Historically, an annuity could be understood as a sort of reverse life insurance policy. In this context, “reverse” means that you get payments for a fixed period (or until you die) for paying into the annuity for many years. When their modern history began, annuities were usually tied to life insurance policies. It sounded great; if I die, my family gets my life insurance money. If I live a long time, I’ll have steady money coming in to retire on.
Today, annuities come in many different types, but in essence, they involve investing your money in a large corporation that agrees to make payments to you at some future date for a fixed period of time (technically that is not true; Social Security is the biggest annuity program the world has ever known). Because an annuity is an agreement between you and a large financial institution, there is a contract. There are also several different contract periods that you need to understand.
Many working investors lament the fall of the traditional employer pension plan. Annuities are often referred to as “buy a pension” plans because they behave in a very similar way after retirement. With both pensions and annuities, you have a guaranteed income until you die (assuming that option was chosen). As long as the company that sells you the annuity is solvent, you will receive your payments. This is beneficial for those of us who have saved a limited amount and are not sure where we will stand in the distant future should we live longer than the average life expectancy. Those of us with enough cushion to weather some bad times in the markets will not want to pay the fees associated with an annuity.
The first contract period is known as the accumulation phase. During this period, your payments start and growth begins. Your payments will continue until the next stage where the money stream reverses course and the annuity starts paying you. The magic moment in time where your payments stop is often referred to (by insurance companies at least) as the annuitization phase. The payout phase usually begins when the investor retires. This phase can be really long or really short, depending on how much money was invested, how big the payments are, and how good a deal the investment was in the first place. It is worthy of note that all monies invested will continue to grow during all three phases of the process.