Under European Union law, an annuity is a financial contract which provides an income stream in return for an initial payment with specific parameters. It is the opposite of a settlement funding. A Swiss annuity is not considered a European annuity for tax reasons.
Immediate annuity
An immediate annuity is an annuity for which the time between the contract date and the date of the first payment is not longer than the time interval between payments. A common use for an immediate annuity is to provide a pension to a retired person or persons.
It is a financial contract which makes a series of payments with certain characteristics: either level or fluctuating periodical payments made annually, or at more frequent intervals in advance or arrears duration may be: fixed (annuity certain) during the lifetime or one or more persons, possibly reduced after death of one person during the lifetime but not longer than a maximum number of years during the lifetime but not shorter than a minimum number of years
Annuity certain
An annuity certain pays the annuitant for a number of years designated. This option is not suitable for retirement income, as the person may outlive the number of years the annuity will pay.
Life annuity
A life annuity or lifetime immediate annuity is most often used to provide an income in old age (i.e., a pension). This type of annuity may be purchased from an insurance (Ireland and the UK, Life Assurance) company.
This annuity can be compared to a loan which is made by the purchaser to the issuing company, who then pay back the original capital with interest to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant but life annuities are payable until the death of the last surviving annuitant. In order to guarantee that the income continues for life, the investment relies on cross-subsidy. Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will support those living longer (longevity insurance).
Cross-subsidy remains one of the most effective ways of spreading a given amount of capital and investment return over a lifetime without the risk of funds running out.
Life annuity options
Although this will reduce the available payments, an annuity can be arranged to continue until the death of the last survivor of two or more people. For example, many annuities continue to pay out (perhaps at a reduced rate) to the spouse of the main annuitant after his or her death, for as long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity or survivorship annuity. However, if the annuitant is in good health, it may be more beneficial to select the higher payout option on their life only and purchase a life insurance policy that would pay income to the survivor.
Other features such as a minimum guaranteed payment period irrespective of death, known as life with period certain, or escalation where the payment rises by inflation or a fixed rate annually can also be purchased.
Annuities with guaranteed periods are available from most providers. In such a product, if death takes place within the guaranteed period, payments continue to be made to a nominated beneficiary.
Impaired life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the annuity rate is better (i.e. a higher annuity for the same initial payment). This can have the unfortunate appearance of one "betting against" the nominee.
Life annuities are priced based on the probability of the nominee surviving to receive the payments. Longevity insurance is a form of annuity that defers commencement of the payments until very late in life. A common longevity contract would be purchased at or before retirement but would not commence payments until 20 years after retirement. If the nominee dies before payments commence there is no payable benefit. This drastically reduces the cost of the annuity while still providing protection against outliving one's resources.
Deferred annuity
The second usage for the term annuity came into its own during the 1970s. This is a deferred annuity and is a vehicle for accumulating savings, and eventually distributing them either as an immediate annuity or as a lump-sum payment. Note that this is different from an immediate annuity.