Defining Investing Terms - What is an Annuity?

One thing that I've noticed from people is that many don't know some of the basic terms of investing - such as how does a mutual fund work? What are short term and long term capital gains? What is a JTWROS? (ok maybe that isn't a common one) etc. Well, here on the Trading Post I will try to break down, define and analyze some of these seemingly complex money ideas. I hope this will be useful to everyone.

Annuity
What is an annuity? An annuity is a way to turn a present amount money into a specific number of future payments. To put it simply, if you give me $1000, and I promised you $100 for ten years, that would be an annuity. However, the present value of money is worth more than promised future streams of money, so in reality, you would want me to promise to give you perhaps an annuity of $110.

Pensions are really a form of an annuity, and mortgages are really (in a simplistic sense) the opposite of an annuity. Annuities can also be structured to change too - such as, for example above, $50 the first year, $75 the second year $150 the third year, $125 the fourth year and so on. This could be tied to various measures, such as how well the stock market is doing, or the profitability of a business. Insurance companies also provide a huge assortment of annuity products which can sometimes seem overwhelming. If all the criteria was the same, such as a guaranteed annuity for 20 years fixed, then it would be easy to choose - you would just pick the annuity that was highest (it would be giving you the highest effective rate of return) But there are all sorts of twists, such as continuing for only as long as the annuitant lives, or one that would continue to pay out to a spouse. The length of time can be different too. These all can make it very difficult to compare - and turns what at first appear a financial decision into one very much dependent on ones subjective tolerance to risk.

Excel and other spreadsheets and financial tools have functions that will tell you the equivalent interest rate for a specified present value and annuity value.

Deer in the Headlights

Last weekend while travelling in West Virginia, I was unfortunate enough to hit a deer on the interstate. Actually, it was more like the deer hit me, since it turned around and hit my front fender as I swerved to miss it. Luckily the damage was pretty minor - however I was only a split second from possibly totaling my car. Which got me to thinking about two things: insurance, and emergency funds. For the second, let me just say for now that situations like that really show the need to have at least $500 in the bank just in case the unforseen jumps out in front of you.

For insurance, I find that a remarkable number of people really don't know much about their coverage, and can't really tell you what's a lot, a little or appropriate. Of course, an insurance salesman would be sure to tell you that you can't ever have too much insurance, but frankly, what else would they tell you? To be honest, I'm not sure that I know a lot about insurance, but I'll share my philosophy about it.

Of course it may seem obtuse to say that insurance is all about risk. But it really is, and figuring out the risk requires a reasonable knowledge of your financial situation. Without a clear understanding of your own finances, you really have very little way to calculate what your true risk is in a given set of circumstances. Secondly there's a very big difference between financial pain, and financial disaster - totaling my 1995 Saturn would be financial pain - I'd hate to have to pay $2000 to try to find another old clunker. Losing my house, that would be disaster. Similarly for medical bills - breaking an arm and paying $1500 would hurt, having a heart attack and paying $90000 would be disasterous. Obviously if you are really tight from paycheck to paycheck, you may be in the situation that even a small event could mean financial disaster, but obviously don't have the money to spare to eliminate the chance of disaster with "bulletproof" insurance. In this case most people are forced to take their chances with increased risk of financial disaster

This all plays into my decisions in choosing my coverage. For my auto insurance, I have a $100,000/$300000/$100000 coverage, but no collision coverage on my clunkers. For my house, I have a $1000 deductible. I would have chosen something around $5000-$10000, but I think that it would have saved me <$20/year on my policy. For life insurance, I'm currently covered through work, and would have enough to pay for the house in the event of my untimely demise - for now since I'm really young, and don't have any kids, I don't feel that I really need more than this. Over time this will likely change.

MSN had a good article about car insurance not too long ago:http://articles.moneycentral.msn.com/Insurance/InsureYourCar/DumpTheInsuranceOnYourClunker.aspx

Let me know what you think. Did I miss anything obvious? Perhaps you could share a good deer in the headlights story!