What it is:
How it works (Example):
To understand how this works, let's assume you'd like to invest in an annuity that, after you retire, will provide guaranteed monthly payments of $1,000 to you every month for as long as you live. Under the terms of this annuity contract, you're required to deposit $175,000 to get the guaranteed future stream of income. If the contract has a life-plus-five option, on the day you die, the payments that you originally received start flowing to your beneficiary, but after five years, they stop. This also means if, for example, only $100,000 of the $175,000 has been paid out at the time payments are stopped, the insurance company keeps whatever is left over.
Why it Matters:
An annuity is a contract whereby an investor makes a lump-sum payment to an insurance company, bank, or other financial institution that, in return, agrees to give the investor either a higher lump-sum payment in the future or a series of guaranteed payments. The size of the monthly payments is a reflection of the calculation the insurance company makes regarding the estimated lifespan of the owner (the annuitant).
Some insurance companies offer a life-only option or life-plus-ten option. In a life-only option, the annuity payments stop upon the owner's death. In a life-plus-ten , the annuity payments go to the named beneficiaries for ten years after the annuitant's death.
Annuities with a life-plus-five options tend to offer larger monthly payments than annuities with life-plus-ten options, but they usually offer smaller payments than annuities with life-only options.
Although annuities are controversial because they tend to come with high fees and commissions, they may be good bets for some income investors. Ultimately, the appropriateness of an annuity is dependent on the investor's financial goals, tax situation, and the types of annuities available. Inflation and interest rate expectations may affect the type of annuity an investor chooses, as will the investor's wishes for his or her dependents and heirs.