A single-premium deferred annuity is a financial product that guarantees payments over a specified period that begins some time after the purchase of the annuity. The buyer purchases the annuity with one lump sum, the single premium. The entity that sold the annuity invests the premium and pays a guaranteed interest rate into the buyer’s account. The time over which the premium accrues interest is the accumulation phase, and when it ends the seller begins making payments to the holder of the annuity. The holder receives fixed payments at regular intervals, which last until the account is exhausted or for the lifetime of the holder, depending on the original contract.
This type of annuity is often purchased as a retirement savings instrument. Unlike some investments, such as stocks, a single-premium deferred annuity guarantees that the investor will get the principal back. As long as the annuity is sold by a reputable institution, the investor does not need to fear the loss of his life savings. These annuities, especially if they make payments for the lifetime of the holder, act like insurance products because they provide a fixed income that protects the annuity holder from the risk of outliving his savings.
In the United States, the primary attraction of the single-premium deferred annuity is its tax status. The gains from investing the premium have tax-deferred status, which means they are only taxed when payments begin. Tax deferral is desirable for two reasons. First, the buyer may expect to be in a lower tax bracket at the time of dispersal, so the taxes will be lower than if he paid them as they accumulated. Second, the money that would have been paid in taxes if the annuity did not have tax-deferred status remains in the account and accumulates interest, so even though the payment must be made eventually, more interest accrues because it is deferred.
Some investors are drawn to the single-premium deferred annuity because it offers a guaranteed interest rate. This is only a benefit in some circumstances, however. If interest rates are high, then annuities must offer large returns in order to be competitive, but if interest rates are low, then annuities will offer low guarantee rates. When the interest rate fluctuates, it affects the annuity holder even though it does not directly influence his returns because it changes his opportunity cost. If the interest rate rises, he is losing money because he could be making more by investing the money that is locked in to the annuity in other assets; an investor must take into account the long-term nature of the instrument when deciding whether to invest in a single-premium deferred annuity.