How Does an Annuity Work?

“According to a 2004 government report, Social Security payments currently cover just 39 percent of the income you'll need for retirement – and probably less in the future.” - Great American

Well, since the above statement has been made by the government, we dare not question its veracity. However, the above statement paints quite a scary picture, especially for those who are about to retire. So, how does one tackle this situation? Well, investment seems to be your best bet.

Today, the investor has many options at his disposal. Annuities, CDs, bonds, money market funds are some of the popular options. But before investing in any instrument, one has to carefully analyze one’s risk appetite. For instance, annuity is the best option for a cautious investor like you and me.

Annuity is a financial contract between an individual and an insurance company, wherein the individual pays a single premium or a series of premiums to the insurance company in return for an assured income.

Working of Annuity

The individual enters into contract with an insurance company. The insurance company allows to choose:
- Premium payment frequency: Here you define whether the premiums will be paid in installments or in a single lump sum.
- Receipt of Payments: You have to specify whether you would like to receive the payment for a fixed period or for life. You also choose the frequency of the payment i.e. whether you would like to receive the payment on a monthly, quarterly or on an annual basis. You also choose the date from when you would like to start receiving the payments.
- Fixed or variable: Here you have to define as to whether you would like to see fixed or variable interest rates.
Once the insurance company receives your contributions, they start investing it in mutual funds, bonds, fixed interest securities etc. In case of an equity-indexed annuity, the funds are invested in a stock index.
Your annuity policy starts receiving interest on a tax-deferred basis. Tax deferred means that the income from the annuity cannot be taxed until it is withdrawn or received as payment.

You start receiving the payment from the date stipulated by you.

Annuity Stages:

Accumulation stage: Accumulation stage denotes the period between the date on which you bought the policy and the date when the insurance company starts making the payouts. Under this stage, you start paying premiums to the insurance company. The premium can be paid in lump sum or in installments.
Payout/Distribution stage: Here the insurance company starts making payment to the annuitant. The payment can be received on a monthly, quarterly or on an annual basis. In case of immediate annuity, there is no accumulation stage as the company immediately starts making payment after the purchase of the annuity policy.

Annuity, thus, provides the investor with an option of earning a decent and regular income and also offers a protective cover over the principal amount.

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