Life Insurance Annuity Explained

The purpose of life insurance is to provide for your chosen beneficiaries when you die. There are different ways for the death benefit provided by this kind of insurance to pay out. Some choose a lump sum payment that divides the full amount of the benefit at one time, tax-free, among the beneficiaries. Others choose to receive a life insurance annuity instead.

What Is a Life Insurance Annuity?

If a recipient of death benefits so chooses, they can receive their benefits as a periodic income stream. This is called a life insurance annuity because it pays out the money in increments over a set number of years. During that period, any remaining funds earn a fixed and taxable interest rate. 

How Does a Life Insurance Annuity Work?

In essence, an annuity is a contract with an insurance company designed to provide for a nest egg that can furnish ongoing support. Annuities are a common tool used by people saving for retirement; the life insurance version is focused on supporting loved ones after the policyholder's death.

Under the contract, the policyholder pays either a lump sum or installments to the insurer. The policy's beneficiaries, if they choose not to take the death benefit as a lump sum, are then entitled to a series of payments at a future date.

A fixed period annuity — also known as a period certain or specific income annuity — pays that money out for either 10, 15, or 20 years. These are often a preferred option for older beneficiaries who might want to ensure that they themselves don't pass away before the full amount of the benefit pays out.

Lifetime annuities pay out to beneficiaries until they die. These are a good option for younger beneficiaries who might want to see more interest gains across the extended payment timeline.

There are a wide range of life insurance annuity products on the market, with major types including:

• Fixed contracts with a guaranteed interest rate
• Variable contracts attached to baskets of bond and stock funds
• Indexed contracts whose value is tied to a specific stock market index

Because the lump sum paid into an annuity appreciates in value, it has become a popular way to grow and diversify a savings portfolio. In some cases, variable annuities focused on building retirement savings come with their own built-in death benefits equal to the original amount paid into the annuity. There are also variable annuities that offer enhanced death benefits which pay out the annuity's highest recorded value.

Is a Life Insurance Annuity a Good Investment?

There are pros and cons to annuity contracts. Whether they're worth it to you as an investment depends on how these benefits and drawbacks weigh out in the case of any particular annuity product.

The upsides:

• An annuity provides a dependable income supplement
• Contributions to an annuity appreciate in value, tax-deferred until it begins to pay out
• Fixed annuities offer a guaranteed return rate
• Variable annuities can offer enhanced death benefits

Annuities may be a preferred option for beneficiaries who might find managing a lump sum insurance payment overwhelming, who don't need to use the death benefit to cover various debts or end-of-life expenses for the deceased, or who might want a secure way of diversifying their investments (fixed annuities in particular don't pay out comparably to more traditional investments, but they do provide a guaranteed cushion regardless of the vagaries of the market).

Annuities do have drawbacks that require careful consideration before you commit:

• The associated taxes and fees can cut significantly into their value
• They have a lower rate of return than other kinds of investment
• It can take numerous years to get the annuity's full value
• It is punishingly expensive to withdraw money from them early

If you're looking to maximize investment returns, in the long run it's usually a better idea to accept a lump sum death benefit payment and put that money into a more traditional investment vehicle.