The primary function of life insurance is to create an estate or principal sum; the primary function of an annuity is to liquidate a principal sum, regardless of how it was created. Despite this basic dissimilarity in function, life insurance and annuities are based on the same fundamental pooling, mortality and investment principles.

In the first place, both life insurance and annuities protect against loss of income. Life insurance furnishes protection against loss of income arising out of premature death; an annuity provides protection against loss of income arising out of excessive longevity. It might be said that life insurance provides a financial hedge against dying too soon, while an annuity provides a hedge against living too long. From an economic standpoint, both contingencies are undesirable. A second common feature is the utilization of the pooling technique. Insurance is a pooling arrangement whereby all make contributions so that the dependents of those who die prematurely are partially compensated for loss of income; an annuity is a pooling arrangement whereby those who die prematurely make a contribution on behalf of those who live beyond their life expectancy and would otherwise outlive their income. A third common feature is that the contributions in each case are based on probabilities of death and survival as reflected in a mortality table. For reasons that will be apparent later, the same mortality table is not used for both sets of calculations. Finally, under both arrangements, contributions are discounted for the compound interest that the insurance company will earn on them.

The annuity concept is founded on the unpredictability of human life. A person may have accumulated a principal sum for his or her old-age support that, assuming that the sum is to be liquidated over his or her remaining years, should be adequate for the purpose. Such a result, however, requires estimating the length of the individual�s lifetime. He or she might have average health and vitality for his or her age and could expect to live exactly the calculated life expectancy (derived from a mortality table). But because the individual could not be sure of not surviving beyond this predicted life expectancy, to be on the safe side, he or she would have to plan to spread the accumulated principal over a much longer period than he or she is likely to live. Even then there would be some danger of surviving the period and finding the assets and income totally consumed prior to death. On the other hand, the individual might die after only a few years, leaving funds to his or her estate that could have and should have been used to provide the person with more comforts during his or her lifetime. If the individual were willing to pool savings with those of other people in the same predicament, the administering agency, relying on the laws of probability and large numbers, could provide each of the participants with an income of a specified amount as long as he or she lives�regardless of longevity. No one could outlive his or her income. Such an arrangement, however, implies a willingness on each participant�s part to have all or a portion of his or her unliquidated principal at the time of death used to supplement the exhausted principal of those who live beyond their life expectancy.

Each payment under an annuity is composed partly of principal and partly of the income on the unliquidated principal. For each year that goes by, a larger proportion of the payment is composed of principal. If a person exactly lives out his or her life expectancy, as computed at the time the individual enters on the annuity, the principal will be completely exhausted with the last payment prior to death. If the person lives beyond his or her life expectancy, each payment will be derived from funds forfeited by those who die before attaining their life expectancy. It is an equitable arrangement since at the outset no one can know into what category he or she will fall. There is no other arrangement under which a principal sum can�with certainty�be completely liquidated in equal installments over the duration of a human life.

Annuities may be classified in many different ways, depending on the point of emphasis. For most purposes, they can be classified by the following:

This is a simple dichotomy and refers only to whether the annuity covers a single life or more than one life. The conventional form is a single-life annuity. If the contract covers two or more lives, it may be a joint annuity or a joint-andsurvivor annuity. A joint annuity provides that the income will cease upon the first death among the lives involved; it is seldom issued. A joint-and-survivor annuity, on the other hand, provides that the income will cease only upon the last death among the lives covered. In other words, payments under a joint-and-survivor annuity continue for as long as either of two or more specified persons live. This is a very useful contract, and it enjoys a wide market. Annuity contracts involving more than two lives are rarely sold.

Annuities may also be classified as immediate or deferred. An immediate annuity is one in which the first payment is due one payment interval after the date of purchase. If the contract provides for monthly payments, the first payment is due one month after the date of purchase; if annual payments are called for, the first payment is due one year after the date of purchase. However, in all these cases the annuity is "entered on" immediately. The first payment begins to accrue immediately after purchase. An immediate annuity is always purchased with a single premium; the annuitant exchanges a principal sum for the promise of an income for life or for a term of years, as the case might be.

The immediate annuity has been supplanted in importance by the deferred annuity, under which a period longer than one payment interval must elapse after purchase before the first benefit payment is due. As a matter of fact, there is normally a spread of several years between the date of purchase and the time when payments commence. This contract is usually, but not always, purchased with periodic premiums payable over a number of years, up to the date income benefits commence. It is suitable for many people, including a person of ordinary means who wants to accumulate a sum for his or her old age.

Deferred annuities may be purchased with either single premiums or periodic premiums. Originally an annuity was envisioned as a type of contract one would buy with a lump sum, accumulated perhaps from a successful business venture or possibly inherited, in exchange for an immediate income of a stipulated amount. Immediate annuities are still purchased with a lump sum, but most annuities today are purchased on an installment basis. High income taxes and estate taxes as well as inflation have made it difficult for most people to accumulate the purchase price (consideration) for a single-premium annuity. The deferred annuity provides an attractive and convenient method of accumulating the necessary funds for an adequate old-age income.

The dichotomy here is pure versus refund annuities. A pure annuity, frequently referred to as a straight life annuity, provides periodic�usually monthly�income payments that continue as long as the annuitant lives but terminate at that person�s death. The annuity is considered fully liquidated upon the death of the annuitant, no matter how soon that may occur after purchase, and no refund is payable to the deceased annuitant�s estate. Moreover, no guarantee is given that any particular number of monthly payments will be paid. This nonrefund feature may be applied to either an immediate or a deferred annuity. In other words, it is possible to obtain a contract under which no part of the purchase price will be refunded even if the annuitant dies before the income commences. On the other hand, the contract could call for a refund of all premiums paid, with or without interest, in the event of the insured�s death before commencement of the annuity income, with no refund feature after the annuitant enters on the annuity. In the description of a deferred annuity therefore it is necessary to distinguish between the accumulation and liquidation periods in labeling the contract as pure or refund.

A refund annuity is any type that promises to return (in one manner or another) a portion or all of the purchase price of the annuity. These contracts take several forms, the most important of which are discussed in the next section. As might be expected, refund annuities are far more popular than pure annuities.