Annuties

Annuities

An annuity is a fixed-income investment, where you pay a chunk sum up front and receive constant payments on a regular basis. The payments will be more than archetypal savings accounts or CDs due to the fact that you lose the principal. You are specifically paid the standard interest rate for savings, in addition to a few of your principal as well.

To estimate how much will be required to be invested to obtain a particular payment, you can make use of use the Present Value of an Annuity formula. Characteristically it deciphers the amount of money you are loaning the bank (or insurance company) in return for regular repayment.

A=p⁄r[1-(1+r)-t]

A is the total amount of the annuity, P is the payment, r is the interest rate, and t is the number of periods. Ensure that you are consistent with the time period - if you use months, you ought to divide the annual interest rate by 12 and multiply the number of years by 12.

Below is an example: Assuming that Mercy wants to purchase an annuity that pays N1000/month for the next 20 years. The interest rate on this annuity is 6%. How much will she have to pay now to obtain such an annuity?

From the result obtained, she would be required to pay N139,581 today to receive guaranteed payments of $1000 a month for the next 20 years (a total of $240,000). The bank or insurance company still makes money by investing that lump sum at a higher rate of return than they are paying out to Mercy.

This type of annuity is a fixed annuity due to the fact that it pays a set payment every month. It is as well a fixed-period annuity due to the fact that it pays for 20 years. Other annuities possess variable rates depending on the achievement of bonds or stocks held by the institution. A few pay for the rest of the investor’s life, however long or short that may be.

Frequently, insurance companies take care of annuities due to the fact that they are very good at knowing how long people will live. If their customers all lived too long, they would need to keep paying annuities.

An annuity can therefore be defined as a contractual financial product sold by financial institutions that is meant to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. The period of time when an annuity is being funded and before payouts begins is known as the accumulation phase. Immediately at the commencement of the payment is referred to as the annuitization phase of the contract.

Annuities were designed to be a dependable means of obtaining a constant cash flow for an individual during their retirement years and to lessen fears of longevity risk, or outliving one's assets.

Annuities can as well be formed to turn a huge lump sum into a steady cash flow, like for winners of large cash settlements from a lawsuit or from winning the lottery.

Defined benefit pensions and Social Security are two instances of lifetime guaranteed annuities that pay retirees a constant cash flow till they pass.

Types of Annuities

Annuities can be planned with regards to a broad array of details and factors, like the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be produced in order that, upon annuitization, payments will continue in so far as either the annuitant or their spouse (if survivorship benefit is elected) is alive. On the other hand, annuities can be planned to pay out funds for a fixed amount of time, like 20 years, irrespective of how long the annuitant lives. In addition, annuities can start immediately upon deposit of a huge sum, or they can be planned as deferred benefits.

Annuities can be planned generally as either fixed or variable. Fixed annuities make available regular periodic payments to the annuitant. Variable annuities allow the owner to receive greater future cash flows if investments of the annuity fund do well and smaller payments if its investments perform poorly. This makes available a less stable cash flow than a fixed annuity, but permits the annuitant to reap the benefits of huge returns from their fund's investments.

One criticism of annuities is that they are illiquid. Deposits into annuity contracts are basically locked up for a period of time, referred to as the surrender period, where the annuitant would be penalized if all or part of that money was touched. These surrender periods can last for about 2 to more than 10 years, depending on the specific product. Surrender fees can begin at 10% or more and the penalty characteristically lessens every year over the surrender period.

While variable annuities is made up of market risk and the potential to lose principal, riders and features can be added to annuity contracts (normally for a few extra cost) which permit them to function as hybrid fixed-variable annuities. Contract owners can gain from upside portfolio potential while at the same time benefiting from the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio lowers in value. Other riders may be purchased to add a death benefit to the contract or accelerate payouts if the annuity holder is diagnosed with a terminal illness. Cost of living riders are widespread to regulate the annual base cash flows for inflation based on changes in the CPI.

Who Sells Annuities

Life insurance companies and investment companies are the two sorts of financial institutions that offers annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to handle mortality risk – that is, the risk of untimely death. Policyholders pay an annual premium to the insurance company who will pay out a huge sum upon their death.

If policyholders die prematurely, the insurer will pay out the death benefit at a net loss to the company. Actuarial science and claims experience permits these insurance companies to price their policies in order that on average people will live long enough that they earn a net profit. Annuities, on the other hand, take care of longevity risk, or the risk of outliving ones assets. The risk to the issuer of the annuity is that annuity holders will live outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.

In the majority of instances, the cash value within permanent life insurance policies can be exchanged through a 1035 exchange for an annuity product without any tax implications.

Agents or brokers selling annuities are required to hold a state-issued life insurance license, and as well a securities license in the case of variable annuities. These agents or brokers basically earn a commission based on the notional value of the annuity contract.

Those that buys Annuities

Annuities are proper financial products for individuals wanting steady, guaranteed retirement income. Due to the fact that the huge sum put into the annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity requirements. Annuity holders cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that he or she is trading a liquid lump sum for a guaranteed series of cash flows, the product is suitable. A few purchasers hope to cash out an annuity in the future at a profit, nevertheless, this is not the intended use of the product.

Immediate annuities are frequently purchased by people of any age who have received a large sum of money and who prefer to exchange it for cash flows in to the future. The lottery winner's curse is that a lot of lottery winners who take the huge sum windfall frequently spend all of that money in a comparatively short period of time.

Annuity Consideration'

The money that an individual pays to an insurance company in exchange for a financial instrument that makes available a stream of payments for a specific length of time is known as annuity consideration. An annuity consideration may be made as a lump sum or a as a series of regular payments. 

Annuity is also known as a "premium".

The payments made available by the annuity can be shared monthly, quarterly, semiannually or annually. Payment amounts are based on a number of factors, which includes the amount of the annuity consideration, the age at which the annuitant starts to receive payments, the annuitant's life expectancy, the annuity's expected investment returns and whether the annuity is fixed or variable.

An annuity can as well be defined as a contract between you and an insurance company that is planned to meet retirement and other long-range goals, under which you make a lump-sum payment or series of payments. In return, the insurer accepts to make periodic payments to you beginning immediately or at some future date.

Annuities characteristically make available tax-deferred growth of earnings and may be made up of a death benefit that will pay your beneficiary a specified minimum amount, like your total purchase payments. While tax is deferred on earnings growth, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, and not capital gains rates. If you withdraw your money early from an annuity, you may pay substantial surrender charges to the insurance company, in addition to tax penalties.

There are mainly three types of annuities — fixed, indexed, and variable. In a fixed annuity, the insurance company accepts to pay you no less than a particular rate of interest during the time that your account is growing. The insurance company as well agrees that the periodic payments will be a particular amount per naira in your account. These periodic payments may last for a definite period, like 20 years, or an indefinite period, like your lifetime or the lifetime of you and your spouse.

In an indexed annuity, the insurance company credits you with a return that is based on alterations in an index, like the S&P 500 Composite Stock Price Index. Indexed annuity contracts as well make available that the contract value will be no less than a given minimum, irrespective of index performance.

In a variable annuity, you can decide to invest your purchase payments from among a range of various investment options, basically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you obtain in the end, will differ depending on the performance of the investment options you have chosen.

Variable annuities are securities regulated by the SEC. An indexed annuity may or may not be a security; nevertheless, the majority of indexed annuities are not registered with the SEC. Fixed annuities are not securities and are not regulated by the SEC.

Calculating Different Types of Annuities

Annuity payments may be required to be made or received over time at a specific time intervals.

The most widespread payment intervals are yearly (once a year), semi-annually (twice a year), quarterly (four times a year), and monthly (once a month).

A few examples of annuities are Mortgages, Car payments, Rent, Pension fund payments, Insurance premiums.

Types of Annuities

Ordinary Annuity

An Ordinary Annuity has the following features:

The payments are constantly made at the end of each interval

The interest rate compounds at the same interval as the payment interval

Example: 

Joseph 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.

Solution:

First, we assign all the terms:

R= ₦50

i= 0.05/12 or 0.004166

n= 18 x 12, or 216

Now substituting into the formular we have:

S in = R[(1+i)^ n -1]

₦50[(1+0.05/12)^216 -1]

S n = 0.05 / 12

S n = ₦50(349.2020206)

S n = ₦17,460.10

Formula for calculating present value of a simple annuity:

R[1-(1+i)^-n] 

Example:

Joseph asks you to assist him determine the correct price to pay for an annuity offering a retirement income of ₦1,000 a month for 10 years. Assume the interest rate is 6% compounded monthly.

Solution:

Substituting into our formula, we have:

R = ₦1,000 

i = 0.06 /12 or 0.005 

n = 12 x 10, or 120

A n = 1,000[1-(1+0.005)^-120]

0.005

A n = ₦90,073.45

Annuity Due: 

In an annuity due, the payments take place at the start of the payment period.

For calculating the sum of a series of regular payments, the following formula ought to be used:

S in (due)= R(1+i)[(1+i)^ n -1]

Example: Joseph wants to deposit ₦300 into a fund at the beginning of each month. If he can earn 10% compounded interest monthly, how much amount will be there in the fund at the end of 6 years?

Solution:

R = ₦300 

i = 0.10/12 or 0.008333 

n = 12 x 6 or 72

Substituting into our formula yields:

S n (due) = N300(1+0.10/12)[(1+0.10/12)^72-1] 0.10/12

S n (due) = ₦300(98.93)

S n (due) = ₦29,679

Formula for calculating present value of an annuity due:

A in(due) = R(1+i)[1-(1+i)^-n]

Example: 

The monthly rent on an apartment is ₦950 per month payable at the beginning of each month. If the present interest is 12% compounded monthly, what single payment 12 months in advance would be equal to a year’s rent?

Solution: 

R= ₦950

i= 0.12/12 or 0.01

n= 12

Substituting into the formula gives:

A n(due) = ₦950(1+0.03)[1-(1+0.01)^-12]

0.01

A n(due) = ₦950(11.37)

A n(due) = ₦10,801.50

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