Annuity Types

An annuity is a long-term investment instrument that provides the annuitant (the person holding an Annuity) with an income stream for a particular time period or even for an entire lifetime. To become eligible for the income stream, the annuitant has to make periodic payments or invest a lump sum towards the annuity premium. Annuities take into account the concept of time value of money. After a specific period of time during which these investments earn returns by way of interest, the annuity begins to provide a continuous stream of income to the annuitant for a limited period of time that may extend till the death of the annuitant depending upon the type of the annuity contract.

The three common classifications of annuities include:

1.      Fixed annuities - Annuities with fixed payments are called fixed annuities. These are used for investments into lower risk financial instruments such as the government securities and corporate bonds. These annuities offer a fixed rate of return for up to ten years and are not regulated by the Securities and Exchange Commission (SEC) due to their lower risk profile.

2.      Variable annuities - The Securities and Exchange Commission (SEC) closely regulates these types of annuities. They invest portions of the premium into the money market instruments and have a relatively higher risk profile. Due to the relatively volatile nature of money market instruments, these annuities vary in their rates of return.

3.      Equity-indexed annuities – In this case, the annuitant makes a lump sum payment to the insurance company towards the premium of the annuity. Returns on these annuities are fixed at par with those on equity instruments. When the equity instruments provide better returns, these annuities follow suit. In case the performance of equity instruments is not up to the mark, these annuities also fare badly. In other words, the returns on these annuities are pegged to the mean returns on equity instruments.

Annuities are commonly used to provide a steady income in the later stages of life when the earning potential of an individual deteriorates. For the same reason, annuities are also referred to as Pension plans. Annuities provide financial security to the aged and prevent the possibility of an annuitant outliving his income and ending up broke in an old age. An annuitant can invest in a scheme while he is at the peak of his earning potential and can reap the benefits in the form of regular income stream in the later stages of life. At a fundamental level, annuities are nothing but regular income streams of one’s own investments for a specific period of time after adjusting for the different variable components such as the interest rates, inflation and service charges of the insurance company.

Annuities are often compared to life insurance products. Annuities differ from common life insurance products in a fundamental way. Annuities offer a guarantee of regular income for a certain period or life to an investor and do not provide any kind of insurance cover to the annuitant.