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The second usage for the term annuity came into its own during the 1970s. 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of deferred annuities have one thing in common: any increase in account values is not taxed until those gains are withdrawn.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.
Upon immediate annuitization, a wide variety of options are available in the way the stream of payments is paid. If it is paid over the life of the annuitant (the person receiving the annuity payments), it would commonly be called a life annuity, but also known as a life-contingent annuity or simply lifetime annuity. If the annuity is paid over a fixed period it is known as an 'annuity with period certain'. It can also be paid over the lifetime of the annuitant(s) or for a fixed period whichever is longer. This is known as 'life with period certain'.
A hybrid of these is when the payments stop at death, but also after a predetermined number of payments, if this is earlier: a temporary life annuity. The difference with the period certain annuity is that the period certain annuity will keep paying after the death of the annuitant until the period is completed.
A life or lifetime immediate annuity is most often used to provide an income in old age, i.e. a pension. The annuity may be purchased from an insurance company.
The annuity works somewhat like a loan that 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. 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.
Cross-Subsidy remains one of the most effective ways of spreading a given amount of capital and investment return over a life time without the risk of funds running out.
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