An Overview of Annuities

“A brief introduction as background for other posts about annuities”

An annuity is a contract between you and an insurance company whereby the insurance company will pay you a certain amount of money, on a periodic basis, for a specified period. For example, you might pay an insurance company ten thousand dollars and in return you will receive 100 dollars a month for 10 years.

Typically an annuity will be the basis for a pension, but this need not be the case. And some annuities are structured to provide tax benefits, this being the case especially for pension annuities.

Annuities, at a high level, can be divided into two categories: immediate annuities and deferred annuities.

An immediate annuity almost always involves a lump sum payment and the “distribution phase” begins as soon as you have made this payment.

A deferred annuity almost always involves an “accumulation phase” where you make periodic payments to create a capital sum which is later used to provide the payments to you during the distribution phase.

The distribution phase might be a fixed term or it might be until the end of your life (or, in the case of a joint annuity, until the later of the end of your life or the end of your spouse’s life).

The payouts during the distribution phase are a combination of a return of the capital that was used to establish the annuity plus additional money earned by investing the capital sum. For distribution phases that run until the end of your life, the payout amount also depends upon your life expectancy. The inclusion of the return of the initial capital is what makes the returns appear particularly high – especially for lower life expectancies.

The investment component of the payout can be either fixed or variable. Fixed returns are either guaranteed by the annuity provider or a result of investing in products with fixed returns, such as bonds. Variable returns are typical achived by investing in stocks.

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