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How Annuities Work - the basics

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Oliver wrote to me asking whether I could expand a little on how an annuity works. I'll directly answer his questions at the end of this article, but before we get there let's discuss some basics.

What is an annuity?

During their working lives many people save up, so that on retirement they can purchase an annuity, which is a stream of regular payments (usually monthly).

(Financial purists will argue that the annuity payments need not be monthly, they could potentially be quarterly, half-yearly or annually - and they're correct of course, but the vast majority of the time the annuity payments take place on a monthly basis, so this article is worded as if that is the case for all annuities.)

Life annuities & term annuities

A life annuity (or more strictly speaking a "single life annuity") is a stream of monthly payments received until you die. A term annuity is a stream of monthly payments received for a period of time which is agreed up front (e.g. 10 years).

Joint life annuities

A joint life annuity is a stream of monthly payments paid to a husband and wife, until both of them have died (I say husband and wife, but it could also be common-law partners). Some joint life annuities may be structured so that the annuity payments fall by a certain percentage on the first spouse's death (and then to zero on the death of both spouses).

Guarantee term

Single life and joint life annuities may also have guaranteed terms (e.g. 10 years) of payment. Should both the husband and wife die before the end of the guaranteed term, annuity payments will continue to be paid to their dependents until the end of the guaranteed term.

Conventional annuities and living annuities

Conventional annuities are also known as "conventional life annuities", and they involve guarantees that the annuity payments wont decrease and sometimes that the annuity payments will increase at a fixed rate, or at a rate which is a percentage of inflation (an annuity increasing at 100% of inflation is the gold standard of annuities); unless the annuitant or his/her spouse dies.

What is a retirement annuity?

Don't confuse the term "Annuities" with the term "Retirement Annuities". A Retirement Annuity is an investment vehicle used to save BEFORE retirement, the proceeds of which are used to purchase an annuity at retirement.

Back to Oliver's questions

 

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