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How Annuities Work - the basics |
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.
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.)
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).
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).
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 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.
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.
QUESTION: If I buy a joint-life annuity for me and my wife. What happens if one of us dies before the 10yrs? ANSWER: If you have purchased a guarantee that the full pension be paid out for 10 years and one of you dies within the 10 year period, then the full monthly pension will continue to be paid to the survivor until the end of the 10 years, after which it will reduce by the percentage chosen (e.g. 50%) until the death of the surviving spouse.
QUESTION: What happens if both of us die before 10yrs? Is there a payout to our beneficiaries? ANSWER: If you have chosen a guarantee term of 10 years, then annuity payments will continue to be paid to your beneficiaries until the end of the 10 year period.
QUESTION: What happens if both of us live longer than 10 yrs? Does the payment continue, yet at an unguaranteed amount? ANSWER: If both of you are alive after 10 years the annuity will continue to be paid. The amount of the annuity payments depend on your choices made when purchasing the annuity. For example, if you purchased a level annuity then you receive the same annuity payment every month (no increases to account for inflation). When the first of you dies, the payment will decrease by a specified percentage you'd chosen at the start (e.g. 50%).
QUESTION: What happens if we die in e.g. year 15 - is there still a payout to our beneficiaries? ANSWER: For conventional life annuities, if your guarantee term chosen is shorter than 15 years, then there will be no payout to your beneficiaries on your death in year 15.
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