What is Annuity? – Meaning, Definition, and Types

Are you planning for retirement? You might be wondering about options available for retirement with maximum returns. “Annuity” can be one of the best options among the others that are available. Can an annuity provide you with a regular source of income during retirement? 

All your questions will get the answers after you complete this article. Here, we will discuss the meaning, definition and types of annuity. Ready to learn all about annuities? 

Understanding Annuity with an Example

An annuity is a financial product in terms of which the company enters into a contractual agreement with you where you pay a single sum or several instalments. Consequently, you promise to pay the specified amount in limited instalments, right away or upto a future date. An annuity’s main objective is to prevent people from suffering financial issues in old age by offering them a dependable source of income.

Here’s an simplified example to help you understand it well. Suppose you have invested Rs. 1 Lakh in an annuity instrument. The company gives an assurance of paying Rs. 20,000 for the next five years. This setup is to display how annuities generate a consistent income flow incase one plans to retire in the future.

In discussing the National Pension System (NPS) in India specifically, annuities have an essential role to play. Another requirement when investing in NPS is that a part of your income is mandatorily invested to purchase an annuity that provides a pension.

Types of Annuities

Various forms and variations of annuities cater to multiple financial objectives and risk appetites. Here, we’ll discuss the most common types:

Fixed Annuity:

This type guarantees that you are paid a particular sum for a given period or the rest of your life. It is particularly beneficial for those customers who seek regular and assured earnings since the yields earned are fixed and readily determinable. For example, if you invest in a fixed annuity of Rs. 100000, at an interest rate of 7%,  you will earn Rs. 8,821.77 per annum less charges (fess or others, if any) for the next twenty years. Due to the predictable nature, as a minimal annual return you will be provided with some interest on the amount. 

Variable Annuity:

In this type, one can negotiate concerning the cash flows relating to some of the investment decisions that the annuitant makes. For instance, if you invest Rs. 100000, in a variable annuity with stocks and bond funds, then annually, this product would pay higher if suitable investment was made. However, with high risks involved, there is the benefit of achieving higher returns. This means that the investor’s earnings can also go down the drain, hence, it is ideal for those investors who do not have a problem with the fluctuation of the market.

Immediate Annuity:

It is usually paid after each calendar month after the initial  Payment has been paid in one lumpsum amount. For instance, if you to retire at Rs. 200,000 (Let’s say) and get an immediate annuity, then you would be receiving monthly checks the following month. It is desirable for individuals who expect to receive an income after they reach retirement age, such as retired people.

Deferred Annuity:

Earnings from a deferred annuity usually occur later; i.e, payments are made in the future. Therefore, the invested sum will get a chance to increase. For instance, you are set to invest Rs. 50,000 in a deferred annuity to begin receiving your payments after ten years. They include those who wish to invest beyond the amount in their pension account to secure more significant rebates once they retire.

Indexed Annuity:

It gives returns correlated with an index, such as the stock market index. Hence, it presents moderate risks for moderate gains. If you invest in an indexed annuity and the index has excellent returns, then you also have greater returns right to the specific limit. This type can earn more than fixed annuities, shielding the investor against massive losses. Hence, it is more suited for those investors who seek high returns but with a certain level of security.

How do Annuities Work?

• First, the individual pays a lump sum amount for the annuity plan to be invested on the individual’s behalf.
• The company then pays the annuitized amount to the individual. The income can be paid monthly, quarterly, or yearly.
• The amount of income to be paid is calculated by considering the period covered by the annuity.Certain charges might also be levied in the final calculation.
• The individual can decide to receive the income payments for the remaining part of their life or a specific duration.
• The income will be determined depending on the type of income payout chosen, which can be a specified income (fixed annuity) or a variable income that depends on the fund created out of the annuity (variable annuity).

Advantages of Annuities

Annuities offer several advantages, making them a popular choice for retirement planning:

• Guaranteed Income: Perhaps the most significant advantage of annuities is the reassurance, which comes with the knowledge that there is a steady income that can be relied on perhaps during their retirement period.
• Tax Benefits: Annuity gains are usually taxed as ordinary income when received rather than as LTCG (Long Term Capital Gains). Often, the money put into an annuity is allowed to compound tax-free, meaning that no taxes are paid on the growth until the annuity is paid out or one reinvests. There are some relaxations exclusive to annuities like some annuities provide withdrawals notably for critical illness, where the possibility of higher withdrawal is likely.
• Customization: Annuities are versatile and can be customized to your preferences regarding payment duration, beneficiary choice, etc.

NPS Returns and Annuity

The return on your NPS investments varies according to the performance of the fund. Navigating for NPS returns is significant since there is an indication that superior returns lead to an enormous corpus and, therefore, a better annuity. Thus, monitoring your NPS returns and making necessary changes to your investments is crucial for achieving your desired retirement income.

Use of NPS Return Calculator

In this regard, items like the NPS return calculator are helpful when planning retirement. This calculator assists you in calculating the expected returns of the investments you make in NPS so you can forecast how much annuity you could get. By entering values like your contribution, age, and the expected rate of return, one can see the future financial prognosis.

Wrapping Up

Investing in annuities today is akin to planting a money tree. You must secure your future by choosing the right annuity. Annuities act as a significant retirement tool for individuals looking to create a stable and secured income with good NPS returns in the long run. 

So why wait? Now that you have checked out our article for detailed information on annuities. Let your investment in an annuity ensure that your money keeps coming without any financial pressure.