What is life annuity?

A life annuity is an investment that provides an income to you for as long as you live. Each payment consists of interest earned plus the return of a portion of the invested capital.

If you live a long life, the sum of all payments will far exceed the capital spent to purchase the annuity.  Should you die prematurely, however, the total amount of payments you actually receive will be less than the capital used to purchase the annuity.

The main advantage of an annuity is that it will make periodic payments (i.e. monthly, annually, etc.) for the remainder of your lifetime. In other words, you cannot outlive your funds. This is becoming more important as life expectancy continues to increase; the annuity provides some assurance that you won’t outlive your funds.

A life annuity would be a very good investment for an individual or couple that expects to live beyond normal life expectancy. Of course there is no way to know this, but if your parents lived beyond their normal life expectancy, there is a good chance that you may live a long life, too.

The main disadvantage of an annuity is that you forego control of capital in return for a lifetime income. In today’s market, not only would you be losing access to the capital, it also means you could be locking in a historically low interest rate.

You may want to ensure that you (or your estate) will receive a total retirement income equal to at least what you invested. This can be arranged by purchasing a life annuity with a guaranteed payment period — this type of annuity would provide a specified minimum payment, regardless of whether or not you are still alive.

A life annuity with a minimum payment period provides a lower monthly income than a life only annuity. Furthermore, the longer the minimum payment period, the lower the monthly income.

You can purchase an annuity on your life only or you can set up a joint life annuity covering both you and your spouse. Such an annuity will pay an income to you or your spouse for as long as either of you lives.

The most common annuity is the level income annuity. This annuity will pay a specified amount of income for the remainder of your lifetime. The alternative is to purchase an annuity with income increasing annually — this type of annuity may increase each year by a certain percentage or by the inflation rate (as measured by the CPI).

The example below illustrates how much income you can generate if you were to purchase an annuity for $50,000 (as of Jan. 15, 2010):

The annuity can be a very effective way to produce a level of increasing income for the remainder of your lifetime. •

Clay Gillespie is a financial advisor and portfolio manager with Rogers Group Financial. The views expressed are those of the author and not necessarily those of Rogers Group Financial, which makes no representations as to their completeness or accuracy.