What is an Annuity?
An annuity, in the financial services industry is a contract under which one party the insurer - promises to make a series of periodic payments in exchange for a premium or a series of premiums.
Example of an annuity:
Mr. Gray has worked for Company X for forty years and retired at age 65 years on the December 31, 2007. His wife is 60 years old on that same date.
The company's Pension Plan will pay a pension to them both as follows:
- Pension is payable monthly starting on January 1, 2008
- Pension is $200,000 per month while both are alive
- On the death of any one, the pension will fall to $100,000 per month and continue until the death of the second
The pension is a regular series of payments; therefore the pension is an Annuity.
Different types of Annuities:
- An Annuity that is paid at the beginning of each period is called an Annuity Due(e.g.) Rent, Insurance Premium
- An Annuity that is paid at the end of each period is called an Annuity payable in Arrears(e.g.) Paying a loan monthly to the Bank
- An Annuity which must be paid for a specified period is called an Annuity Certain. (e.g.) Borrowed loan at the Bank. Said loan must be repaid in equal monthly instalments for sixty months.
- An Annuity with equal payments is called a Level Annuity.
- An Annuity with decreasing payments is called a Decreasing Annuity
- An Annuity which is payable for as long as the payer is alive is called a Life Annuity e.g. Whole Life Insurance Premiums
- An Annuity which is payable for a definite period (e.g. 5 years) but will only continue thereafter if the payer/receiver is alive is called an Annuity with a certain period plus Life thereafter. Most pensions are paid like this