The fixed annuity (also called a life annuity) contract is the most common type of annuity. The main purpose of this contract is to provide a lifelong income stream to the investor. The investor invests a lump sum of money in exchange of a set of periodic payments (mostly monthly) until the moment of his death.
Example of a Fixed Annuity
Mr. Rogers is about to retire. His house is paid and he has some savings aside to insure a great retirement. However, he doesn’t want to see his portfolio value going up and down all the time. He remembers clearly what happen in 2008 and certainly doesn’t want to feel unease at retirement. His investment currently shows $500,000. He decides to take off $250,000 from his investment and buy a life annuity.
The life annuity is purchased from a Life Insurance Company and the periodic payments are fully guaranteed. The company agrees to pay Mr. Rogers the sum of $17,500 per year, the equivalent to 7% of his $250,000. The amount of the payment was based on the age and overall health condition of Mr. Roger. In other word, the Life Insurance Company doesn’t expect M. Roger to live for another 40 years (which would equal to a sum of payments of $700,000).
Calculation of the Investment Return
The investment return on a life annuity is unknown as it all depends on the date of death of the beneficiary, Mr. Rogers. For example, if the investor were to die three years after purchasing his annuity, he would have received a total payment of $52,500 from an investment of $250,000. Please note that on a regular life annuity contract, the remaining of the investment stays with the Life Insurance Company. Therefore, the estate of Mr. Rogers would lose $197,500. This is definitely not a good investment return!
On the other side, if Mr. Rogers beat the odds and live for 30 years, he would receive the sum of $525,000. This is a total investment return of 110% or a 5.65% annualized return. If you were to invest money today for 30 years, it would be impossible for you to find an investment paying a guaranteed 5.65%. This is why the life annuity could be a very interesting option for retirees.
Main Flaw of the Life Annuity
The main flaw of the life annuity is that the capital used to buy the contract is not guaranteed. This is why is it very important to make sure you don’t invest all your money into a life annuity and that you have a great life expectation (no family record, good health, healthy habits, etc).
If you pass away like Mr. Rogers three years only after buying a life annuity, you will be wasting a lot of money. While included in a financial planning approach, it is common to find a life insurance combined with the life annuity in order to protect the capital in such situation. This is called a guaranteed life annuity.
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