Understanding the Mathematics of Personal Finance


A single clear, concise, definition of annuity is impossible to create, because there are two principal financial vehicles called annuities and an untold number of varia­tions and combinations within each of these two vehicle categories. A fixed annuity is considered in the United States to be a savings scheme with certain tax advantages and is regulated by the IRS. A variable annuity is considered in the United States to be an investment scheme, again with certain tax advantages, and is regulated by the U. S. Securities and Exchange Commission (SEC).

An annuity is a contract between you and an insurance company by which you give the insurance company money either in a lump sum or over time (the accumula­tion period) and then it starts sending you periodic payments. While the company has your money, it is investing this money and returning some of the profits (and possibly losses) to your account. The payments might continue for some fixed, specified, period of time or they might be for life.

A fixed annuity is an annuity that provides a guaranteed rate of return. The insurance company is taking the risk—it is betting that it can invest the money and earn a higher rate of return than the rate of return that it promised to give to you.

A variable annuity is an annuity in which the insurance company is investing the funds in your account for you and you are assuming both the opportunity for higher returns and the risk of investments. Variable annuities can get quite involved in that there might be a guaranteed part (i. e., a fixed annuity inside the variable annuity) and a host of subaccounts with different levels of risk and opportunity.

Annuity contracts can contain fees and/or periodic service charges. I ’ m not considering these costs here because they don’t interact with understanding how the annuities work. Obviously, when shopping for an annuity, consider all of these costs and look for a (reputable) company with the lowest costs.

In the pages to follow, I’ll be discussing some basic annuities. Because of the incredible number of variations available, I can’t possibly discuss them all. My best advice is for you to read and/or make the salesperson explain things very, very, slowly until you’re sure you understand exactly what you’re buying. For example, there are rules concerning contract cancellation and return of remaining funds. Some

Understanding the Mathematics of Personal Finance: An Introduction to Financial Literacy, by

Lawrence N. Dworsky

Copyright © 2009 John Wiley & Sons, Inc.

contracts just say no; some contracts allow for cancellation in the case of, say, medical emergencies. Fees are usually associated with these cancellations.

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