Life Annuity: Definition, How It Works, Types

What Is a Life Annuity?

The term life annuity refers to a financial product that features a predetermined periodic payout amount until the death of the annuity owner—called the annuitant. An annuitant typically pays into the annuity periodically when they are still working. Annuitants may also buy the annuity product in one large, lump-sum purchase—usually at retirement. Life annuities are commonly used to provide guaranteed and/or supplemental retirement income that cannot be outlived.

How a Life Annuity Works

Life annuities are insurance or investment products that provide the beneficiary with fixed payments at regular intervals—either monthly, quarterly, annually, or semi-annually. Life annuities, also known as lifetime annuities, are generally sold by insurance companies. They essentially act as longevity insurance, as the risk of outliving one's savings is passed on to the annuity issuer or provider.

Life annuities come in two different phases. The first is the accumulation phase or deferral stage. This is the period when the buyer funds their annuity with premiums or with a lump-sum payment. The second stage is the distribution or the annuitization phase. During this period, the issuer or insurance company makes regular payments to the annuitant.

Once funded and enacted, the annuity makes periodic payouts to the annuitant, thus providing a reliable source of income. The issuer normally stops making periodic payments if the annuitant dies or if another triggering event occurs to close the annuity. But these payments may continue to the annuitant's estate or beneficiary if the annuitant had purchased a rider or other option on the annuity.

The majority of annuities generally pay a benefit every month, but some make quarterly, annual, or semi-annual payments. Payment intervals depend on the specific needs of the annuitant or their tax circumstances. Many retirees fund a life annuity to match their recurring housing costs—mortgage or rent—as well as any other costs, including assisted living, health care, insurance premiums, and medical expenses.

While a life annuity pays a guaranteed income, it is not indexed to inflation, which is the pace of price increases in an economy. As a result, purchasing power may erode over time. A life annuity, once enacted, is not revocable.

Special Considerations

It's important for people to consult a reputable professional before purchasing any annuity product. That's because annuity products tend to be fairly complex in nature with major implications for the annuitant's standard of living. Due to the tax-preferred nature of annuities, very wealthy investors or above-average income earners often use these life insurance products to transfer large sums of money or to mitigate the effects of taxes on their annual income.

While life annuities are often used to provide or supplement retirement income, they are also used as a payment method in structured settlements and for lottery winners. For instance, if someone wins a lawsuit, they may be provided with a series of fixed, regular payments to the beneficiary. Lottery winners may opt to take a lottery annuity rather than a fixed, lump-sum when they win large jackpots. These payouts provide regular payments annually over a certain number of years. For example, a Mega Millions jackpot winner can choose to take 30 payments—one paid out immediately. The remaining payments are distributed annually for the next 29 years.

Types of Annuities

There are several types of life annuities, each with its own benefits and purpose, and they include:

Immediate Annuity

An immediate annuity only has a distribution phase, as is also the case with a payout annuity, an income annuity, or a single-premium immediate annuity.

Guaranteed Annuity

A guaranteed annuity—also called a year's certain annuity or a period certain annuity—pays out for a certain period and continues to make payments to a beneficiary or estate after the annuitant's death.

Fixed Annuity

A fixed annuity pays out a fixed percentage or interest rate on the owner's contributions into the annuity.

Variable Annuity

A variable annuity pays out based on the performance of a basket of investments or an index. Variable annuities offer the potential for higher returns or payouts when markets are performing well. However, they also contain more risk than fixed annuities since the account could decline in value when the markets perform poorly.

Joint Annuity

A joint annuity makes payouts until both spouses die, sometimes at a reduced amount after the death of the first spouse.

Qualified Longevity Annuity Contract (QLAC)

A qualified longevity annuity contract (QLAC) is a type of deferred annuity that is purchased using funds from a qualified retirement plan or an individual retirement account (IRA). A QLAC annuity provides monthly payments until death and is exempt from the required minimum distribution (RMD) rules from the Internal Revenue Service (IRS). In 2020 and 2021, an individual can spend 25% or $135,000 (whichever is less) of their retirement savings account or IRA to buy a QLAC.