What is a Deferred Income Annuity?
At Mountain Financial, one of the problems we encounter in explaining different types of financial vehicles is that our clients sometimes have difficulty understanding them. But not all of them are complicated. For instance, once you know how a deferred income annuity works, you can readily see why they are such a popular retirement strategy, even for people with ordinary incomes.
At its simplest, a deferred income annuity is an insurance product that guarantees you a specific level of income in your retirement. It starts paying out at a specific time you establish and continues for the remainder of your life – even if you live a very long time. Your income will be based on what you invest through either a lump sum payment or regular premiums.
What Can an Annuity Do For Me?
An annuity is somewhat like a private pension. The annuity terms are defined by the contract you make with your insurance company. Unlike a pension, however, you are free to determine the age at which you want to start collecting the income, and you can choose how much to receive based on how much you are able and willing to pay in. In addition, part of the contract guarantees that you will continue to receive the income for as long as you live.
There are several different types of annuities. The most basic one begins payments to you at a designated age, and the payments terminate when you die. However, if you are married, you and your spouse can create a “Joint and Survivor” annuity that will provide income for both of you while you are alive and continue paying out during the life of the survivor, even after one of you dies. You can also have a “Certain and Continuous” annuity that will make payments to a beneficiary for a specified number of years after you pass away.
How Do Annuities Work?
There is a reason that deferred income annuities are sold by insurance companies. Annuities work in much the same way that other insurance operates: by pooling the resources of many people to cover certain eventualities that happen to only a few people. They also cover things that eventually happen to everyone, but in a way that is spaced out over time.
Insurance companies rely on actuarial tables to estimate the likelihood that a given event will happen to a person with specific traits. For example, when it comes to auto insurance, actuarial tables are used to estimate the likelihood that a person belonging to a particular group of people (for example, within a given age bracket, with a certain number of vehicle tickets, living in a given region) will end up making an insurance claim. Based on that information, the insurer sets rates and collects premiums from its customers. Because it calculates the statistical likelihood of certain events happening over a broad population of rate-payers, it is virtually guaranteed that the company will collect more funds in a given year than it will have to pay out. This keeps annuities affordable.
Similarly, in an annuity contract, the insurance company bases its rates on how much they expect to pay out to you and to others similarly situated over your expected lifetimes.
When you invest in a deferred income annuity, you either pay a certain amount up front or contribute annual premiums. Insurance companies will require a minimum investment based on your age, taking into account the age at which you want to start receiving the income. Generally, the greater the time gap between these two ages, the lower your premiums because you will pay in over a more extended period of time. During this interim time, the insurance company can invest those funds.
You might ask: why don’t I just invest my own funds and just pay myself after I retire rather than purchase an annuity? That is always an option. But are you confident you can invest your own limited funds so that it guarantees you a particular income at a specific point in the future? Many people would prefer not to have to learn how to invest and then take on the risk that their investment choices will not pan out when they need them.
This is where insurance companies have a great advantage. With a deferred income annuity, the insurance company takes on the investment risks, not you. But their risks are minimized. Not only do they have investment professionals managing the funds, but they have a vast pool of assets. If certain investments do not provide a sufficient return within a given time frame, the insurance company still has extensive assets invested in other ways or can wait out a downturn until a particular investment provides better returns. They are not dependent – as you would be – on making sure that a limited amount of funds invested can provide a sufficient return within a finite period of time.
Income for Life Guaranteed
With annuities, insurance companies are taking the chance that you will not live past your average life expectancy while you are taking the chance that you will live at least that long. The insurance company is willing to take that chance because the actuarial schedules they rely upon virtually guarantee that they will collect more funds in any given year than they have to pay out to the pool of individuals who receive annuity payments.
Purchasing an annuity can give you considerable peace of mind, knowing that your retirement income is taken care of for as long as your retirement lasts. So long as you have upheld your end of the contract by making your premium payments, the insurance company guarantees you a future income that will not outlast your lifetime.
For more information about annuities and how we can structure the right one for you, contact Mountain Financial today.
