Everything you need to know about a life annuity

As a beneficiary of a life insurance policy, one option is to receive the death benefit in the form of an annuity. But while life insurance and annuities are related products, they work in seemingly opposite ways.

With whole life insurance, you make fixed monthly payments to an insurance company for as long as you are alive, in exchange for a death benefit payment to your beneficiary (s) upon your death. With an annuity, you make a large initial payment to an insurance company and in return, you receive fixed monthly payments for as long as you continue to live. Why consider combining the two? This article will help you by providing a high level overview of the following.

How life insurance and annuities can complement each other

There are many different types of life insurance. A policy can be temporary or permanent. But the only defining characteristic of all life insurance policies is a death benefit. This is the most important reason to take out a policy.

If you are the beneficiary of a life insurance policy, what you do with this benefit is up to you. Insurance companies generally give beneficiaries the choice of getting paid in one of three ways:

A lump-sum payment. This is the most popular option, and the default choice: you get a large sum of money deposited directly into your bank account, whatever you choose.

Installment payments. You can also choose to receive the benefit amount in a series of payments over time. The insurer holds the money in an account that can pay interest and sends you a monthly check for the amount you choose until the capital is used up. If you decide you need more each month, simply ask the company to increase the amount — but the principal will run out much sooner. The insurance company takes your benefit payment, invests it for the long term on a tax-deferred basis, and in return, provides you with a monthly income stream that lasts for the rest of your life.

Why do some beneficiaries choose life annuities

As noted at the beginning, life insurance and annuities are closely linked: they both rely on actuarial science, the discipline that applies probability mathematics and statistics to assess financial risk. A life insurance policy provides protection against the risk of premature death by offering a tax-free death benefit to replace the income you would have otherwise earned to care for your family. It's widely understood — but what do life annuities help provide protection? By providing monthly payments that last a lifetime, an annuity can help protect you against the risk of longevity — and help you survive your savings.

While it may seem odd to worry about longevity, the problem of asset survival is a very real problem faced by people who are nearing or in retirement. Thus, the promise of guaranteed income for life can be appealing to many older beneficiaries, especially if they are in good health. If a beneficiary stays healthy and lives long enough, combined pension payments may be greater than the original life insurance policy payment. But there can also be downsides: if you're a relatively young widow or widower who needs income to raise a family, monthly payments may not be enough to replace the monthly income that a working spouse would have otherwise provided.

Life annuities and family trusts

If you don't want to give your beneficiary the choice of obtaining an annuity — for example, because he has special needs — you can choose for him using a trust: a legal entity created for estate planning purposes, and administered by a trustee of your choice. A well-established trust can hold and distribute assets to your beneficiaries under the terms and conditions you choose when creating the trust.

Parents who want to support a disabled child often create a special needs trust that is financed by their life insurance policy. Once the life insurance death benefit has been paid, this product can be used to buy an annuity, which ensures a continuous flow of income.

Different types of annuities and how they work

If you are considering this option, you should be aware that there are many types of annuity contracts that are designed to serve a variety of tax-deferred investment and income distribution purposes. Here is a quick overview of the main types of annuities and their characteristics

Fixed and variable

With a fixed annuity, your money grows tax-free at a fixed interest rate, and that's the norm for life insurance annuities. It can be a predictable way to generate a continuous flow of payments, but the returns may be lower than many market-based investments. A variable annuity allows you to invest in the markets thanks to a wide range of investment options with the potential for tax-deferred growth. This can lead to higher returns — and larger income payments — but your capital can also lose value. Variable annuities can also be quite complicated, so they're better suited for savvy investors.

Deferred and immediate

You don't have to start receiving payouts right away. If you are nearing retirement and receiving life insurance benefits, you may not need monthly payments while you are still working. Deferred annuities allow you to defer payments for as long as you want. By doing so, you'll also give your money more time to build up tax-deferred growth, making your eventual income payments bigger than they would be with an immediate life annuity.

For life and for a fixed term

A life annuity gives you lifetime income, and the longer you live, the more value you get from it. However, when you die, the payments stop, even if the total income distributed does not correspond to the amount initially invested. If you don't like the possibility of leaving money behind, you can get fixed-term annuities with terms of 10, 15, or 20 years. The payments do not last indefinitely, but they can outlive you: if you die during the fixed period, the benefits will continue to be paid to the beneficiaries you have designated