A life annuity is a contract with a life insurance company that pays out while the purchaser is alive. These policies provide income to fund or supplement one’s retirement. Many types of life annuities exist, but they all have this same basic goal. Below we will analyze how a life annuity works and the different types that you need to be aware of. You may want to speak with a financial advisor if you’re considering buying a life annuity to make sure you’re making the right decision.
How a Life Annuity Works
A life annuity is a life insurance product that makes periodic payments to the annuity owner, called the annuitant. The amount of the policy’s payment is set ahead of time and the annuitant pays in advance for that benefit. The annuitant can either pay monthly premiums or make a lump-sum payment in exchange for guaranteed payouts from the policy.
Life annuities may also pay the annuitant at different intervals depending on the policy. Monthly distributions are common, but policies might also pay quarterly, semi-annually or annually. The primary purpose of a life annuity is to receive a guaranteed income for life, meaning until the policyholder dies.
However, life annuities may not be adjusted for inflation. Thus, while they make guaranteed payments, the value of those payments may decline over time. If the annuitant lives many years after they retire, the policy may be significantly less in their later years.
Life Annuity Phases
Life annuities generally have two phases. Their relationship with the policy shifts when moving from one phase to the other. Those phases are the accumulation phase and the distribution phase.
1. Accumulation Phase
During the accumulation phase, the annuitant funds the policy. As mentioned, annuitants often make monthly payments during the accumulation phase. For example, they might pay into the policy for 10 years. Alternatively, the policyholder can make a lump-sum payment and pay the entire amount at once.
2. Distribution Phase
The distribution phase is when the life annuity begins making regular payments to the policy owner. This phase can start at different points depending on the type of annuity. However, these policies generally make guaranteed payments until the death of the annuitant. The policy might sometimes continue to pay after the annuitant’s death. For example, the annuitant might purchase a rider that entitles a beneficiary to payments even after the annuitant dies.
Types of Annuities
There are many different types of annuities. The exact way the annuity works might be different depending on the type. Here are some of the most common types of annuities.
- Immediate Annuity: Immediate annuities, as the name suggests, begin their distribution phase immediately. This happens when the annuitant makes a single, lump-sum payment toward the annuity. That payment then provides an income stream that lasts a certain period of time, which could be as little as five years.
- Fixed Annuity: A fixed annuity pays the policyholder a specific, guaranteed interest rate on their contributions to the plan. Because the rate is fixed, it won’t change for the duration of the annuity.
- Variable Annuity: A variable annuity also pays the policyholder an interest rate, but that rate might change at different points while the policy is open. Those variations are usually based on an index or portfolio of investments. This means variable annuities have the potential to pay more to the annuitant. However, it could also pay less than a fixed annuity if the investments to which it is tied don’t perform well.
- Guaranteed Annuity: A guaranteed annuity guarantees payments for a certain period of time. This type of annuity also continues to pay out to beneficiaries after the annuitant’s death.
- Joint Annuity: A joint annuity is one that typically covers two spouses. The policy makes payments until both spouses die, although the payout rate might be reduced after the first spouse’s death.
The Bottom Line
Life annuities are life insurance products that make guaranteed payments to an annuitant. The annuitant pays into the policy either by paying premiums or with a lump-sum payment. Then, the policy pays the annuitant either monthly, quarterly, semi-annually or annually. Generally, these payments continue until the death of the annuitant but in some cases, the policy might also cover beneficiaries. Many types of annuities exist and the life annuity might work differently depending on the type.
Tips for Life Insurance
- Deciding how much life insurance to buy isn’t easy, especially with so much to take into consideration. SmartAsset’s life insurance calculator can help you estimate how much life insurance you need in your unique situation.
- A financial advisor can guide you through major financial decisions, like buying life insurance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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