The term annuity in current use in the insurance industry, refers to two very different types of contracts with very different purposes. Traditionally, for at least four hundred years, the term annuity refered to what is more correctly called today an immediate annuity. This is an insurance policy which makes a series of either level or fluctuating payments, paid out over a fixed number of years or during the lifetime(s) of one or two individuals, or in any combination of lifetime plus period certain guarantees. The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings. A common use for an immediate annuity might be to provide a pension income to a person who is about to retire.

The second usage for the term annuity came into its own during the 1970's. This contract is more correctly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings. Note, this is different from the immediate and is the cause of much confusion when people discuss annuities without carefully defining which type of annuity they have in mind.

Under the heading of deferred annuities are contracts which may be similar to bank certificates of deposit (CD) in that they offer the buyer a safe interest rate return on his money; to stock index funds or other stock funds, where the growth of the account is dependent upon the performance of the market. All varieties of deferred annuities have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.

To complete the definitions here, a deferred annuity which grows by interest rate earns alone is correctly called a fixed deferred annuity. A deferred annuity which permits allocations to stock or bond funds and for with the account values are not guaranteed to drop below the initial amount invested, are correctly called variable annuities. In the last ten years a new category of deferred annuities, called equity indexed annuities (EIAs). These policies are a hybrid of the two types of deferred annuities just described. The EIA offers a guarantee that the account value will never drop below the initial amount invested while also offering a chance to participate in the upside potential of any increase in the value of a major stock index, such as the S&P500 or Dow Jones Industrial Average.

By law an annuity contract can only be "manufactured" by an insurance company. They are distributed by, and available for purchase from, duly licensed bank, stock brokerage, and insurance company representatives. Some annuities may also be purchased directly from the "manufacturer", i.e., the insurance company writing the contract.

In a typical immediate annuity contract, an individual would pay a lump sum or a series of payments (called premiums) to an insurance company, and in return receive a fixed income payable for the rest of his life. The exact terms of an annuity product are drawn up in legal terms in a contract.

As well as referring to insurance products, it is common in finance theory to call any stream of fixed payments over a specified period of time an annuity. This usage is most commonly seen in academic discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money concepts.

From Wikipedia - The free encyclopedia