How do annuities work?


Essentially, an annuity is a contract agreement between a consumer and an insurance company, in which the buyer is the contract owner.

Typically, contract owners get annuities issued on their own lives, but sometimes people purchase annuities whereupon the annuitant is the insured, and not the recipient of benefits.

Under an annuity contract, the buyer has certain rights and liabilities. The contract owner has the right to designate the annuitant, whose function is equivalent to the role of the insured in life insurance policies. The contract owner is required to name a beneficiary who is entitled to receive any survivor benefits after the annuitant's death.

How Annuities Work - Step by Step

  1. Establishing an annuity: the contract owner, or insurer, pays to the insurance company a single premium payment or a series or periodic payments.
  2. Accumulation phase: the principle part of the premium installments starts accumulating interest which grows every year. The interest rate that accumulates in the first year is added to the initial principal, and the received sum starts accumulating compound interest from the second year onwards.

    Annuity buyers have two main options:

    • Under a fixed annuity, the insurance company invests every premium into its general investment account, crediting the current rate of interest to the annuity's savings account, while at the same time guaranteeing a minimum rate of return.
    • Under a variable annuity, there is no guaranteed or fixed minimum interest but the potential for investment gains is greater.
  3. Payout phase: the beginning of this period is specified in the annuity contract. The payout period begins when the policy owner starts receiving installments from the annuity. These annuity payments feature three basic parts: premium deposits, interest earnings and the principal of annuitants who die early, pooled through the risk of longevity. The interest portion of the annuity payments is subject to income tax.
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