How Do Annuities Work?

At its most basic, an annuity is an agreement between you, and an insurance company.  You agree to give them a certain amount of money, and they agree to pay you back with a certain growth over a certain period of time.

The Accumulation stage is the period of time where you contribute to the annuity, and the insurance company applies the agreed upon growth.  This can be a single premium – you make one big contribution, or it can be periodic payments – regular or flexible contributions over time.  This is also the time when the insurance company updates the value of your account based upon the terms agreed upon in the contract.

Annuitization is a point in time (often retirement) when the insurance company calculates how much of a benefit you have built through the accumulation stage and begins the payout stage.

The Payout stage is the period of time where the insurance company pays you the agreed upon payout.  The amount you receive is based on your accumulated value and the payout options you select.  A straight life option usually provides the highest monthly benefit and provided income until the annuitant dies.  A joint life option provides a lower monthly benefit because it provides income until the death of the annuitant and the death of their spouse.  A life with guaranteed term option reduces the monthly benefit but  guarantees income for a certain number of years, even if the annuitant dies.  If the benefit is inflation adjusted each year, the initial payment is smallest, but will grow with time and inflation.

Annuity options vary widely and are defined by the contract you sign.  As a result, it is important to read and understand the contract before purchasing an annuity.

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