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Annuity
The term annuity, in current use in the
insurance industry, refers to two very different types
of legal contracts with very different purposes.
Traditionally, for at least four hundred years, the
term annuity referred to what is more correctly called
today an immediate annuity. This is an insurance
policy which makes a series of either level or
fluctuating payments, paid out over a fixed number of
years or during the lifetime(s) of one or two
individuals, or in any combination of lifetime plus
period certain guarantees. The overarching
characteristic of the immediate annuity is that it is
a vehicle for distributing savings. A common
use for an immediate annuity might be to provide a
pension income to a person who is about to retire.
The second usage for the term annuity came
into its own during the 1970s. This contract is more
correctly referred to as a deferred annuity and is
chiefly a vehicle for accumulating savings.
Note, this is different from the immediate and is the
cause of much confusion when people discuss annuities
without carefully defining which type of annuity they
have in mind.
Under the heading of deferred annuities are contracts
which may be similar to bank certificates of deposit
(CD) in that they offer the buyer a safe interest rate
of return on their money, or to stock index funds or
other stock funds, where the growth of the account is
dependent upon the performance of the market. All
varieties of deferred annuities have one thing in
common: any increase in account values is not taxed
until those gains are withdrawn. This is also known as
tax-deferred growth.
To complete the definitions here, a deferred annuity
which grows by interest rate earnings alone is
correctly called a fixed deferred annuity. A deferred
annuity that permits allocations to stock or bond
funds and for which the account value is not
guaranteed to stay above the initial amount invested
is correctly called a variable annuity. In the last
ten years a new category of deferred annuities have
emerged, called equity indexed annuities (EIAs). These
policies are a hybrid of the two types of deferred
annuities just described. The EIA offers a guarantee
that the account value will never drop below the
initial amount invested while also offering a chance
to participate in the upside potential of any increase
in the value of a major stock index, such as the
S&P500 or Dow Jones Industrial Average.
By law an annuity contract can only be
"manufactured" by an insurance company. They
are distributed by, and available for purchase from,
duly licensed bank, stock brokerage, and insurance
company representatives. Some annuities may also be
purchased directly from the "manufacturer,"
i.e., the insurance company writing the contract.
In a typical immediate annuity contract, an
individual would pay a lump sum or a series of
payments (called premiums) to an insurance company,
and in return receive a fixed income payable for the
rest of their life. The exact terms of an annuity
product are drawn up in legal terms in a contract.
We should mention that the term "anuity" is
also used in finance theory to refer to any stream of
fixed payments over a specified period of time. This
usage is most commonly seen in academic discussions of
finance, usually in connection with the valuation of
the stream of payments, taking into account time value
of money concepts.
By Annuity Info Center
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