There are dozens of different flavours of annuities that perform different functions and pay their holders out in different ways, but for our purposes let’s just talk about the most common one you’ll hear about — we’ll call it the vanilla annuity.
Here’s how it works: you decide that in retirement you want to never run out of funds and find yourself in the desperate position of not being able to support yourself, so you turn over money — generally a large lump sum — to an insurance company, and the company in turn, promises either right away or at some point in the future to commence providing you with regular payments for the rest of your life. In coming up with the annuity terms, the insurance company’s actuaries will consult their tables and determine that in all likelihood you’ll pass away at a point at which they’ll have made more money from you then you from them. You, naturally, hope that you’ll outlive your life expectancy and take the insurance company to the cleaners — but rest easy knowing you’ll never go broke in your lifetime.
The two major types of annuities are fixed and variable. A fixed annuity is the no-surprises annuity — it works much like a bank CD and promises to provide you with consistent payment based upon a fixed interest rate. A variable annuity will instead be invested in bonds and equities, and pay you more or less money depending on the performance of your investments. Annuities have fallen out of favour by many sophisticated seniors because of the high sales commissions and various fees that are so often tacked onto their price tags.