What it means
In a basic life annuity, the buyer pays a premium and the insurer promises to pay a set amount, such as monthly, until the buyer dies. Payments stop at death, so any unused premium stays with the insurer unless the contract includes extra protection.
The income is higher than a person could safely draw from savings on their own, because the insurer pools many buyers. Those who die early help fund the payments of those who live long, a benefit sometimes called mortality credits.
The payout depends mainly on age, sex where permitted, interest rates and options chosen. Older buyers receive a higher percentage because the expected payment period is shorter.
Options can change the shape of the contract. A period-certain feature guarantees payments for a minimum number of years, a joint-life option continues payments to a spouse, and an inflation-linked option raises payments over time at the cost of a lower starting income.
The main drawbacks are loss of flexibility and credit risk. Money paid in is generally not accessible, and the buyer relies on the insurer's strength, although many places have guarantee schemes.
Taxes and inflation deserve attention before buying. A level annuity loses buying power each year, so a payment that feels comfortable at 70 may feel tight at 85.
Buyers sometimes split the purchase over several years, which spreads out the interest rate they lock in.
In practice
Real-world examples.
Example
A retired teacher uses $200,000 from her pension lump sum to buy a life annuity. She covers her fixed living costs with the guaranteed income and keeps her other investments for travel and gifts. The arrangement lets her spend with confidence, because the basics are paid whatever the markets do.
Example
A business owner selling his company puts part of the proceeds into an annuity that starts paying at age 65. The payments arrive monthly for life, and he uses the rest of the proceeds for a new venture. If the venture fails, the annuity still provides a floor under his living costs.
Example
A financial adviser compares an annuity with a 10-year period-certain guarantee against a plain life annuity. The guaranteed version pays slightly less each month but ensures the client's family receives payments if the client dies in year four. The adviser shows that the cost of that protection is about $100 less per month in income.
Formula
Calculation
Annual income = Premium x Payout rate
Suppose a 70-year-old pays a $300,000 premium for a life annuity with an illustrative payout rate of 6.5% a year. Annual income = 300,000 x 0.065 = $19,500, or 19,500 / 12 = $1,625 a month. The break-even point is 300,000 / 19,500 = about 15.4 years, so the buyer comes out ahead on payments if they live beyond age 85. A buyer who lives to 90 would collect 19,500 x 20 = $390,000 over 20 years, well above the $300,000 premium. A buyer who dies at 75 would collect only 19,500 x 5 = $97,500, which is why the product is insurance against living long.Case study
Seen in the real world.
Harlan Stone is an illustrative, fictional 66-year-old engineer who worries about running out of money. With $900,000 in savings, he places $300,000 in a life annuity paying about $19,500 a year, which together with his state pension covers his essential costs.
He invests the remaining $600,000 for growth. When markets fall, his essential bills are still paid, which lets him avoid selling investments at low prices. The invented example shows how an annuity can act as a floor under retirement income.
Harlan also asked for a 10-year period-certain guarantee, which reduced the annual payment slightly but ensured that his daughter would receive payments if he died early. He treated the lower payment as the price of peace of mind.
Watch out
Common mistakes.
- Believing the money is lost if you die early. That is true of a plain annuity, so buyers who want a payout to heirs need a guarantee period, at lower income.
- Comparing annuity income with investment returns. The payments include a return of your own capital, so they are not the same as a yield. A fair comparison looks at how long the income lasts, not only the headline rate.
- Putting all savings into one annuity. Most advisers suggest keeping some flexible funds for emergencies.
Questions
People also ask.
What is the difference between a life annuity and a fixed-term annuity?
A life annuity pays until death, while a fixed-term annuity pays for a set number of years.
Are annuity payments taxable?
Tax treatment depends on the jurisdiction and on how the annuity was funded, so check local rules. In some places only the interest element is taxed, while in others the whole payment is.
What happens if the insurer fails?
Protection depends on local guarantee schemes, which often cover only part of the benefit. Buyers with large premiums sometimes split them between two insurers to reduce this risk.
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