An annuity is a sum of money which is paid in equal portions at regular intervals.
The term is most often used to refer to a series of identical payments or repayments which are made up of settlement payments plus interest. The size of annuity payments remains constant even though the ratio of settlement payments to interest may change.
Typically annuities are paid on an annual basis, but this does not have to be the case. For example, annuities can be paid on a quarterly, semi-annually or monthly basis.
Example 1: When a person mortgages their home using an annuity mortgage (repayment mortgage), the mortgage must be paid off by a series of regular, equal repayments.
Example 2: Swiss consumer credit laws dictate that the portion of annuities for personal loans which can be made up of interest must decline over the loan term. This is because repayments remain the same over the loan term, but because the repayments diminish the debt, interest on the outstanding debt declines.
In finance, the term annuity commonly refers to a type of insurance policy or fund which provides a regular income derived from money previously contributed to the insurance scheme or investment fund. Annuities are most commonly used to convert a lump sum of money into a regular income and to provide a guaranteed income.
In this form of annuity, assets are paid into a fund (typically a life insurance policy) over an accumulation period by an “annuitant”. In some cases, a single, lump-sum payment is made. Interest is normally paid by the insurance company or fund manager, growing the assets.
After a predetermined amount of time, the accumulation period ends and the annuitization phase begins.
During the annuitization phase, a series of regular, equal payments are paid out to the annuitant by the insurance company or other financial service provider. These may be paid out directly from assets which have accumulated in the fund (plus interest), or they may take the form of insurance benefits paid out over either defined or indefinite terms. Here too, annuity payments always remain identical although individual components (settlement payments and interest rates) may change.
Example: You contribute 300 Swiss francs per month to a fund over an accumulation period of 20 years. At the end of the accumulation period, the fund holds 72,000 francs plus around 3698 francs of interest, a total of 75,698 francs. During the 10-year annuitization phase, those assets are paid out as a pension of around 630 francs per month.