Deferred Annuities

What is a deferred annuity?

What distinguishes annuities as deferred annuities is that they do not pay income immediately. First, there is a period of deferment, during which you can pay into the annuity gradually, and you capital builds interest.

In detail

For a deferred annuity, you make payments for some duration called your accumlation phase or deferment period; this period may last as long as you wish, and as long as it lasts, you are free to pay more money into your annuity. Putting in more money means that your income payments (when they occur) will be larger. After you indicate that you wish to begin your pension (income phase), the life insurance company that created your annuity will pay you an income.

Pension

Depending on your deferred annuity, your income may come in a variety of ways or give you your choice of pension plans. E.g. you may take it all in a single lump sum, you can receive an income for the rest of your life, or you can receive an income for a certain number of years. For a detailed explanation of the different pension options, read about different annuities' guarantees of duration.

A popular use of deferred annuities

Deferred annuities are designed for retirement planning: you invest in them while you're drawing a salary, then when you retire, you trigger the pension so that you will continue to receive an income for the rest of your life. However, we more usually see people purchasing annuities for the sake of shorter-term investment.

Deferred annuities are not legally classified as investment products, but they tend to offer interest rates higher than or competitive with usual investment products. They have another advantage, due to their nature as life insurance products: they are tax-advantaged. The interest you earn on your annuity is subject to income tax, but the taxes don't need to be paid until your income phase. What this means is that you get to hold onto your interest and earn compound interest on that. Compare this with CDs, which do require you to pay taxes each year, as interest is accrued. Let's look at an example.

Say you put $1000 into a deferred annuity and another $1000 into a CD, both of which guarantee an interest rate of 6%. Let's assume a tax rate of 20% and that you cash in both products after 5 years. Your figures look like this:

	annuity	CD
0 years	$1000.00	$1000.00
1 year	$1060.00	$1048.00
2 years	$1123.60	$1098.30
3 years	$1191.02	$1151.02
4 years	$1262.48	$1206.27
5 years	$1270.58	$1264.17

What we see here is that for the CD you pay taxes on each year's interest as time goes on. With the annuity, however, you pay no taxes until the end; meanwhile, you compound interest on the money that will eventually be paid in taxes.

If you don't take your payment in a lump sum but instead opt for a pension, then you get to further defer the taxes: with most annuities, the life insurance company guesses how long the pension will be paid (how long you will live) and with based on that estimate, issues a portion of your capital and a portion of your interest with each pension payment.