What Is a Life Annuity?
A life annuity is an insurance product that features a predetermined periodic payout amount until the death of the annuitant. They are commonly used to provide for a guaranteed income in retirement that cannot be outlived. Typically, the annuitant pays into the annuity on a periodic basis when he or she is still working. However, annuitants may also buy the annuity product in one large, lump-sum purchase, usually at retirement.
How a Life Annuity Works
Life annuities, with their guaranteed lifetime payments, are essentially longevity insurance, as the risk of outliving one's savings is passed on to the annuity issuer, usually an insurer. Life annuities are often used as a payment method for lottery winners and in structured settlements. Defined benefit pension plans are a form of a life annuity, in that they pay a lifetime benefit based on an employee's salary, age, and length of service.
Once funded and enacted, the annuity makes periodic payouts to the annuitant, usually monthly, providing a reliable source of income. When a triggering event occurs, such as death, the periodic payments from the annuity usually cease, though they may continue to pay out depending on the option the annuity buyer chooses.
While annuities generally pay a benefit every month, but can also pay quarterly, annually or semi-annually, depending on the needs or tax circumstances of the annuitant. Many retirees fund a life annuity to match their recurring housing (mortgage or rent), assisted living, health care, insurance premium or medical expenses. While a life annuity pays a guaranteed income, it is not indexed to inflation, so purchasing power can erode over time. A life annuity, once enacted, is not revocable.
There are two phases to an annuity: accumulation (or deferral), when the buyer funds an annuity with premiums, and distribution (or annuitization), during which the annuitant receives payments until death.
Because of the complex nature of annuity products and their implications for the annuitant's standard of living, people are advised to consult a reputable professional before purchasing any annuity product. 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.
Example of an Annuity
There are several kinds of life annuities, each with its own purpose. For example:
- Immediate annuity: Has only a distribution phase, as is also the case with a payout annuity, an income annuity, or a single-premium immediate annuity.
- Guaranteed annuity: Pays out for a certain period and will continue to pay to a beneficiary or estate after the annuitant's death. Also called a year's certain annuity or a period certain annuity.
- Fixed annuity: Pays out a fixed percentage.
- Variable annuity: Pays out based on the performance of a basket of investments or an index.
- Joint annuity: Pays out until both spouses die, sometimes at a reduced amount after the death of the first spouse.