An annuity is a series of payments at a regular interval, such as weekly, monthly or yearly. Fixed annuities pay the same amount in each period, whereas the amounts can change in variable annuities. The payments in an ordinary annuity occur at the end of each period. In contrast, an annuity due features payments occurring at the beginning of each period.
The classic example of an annuity due is rent. When you sign a lease for an apartment, you commit to pay rent on the first of each month. This qualifies as an annuity due because the payments occur at a regular interval (monthly) and at the beginning of each period. Insurance premium payments are another common example of annuity due. Notice how annuity due is usually found in situations where you are paying out money.
Ordinary annuities are seen in retirement accounts, where you receive a fixed or variable payment every month from an insurance company, based on the value built up in the annuity account. In a fixed annuity account, your monthly payment is based on a fixed interest rate applied to the account balance at the start of payments. Variable annuity account payments are based on the investment performance of your account. Retirement annuities send you payments at the end of each period. That’s standard when you are the recipient of annuity payments rather than the payer.
A Word About Annuity Accounts
An annuity account is meant to pay you money each month for either a fixed number of years or until you die, according to your contract with the insurance company. The largest insurance carriers are likely to make all payments on time, but annuities from smaller carriers carry some risk that the insurer will default on its payments. All financial annuities carry the risk of underperforming relative to the broader stock market, especially compared to the returns available from low-cost index funds. A financial adviser can review the pros and cons of retirement annuities with you before you commit to one.
A fixed annuity’s present value is how much the future cash flows are worth in today’s dollars. It’s figured by reducing the value of each payment based on a discount factor (typically the current interest rate on short-term U.S. Treasury debt) and the time until the payment occurs. Consider two fixed annuities, one an ordinary annuity and the other an annuity due, but otherwise identical. The annuity due will have the higher present value, because you collect your money sooner, leaving less money to be discounted.
Video of the Day
- Hemera Technologies/AbleStock.com/Getty Images