An annuity is a financial planning product which allows a person to have a monthly stream of income until they die. In contrast with a life insurance product which is meant to create an estate when activated, an annuity is designed with the purpose of liquidating an estate or turning it into cash payments. Modern annuities and the current uses they have in retirement planning have only been relevant for a few decades now in the United States. However, the concept of an annuity is one that has been developed for a long time. Let’s go on a little history lesson, shall we?
Like many civic and societal inventions, the first concept of an annuity was introduced in the Roman Empire. Rome gave its citizens the opportunity to make one large payment into what was called the “annua” and in return the citizens would receive annual payments till death or for a specified period of time. This can easily be seen as a precursor to the annuity payment types we see today that we will discuss later. Rome was also known for paying their soldiers in annuities as compensation for their service, almost like a pension plan. It was also a Roman annuity dealer who created the first actuarial table, which is mind-blowing to me. This is yet another concept that we have to thank the Romans for originating.
Fast forward to the Middle Ages and annuities are now being used in a different way: raising capital. Feudal lords and Kings used annuities as a way to fund their constant wars with other kingdoms. Constituents would pay into what was called the “tontine” by doing so they pooled their money with other investors and helped pay the costs of war. The “tontine” was unique in the sense that the money was split in payments to all the living investors, so the incentive to be the last among the living was very high as you would receive the rest of the money in the “tontine”. Moving forward European governments, rather than issuing debt in the form of bonds, used government-issued annuities to finance government projects outside of the scope of war. As the age of colonialism and exploration started, annuities started to play a different role in society.
Colonial America started using annuities as a way to pay their pastors. Donations to the congregation from the leaders of the church and its members were used to fund annuities as the payment plan for the ministers of the church. In 1812, the “Pennsylvania Company for Insurance on Lives and Granting annuities” was created. The establishment of this company pushed forward the use of Life insurance and annuity products in American society. This also paved the way for annuity products to be used as a source of payment for Union soldiers in the civil war. Public distrust in banks following the Great Depression led investors to look elsewhere to place their money. Insurance companies were then seen as more trustworthy, and thus again annuity products continued to gain traction with the American people.
That brings us closer to today and what annuities can do for your financial plan. In short, there are two main types of annuity products which are fixed and variable annuities. The purchaser of a Fixed Annuity makes a single payment or a series of payments to a Life Insurance Company in exchange for the promise of a future income stream. The income stream may be guaranteed for a certain number of years or for the life of the purchaser. The money that is contributed to the annuity earns a fixed interest rate that is declared when the annuity contract is issued and may be guaranteed for a certain number of years after which time the rate will either increase or decrease based on the market rates at that time. The current low-interest rate environment has kept fixed annuity rates quite low.
Variable Annuities also allow for a single investment or a series of periodic investments into the annuity contract. Money that is invested into a variable annuity may be allocated to a “fixed account”, similar to the fixed annuity discussed above but, most often, the funds contributed to a variable annuity are invested into “separate accounts”. Separate Accounts are similar to mutual funds in that they invest in different market sectors; stocks, bonds, and cash. In fact, most separate accounts are managed by the same investment managers that run retail mutual funds bearing the same name. For example, the ABC Growth Fund management team may also manage the ABC Growth Fund “separate account” or “insurance series”.
Annuities are an interesting product with a storied history and many complex benefits. Hopefully you have enjoyed the brief history lesson I gave today. I found it all interesting, but, then again, I am a finance and history nerd. Annuities can be a beneficial tool to add to your investment strategy if used correctly and discussed with our financial advisor.
If you are interested in learning more about the benefits of annuities, feel free to reach out to us and we would be happy to provide more information about annuities and discuss how they could fit into your plan.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.