What is an Annuity?
An annuity is an agreement under which you invest money, and in return you receive a stream of income for a specified period of time. As you near retirement, annuities can be one way to guarantee that you don’t outlive your retirement income, but choosing an annuity can be tricky and shouldn’t be done without personalized advice. That being said, here’s a brief overview of how annuities work.
When you choose a deferred annuity, you’ll invest in the annuity and there will be a waiting period during which the annuity will accumulate money before you begin receiving payouts.
With an immediate annuity, on the other hand, you’ll invest in the annuity and the payouts begin very soon after you make your investment.
Variable vs. Fixed Annuities
While “deferred” and “immediate” refer to when you’ll receive annuity payments, annuities also differ based on whether you receive a fixed amount each payout period (fixed annuities) or whether the amount of your payout is determined by the performance of the market or a specific group of investments (variable annuity).
What about the timing of your payouts? That depends on the type of annuity you choose, and the options are wide-ranging. Payouts can be made monthly, annually, or in one lump sum. Plus, annuities differ based on the period of time over which you’ll receive payouts. For example, you can purchase an annuity that provides an income for a certain period of years, or one that provides an income for the remainder of your life. If you’re married, you also have the option of buying an annuity with a survivorship benefit, so that your spouse will continue to receive annuity payouts after you pass away.
Aside from providing a guaranteed income stream, an annuity can be an attractive option for putting away additional savings toward your retirement. If you are already meeting your annual contribution limits for your 401(k) and IRA, an annuity can serve as a vehicle for allowing you put away extra money, tax-deferred, toward your retirement. Unlike 401(k)s and IRAs, there’s no annual limit on how much you can invest in an annuity.
Annuities often carry with them high fees, including broker commissions and annual insurance and investment management fees. Plus, some annuities are packaged, or “bundled” in a way that can make it hard for an investor to understand exactly what he or she is getting.
The best strategy when it comes to choosing an annuity is to do your homework, seek the guidance of a trusted financial advisor, and never buy anything until you understand what you’re getting, down to the last detail.
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Calculating Different Types of Annuities
An annuity is a series of payments required to be made or received over time at regular intervals.
The most common payment intervals are yearly (once a year), semi-annually (twice a year), quarterly (four times a year), and monthly (once a month).
Some examples of annuities: Mortgages, Car payments, Rent, Pension fund payments, Insurance premiums.
TYPES OF ANNUITIES
An Ordinary Annuity has the following characteristics
· The payments are always made at the end of each interval
· The interest rate compounds at the same interval as the payment interval
For calculating the sum of a series of regular payments the following formula should be used:
S n = -----------------
Example: Alan decides to set aside $50 at the end of each month for his child’s college education. If the child were to be born today, how much will be available for its college education when s/he turns 19 years old Assume an interest rate of 5% compounded monthly.
First, we assign all the terms:
i= 0.05/12 or 0.004166
n= 18 x 12, or 216
Now substituting into our formula, we have:
S n = -------------------
S n = --------------------------------
0.05 / 12
S n = $50(349.2020206)
S n = $17,460.10
Formula for calculating present value of a simple annuity:
PV = --------------------
Example: The monthly rent on an apartment is $950 per month payable at the beginning of each month. If the current interest is 12% compounded monthly, what single payment 12 months in advance would be equal to a year’s rent?
C = $950
i= 0.12/12 or 0.01
Substituting into the formula gives:
PV (due) = ---------------------------------------
PV(due) = $950(11.37)
PV(due) = $10,801.50