annuity

finance

Written byDoug Ashburn

Fact-checked byThe Editors of Encyclopaedia Britannica

Close-up of a stopwatch resting on a U.S. hundred-dollar bill, showing part of Benjamin Franklin's face.

Money + time = more money.

An annuity is series of periodic payments made at regular, fixed intervals, such as a contract with an insurance company to provide a steady income stream in retirement. Although the word stems from the Latin annus, meaning “year,” the most common annuity payout interval is monthly. Company and government pension plans are a type of annuity; Social Security is also a form of annuity, as employees pay into the program throughout their working years (with half the money coming from employers) and, once they reach retirement age, may begin receiving a monthly benefit for the rest of their life.

There are two main classes of annuities:

Annuities certain. Under an annuity certain, the payments are to continue for a specified number of payments, and calculations are based on the assumption that each payment is certain to be made when due. For example, a multiyear guaranteed annuity (MYGA) offers compound, fixed-rate growth over the life of the annuity, typically between three and 10 years.
Contingent annuities. With a contingent annuity, each payment is contingent on the continuance of a given status. In a life annuity, for example, in exchange for an up-front payment or series of payments (the “accumulation” period), once payments to the annuity holder begin (the “annuitization” phase), payments continue for the rest of the holder’s life. In other words, each payment is contingent on the survival of the annuity owner.

A special case of the annuity certain is the perpetuity, which is an annuity that continues forever. Perhaps the best-known example of a perpetuity is the interest payment on the British government bonds called consols. Because these obligations have no maturity date, it is intended that the interest payments will continue indefinitely.

Building a comfortable retirement typically involves combining Social Security with other sources of income.

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The contingent annuity used in life insurance and pension plans depends on the concept of risk sharing. The price of an annuity that pays a given sum for life is based on the life expectancy of the annuitant at the time the annuity is to begin. In effect, the annuitant joins with a large number of other persons of the same age in establishing a fund that is calculated, on the basis of mortality tables, to be sufficient to pay each person the agreed income for life. Some will live longer than others and receive more in payments than they have put into the fund, whereas others will not live long enough to receive all that they have put in. The risk-sharing principle makes it possible to purchase an annuity that guarantees much higher payments than could be obtained if the same sum of money were invested at interest. It has the disadvantage that upon the death of the annuitant, nothing is left for their heirs.

Immediate and deferred annuities—typically purchased from an insurance company—are designed to provide a steady income stream in retirement, but choosing one can be complicated. Some come with fixed payments, while others may be variable, based on the performance of the investments (or may be tied to the performance of a stock index such as the S&P 500). And then there are riders—add-ons and other contingencies—to tailor the annuity to your exact needs. But each rider comes with a fee that will either add to the up-front cost or reduce the annuity payments.

This article was most recently revised and updated by Doug Ashburn