Life Annuity

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21 Aug, 2024

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A life annuity is a financial instrument that serves as a post-retirement income source for individuals. The annuitant invests in an annuity and pays premiums or lump sum towards the investment. The annuity issuer then pays the annuitant monthly from retirement to death.

Also known as a lifetime annuity, it is a type of insurance. And interestingly, most insurance companies provide different annuity plans to their customers based on their goals. An advantage of annuities is that annuitants cannot outlive the coverage, even if the annuity issuer has to bear the additional cost.

What is a Life Annuity?

A life annuity insurance is a financial product for post-retirement. Annuitants pay while employed and can receive regular income from the annuity once they retire.
A few policies pay quarterly, half-yearly, or annually, whereas most plans only pay monthly.
Annuities have two phases – accumulation and distribution. In the accumulation phase, the annuitant pays the annuity issuer. In the distribution phase, the issuer pays the annuitant.
Lifetime annuities, though a type of insurance, are not the same as life insurance. The former pays out at the annuitant's retirement, whereas the latter pays out during the insured's death.

How Does A Life Annuity Work?

Life annuity insurance is one of the many retirement plans available. In this type of annuity, the individual prepares for retirement while still employed. Then, they can make regular premium payments towards the annuity. This will reduce the financial burden on them and contribute to savings. Or sometimes, individuals receive a lump-sum amount, maybe as part of an inheritance or by winning a lottery. In such cases, they can invest the whole amount in the annuity. This is the accumulation phase. After that, the payments keep accumulating in the annuity fund.

Once they retire, they start receiving regular interest payments from the annuity. Most plans pay monthly, while some pay quarterly, half-yearly, or annually. It depends on the individual to choose the right plan for them. They can choose how much to pay and how much to receive. The phase where the annuity issuer pays the annuitant post-retirement is the distribution phase.

An important feature is that the net amount paid to the annuitant might exceed the amount received throughout the annuity. Thus, they cannot be outlived. The annuity provider may or may not incur losses. Firstly, many people might have an annuity plan with the company. The distribution phase might be varied for each of these people. Thus, the issuer gains somewhere and loses elsewhere.

Secondly, the accumulation phase usually lasts for years and even decades. Hence, the premiums keep adding to the annuity and are compounded as long as they stay. The annuity issuer can use this money for their operations, or they can invest elsewhere to make financial gains. These gains can help them pay back the annuitants if the distribution phase is longer.

Though lifetime annuities mostly end with the annuitant's death, customers now have more options than a straight life annuity. For example, they can choose plans which pass on the residual amount to the beneficiaries (in case the accumulation phase was greater than the distribution phase), as in a life annuity with a certain period. Or, they can purchase a rider for this purpose.

Examples

Let's discuss some examples of a life annuity.

Example #1

First, let's consider a hypothetical example. Annie was a dentist. When she turned 40, she started a life annuity. According to the plan, Annie has to pay $100 monthly. However, since she retired, she has received $500 monthly. Further, Annie purchased a rider on the annuity, ensuring that the investment payments were paid to her husband after her death.

Example #2

Post-retirement can be a huge transition. The preparation that goes into it can often start decades before. Individuals like to be extra-cautious when they think about retirement. Thus, the prominence of the many retirement investment options in the market grows. Retirees should always receive professional advice on the best financial investment.

Recent research reports that retirees believe the market to be the greatest financial risk to their investments. However, in reality, the biggest threat is their longevity. Here, longevity is correlated to the probability that retirees might run out of funds. As it turns out, life annuities can be the best option at their disposal.

Life Annuity vs Living Annuity vs Life Insurance

Life annuities, life insurance, and living annuities are all similar financial instruments. But they differ in many aspects – function, goal, etc.

A living annuity is a financial investment tailored for the post-retirement period. These investments earn a regular income for the annuitants while helping their funds grow.
On the other hand, life insurance insures the person entering the contract. It is based on contingencies, and the insurance company promises to transfer the amount to the individual's beneficiaries upon the policyholder's death.
The investment automatically passes to the individual's living annuity and life insurance beneficiaries. However, in a life annuity, the annuitant must seek such an option or purchase a rider.
A living annuity is a financial security; thus, investment risks are associated. In addition, the monthly income is subject to market forces and conditions. In the case of a life annuity, guaranteed monthly payments are made to the annuitant.
Life and living annuities payout during the annuitant's lifetime, whereas life insurance pays only upon the insured's death.
Life annuities, once started, are not flexible. Premium payments have to be made until retirement. But living annuities and life insurance can be revoked if the individual wishes. Living annuities even permit the annuitant to make any policy changes. The frequency, though, is restricted.
Life insurance claims are not taxable. Annuities are taxable, depending on their type. Quantified annuities can be taxed, whereas unquantified ones cannot.

Frequently Asked Questions (FAQs)

1. What is a straight-life annuity?

In a straight annuity, the issuer stops making regular payments to the beneficiary upon the annuitant's death. That is, even though the amount received by the company exceeds the amount paid to the annuitant, the residual amount cannot be claimed by the annuitant's beneficiaries.

2. What is a single-life annuity?

A single-life annuity is the same as a straight annuity. The annuitant is paid till their death. But after that, no claims to the annuity fund can be made. The annuitants will not be able to purchase a rider for such annuities.

3. What is a life annuity with a period certain?

A period certain annuity ensures that the annuitant's beneficiaries receive the annuity amount even if the annuitant passes away. They receive the full amount that was entitled to the annuitant. Thus, a period certain annuity is the opposite of a straight annuity.