How Do Annuities Work?
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Funding Phase
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An annuity works very much like the reverse of life insurance. With life insurance, you pay a small amount over a period of time. If you die during that time, the insurance will pay out a large amount all at once to your beneficiaries. With an annuity, an investor pays in a large amount to the insurance company all at once and then the insurance company pays back the investor a small amount over a period of time. This initial investment is called "funding the annuity" and must be completed before the annuity enters the distribution phase.
Capital Management
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Annuities are generally purchased from insurance companies. The insurance company takes the funding from the annuity and invests it either in securities or in funding other policies which it believes it can make a profit. Ideally, the company makes more money on these investments than it pays out to the annuity holder. However, it is not necessary to clear a profit on every payment as long as the profit emerges over a period of time.
Distribution Phase
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An annuity pays out an agreed upon amount over a specific time period. The most basic annuity pays out over the annuitant's life. When the annuitant dies, the payments stop and the investment terminates with no additional funds changing hands. Other annuity forms include paying out over both the annuitant's life, and a spouse's life. Thus, if the annuitant dies, the spouse continues to receive payments until the spouse dies at which point all payments stop.
Distribution Tweaks
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Because there is some risk in the annuitant (and spouse) dying within a relatively short period of time and thus not getting much return from the initial annuity funding, some annuities offer further minimum guarantees often in the form of a "period certain." A period certain provision specifies that if the annuitant dies, the payments will continue for a specific period of time even after the annuitant's death. For example, an annuity with a 10-year period certain would payout the payments for 10 years regardless of whether the annuitant lives that long. So, if the annuitant died after just six years, then a beneficiary would continue to receive the payments for another four years (10 years total) at which time all payments would cease.
How the Insurance Company Profits
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The insurance company can profit in two ways. First, if the amount of money taken in to fund the annuity is greater than the amount of money paid out over the life of the annuity, then the insurance company profits from the extra funding.
Second, if the investments the insurance company makes with the initial funding produce more profit than it takes to pay out the annuity the insurance company makes money.
Generally, the less time an annuitant lives, the greater the profit for the insurance company.
How the Investor Profits
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An investor is guaranteed a certain payment (usually monthly) for a certain period of time (usually for life). If the payments made exceed the amount the annuity was funded with, then the investor profits. Generally, the longer the annuitant lives, the more the investor comes out ahead.
Rules and Restrictions
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Annuities often come with strict rules and restrictions on the funds invested. In some cases there is no way to get the original investment back. In others, there may be a procedure to cash out the investment, but this will come with a minimum amount of time passing and potentially other fees or penalties.
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