There are two basic types of annuity:
The Immediate Annuity
You hand over a lump-sum premium to an insurance company and in return you get an immediate flow of regular income payments.
The Deferred Annuity
A deferred annuity is a savings vehicle. It has an accumulation phase and a withdrawal phase. It is more tax-efficient than a bank deposit. Many people use a deferred annuity as a tax-efficient way to save for their retirement. The withdrawal phase need not be in the form of regular income to the investor; it could be a lump sum.
Annuities: As They Were, As They AreAnnuities are sold by life insurance companies. Traditionally, in return for your lump sum premium the insurance company paid you an income. The income was guaranteed for your lifetime.
Annuities paid a higher interest rate than banks could. This was because annuities and bank deposits were (and are) completely different. When you buy a lifetime annuity, you effectively sell your money for ever in return for an interest rate and lifetime income. Banks only have your money on loan; they don't get to keep it at the end of your life, so they cannot offer you as good a return as an annuity can.
For example, let's say you have accumulated $200,000 in a bank account and earn interest of 4% a year. If you take an annual income of $15,000 from this account, you will run out of money before 20 years have passed. The advantage of purchasing an annuity with your money is that you will get an income for as long as you live - even if it's another 40 years.
Annuities have traditionally been used as a means of providing a lifetime pension. People saved while they worked and bought an annuity to provide an ongoing income in retirement.
Nowadays, innovations in financial products have led to a broadening of the meaning of an annuity.
To offer an explanation of annuities in a modern context, we've split them into immediate annuities and deferred annuities. Alternatively, What is an Annuity provides a more visually friendly guide to understanding how annuities work.