A deferred annuity is a annuity plan where an investor elects to start receiving payments at a later date.
This type of plan is often catered to those who financially plan for long term savings.
It is also in contrast with an immediate annuity plan where the buyer starts collecting payments from the next payment date.
People who purchase deferred annuity can either make payment in two ways.
- Lump sum payment
- Recurring series of installments
For lump sum payments, investors basically pay a lump sum at one time, and choose to receive a monthly income commencing at a later date.
For example, someone would make a $100,000 payment now and start receiving cash payments from the beginning of 1st January 2035.
This can be a shrewd method of money management as a dollar today would not be worth a dollar in a decade. It would also ensure a future source of income no matter what types of financial catastrophe one might encounter from today till the date payment starts.
Most people who purchase deferred annuity plans would select regular monthly payments simply because they don’t have so much cash for a single upfront lump sum payment.
This would work somewhat like a savings plan where money is deposited in a personal account, which he or she would be able to access in future.
The difference here is that annuities tend to offer better protection against inflation and the depressed effects caused by the time value of money.
This is also why those who buys such plans are often labelled as investors.
For example, a person might pay $100 a month until the end of 2030, and then start receiving monthly cheques from the insurer from 2031 onwards.
Such contract arrangements can be said to consist of two phases.
- Savings phase
- Income phase
The savings phase, or accumulation phase, is the period where the individual regularly invest money into the annuity account.
The income phase is when the account holder starts reaping the rewards from all the years of saving.
How deferred annuity works
If a deferred annuity contract is allowed to run it’s entire lifespan, the total amount of money an annuitant would receive would be more than what was put in.
This is barring any extraordinary events.
The reason why this is possible is that insurers offer attractive interest rates on the funds, with most of them guaranteeing a specific minimum interest earned.
This makes annuities a worthy alternative of fixed deposits.
Insurers would use the funds collected for their financial activities, such as investing in treasury bonds, and generate a return higher than the interest paid to the account holder.
It ensures that every party wins.
The governments gets buyers of the bonds they issue, the insurer clocks a profit, and the saver gets to collect a recurring income in the future.
Deferred annuities can be fixed income or variable income.
As the name suggest, fixed income annuity investors would received a fixed income when the payment period commences.
Variable income annuities would mean fluctuating income received as the performance of the fund is tied to the performance of stocks or indices that they are pegged to. This because the funds have been used to purchase them.
However, because the primary purpose of most annuity investors is stability and predictability, it’s no surprise that the average person who opt for fixed income annuities.
More advantages of deferred annuity
The basic premise of investing in such financial products is for financial and retirement planning.
Going into retirement age without the ability to work for a living can be a fear on the back of everyone’s minds.
But other than the financial benefits that would be harvested in future, it can also have more immediate financial advantages.
Because of the deferred income arrangement with such products, it would also carry deferred tax.
This means that income inside the annuity wouldn’t have to pay tax until they are withdrawn. The account that holds tax-deferral funds are also called tax-deferred accounts.
In fact, some investors used annuity accounts as a financial management tool rather than a method of receiving future payments. They use these types of accounts to hold their money to defer tax, enabling the funds to earn an interest before becoming payment towards tax. They can then withdraw the funds as and when needed, withdraw a whole lump sum, or even transfer to a different account.
This essentially means that the account is used like a savings account, but with better interest, tax benefits, and guarantees provided by the insurer.
Premature surrendering before maturity date will result in the annuitant receiving a surrender value. This would be made up of guaranteed cash value, plus any add-ons like terminal bonus, less outstanding loans and interest. The funds withdrawn can also be taxed as ordinary income.
Most deferred annuities would also have features that allow the annuitant to:
- Add funds to the accumulation account
- Make lump sum withdrawals
- Change the payment commencement date and structure
- Earn an interest on the funds
However, there would be terms that govern how these features work and conditions that must be met.
Different insurance companies would also have their own terms and rules regarding annuities.
One particular feature that people generally like is a death benefit component that is attached to the account. It ensures that beneficiaries would receive a certain amount of money upon the death of the annuitants.
This is important as the investor wouldn’t want all that money in the account, which consist of principal and interest earned, to be forfeited by the insurer if there is an early death before commencement of payments.
For example, a $100,000 lump sum deferred annuity that is set to start paying 10 years later on a monthly basis for 20 years can have a total payment amount of $125,000 over the life of the plan. Should the investor die before or during the payout period, then the listed beneficiaries would receive the payments in his place or receive the money in one lump sum which equals the cash value in the account balance.
For variable income annuities, a minimum payout amount would be indicated with the actual amount determined by market forces.