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What is an Annuity?

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  • Originally Written By: Mary McMahon
  • Revised By: A. Joseph
  • Edited By: Bronwyn Harris
  • Last Modified Date: 22 March 2014
  • Copyright Protected:
    2003-2014
    Conjecture Corporation
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An annuity is a periodic distribution of money that was earned on an investment. The investor and an insurance company or investment firm sign a contract that lists the terms of the annuity, such as how it is to be purchased and how the earnings are to be paid. This type of investment typically can be purchased with a lump-sum payment or with installments paid over time. The earnings rate depends on whether the annuity is fixed, variable or indexed. Distributions are paid to the annuitant, or recipient, on a set schedule, such as every three months, every six months or once a year.

Retirement Funds

Typically, a person uses this type of investment as part of a retirement plan to ensure a fixed and stable income after he or she stops working. A common form of annuity is a retirement pension. While the individual works, he or she pays into a pension fund, and that money is invested. After the person retires, he or she receives a portion of the earnings on a regular basis, as indicated in the contract.

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Differences from Life Insurance

Most people work with investment firms or insurance companies to set up annuities. Unlike a regular life insurance policy, an annuity does not require a physical examination, and except in certain instances, it is designed to be paid to the person during his or her lifetime, rather than to his or her surviving children, spouse or partner. This means that — unless the contract says otherwise — the distributions stop when the annuitant dies.

Fixed, Variable or Indexed

A fixed annuity is a safe investment because it guarantees a specific rate of return with every payment. Even if the stock market slumps, the distributions will remain the same. If the market grows more than expected, though, the investor will not receive anything extra.

In variable annuities, the annuitants can choose how the money is invested, and their payments depend on how well their investments perform. This could result in greater returns or much smaller payments than they would receive from fixed annuities. Indexed annuities provide returns that are based a specific market index, although they typically guarantee certain minimum rates of return.

Planning

A professional financial planner can provide advice on which option is better for an annuitant. For example, a couple might be advised to consider one that is fixed and one that is variable. A single retiree who intends to rely on the annuity for income might be advised to choose a fixed annuity.

Some Exceptions Possible

Most financial firms establish annuities that end with death, under the assumption that some annuitants will die before they have been paid the full return on their investment and others will outlive their investment, leaving a margin for profit if the company invests well. In rare instances, annuities can be contracted to roll over to surviving spouses, partners or minor children after the investors die. This is common with government pensions, which surviving children can collect until they turn 18 or 21, depending on the applicable laws.

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Discuss this Article

anon343229
Post 11

Great article and feedback. Most people, whether getting ready for retirement and old age or not, should read this and other related articles. Annuities are a great product but the purchaser needs to know what they are buying. Thanks for sharing.

anon292794
Post 10

I am going through a divorce and will be getting a pension or annuities from my husband. How can I get these? I am 54 and not of retirement age.

anon273500
Post 9

What happens if I die in a year? What happens to the money in my annuity investment?

anon118443
Post 7

An annuity always goes to a beneficiary with the exception of an immediate annuity. All other annuities are given to a beneficiary, which the annuitant assigns to the annuity, much like a life insurance policy. This is not rare.

anon108306
Post 6

What is a guaranteed return option on an annuity? And is it worthwhile to do? My broker is pushing it on me. He says for a 1 percent fee I am guaranteed protection. Is this true?

anon104586
Post 5

You answered my question well. I also like the additional information as well. Thanks.

parmnparsley
Post 4

@ Alchemy- Credit cards are also a type of annuity. If you max out your card and only pay the minimum amount, you are essentially making payments to an annuity. Instead of paying your balance in full, you are paying a predetermined balance, in monthly installments, over a given time period.

This does not appear to be an annuity because credit card companies do not tell you what the future value of the annuity is. If you are only making the minimum payments on a credit card, you entered into an annuity without actually knowing what the value of the loan will be. Essentially any loan is an annuity; the catch is the lender is the beneficiary.

Alchemy
Post 3

A winning lottery ticket allows you to take a cash option or an annuity option. Someone receiving an annuity is simply receiving regular payments for a set amount of time, or until a predetermined dollar amount is reached. Understanding how an annuity works will help you determine whether to take the cash or annuity.

Say you scratch a million dollar ticket and you choose the annuity option. You will receive a $50,000 payment, and an additional $50,000 payment for the next 19 years.

If you took the annuity option and invested the payment every year at say five percent you would end up with a little over 1.65 million dollars. On the other hand, if you took the 50% cash option and invested it at five percent compounding interest for the same twenty years you would end up with about 1.32 million dollars.

The difference of a third of a million dollars is significant, but honestly, the final value of the lottery winnings would depend on how you were going to invest and spend the money.

anon47563
Post 1

This is the first common sense article I have found in a long time. I learned more from this web site and thank you for all your help.

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