What is an Annuity?

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.

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.

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.

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.

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.

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.