Understanding Annuities

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Your aunt is 60 years old. She expects to live up to 80 years of age. She would like to receive a fixed monthly payment of $1000 per month for the next 20 years. The market interest rate is 4% and compounding is done on a monthly basis. She is asking you how much should she invest from her retirement savings into an immediate annuity so that she is guaranteed a $1000 monthly payment? Choose the right answer.

  • (A) 240,015
  • (B) 165,022


Prerequisite to solving this problem is to understand the time value of money.

What is an Annuity?

Annuity is basically a tax deferred investment. Annuities are sold by insurance companies / agents, banks, and brokerage firms. The capital gains you receive are not taxed until you start receiving payments. Just like a traditional IRA, the earliest you can withdraw money without paying a penalty is when you are 59.5 years of age. When you start collecting monthly payments at the age of 59.5 years, only the portion of money that is considered capital gains or interest income is taxed at your current applicable tax rate. Unlike a 401k or an IRA, there is no limit to the contribution you can make per year into an annuity.

Who should invest in an annuity?

If you have already maxed out  your 401k and IRA contribution to the IRS specified limit per year, then you should consider investing in annuities. It makes sense to invest in annuities if you are in the high income tax bracket. Annuities provide a way to invest money that grows in tax deferred account. If you are investing in an annuity, you are basically putting away money for retirement. If you withdraw money early, especially within the first few years, you may be hit with severe surrender charges and a tax penalty.

Types of Annuities:

  • Immediate Annuities:  you make a lump sum payment. Soon after that, you start receiving monthly payments according to your selected payout option.
  • Deferred Annuities: the deferred annuity grows over a period of time. It can be converted to an immediate annuity when you want to start withdrawing money on a monthly basis.
  • Both types of annuities can be further categorized into (a) fixed or (b) variable type annuities.
    • Fixed – with fixed annuities, the principal and interest income are guaranteed.
    • Variable – you choose the investments being made in the annuity and the amount you earn depends on how your selected investments perform.

Annuities Payout Options:

Insurance companies look at your age and several other factors to calculate your life expectancy in coming up with the payment amount for each of these options below:

  • Life Annuity – you will receive monthly payments until you die. This is an effective edge against worries of you running out of retirement savings.
  • Joint Life Annuity – you or your spouse receive monthly payments until both of you die. The monthly payments here will be slightly less than Life Annuity.
  • Guaranteed Period: you will receive monthly payments for the fixed period of 10, 15, or more years you signed up for. If you die within the period, the remainder payments will be made to the listed beneficiary.
  • Life with Guaranteed Period: this is a combo approach. As the name implies, you will receive payments until you die. It also includes a guaranteed period you specify – example 10 years. In case you die within the 10 year period, then the remaining payments will be made to the beneficiary listed.
  • Lump Sum Option: Though this is a option on table, it is not recommended due to the tax disadvantage – you will be taxed highly the year you collect your lump sum payment.
  • Not Collecting Annuity Payments: If you don’t need the money and you don’t collect payments, then the annuity can get transferred to your beneficiary at the time of your death.

Questions to ask before investing in an Annuity with any brokerage firm?

  • What is the expense ratio? How does the firm make money? What percentage of your investment is taken as management fees?
  • What are the surrender charges?
  • Once you select your payout option, you should ask what would be the exclusion ratio? Exclusion ratio  means how much of your monthly payments that you receive wouldn’ t be subject to taxes. If you receive $500 per month, and the exclusion ratio is 90%, then you will be taxed on $50 per month.

You really need to drill down on the questions questions above, and have a very clear understanding before you invest in annuities. I would also suggest that you read one of the books in the “Further Reading Resources” and do your own research before investing in annuities. Investing ~$20 in books, reading, and understanding can go long ways in protecting you from getting ripped off.


You need to calculate the present value of future monthly cash flows.

In an Excel cell type “=PV(0.04/12,12*20,-1000)”, and you get $165,021.86. 

Hence the correct answer is Option B – 165,021.86.

Further Reading Resources:

Annuities For Dummies®

The Annuity Stanifesto

How to NOT Get Ripped Off when Buying an Annuity

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