Definition

An annuity is a sum of an investment or money that is paid at regular intervals. It is a contractual financial product offered by financial institutions, designed to receive funds from an individual and pay the payment stream to the individual later at predefined period of time.

Explanation

There are two types of annuity: fixed and variable. The purpose of fixed annuities is to save money for the long term. With fixed annuity, it is guaranteed that certain amount will be given to an individual after a pre-decided period of time at the rate agreed at the time of purchasing the annuity. It provides a moderate level of risk to investors. On the other hand, variable annuity differs from a fixed rate because of fluctuation in the rate of return with the market. High level of risk is involved in variable annuity.

Annuities were designed to secure the steady cash flow for an individual during the years of retirement. It also helps individual in order to alleviate fear of longevity risk.

The drawback of an annuity is that it is not liquid. Funds invested under this contract are locked up for a certain time period and it is known as surrender period. If investor draws the fund from surrender period, a penalty will be imposed. The surrender period may be considered from 2 years and it can last for 10 years.