What it is:
How it works/Example:
An annuity is a contract whereby an investor makes a lump-sum payment to an insurance company, bank, or other financial institution that in return agrees to give the investor either a higher lump-sum payment in the future or a series of guaranteed payments. The choice to receive a series of payments is called annuitizing.
If the owner of the annuity chooses to annuitize, he or she typically begins receiving payments after the surrender period expires and the investor is at least 59 1/2 years old. The surrender period is the time (usually about seven years) during which the investor must keep all or a minimum portion of the money in the account or face surrender fees equal to a percentage (usually about 10%) of the withdrawal amount.
Annuitization is usually not required; rather, investors can simply make withdrawals when they need money.
Why it matters:
The size of the original investment, the contractual terms of the annuity, and interest rates determine how (and sometimes when) the investor annuitizes. For example, immediate annuities (also called single-premium immediate annuities or SPIAs) annuitize immediately (within one year of purchase). That is, the investor begins receiving payments as soon as he purchases the annuity and continues to receive them until he dies. The owner gives up all claims to his or her initial investment but does so knowing that he or she will have monthly cash flow for life (the rate of return on these annuities is therefore determined by how long the investor lives). Deferred annuities, on the other hand, annuitize at some future date.
Most annuity payments cease upon the death of the annuitant (this is what makes them different from regular life insurance policies, which generally make a payment to a beneficiary upon the death of the insured).