How Do Annuities Make Money?
Learn how annuities work and how they make money: They are investments that are offered typically by insurance companies and are similar to life insurance. However, the payout structure is in the opposite order. To better understand what an annuity is we will first look at how life insurance works:
Life Insurance:
With life insurance, a policy holder will make small payments every month to the company until they die and in return the company will make a large payment to the beneficiary. The beneficiary only receives money after the policy holder passes and it’s a large payment.
Annuity:
The policy holder (annuitant) will make a one time up front large payment to the insurance company. The company will then agree to make small monthly payments to the investor every month until the policy holder dies. The payments stop after the policy holder passes and the policy is then terminated.
How the Insurance Company Profits:
The company takes the lump sum payment and then reinvests that money into other investments and securities. They are basically using the policy holders’ money to reinvest for profit. If the monthly returns that they earn on their investments are greater than what they pay out to the annuitant, they profit. Sometimes the money that they payout monthly to the annuitant is greater than the profit earned monthly. However, over the long run, the insurance company will make a great overall profit.
How the Investor (Annuitant) Profits:
The investor makes profit by living longer. They profit if the amount of monthly payments that they collect over time is greater than the large investment itself.
Types of Annuities:
Basic Life Annuity:
Supplies regular income for life. They can be bought by both single life or as joint and beneficiary. Monthly payments stop after investor dies.
Term Certain Annuity:
Will provide beneficiaries with a guaranteed regular income for a specified time frame even after the investor passes.
Prescribed Annuity:
Propose possible preferential tax treatment if you plan on investing non registered funds.