How an Annuity Works

Holders of annuities receive periodic monthly payments.

An annuity is an insurance policy in which the policyholder provides an insurance company with a large sum of cash or other assets. In exchange, the company agrees to provide the policyholder regular payments for a designated period of time.

Features

Insurance companies generally take the policyholder's assets and use them to finance a series of investments. The insurance company estimates that the money generated by these investments will be larger than the amount it has agreed to issue to the policyholder, thereby granting it a profit.

Types

There are two main types of annuities: fixed and variable. In a fixed annuity, the size of the payments that a policyholder receives is consistent across the life of the policy. Under variable annuities, the payments change: In most cases, they are pegged to one or more financial indexes that track the prevailing rate of interest.

Function

While an annuity is a profit-generating vehicle for an insurance company, for policyholders annuities offer a means of establishing financial security. Many annuities are valid until the policyholder's death. So, under a fixed annuity, a person may be assured of a certain monthly income for life.

References

• BankRate: What, exactly, is an annuity?
• Investopedia: Annuity Definition
• U.S. Securities and Exchange Commission: Annuities