Annuities are contracts between a policyholder and the contract holder, often an insurance company. Policyholders give the insurance company a specified amount of money in exchange for future payments. The timing and amount of the payments depend on the terms and the type of annuity.
Policyholders fund annuities through a lump sum or multiple payments. Annuities are available in many forms and with many possible features. There are a variety of annuities available to meet your financial goals and they can be a consistent source of retirement income. Two of the most common types of annuities are ordinary annuities and annuities due. An ordinary annuity is when payment is due at the end of a period. On the other hand, an annuity due is when the payment is due at the beginning of a period. Keep reading to learn more about each type of annuity !
Ordinary Annuities
Image via Flickr by Got Credit
An ordinary annuity pays a specified amount for a specified period of time, with starting and ending payments occurring according to a set schedule. Payments are the same throughout the contract, and payments are made at the end of the payment period. This means that, with an ordinary annuity, monthly payments occur at the end of each month. Stock dividends are paid like an ordinary annuity, with the dividends covering the previous quarter. Issuers prefer ordinary annuities because the policyholders are paid later, giving the issuer more time to hold the cash. For annuity holders who are making payments on their accounts, ordinary annuities are beneficial at this stage.
Valuing Ordinary Annuities
Ordinary annuities are more attractive to the insurance company or other business issuing the annuity because payments are due at the end of each period. This gives the issuer more time to use the money. Policyholders receive their payments at the end of the month, which provides less time to use the money in the regular payments.
The present value of any type of annuity is the value of future payments. All annuities can be valued using a formula that considers the current value, amount of each payment, the interest rate, and the number of payments to be received. This formula can determine the difference between years of payments or a lump sum option. Annuity providers also have annuity tables that help calculate the value of an annuity at a specific time using a calculation to apply to the payment amount every period.
Annuity Due
Annuity due contracts pay at the beginning of the payment period. For example, in a contract with monthly payments, those payments are to be made at the beginning of the month. This type of annuity is more attractive to the holders since they get paid earlier.
Valuing Annuity Due Accounts
An annuity due is worth more money to the person collecting the payments; it also is more costly for the insurance company making the payments since each payment is made one term earlier than an ordinary annuity.
Annuity due accounts have a higher present value since the early payments allow the money more time to generate a significant return.
Present Value of Ordinary Annuities and Annuities Due Formula
Calculating the present value of annuity due or an ordinary annuity can be done using the following formula: P = PMT * [1 – [ (1 / 1+r)^n] / r]. Within this formula, P = present value of your annuity, PMT = amount of each payment, r = discount or interest rate.
What Are Some of the Options for Annuities?
Variable annuities invest policyholder deposits in various investments, while fixed annuities grow the deposits at fixed interest rates. Indexed annuities provide returns based on how a selected index fund performs.
Many annuities grow over time and are known as deferred annuities. On the other hand, immediate annuities begin payments shortly after a one-time investment is placed and offer tax-deferral benefits. Immediate annuities may be difficult to cash out, and those with lifetime payments cease those payments upon the annuity holder’s death.
Investors may also choose qualified or nonqualified annuities. Qualified annuities offer protection of investments and tax benefits by meeting Employee Retirement Income Security Act guidelines. Qualified annuities can be paired with individual retirement accounts and other retirement accounts.
Regardless of the type of investment or account the annuity grows in during the accumulation phase, fixed payments begin in the annuitization phase as fund growth stops. While monthly payments are common, annuities may be paid off in lump sums, payments every other month, or once a year.
What Are the Pros and Cons of Annuities?
Annuities provide guaranteed income and can be a dependable supplemental income in retirement. Like every investment option, they have pros and cons that investors need to weigh before deciding. They can, however, have complicated rules to navigate.
Pros
- Dependable payments based on the annuity agreement that serve as supplemental income.
- Tax-deferred growth through pre-tax contributions to the account, with taxes deferred until payments begin.
- Growth is guaranteed for fixed annuities, protecting investors from loss of principal.
- Death benefits, and sometimes enhanced death benefits, protect family members by paying out the value of the annuity or more to beneficiaries.
Cons
- Returns can be weak compared to some investment vehicles.
- Variable annuities could result in losing money depending on how the investments perform, and they may carry high fees.
- Fixed annuities can result in reduced spending power if inflation is high.
- Withdrawal and surrender fees may be high.
- Immediate annuities are difficult or impossible to close or pass on to a beneficiary.
How Are Annuities Passed to Beneficiaries?
Most annuities offer a death benefit to protect the investment during the accumulation and annuitization phases. Some annuities may offer additional death benefits for an extra fee, increasing the benefit amount beyond the account’s value during the accumulation phase.
Annuities that have begun paying out can be set up to continue the payments to a surviving spouse. In addition to life insurance type benefits, annuities may also be set up with lifetime payments, where the payments continue through the policy owner’s lifetime, possibly exceeding the value of the original account.
Note that some annuities, especially immediate annuities, may offer payments until the policyholder’s death. These payments, and any remaining value, may disappear after the policyholder dies.
Weighing Retirement Plan Options
Retirement planning can be very complex, with ever-changing regulations and tax implications. Investors face possible highs and lows in future market performance, making monitoring investments and realigning funds essential as retirement approaches or job situations change.
Contact Hawaii Partners 3D Wealth Advisors Today!
For assistance in maximizing the benefits of your retirement investments, contact the experts at 3D Partners Wealth Advisors. We can help you with long-term financial planning, including tax planning & preparation, estate planning, and more. You can reach our Honolulu, HI office at (808) 818-7561 or via our secure online messaging form. We’d be happy to answer any questions you may have or get you set up with a wealth advisor.