How Does An Annuity Work?
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UPDATED: Jul 16, 2021
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The simplest type requires the annuitant to pay a lump sum to an insurance company at the time the payments are to begin (for example, at age 65). Such a contract is called a Single Premium Immediate Annuity or SPIA. If the contract calls for payments for as long as the annuitant lives, the payments can be maximized. They will probably exceed the returns that would be produced from other types of fixed dollar investments, and the annuitant is purchasing an income that will not run out during his or her lifetime. The disadvantage of such a contract is that if the annuitant should die unexpectedly after having received only a few annuity payments, the total amount received from the insurance company might be much less than the amount paid to the insurance company by the annuitant. On the other hand, if the annuitant lives to a very advanced age, the amount that the insurance company will pay out in annuity checks is much more than the lump sum that the annuitant paid to the company at the beginning of the contract.
Instead of immediate income, deferred income payments are possible, as in a Single Premium Deferred Annuity or SPDA. Here, the annuitant makes a single payment to the insurance company, but the payments to the annuitant do not start until some time later (the maturity date). The annuitant can take the total value at the maturity date in a lump sum or in annuity payments.
Instead of giving an insurance company a lump sum payment, some deferred annuities allow the annuitant to build up the value over time by making periodic payments. The payments are usually flexible, and are deposited as the customer chooses. The fund being accumulated increases with each payment and also as a result of investment earnings. The annuity payments then begin at the annuitant’s retirement age or some other appropriate time. The payout can take several forms such as to one person or to two people with minimum amounts guaranteed to the payees.
So although the basic idea of annuities is very simple, there are many variations possible in the way the funds are accumulated as well as in how they are paid out.