.

What are the different types of annuities?

Annuities can be classified into two categories depending on the characteristics it possesses in investing.

Income annuities: The primary role of an income annuity is to provide a fixed income source during the retirement years of an individual.
Tax-deferred annuities: A tax-deferred annuity plays a crucial role in the accumulation of your savings for the rest of your life, which you can use easily during your retirement.

Different types of annuities with their Valuation & Examples?

Immediate annuities: It is a type of long-term and a tax-deferred annuity that you purchase from an insurance company. It provides you with the benefits of prompt and regular payments in exchange for a total investment. Apart from this, immediate annuities guarantee you either a lifetime payment or for a specified time. For example, the contracts you purchase from an insurance company or a bank that provide you with immediate regular payments. But they do so in exchange for a lump-sum investment. Thus, these payments come with a lifetime guarantee or for a specific time.
Deferred income annuities: The primary role of an income annuity is to provide a fixed income source during the retirement years of an individual.
Fixed annuities: It is a type of annuity providing for the accumulation of liquidity in the bank depending on a tax-deferred annuity. You need to deposit a lump-sum of the cash to a life insurance company in return of credits. Moreover, it has the annuity account which guarantees you a fixed interest rate on the principal investment.
Variable annuities: In this type of annuity, a tax-deferred annuity based retirement vehicle plays a crucial role in the development of an individual. Moreover, it allows you to choose from a variety of investments to pay you a level of income on retirement. This is determined by the performance of the investments you want.

Is a fixed annuity better than a variable annuity?

The fundamental difference between a fixed and variable annuity is that a variable annuity does not guarantee an interest in return from the investments made. However, some variable annuities come up with the offering of a fixed-rate account which is secured by the issuing insurance company.

Textbooks On Annuity

Book 1

Annuity Markets

Published by Oxford University Press in 2008

By Edmund Cannon, Ian Tonks

Book 2

The Role of Annuity Markets in Financing Retirement

Published by MIT Press

By Jeffrey R. Brown, Olivia S. Mitchell, James M. Poterba, Mark J. Warshawsky

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