Annuities can be a confusing because they combine elements of insurance with characteristics more popularly associated with pensions. In the most common type of annuity, an individual pays a financial company a certain sum of money in return for a future stream of payments. These future payments are typically taken during retirement and serve as retirement income. Annuities can guarantee a certain number of payments (over a certain number of years), or they can guarantee payments for life (“life annuity” or “lifetime guaranteed annuity”) guaranteeing an individual monthly payments of income until the individual dies. This can provide security to a retiree, knowing they can’t outlive their income. The downside to this life time security is that one might spend a lot of money on a life annuity and then die shortly thereafter and receive very little benefit from the annuity. In other words, if you live beyond typical life expectancy, you do very well with an annuity, but if you die prematurely, the life insurance company that grants the annuity makes a lot of money. Such annuities are typically offered by life insurance companies because they are experts in calculating how long, on average, a person with certain characteristics (e.g. smoker/non-smoker, blood pressure, cholesterol, family health history, etc) is likely to survive and draw annuity payments.
For many people, thinking of Social Security (in the US) or Canada Pension Plan (in Canada) or a defined benefit pension–the traditional pension that many public employees and school teachers have–is an easy way to understand life annuities. In these cases, we make many small payments–through Social Security taxes on our income or through retirement plan contributions where we work–that serve to “purchase” the annuity. An annuity can also be purchased outright, however, before or after retirement. If one receives a large inheritance or other financial windfall, for example, one can purchase an annuity all at once with a lump sum. Similarly, if one has saved money in a 401k or similar defined contribution retirement account, one can use that lump sum to purchase a lifetime guaranteed annuity, effectively converting a large account balance into a stream of guaranteed, future monthly payments.
This video gives a (mathematically complicated) explanation of how to calculate the present value of a future stream of annuity payments:
Click here for actual pension calculators that give present values for pensions and life annuities using both actuarial and life expectancy methods. You can experiment with different numbers for interest, payment size, and inflation to see how they work.
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