This is a question from a reader. If you have a question you would like answered, please email it to me.
For background information, I discuss annuities here and whole life here, here and here, so this will be more of a juxtaposition of the two.
The annuity referred to in the title is a deferred annuity, which can be compared to a savings account. The main differences are 1) all annuities are issued by an insurance company (even the ones you get at the bank) and thus are not covered by FDIC insurance, and 2) the tax on the interest credited on an annuity is deferred until you take it out.
Deferred annuities come in two flavors, fixed and variable. A newer type called indexed annuities are really just fixed annuities with a creative method used to determine the amount of interest credited. The principal of a fixed annuity is guaranteed by the issuing insurance company. The interest rate, which is sometimes fixed for a certain period, much like a CD, is variable, although a minimal rate is usually guaranteed.
There is no death benefit associated with a deferred annuity. The beneficiary will receive the value of the annuity upon the death of the annuitant. So in that respect, it is no more a substitute for a life insurance policy than a stock, bond, or savings account.
Variable annuities provide the opportunity to invest in equities through insurance company sub-accounts, which function similarly to mutual funds. Although the variable annuity principal is not guaranteed, most companies offer a rider, for an additional fee, that will guarantee the principal. For example, if $100,000 was invested, but the value was only $80,000 at death, the beneficiary would receive $100,000 at the death of the annuitant. So in that case, there would be a death benefit, but it would hardly be a substitute for a life insurance policy.
All annuities have an annuitization feature, which allows for the principal to be converted to a stream of income that cannot be outlived. As an example, a $500,000 annuity at age 65 with a specific company would produce the following optional amounts for a male (female): Life only, $2,902 ($2,657); Cash refund, $2,657 ($2,507); Life with 10 year certain, $2,799 ($2,604); Life with 20 year certain, $2,525 ($2,440).
Life only pays for as long as the annuitant is alive, be it one month or 50 years. To mitigate the risk of an early death (and hence not receiving all of the principal back), additional options are available. The cash refund will provide any unpaid principal at death. In our example, if death occurred after 15 years (180 monthly payments), the beneficiary would receive a lump sum of $21,740, as only $478,260 would have been received (180 x $2,657).
Life insurance and annuities are not interchangeable; they are two completely different vehicles that are used to accomplish completely different objectives. Life insurance provides protection against dying too soon while annuities provide protection against living too long.