Types of Annuities
An annuity contract is an insurance policy that promises the periodic payment of a sum of money for the life of an individual (or the joint lives of two or more individuals) or for a term of years. Annuities may be classified in a number of ways based on factors such as how premiums are paid (single premium or multiple premiums); when benefits begin (immediately or on a deferred basis); and how benefits are expressed (fixed, variable, or indexed benefits). These types of annuities are not mutually exclusive each annuity will fall into all three classes. Also, annuities may be classified as individual annuities or as group annuities (issued to a group policyholder for the benefit of many individuals). Furthermore, annuities may be used in qualified pension arrangements ("qualified annuities") or they may be sold in the general market ("non-qualified annuities").
An immediate annuity almost always is purchased with a single premium, and the first annuity payment will begin within one payment interval (e.g., one month, or one year) from the date of purchase. Immediate annuities are used for a variety of purposes, but the primary purpose is to amortize a sum of money in the form of periodic payments for a stated period, e.g., the life of the owner. Other sources of funds used to purchase immediate annuities come from the sale of a family farm or business, lump-sum distribution under a pension or other retirement plan, personal savings, or personal investments.
With a deferred annuity, the premiums paid to the life insurance company are held by the company until the annuity starting date, i.e., the date on which annuity payments begin. Thus, annuity payments are "deferred" for some period. In the case of a "fixed" deferred annuity, the premiums held by the insurance company are credited with interest at a rate guaranteed for the duration of the annuity.
In the case of a "variable" deferred annuity, the premiums are placed in a "separate account" of the life insurance company, and the funds are invested by the life insurance company in various investment options. Many variable annuities offer the policyholder a choice among a number of diversified investment options with different investment strategies. The value of the variable deferred annuity contract is not guaranteed, and will vary according to the performance of the investments made by the separate account. (Most variable annuities offer a fixed account investment option as well.)
A third type of deferred annuity is a hybrid of the fixed and variable annuity. The "fixed indexed" annuity, or simply "indexed" annuity contains a guarantee by the insurance company that a minimum rate of interest will be credited to the premiums paid under the contract (like the fixed annuity). However, like the variable annuity, it provides that additional amounts will be credited based on some external equity market index such as the Standard and Poor's 500 Index. The contract may credit the full amount of the index or only a portion of the index.
It is common (almost universal) for a deferred annuity to include a minimum guaranteed death benefit which ensures that the beneficiary will receive the greater of the premiums paid or the market value of the annuity at the time of death. Most variable annuities provide higher death benefits. For example, the death benefit may be "locked in" at regular intervals (e.g., every five years) to preserve increases in value up to that lock-in-date, or may be guaranteed to equal the premium paid, plus a guaranteed return of some amount, e.g., 5 percent. Prior to the time annuity income payments begin, the amounts accumulated in a deferred annuity (both fixed and variable) may be withdrawn. However, there are substantial disincentives for with withdrawals prior to retirement. If withdrawn, amounts are subject to income tax at ordinary income tax rates. If withdrawn before age 59 ½, amounts also are subject to penalty taxes. In addition, companies typically impose contractual penalties ("surrender charges") on amounts withdrawn within a certain period after being paid into the annuity. Generally, contractual surrender charges are reduced the longer monies are accumulated in the contract. In addition, some annuities, which guarantee interest for longer periods may impose a "market value adjustment" on withdrawals prior to the end of the guarantee period.
Distribution of Income
The flexibility of payouts is an important part of an annuity's structure. Annuity payments can be either fixed or variable. If the annuity payments are fixed, the insurance company guarantees that the dollar amount of each payment will remain the same for the duration of the contract. If the annuity payments are variable, the insurance company will guarantee that payments will be made for the duration of the contract, but the dollar amount of each payment will vary with the value of the underlying investments.
On the annuity starting date, amounts accumulated in a deferred annuity are applied under an annuity option and a stream of payments commences. The owner of a deferred annuity generally may wait until the time annuity income payments are to begin to select the form in which the annuity payments will be paid. The purchaser of an immediate annuity selects the form of payment at the time of purchase. Virtually all annuities offer policyholders a choice among the following basic options:
Straight Life Annuities
A straight life annuity provides an annuity income that is entirely contingent on the continued life of an individual. Annuity payments continue as long as the annuitant survives, but the payments stop when the annuitant dies regardless of how soon that may occur after the annuity starting date. No further amounts are payable to the annuitant's estate of beneficiary.
Joint and Last Survivor Annuities
A joint and last survivor annuity covers two lives and provides income payments as long as either of the two annuitants live. In some cases, the joint and last survivor annuity continues the same income until the death of the last survivor. Other versions of the joint and survivor annuity provide that the income will be reduced following the death of the first annuitant to two-thirds or one-half of the original income.
Life Annuities with Refund Features
Most individuals who purchase a life annuity purchase a contract with some form of death benefit or refund feature. There are two broad categories of such benefits. The first group comprises annuities that make payments for as long as the individual lives, but provide that if the individual should die before payments have been made for some minimum number of years, e.g., 10, the payments will continue until the end of the stated period. This type of annuity is often referred to as a life annuity with a period (or installments) certain. The second type of death benefit or refund feature provides that if the annuitant dies before some specified amount or portion of the premium has been paid to the annuitant, some or all of the premiums will be refunded to a beneficiary. Depending on the specific type of refund, these types of annuity are referred to as either cash-refund annuities or installment refund annuities.
Term Certain Annuities
A term certain annuity guarantees payments for a chosen period of time whether the annuitant lives or dies. Typically, the payments are guaranteed for 5, 10, 15, 20, or 30 years.
Annuities Are Insurance
In contrast with life insurance, which provides financial protection against the risk of premature death, an annuity provides financial protection against the risk of out-living one's income or being without needed assets during retirement. As with life insurance, there is risk-shifting and risk-sharing in an annuity. The owner of a deferred annuity may always choose a life annuity (i.e., a stream of payments until he or she actually dies). Thus, the financial risk associated with "living too long" is shifted from the individual to the insurance company, which is able to distribute that risk over a pool of annuitants.
In the case of a deferred annuity, even if a policyholder does not ultimately select a life contingent annuity, the issuing company has put itself at risk, throughout the deferral stage, that such selection could be made. This mortality risk subjects deferred annuities (from the date of issue) to strict State insurance regulation. A life insurance company, at the time a deferred annuity is issued, guarantees to the purchaser an annuitization rate (e.g., a guarantee that, if she annuities at age 65, she will receive at least $6.82 per month for life for each $1,000 applied at annuitization). This guaranteed annuitization rate will not change regardless of when annuitization occurs, and grows in value to the policyholder as life expectancies increase.
Variable annuities are sold by prospectus that contains more complete information, including fees, charges and expenses, and risks pertaining to the specific variable annuity contract. Always read the prospectus carefully before purchasing a contract. Variable annuities are long-term investment products designed for retirement purposes. Withdrawals or distributions may be subject to surrender charges, and will reduce the guaranteed benefits and contract value. Withdrawals of taxable amounts are subject to ordinary income tax, and if made prior to age 59 ½, may be subject to an additional 10% Federal income tax penalty.
All guarantees are based on the claims-paying ability of the insurance company issuing the annuity contract.
Annuities: Are not FDIC Insured • Are Not Guaranteed by a Bank or Savings Association • Are Not Insured by any Federal Government Agency • May Go Down in Value if it’s a variable annuity