When planning for retirement, one of the decisions you'll consider is what kind of annuity to buy.
There are two main types: ordinary annuity and annuity due.
Both have their pros and cons, so how do you decide which is right for you? Let's take a look at the differences between the two options.
What is an annuity?
An annuity is a contract between an individual and an insurance company in which the insurer agrees to make regular payments to the annuitant.
The annuitant is the person who owns the annuity and receives payments. These payments either start immediately or at some point in the future.
An annuity is used as a way to save for retirement and other long-term financial goals.
Ordinary Annuity vs Annuity Due
There are two main types of annuities - ordinary annuities and annuities due.
You may be wondering what the difference between ordinary annuity and annuity due. An annuity due is one that has a payment due or made at the start of the payment interval. An ordinary annuity, on the other hand, pays out at the end of the period. As a result, the methods used to compute present and future values diverge.
An ordinary annuity has that payments are made at the end of each period (usually end of each month). An annuity due, on the other hand, has payments are made at the beginning of each period.
How do ordinary annuity payments work?
Ordinary annuities are annuities in which payments are made at the end of each period. The most common type of ordinary annuity is a monthly ordinary annuity, in which the payments are made at the end of each month.
With a monthly ordinary annuity, the insurer agrees to make periodic payments to the annuitant for a specified period of time, usually for a length (term) of 10, 20, or 30 years. The payments can be made either in a lump sum or in installments.
The main advantage of an ordinary annuity is that it typically has a lower interest rate than an annuity due. This is because the insurer receives payments earlier and can therefore invest them for a longer period of time.
The disadvantage of an ordinary annuity is that the annuitant does not receive any payments until the end of the specified period. This can be a problem if the annuitant needs money earlier than expected.
How do annuity due payments work?
An annuity due’s payments are made at the beginning of each period. The most common type of annuity due is a monthly annuity due, in which the payments are made at the beginning of each month.
Similar to ordinary annuity, the insurer agrees to make periodic payments to the annuitant for a specified period of time, usually for a term of 10, 20, or 30 years. Again, the payments can be made either in a lump sum or in installments.
The main advantage of an annuity due is that the annuitant receives payments earlier than with an ordinary annuity. This can be a big advantage if the annuitant needs money sooner than expected.
The disadvantage of an annuity due is that it typically has a higher interest rate (more expensive) than an ordinary annuity. This is because the insurer receives payments later and therefore has less time to invest them.
How does present value work?
The present value of an ordinary annuity is the money that the annuitant would need to invest today in order to receive a specified series of payments in the future.
To calculate the present value of an ordinary annuity, you need to know the:
- interest rate
- number of payments
- amount of each payment.
You can then use a present value calculator to determine the present value.
Due to inflation, the purchasing power of money decreases over time. This means that the same amount of money will be worth less in the future than it is today. In other words, the present value is used to determine the current value of a certain amount of money in the future.
The present value of an annuity due takes this into account and therefore has a higher present value when compared to an ordinary annuity. This is because with an annuity due, the payments are made at the beginning of each period, so the annuitant receives them sooner, resulting in a higher present value .
How can an ordinary annuity be used in retirement planning?
One of the most common ways to use ordinary annuities is for a Registered Retirement Savings Plan (RRSP). With an RRSP, annuitants can contribute a certain amount of money each year, up to a maximum RRSP limit, and receive a tax deduction for the contributions. The money in the RRSP can then be used to purchase an annuity at retirement.
Another way to use ordinary annuities in retirement planning is through a pension plan. With a pension plan, an employer agrees to make periodic payments to the employee after retirement. The payments from the ordinary annuity are used to supplement the employee's income during retirement.
How can an annuity due be used in retirement planning?
There are a few different ways that an annuity due could be used in retirement planning.
One way is to use an annuity due to create a stream of income that starts immediately upon retirement. This can be especially helpful if the annuitant expects to have high medical expenses or other expenses early in retirement.
Another way to use an annuity due is to create a stream of income that starts at a later date, such as when the annuitant turns 70. This can be helpful if the annuitant expects to have lower expenses early in retirement and wants to delay taking income until later.
Finally, an annuity due could be used to create a stream of income that lasts for a specific period of time, such as 10 years. This can be helpful if the annuitant wants to create a "bridge" between retirement and eligibility for government benefits like Social Security.
The pros and cons of choosing an ordinary annuity over other types of retirement income plans
Retirement income plans should be carefully considered before making a decision. There are a few pros and cons to consider when choosing an ordinary annuity over other types of retirement income plans.
The pros and cons of choosing an annuity due over other types of retirement income plans
An annuity due can be a great way to create a stream of income in retirement, but it's important to understand the pros and cons before making a decision.
Ultimately, the decision should be based on the individual needs and goals of the annuitant, the person who is receiving the benefits from the annuity.
How to decide which type of annuity is best for you
The right annuity depends on your individual financial situation and needs. If you need money sooner than expected, then an annuity due may be the better choice. However, if you are looking for a lower interest rate, then an ordinary annuity may make more sense.
It is important to speak with a financial advisor to determine which type of annuity is best for you. They are able to help you understand your options and make the best decision for your unique situation.
We covered the basics of annuities and how they work. We looked at ordinary annuities and annuity due payments, and explored when each is most advantageous for retirement planning.
The bottom line? Annuity due payments can be a great way to ensure a steady stream of income in retirement. If you’re thinking about an annuity as part of your retirement plan, it’s important to understand the different types available so that you can choose the one that’s best for you.
Reach out to Dundas Life today for help choosing the right retirement income plan for you.