Dream with me for a minute. Imagine that you woke up this morning and realized that the quick pick numbers on the Powerball ticket you bought at the convenient store the other day matched all six balls in last night’s drawing.
Lump sum or annuity?
Among the many important decisions you’ll have to make is weather you want a lump sum or series of payments over twenty years. If you were to choose the series of payments, you’re opting for what we call in the financial planning world an annuity.
Now you know what an annuity is in it’s simplest form. Unfortunately, the insurance industry has added so many bells and whistles to annuity products that they’re far from simple.
When I used to teach my financial consultant trainees about annuities, I always found it helped them understand the concept better if we put them into categories. Most annuity products can be categorized as either a fixed annuity or variable annuity and again as immediate or deferred.
Fixed or variable
A fixed annuity means that it accrues interest at a minimum guaranteed rate. The interest paid is generated by underlying investments in bonds or other securities that pay interest and the eventual return of principal. Since annuities are also insurance products, fixed annuities are typically guaranteed to pay a minimum rate plus additional earnings (or dividends) on top of the guaranteed amount.
On the other hand, a variable annuity offers no guaranteed rate. Instead, the return generated by a variable annuity depends on the performance of underlying investments – usually publicly traded stocks and other non-interest bearing securities. Variable annuities can even lose principal in the event of a drop in the stock market.
Immediate or deferred
Most annuities can also be classified as either immediate or deferred, a reference to when the payments (to you) begin. As the name implies, an immediate annuity will begin payments right away. That could be in a month, a quarter or even a year from the contract date, depending on when you request your first payment. Deferred annuities often don’t begin to pay out for several years. During that time, you can typically increase the size of the annuity principal by contributing more premiums to it.
To summarize, you could have a fixed annuity that’s immediate or deferred. Likewise, a variable annuity can be either immediate or deferred.
The connection to Powerball
Okay, so how does this lesson about annuities tie in with Powerball? Remember, if you ever win the Powerball lottery one of the most important decisions you’ll have to make is whether you want to receive your winnings as a lump sum or annuity – a series of payments.
You don’t need me to tell you that your chances of getting hit by lightning in this life are better than matching all six Powerball numbers. However, anyone can purchase an annuity contract. If you have a sizable lump sum from insurance proceeds, the sale of property or a business or what have you, you can convert that money into a series of payments with an immediate annuity. In many cases you can even roll all, or a portion of, your retirement account into an annuity. (Be sure to educate yourself on potential tax consequences if you consider this move.)
Suppose you don’t have a large sum of money. You can purchase a deferred annuity with a smaller sum of money and add to it over the years to build up your own annuity “jackpot.”