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Understanding Annuities

What is an annuity?

An annuity is a financial product that allows you to be paid an income in return for a lump sum. It’s an agreement between an insurance company and individual where the individual makes a series of payments or a lump sum to purchase the annuity, and then the issuer agrees to regular payments that are made to the annuitant. Examples of annuities are regular deposits into a savings account, monthly insurance payments, or home mortgage payments. Annuities are defined by the frequency of payment days, which could be made weekly, monthly, quarterly, yearly or any other time intervals.

The rates are set by the insurance companies and usually are expressed in terms of $10,000 or $100,000 lump sums. For example, a 65-year old man could be quoted an annuity rate of an $800 income for every $10,000 lump sum.

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Who needs an annuity?

Anyone who has a lump sum and wants to turn this into an income could buy an annuity but its more common to come across annuities when coming up to retirement and wanting to convert a pension fund into a reliable income. These are referred to as pension annuities.

If you belong to an employer’s final salary scheme then your pension is usually paid directly from the scheme so you don’t need to think about getting an annuity. Your pension scheme manager will be able to give you whatever options are available for you.

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Deferred or Immediate Annuities

You can get a deferred or immediate annuity. With a deferred annuity, your money will be invested until such a time that you are ready to begin withdrawing money, usually in retirement. With an immediate annuity you will receive payments just after you make your first investment, so if you’re approaching retirement age already then you should consider purchasing an immediate annuity.

Deferred annuities build up money while the immediate one pays out. Deferred annuities can be converted into an immediate annuity when the owner wants to start collecting.

Within these two categories, deferred an immediate, annuities can also be fixed or variable depending on whether you are getting a fixed sum or if its tied to the performance of the overall market or investments. You could also have a combination of the two. After looking at the bigger categories we will look into the varying different types of annuities and whom they are for.

Fixed Annuities

This type of arrangement guarantees a fixed-amount payment of the life of the contract. They offer a guaranteed income for a fixed period of time and a guaranteed lump sum at the end of your chosen plan. The issuer guarantees that the rate will never fall below a certain minimum. Most fixed annuities will reset the interest rate every three or five years or periodically.

Variable Annuities

This type of annuity provides a guaranteed level of income that is lower than a normal annuity, with the potential of future increases depending on the result of the performance of a chosen investment fund. Variable annuities offer a much wider choice of investment options depending on the investors desire for risk. The funds can be invested in bonds, stocks, mutual funds or money market instruments, or any combination. These investments are not guaranteed like fixed term annuities and the value will fluctuate with the market. Payment can still be fixed or variable depending on the fluctuating value of the investment account.

Single or Joint Life Annuity

A joint annuity will give a partner more security so you should decide if you want an annuity that covers your partner or just yourself. A single life annuity will pay you an income until you die, but if you are a couple and you die first then this could mean your partner is stuck without money. A joint life annuity continues to pay a decided amount or all of the annuity income to your partner after you die. If you choose a joint annuity then there are some trade-offs. Because it will continue to be paid after you are dead the rates are usually lower.

In general, the higher the proportion of income paid to your partner after your death, the lower your starting income would be. If your partner is younger than you then the insurance company will offer a lower annuity because they expect to pay out for longer.

Impaired and Enhanced Annuity

Some companies will offer a higher annuity rate to those with lower life expectancy so if you have health problems then you might get an impaired annuity. Approximately one in three will be offered an enhanced or impaired life annuity if you have serious health problems such as a history of diabetes, heart disease or cancer, or if you are overweight or a heavy smoker.

Usually you will have to go through an independent financial advisor to apply and get one of these, and they are individually written so you will probably need medical information as well as taking extra tests. Your health and lifestyle will reflect whether you can get more or less income, but in general if you are likely to receive the income for fewer years because of health risk then you could receive more income.

Investment Linked Annuity

These annuities will allow you to tap into more income that you would not receive if going for a general annuity. You will still have to hand over your fund in return for your annuity income, but you will be able to benefit from future stock market growth. As always there is a huge risk with all stock market linked investments and there are no guarantees that you will be improving your income.

Unit-Linked Annuity

With this type of annuity your money is invested in a unit-linked pension fund, which works in sort of the same way as a unit trust. Your income will fluctuate depending on the stocks, shares and other assets that your units represent. You are able to switch between your providers different funds if you want to get specific with your investment strategy, but this could mean higher costs.

If you are an experienced investor then you might prefer a self-invested unit-linked annuity that would give you much more control.

Purchased Life Annuity (Conventional Annuities)

This will give you an income for life, but it’s not a pension annuity. You buy it using a lump sum, your savings for example. However your options will be limited to a conventional annuity as apposed to an investment one. You have to decide whether you want it to be fixed or variable, and if you want to cover a partner or just yourself.

With a purchased life annuity you can choose to have your capital protected rather than just a guarantee. Taking one of these means that after you die the remaining annuity money is repaid to your estate and can be passed own, however if the gross income paid out is great than the invested amount then nothing will get passed down.

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Annuity Guarantees

Whenever an annuity has a guarantee it will be paid out for a set time period, usually five or ten years, even if you die during that time. If you die during a guarantee period then the payments may continue to your estate for the remainder of the guarantee period, or sometimes will be paid as a lump sum.

An annuity with a guarantee is sometimes seen as a substitute for a joint life annuity but it’s not the same. A maximum guarantee period is only ten years, and therefore an annuity guarantee won’t fully protect your estate in the long term.

Payout options, Risks, Fees and Tax

Annuities are usually quite flexible and can fit the individuals’ specifications which makes them very attractive to investors. You can set a specific payment amount for set period or receive payments for a lifetime, which will then cease when you die. With a joint and survivor annuity your payments would continue to be passed on until he or she dies as well.

An annuity is only as strong as the insurance company that is issuing it. A purchaser should always investigate the financial ratings of the firm they are looking at. Every state has a guarantee fund that protects investors, however these guarantees have limitations and each investor should check the specific laws in their state.

There are always fees when it comes to annuities. Depending on ten the company there might be a commission that goes to the sales person, administrative costs, guarantee fees and selling costs, and these are usually packaged into an item called the mortality and expense charge. Insurance companies also make additional charges for life and survivor annuities, and if you want early withdrawals you will incur a substantial surrender charge.

Only part of the income is taxable because the tax system treats part of the return as a repayment of the lump sum you invested, so it will depend on the lump sum you started with. Tax is 20% for purchased life annuity and basic taxpayers don’t have to pay any more tax on their annuity income, but higher-rate taxpayers would have to pay an extra 20%.

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