Retirement plans are mainly classified into two types on the basis of benefit calculation namely:
- Defined benefit plans This is a pension plan where a final amount is calculated based on a formula that involves the service of a person with an employer and paid to all retirees from a dedicated trust fund.
- Defined contribution plans An individual holds a separate account to which an amount is contributed periodically by the account holder which is then used to make purchases in the markets.
The amount contributed and the performance of the investments in the market determines an individual’s benefits. Individual Retirement Account (IRA), 401(k), profit sharing plans are the some of the most common plans in recent years.
What is an annuity?
An annuity is defined contribution plan where a set amount is paid by an individual to a financial company, who guarantees benefits for lifetime. Annuity amount is invested in various markets and works more like an insurance policy with payout frequency ranging from monthly, annual or one-time lump sum payment.
Types of Annuities
- Immediate payment annuity: A lump sum amount paid by the consumer starts to give the benefits almost immediately on a set period of payment. Payouts can be monthly, quarterly etc. as desired by the consumer and payouts depend on the market performance.
Advantage: If no other sources of income is available post retirement and one needs immediate financial support, then this can be a good option as the payouts start immediately.
Disadvantage: The payout rates depends on the market and this may lead to a highly instable income.
- Fixed income annuity: The rate is fixed on the amount paid for an initially agreed period. Although the rates fluctuate based on the market performance, it will never go below the initial set rate during the lifetime.
Advantage: As a minimum rate is pre-set, there will be a guaranteed amount of benefit even if the market drops below which makes it a relatively safer option to invest.
Disadvantage: The payouts are not immediate and may range from one year to ten years.
- Variable annuities: This works similar to a mutual fund and the amount is spread over multiple investment accounts, that are completely dependent on the market and involves higher risk if the company does not perform well.
Advantage: Offers high returns as the investment is spread over different accounts
Disadvantage: Does not provide an assured benefit and involves high risk of losing the investment.
- Equity indexed annuity: This combines the features of fixed and variable annuities wherein a minimum rate is fixed, and the earnings above this is allowed to be invested, which may yield higher benefit if the market is good.
Advantage: Assures a definite payout with the set frequency and earns more than fixed plan if the market performs well.
Disadvantage: The consumer will earn only the minimum amount agreed upon if the market underperforms and loses the amount earned above the set rate.
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