Annuity – Definition

Cite this article as:"Annuity – Definition," in The Business Professor, updated May 14, 2019, last accessed September 23, 2020, https://thebusinessprofessor.com/lesson/annuity-definition-2/.

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Annuity Definition

An annuity generally means a fixed amount or series of payments made to an individual, especially a retiree for the rest of his life. More comprehensively, an annuity can be described as a financial product which is created and sold by financial institutions that enables an individual receives a stream of income at a specific time.

Before individuals can enjoy an annuity from a financial institution or insurance company, they must have invested or purchased a financial product which upon annuitization releases a fixed payment to beneficiaries. There is a period when annuity is funded by individuals before the same starts paying out a regular income, this is annuitization or accumulation phase.

A Little More on What is an Annuity

Annuities are forms of insurance or investments undertaken by individuals, after a specified period, this investment or insurance begins to pay them back. An annuity can also be called a reliable contract between individuals and financial institutions that guarantees a steady income or cash flow for registered individuals. In most cases, retirees receive annuities in their retirement years. These are series of payments paid for a fixed number of years or the lifetime of individuals. Annuity helps individuals turn little investment into a steady flow of income they enjoy later in their life. Lifetime guaranteed annuities are given to retirees until they die, defined benefit pensions and Social Security are examples.

The classification or structure of annuities is largely dependent on the duration at which steady payments of income would continue. For example, some annuities last for specified period of time while payment of annuities in some cases can only cease when both the annuitant and their spouse die.

There are two types of annuities, fixed and variable annuities. Fixed annuities offer periodic payments while variable annuities offers a less steady cash flow.

Also, the annuitization period of some annuities is immediately after a lump sum is deposited by the annuitant while in some others, deposits continue for a period of time before annuitization takes effect (deterred benefits).

Annuities cannot be traded, they cannot be sold in exchange for money between individuals, this is called illiquidity. This nature of annuity has been criticized. When individuals deposit into annuity account, they cannot withdraw their deposit, if they withdraw some pay off the money, a penalty is awarded.

The potential to lose principal payment alongside some market risk is attributed to variable annuities. However, this can be addressed by adding riders and features to annuity contracts. In cases whereby an annuitant has a terminal illness, riders can be purchased and added as death benefits to the contract. Payouts can also be accelerated for individuals with confirmed terminal illnesses.

Financial institutions; investment companies and life insurance companies sell annuities to individuals. There are different categories of annuity products that these institutions offer. Usually, longevity risk and risk of outliving one’s assets are considered when issuing companies offer annuity products. SEC and FINRA are bodies that regulate annuity products.

Oftentimes, many people have tendencies of outliving their assets, longevity risk on the other hand is hedged through the sales of annuity products to individuals with higher tendencies of dying prematurely.

Also, through a 1035 exchange, cash value in permanent insurance can be traded for a annuity product with no tax attracted.

Individuals who are interested in guaranteeing a steady income for themselves after retirement purchase annuity products. There is no restriction on people who can purchase annuity products in a much as the individual understands how annuity operates and can deposit a lump sum. People who are of age are the categories of people that purchase annuities more.

Individuals can put an illiquid lump sum into the annuity account for guaranteed steady income after a period of time or after retirement.

References for Annuity

Academic Research on Annuity

Adverse selection in insurance markets: Policyholder evidence from the UK annuity market, Finkelstein, A., & Poterba, J. (2004). Journal of Political Economy, 112(1), 183-208.

Annuity valuation with dependent mortality, Frees, E. W., Carriere, J., & Valdez, E. (1996). Journal of Risk and Insurance, 229-261.

Guaranteed annuity options, Boyle, P., & Hardy, M. (2003). ASTIN Bulletin: The Journal of the IAA, 33(2), 125-152.

Natural hedging of life and annuity mortality risks, Cox, S. H., & Lin, Y. (2007). North American Actuarial Journal, 11(3), 1-15.

Uncertainty resolution and the timing of annuity purchases, Brugiavini, A. (1993). Journal of Public Economics, 50(1), 31-62.

Behavioral obstacles in the annuity market, Hu, W. Y., & Scott, J. S. (2007). Financial Analysts Journal, 63(6), 71-82.

Stochastic optimal control of annuity contracts, Devolder, P., Princep, M. B., & Fabian, I. D. (2003). Insurance: Mathematics and Economics, 33(2), 227-238.

Annuity prices and saving behavior in the United States, Friedman, B. M., & Warshawsky, M. (1988). In Pensions in the US Economy (pp. 53-84). University of Chicago Press.

Extra randomness in certain annuity models, Beekman, J. A., & Fuelling, C. P. (1992). Insurance: Mathematics and Economics, 10(4), 275-287.

Annuity markets: Problems and solutions, Blake, D. (1999). Geneva Papers on Risk and Insurance. Issues and Practice, 358-375.

Uncertain lifetimes and the welfare enhancing properties of annuity markets and social security, Eckstein, Z., Eichenbaum, M., & Peled, D. (1985). Journal of Public Economics, 26(3), 303-326.

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