Definition: An agreement between a person and an insurance company where the person pays the company money leading up to his or her retirement and at that point begins collecting a certain amount of money per year from the insurance company for as long as he or she lives.

Example: At age 40, Martin enters into an annuity agreement with an insurance company. He will pay the company $10,000 per year for the next 25 years, at which time he will have reached the retirement age of 65. The insurance company will pay him $50,000 per year until he passes away.

Investeach explains: Annuities have become very complicated because, in their attempt to outdo one another, insurance companies keep adding unique features and options. For example, a person can continue to receive payments until his death or choose to collect less money each year but have the payments continue until both he and his wife die.

Notice how, because the payments continue until death, annuities can dramatically reduce longevity risk.

Finally, when a person lives to a very old age, he or she is really “getting over” on the insurance company. The company can take this chance because of a concept called the “law of large numbers”. The insurance company will sell many, probably thousands, of these annuities. For every one of their customers who lives beyond expectations, there will be another who passes away early!

Riddle me this:

1. How long do a person’s annuity payments last?
2. How can an insurance company take the risk that a person will live years beyond normal?
3. Which risk does an annuity help a person dramatically reduce?

Related terms:

Longevity risk.