Income Generating Annuities
An annuity is a financial instrument that returns to the investor a fixed stream of payments in exchange for an upfront lump sum payment. This calculator can be used to estimate the income stream generated from an annuity. To do so, the calculator requires four inputs:
- The upfront lump sum payment, which is the starting principal
- The expected return on the funds placed in the annuity
- The term or length of the annuity, which is the number of years over which the income stream is paid
- The payout frequency, which can be annually, semiannually (every six months), quarterly, or monthly
The calculator then provides the user with the following values:
- The withdrawal rate, which is the amount received each payment period
- The total interest earned on the investment over the course of the annuity’s term
- A chart showing the balance of the annuity over time as the funds are depleted
Note: Hovering over each column in the chart displays the fund’s balance at that point in time
What is an Annuity?
Annuities are designed to provide the investor with a fixed stream of income in exchange for an upfront payment. Typically issued by insurance companies, annuities are often used by retirees that worry about outliving their assets. The most common annuity is a fixed annuity, which provides the same payment each period. This type of annuity also provides advantages such as:
- Deferred taxes on the fund’s earnings
- Guaranteed periodic payments
- Death benefits to the investor’s beneficiaries
- Access to the funds placed in the annuity
Annuities are considered relatively safe investments when compared to common stocks and bonds. While annuities can be purchased through a variety of financial institutions such as banks and financial planners, only life insurance companies issue contracts.
Immediate versus Deferred Annuities
There are two ways the annuitant, or contract holder, can receive payments from an annuity. As the name implies, an immediate annuity begins payments shortly after the premium is paid. When the income stream is received at a future point in time, the investment is known as a deferred annuity. Retirees usually invest in immediate annuities, while investors looking to defer income taxes choose deferred annuities.
Fees and Commissions
As is the case with other investments, insurance companies will charge fees to recover the cost of maintaining the assets and disbursing the periodic payments. Examples of such fees and commissions include:
- Administrative Fees: a baseline charge to maintain the contract, which pays for services such as recordkeeping
- Surrender Charges: a fee paid when the contract holder wants access to the cash in their account. Typically, this size of this fee declines over time
- Contract Fee: much like the origination fee on a loan, this can be a flat fee collected annually or a one-time charge
- Sales Commission: one to three percent of the starting principal paid to the insurance agent selling the contract
Note: While the contract will detail the annuity’s fees, the person selling the contract has an obligation to review those fees with the person purchasing the contract.