Annuity payments are a popular source of retirement income, but the topic is polarizing among the financial community. Some observers see annuities as an important and useful income source. Others see them as expensive and complicated instruments that don’t being much value to clients.
So, what is an annuity payment, and how do annuity payments work? The goal of this article is to explain just that. It will also examine some pros and cons of annuity payments. We hope to provide a basic understanding of these sometimes-complicated products. Thus, you will be able to decide for yourself whether or not they are a worthwhile investment.
The Concept of an Annuity Payment
Let’s start by describing an annuity. In simple terms, an annuity is a long-term contract between a person and an insurance company. Annuities can be classified deferred or immediate.
A deferred annuity has two phases: accumulation and annuitization. During the accumulation phase, contributions are made to the annuity which grow either at a fixed rate of interest or depending on the performance of a basket of investments. At the end of the accumulation phase, the contract is annuitized, or converted into a series of income payments. This is called the annuitization phase.
An immediate annuity has no deferral phase. For these products, income begins as soon as the purchase payment is submitted to the insurance company.
Types of Annuity Payments
Whether the annuity is deferred or immediate, the types of annuity payments available are usually the same. The owner can select whether the payments are received monthly, quarterly, semiannually, or annually. Here are some of the most common payment options:
- Single Life – This option guarantees a set amount of income for as long as a person lives.
- Joint Life – The lives of two people (usually spouses) are covered under this option. When one covered person dies, income continues until the death of the second covered person.
- Period Certain – A period of a number of years is selected, and payments will last for the duration of that period. If the covered person dies within the period, payments will be made to the contract’s beneficiary for the remainder of the period.
- Life with Cash or Installment Refund – This option guarantees income for the life of a covered person, but if the person dies before receiving income equal to the purchase payment, the beneficiary will receive either a lump sum or a series of payments in the amount of the difference between the cumulative amount of income received by the covered person and the original purchase payment.
Advantages and Disadvantages of Annuity Payments
Annuities are a hot topic in the financial world, and for those who find the answer to “what is an annuity payment?” there will likely be things they like and don’t like. Those who favor annuity payments tout their unique ability to offer an income stream that cannot be outlived as well as flexible options to design an income stream to meet specific needs.
Those who aren’t fans complain about lack of liquidity. Since the terms of an annuity cannot be changed after payments begin, many think this can put the investor in a risky situation. Fees are another common criticism.
Advantages of Annuity Payments
What is an annuity payment? For many, the appeal is consistency and predictability. The way most annuities are structured, the payments do not change once the income begins. This means the investor can forget about managing this portion of their money, and just watch the checks come in.
This income is guaranteed by an insurance company. Insurance companies are financially stable entities and are under considerable regulation to ensure that their claims-paying ability remains strong. Investors don’t have to worry about annuity income being subject to market risk or interest rate risk.
The versatility of annuity payments is attractive. Being able to customize an income stream for one person, two people, or for a certain period of time means that annuity contracts can be tailored for a variety of needs.
Inflation can be a difficult thing to combat, but many annuity products have an optional feature that increases annuity payments by a certain percentage each year. This can make keeping up with rising costs a little easier.
Taxes are a factor for any investment, and annuities are no different. Fortunately, though, the taxation of annuity payments is fairly easy to assess.
For annuities funded with tax-qualified (pre-tax) money, the entirety of each annuity payment will be subject to ordinary income tax.
A portion of each payment from an annuity funded with non-qualified (taxed) money will be exempt from income tax. This portion of the payment is considered an exclusion ratio, and it represents a return of money that has already been taxed.
Whether funding an annuity with pre-tax or post-tax dollars, recipients of annuity payments can know that their annuity tax bill will be predictable.
Recommended read: What Is an Annuity?
Disadvantages of Annuity Payments
Many observers correctly point out that there is little to no flexibility in the ability to change annuity payments once they have begun. Generally, there is no balance that can be withdrawn if a lump sum of cash is needed. Given this lack of liquidity, investors should be sure that they will not have another need for the money they are using to purchase an annuity. For some, the answer to “What is an annuity payment?” may be “lack of liquidity”.
Expenses are another common target of annuity detractors. Although this article is concerned primarily with annuities in their annuitization phase, it is important to know that annuities are commonly subject to fees and charges during their accumulation phase.
For the first few years of an annuity contract, the insurance company will likely assess a surrender charge to any withdrawal from the contract value that exceeds a stated penalty-free amount. This charge declines each year until it reaches zero, but it can start high – sometimes as high as 10%. In addition, variable annuities are usually subject to charges for the insurer’s mortality expense and administration costs.
These costs can ultimately result in a lower amount of money that will end up being converted into annuity payments.
Whether an annuity is deferred or immediate, an interest rate is factored into the payments. Although it’s nice to have some level or earnings attributed to your investment, the interest factored into annuity payments is pretty low.
Think about it:
Insurance companies invest annuity premiums into conservative (and low-yielding) instruments such as bonds. So, the interest rates they credit must be lower than what they receive on their investments in order for them to make a profit.
As a result, interest rates used to calculate annuity payments are usually lower than typical stock and bond yields.
For many investors, annuity income is a valuable source of financial security. A person can have peace of mind in knowing that they will receive a steady, predictable income for a number of years or for the rest of their life. When asking “what is an annuity payment?” it is also important to take into account the downsides, such as liquidity risk and fees that can put a drag on returns. What do you think about annuity payments? We would love to hear your experiences, thoughts, and questions.