Life Annuity: Definition, How It Works, and Types

What Is a Life Annuity?

A life annuity is a financial product sold by an insurance company that features a predetermined periodic payout amount until the death of the annuity owner, who is called the annuitant. An annuitant typically pays into the annuity periodically when they are still working. Annuitants may also buy the annuity in one large, lump-sum purchase, usually at retirement. Life annuities are commonly used to provide guaranteed and/or supplemental retirement income that cannot be outlived.

How a Life Annuity Works

Life annuities come in two different phases. The first is the accumulation phase. This is the period when the buyer funds their annuity with premiums or with a lump-sum payment. The second stage is the income or the annuitization phase. During this period, the issuer or insurance company makes regular payments to the annuitant.

Once funded and enacted, the annuity makes periodic payouts to the annuitant, thus providing a reliable source of income. The issuer normally stops making periodic payments if the annuitant dies or if another triggering event occurs to close the annuity. But these payments may continue to the annuitant's estate or beneficiary if the annuitant had purchased a rider or other option on the annuity.

The majority of annuities generally pay a benefit every month, but some make quarterly, annual, or semi-annual payments. Payment intervals depend on the specific needs of the annuitant or their tax circumstances. Many retirees fund a life annuity to match their recurring housing costs—mortgage or rent—as well as any other costs, including health care, insurance premiums, and medical expenses.

While a life annuity pays a guaranteed income, it is not indexed to inflation, which is the pace of price increases in an economy. As a result, purchasing power may erode over time. A life annuity, once enacted, is not revocable.

Special Considerations

It's important to consult a reputable professional before purchasing an annuity. That's because annuities tend to be fairly complex, with major implications for the annuitant's standard of living.

Due to the tax-preferred nature of annuities, very wealthy investors and above-average income earners may use these life insurance products to transfer large sums of money or to mitigate the effects of taxes on their annual income.

While life annuities are often used to provide or supplement retirement income, they are also used as a payment method in structured settlements and for lottery winners. For instance, if someone wins a lawsuit, they may be provided with a series of fixed, regular payments to the beneficiary. Lottery winners may opt to take a lottery annuity rather than a fixed, lump sum when they win large jackpots. These payouts provide regular payments annually over a certain number of years. For example, a Mega Millions jackpot winner can choose to take 30 payments, with one paid out immediately. The remaining payments are distributed annually for the next 29 years.

The Bottom Line

Life annuities are insurance or investment products that provide the annuitant with fixed payments at regular intervals. Life annuities, also known as lifetime annuities, are generally sold by insurance companies. They essentially act as longevity insurance, as the risk of outliving one's savings is passed on to the annuity issuer or provider.