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What are annuities?

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Annuities are insurance contracts from financial institutions that provide investors with an income stream, typically for retirement. Investors invest in annuities with either monthly premiums or lump-sum payments and the holding institution sends payments in the future for a certain period of time or for the remainder of the recipient’s life.

What is the purpose of annuities?

Annuities are mainly used for retired individuals to prevent themselves from outliving their savings. They offer steady and predictable income streams to help with cost of living.

How does an annuity work?

An annuity has multiple phases and periods. They are:

  • The accumulation phase, which is the time period when an annuity is funded before payouts start. During this stage, money invested in the annuity accumulates on a tax-deferred basis.
  • The annuitization phase begins once payments start.

Financial sums are either immediate or deferred. Immediate annuities are typically used by those of various age ranges who received a large sum of money, (such as an inheritance or lottery winnings), and want to turn it into cash flows for the future. Deferred annuities grow on a tax-deferred basis and provide guaranteed income beginning on a specific date.

Who buys annuities?

Annuities are ideal for individuals seeking stable guaranteed income during retirement. As any lump sum put into the annuity is illiquid and comes with withdrawal penalties, it is usually not suggested for younger individuals or those who need to use liquid assets in the near future. Annuity holders cannot outlive their income stream, which prevents longevity risk.

What are some considerations regarding annuities?

Annuities usually have a surrender period where investors can’t withdraw funds. Surrender periods may last several years, so annuitants must plan out as best they can any financial requirements during this time. For example, if they need a significant amount of cash to purchase a new car or pay for school tuition, it might not be wise to invest in annuity payments.

Contracts also have an income rider (an insurance policy that adds benefits or amends the terms to a standard policy) that provides a fixed income when the annuity begins. Two questions investors should ask when they consider income riders are:

  1. When is the income needed? Depending on the annuity duration, payment terms and interest rates can change.
  2. What are the fees that come with the income rider? While some providers offer income riders for free, many come with high fees.

As long as the purchaser understands that they are exchanging a liquid sum for guaranteed instalments of cash, annuities can be beneficial.

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