What is an annuity?

Insurance companies sell investment vehicles known as annuities. Every single annuity has two basic properties: whether the investment type is fixed or variable and whether the payout is immediate or deferred.

Payments to the investor begin immediately if it’s an annuity with immediate payout.  There is also an annuity with deferred payout meaning that the investor will receive payments a later period of time.

Annuities with fixed investment types offer a guaranteed return on investment. They do so by investing in government bonds and other low-risk securities. Variable investment types, however, means that the return on the annuity investment will depend on performance of the funds (known as sub-accounts). That’s where the money is invested.

There are four possible combinations based on these two properties with two possibilities each. The ones that are generally seen in practice are a fixed annuity - an annuity with deferred payout and variable investments and an annuity with immediate payout and fixed investments.

The basic idea of a fixed annuity is that you give a certain sum of money to an insurance company and they promise to pay you a fixed monthly amount for a certain period of time in exchange.

This certain period of time can be either a fixed period or your entire lifetime. Overall, you are paying someone a large amount of cash, while they pay it off to you piece by piece for as long as you want.

Whether you choose annuitization (lifetime payments) or period-certain, the payment will not change, even to inflation or account.

If you choose for the insurance company to pay off your sum of money into a fixed-period of time (period-certain annuity), then the annuity will continue to pay off until that period is reached. It is actually a pretty simple concept.

Annuitization (lifetime payments) can work well for a long-lived retiree. Annuity plans are usually made because people don’t trust themselves with a large sum of money simply lying around the house. Keeping it in the bank won’t really help either; that’s why the concept of annuities was created.

Making an investment known as an annuity isn’t always a thing that is needed. If you don’t need an annuity or if you simply don’t trust insurance companies with your money, then an annuity probably should be avoided.