How Annuity Works

An annuity is any contract between you and a chosen insurance firm in which you will make either a series of payments or a lump-sum payment. In return for your regular payment, the insurance company will give you regular disbursements, starting either immediately or at a future date. There are three major varieties of annuities: indexed, fixed, and variable. Each type comes with its unique payout potential and risk level.

The main goal of annuity is to serve as a steady stream of income, usually during retirement. Annuity funds accrue tax-deferred and can only be withdrawn penalty-free after age 59 ½. Insurers can make many areas of an annuity to suit your specific needs as a buyer. Apart from choosing between receipt of a series of payments or a lump-sum payment, you can decide when you prefer to annuitize your contributions (this means when you'd like to start receiving payments).

The duration of your annuity disbursements can also differ. You can opt to receive payments for a fixed period, like for 25 years, or the rest of your life. It's good to know that securing a lifetime of payments may lower the amount you get with each check, but it ensures that you never outlive your assets. A central selling point of annuity is that you are sure to get something as when due.

Annuity Example

There are a couple of annuity options you can explore. If you are self-employed and want a fixed annuity for when you retire, you may try a life insurance policy where you pay a fixed amount monthly for a predetermined time frame (typically 59 1/2 years). With this plan, you can receive a fixed income stream from your insurer during your retirement years.

On the other hand, an example of an immediate annuity is when you pay a single premium, say $400,000, to your chosen insurance company. You receive a monthly payment for a specific period afterward. The payout fee for immediate annuities depends on both interest rates and market conditions.

Annuities vs. Life Insurance

Investment companies and life insurance companies are the two primary financial institutions that offer annuity products. In life insurance companies, an annuity is a natural hedge for the insurance products they sell. You and other customers buy life insurance to deal with mortality risk (i.e., the risk of dying prematurely). Policyholders will pay an annual premium to the insurer, who in turn will pay a lump sum upon the policyholder's death.

Unfortunately, if the policyholder dies prematurely, the insurance company must pay out the death benefit and record a net loss to its accounts. Actuarial science and claims experience lets insurance companies price policies so that purchasers will live long enough to earn a profit.

On the other hand, annuities have longevity risk (i.e., the risk of outliving your assets). The risk to your insurance provider is that you, as an annuity holder, will survive to outlive your initial investment. One way annuity issuers can hedge the risk of longevity is by selling annuities to clients with a higher risk of dying prematurely.