In general terms, an annuity is a mathematical concept that is quite simple in its most basic application. Start with a lump sum of money, pay it out in equal installments over a period of time until the original fund is exhausted, and you have an annuity. Expressed differently, an annuity is simply a vehicle for liquidating a sum of money. But of course, in practice, the concept is a lot more complex. An important factor missing from above is interest. The sum of money that has not yet been paid out is earning interest, and that interest is also passed on to the income recipient (the “annuitant”).
Anyone can provide an annuity as long as they can calculate the payment based upon three factors:
However, there is one important element absent from this simple definition of an annuity, and it is the one distinguishing factor that separates insurance companies from all other financial institutions. While anyone can set up an annuity and pay income for a stated period of time, only an insurance company can do so and guarantee income for the life of the annuitant.
The insurance companies, with their unique experience with mortality tables, are able to provide an extra factor into the standard annuity calculation, a survivorship factor. The survivorship factor provides insurers with the means to guarantee annuity payments for life, regardless of how long that life lasts.
Don’t get confused between an annuity and a life insurance contract. Annuities are not life insurance contracts. Even though it can be said that an annuity is a mirror image of a life insurance contract—they look alike but are actually exact opposites. Life insurance is concerned with how soon one will die; life annuities are concerned with how long one will live.