Annuities vs. life insurance: What’s the difference?

Annuities and life insurance provide solutions for different life needs, though each are offered by insurance companies. Annuities provide a stream of income while you or your family are alive, whereas life insurance provides a cash payment on the death of the insured individual.

Here’s how annuities and life insurance work and their similarities and differences.

Annuity and life insurance: Overview

Annuities and life insurance are both products offered by insurance companies, and they provide different types of benefits:

• Annuities is a contract that offers a stream of cash flow for a set period of time, often during retirement, in exchange for money paid in to the annuity.
• Life insurance is a contract that offers a cash payment to the contract’s beneficiaries if the policyholder dies while the policy is active and the terms of the contract are met.

Annuities provide a benefit when you’re alive, and life insurance provides a payout when you pass. But in some cases, annuities may offer features that look a lot like life insurance.

What is an annuity?

An annuity offers a stream of income for a period of time, often for the life of the policyholder, helping to create income stability.

Annuities can ensure that you never outlive your income. Annuities will pay income for the time period specified in the contract. That could be a fixed period such as 20 years or the remainder of the policyholder’s life or even for the duration of the life of the policyholder and a spouse.

Annuities are a financial product offered by insurance companies, and you may purchase an annuity with either a lump-sum payment or a series of payments over time. People often use annuities as part of their retirement strategy, which may include life insurance or traditional retirement accounts such as an IRA.

Annuities come in a variety of types, depending on their potential returns and when they’ll begin paying out a their income:

• Fixed: A fixed annuity guarantees a minimum rate of return to the policyholder and pays out over a specified term.
• Variable: A variable annuity lets you invest in mutual-fund-like investments. The annuity’s returns and your ultimate payout depends on the investments’ performance and cost.
• Indexed: Indexed annuities offer returns that follow an index such as the Standard & Poor’s 500 Index, which holds hundreds of America’s largest companies. This type of contract usually puts a ceiling on upside potential, while providing downside protection.

Annuities can also be classified by when they pay out:

• Deferred annuities: Deferred annuities pay out at a specific point in the future, perhaps in retirement.
• Immediate annuities: Immediate annuities begin within a year or less.

If you’re going for a fixed annuity, then you’ll want to check out the best fixed annuity rates to be sure you’re earning the highest returns.

What features do annuities offer?

Annuities can be structured to offer a broad range of features, depending on what the client needs. This benefit helps make annuities more flexible, but it also makes annuities complex and difficult to understand. Some popular features of annuities include:

• Minimum guaranteed payout: Some annuities guarantee that you’ll get a minimum payout over some period of time.
• Death benefit: The annuity may pay out the remainder of the account to heirs and may also offer an insurance-like payout on the holder’s death.
• Surrender period: Some annuities may offer a longer surrender period, giving clients more time to cancel the contract.
• Survivor’s benefits: Some annuities may allow the surviving spouse to receive the annuity’s cash flow.
• Other riders: Other features can be added to the annuity and may offer insurance-like benefits and payouts.

An annuity with more features and advantages generally costs more. Annuities offer a variety of tax advantages, helping make them a valuable component of retirement planning.

What is life insurance?

Life insurance offers a cash payout to beneficiaries on the policyholder’s death if the terms of the policy have been met. In exchange, the policyholder pays a regular premium to the insurance company, typically on a monthly, quarterly or annual basis. Two main types of life insurance exist:

• Term life insurance: Term life insurance offers coverage for a fixed period of time, perhaps for 5, 10 or even 30 years. If the policyholder passes after the term of the insurance, then the insurance will not pay a death benefit.
• Permanent life insurance: Permanent life insurance offers coverage until the policyholder’s death as long as the other terms of the insurance contract are met (e.g. the premium is paid). This kind of insurance has several varieties (whole, universal and variable) that offer the potential for higher returns over time.

These two major types of life insurance offer significantly different benefits and risks.

What is term life insurance?

Term life insurance provides coverage for a specific period of time and then expires. Premium payments for term life are typically fixed for the life of the contract, while the death benefit may be fixed with some policies or increase and even decrease with time.

A term life policy may require the policyholder to undergo a medical exam to qualify for coverage. Unlike permanent life policies, term life policies do not have a cash value account, meaning that a policyholder does not accrue any value in the account that can grow or be borrowed against.

A policyholder may be able to extend the policy or convert it to a permanent policy before it expires, though the latter feature requires a conversion rider and may cost more. A rider is an addition to a typical insurance policy that provides some extra feature, usually at extra cost.

Term life insurance may be a good fit for those who want coverage only for a specific period, such as young parents or those with a significant debt burden such as a mortgage. Term life is generally cheaper than permanent life, giving many a cost-effective solution for coverage.

What is permanent life insurance?

Permanent life insurance provides coverage for the policyholder until death as long as the premium is being paid. Permanent life has two parts: a death benefit that offers a cash payout on the policyholder’s death and a cash value account that acts like a savings or investment account. This kind of insurance has a couple major varieties with various features:

• Whole life insurance: Whole life insurance offers a fixed premium and death benefit, meaning that these amounts never increase or decrease.
• Universal life insurance: Universal life insurance offers flexible premiums and death benefits, meaning that policyholders may adjust these amounts at some points in the policy’s life.
• Variable life insurance: Variable life insurance provides a death benefit as well as a cash value account that allows you to invest, including in mutual funds. A holder can use the increased cash value to increase the death benefit, among other things.

Other types of permanent life insurance include indexed life insurance, guaranteed life insurance and final expense insurance.

The cash value account can be an attractive feature of a permanent life policy, allowing the holder to save and invest or even borrow from the policy. The potential for gain is higher with cash value that is invested in the stock market, though it comes with higher risk, too.

A permanent life policy often has some exclusions to deter fraud, such as safeguards against dishonest applicants. Plans typically have a clause that prevent it from paying a death benefit if the policyholder has committed suicide. A medical exam is usually required as a condition of opening a permanent life insurance policy.

Permanent life insurance may be a good fit for those who want coverage without an expiration date. They may also be a good fit for those who can take advantage of the cash account. Permanent life is usually more expensive than term life, making it a better fit for higher earners.

Key differences between annuities and life insurance

While annuities and life insurance are both offered by insurance companies, they provide significantly different benefits:

• The goals of an annuity and life insurance differ: An annuity safeguards your income, perhaps for life, whereas life insurance protects your heirs if you die.
• While annuities offer an income stream for the contract’s owner while living, life insurance offers a cash payout to the policyholder’s heirs on his or her death.
• Annuities may be purchased in a lump sum or over time, while life insurance is paid over time in regular installments, often monthly or quarterly.
• Annuities are used in retirement planning, while life insurance is a better choice to prevent financial catastrophe.
• Annuities may offer a death benefit like insurance does, but its primary purpose is to deliver a stream of cash flow.
• Medical exams may be required for life insurance but are not required for annuities.

These differences between annuities and life insurance are some of the most important.

Bottom line

Annuities and life insurance offer different benefits to different people at different times. While annuities offer an income stream to holders while they’re alive, life insurance offers cash to beneficiaries of policyholders when they pass. It’s important to understand which kind of financial product works better for your needs and financial situation.