An annuity is an insurance product designed to provide an individual with guaranteed income for life. More specifically, an annuity is a contract that is a legally binding, written agreement between you and the insurance company that issues the annuity. This contract transfers the risk of outliving your savings during your retirement years from you to the insurance company, otherwise known as your longevity risk.
Annuities work by converting a premium into an income stream that cannot be outlived. This premium may be paid in intervals (such as weekly, monthly, quarterly, or annually) or in a one-time lump-sum payment. Many retirees need more than Social Security and investment savings to provide for their daily needs.
Annuities are designed to supply this income through a process of accumulation and annuitization or, in the case of immediate annuities, lifetime payments guaranteed by the insurance company that begins within a month of purchase — no accumulation phase necessary.
In essence, when you buy a deferred annuity, you pay a premium to the insurance company. That initial investment will grow tax-deferred throughout the accumulation phase, typically anywhere from ten to 30 years, based on the terms of your contract. Once the annuitization, or distribution, phase begins — again, based on the terms of your contract — you will start receiving regular payments.
Annuity contracts transfer the risk of a down market to the insurance company. This means you, the annuity owner, are protected from market risk and longevity risk, that is, the risk of outliving your money.
Annuities come in two basic configurations: immediate or deferred. The option you select will depend on your financial goals. If you want to begin receiving annuity payments right away, you will choose an immediate annuity. Alternately, if you would like to set your payments to begin at some point in the future, you will purchase a deferred annuity and specify the start date in your contract.