Annuities are basically the opposite of life insurance. While life insurance pays off when the
policyholder dies, an annuity contract is designed to pay off while the
policyholder is still living. The
annuity has been called the upside-down application of the life insurance
principle.[1] While this description is not strictly
accurate, it does give a basic concept of annuities. The upside-down concept is based on the idea that life insurance
is the scientific creation of an estate, whereas an annuity is the
scientific liquidation of an estate.
Annuities have two basic properties: (1) immediate or
deferred payout and (2) a fixed or variable
base. An annuity with immediate payout
begins payments to the investor immediately, as the name implies. The deferred payout means that the investor
will receive payments at some later date.
An annuity with a fixed investment type offers a guaranteed return on
investment by investing in government bonds and other low-risk securities,
whereas a variable investment type means that the return on the annuity will
depend upon the performance of the funds, called sub-accounts, where the money
was invested. Based on these two
properties with two possibilities each, there are four possible combinations,
but the ones commonly seen in practice are an annuity with immediate payout and
fixed investments and an annuity with deferred payout and variable investments.
So, as we see, an annuity is the liquidation of a principal sum
to be distributed on a periodic payment basis to commence at a specified time
and to continue throughout a specified time period or for the duration of a
designated life or lives. Of course, an
annuity does not have to be liquidated through periodic payments. The contract owner can choose never to
liquidate (annuitize) the investment, instead allowing it to remain untouched,
eventually going to the listed beneficiary.
Immediate or Deferred Annuity Payout
Immediate Annuity
The immediate annuity is purchased with a
single premium and benefits begin at the end of the first income period, most often
monthly. In other words, a lump sum
purchases an annuity and one month later, the insurer begins to make payments
to the contract owner.
Those who are retiring often use the
immediate annuity. An annuity is
purchased with a lump sum of money (perhaps by cashing out a retirement fund),
with income from it beginning immediately.
The size of the monthly income will depend upon the amount that was
deposited. It is important to remember
that once an annuity is annuitized, it is no longer possible to take lump sum
distributions from it (such as that yearly ten percent distribution). Annuitization sets payout to the mode
selected at the time the contract is annuitized.
If benefits are to start at the beginning of
the first income period (rather than at the end of it, as is normally the
case), the annuity is called an annuity due. The annuity due is used when life insurance
proceeds or cash values are converted into life annuity payments, as, for
example, under the life income settlement option.
Deferred Annuity
The deferred annuity may be purchased on
either a single premium or an installment basis, where payments are made to the
annuity periodically. The benefit
payments begin at the end of a given number of years or at optional ages established
in the contract. The deferred period
may be lengthened under some deferred annuity contracts. There may be a limitation on extensions to a
given maximum age or to a given maximum number of years beyond the maturity
date.
Deferred annuities have two periods: the
deferred period and the liquidation or payout period. Minimum guarantees can be made available in one of these periods,
during both of these periods, or in neither of them. The contract will state how the annuity has been issued.
So, the difference between an immediate and
deferred annuity is easy to recognize: one pays out immediately while the other
pays at the end of the accumulation period.
It is obvious why this difference exists: in the immediate annuity funds
are immediately developed through a lump sum deposit, whereas the deferred
annuity needs time to build up the account through systematic deposits, until
enough capital exists to make payouts on a systematic basis at some later date.
Single Premium and Flexible Premium
Annuities
Single Premium Annuities
In a single premium annuity a lump sum of
money is used to purchase an annuity.
Most fixed-rate annuities have a single premium since the contract owner
is locking in a set rate of return for a specific period, in the same manner
that a rate would be locked in with a Certificate of Deposit (CD). It is the mode used to purchase an immediate
annuity. Service charges may be less
when a single payment is used, since multiple payments involve additional
administrative and handling charges.
Flexible Premium Annuities
Under a flexible premium annuity, it is
possible to make more than one deposit (payment) into the annuity product
purchased. A flexible premium means
that additional monies can be added at any time in the future. This is commonly used for variable
annuities, but generally not with fixed-rate annuities.
Flexible premium annuities are sometimes
confused with installment annuities, but they are not actually the same
type. Under an installment annuity, the
contract may actually dictate that multiple payments must be made,
whereas a flexible premium contract states that it is possible to make
multiple payments (not required).
The amount of payment made to a flexible
premium annuity has no timetable, nor does it dictate the amount that must be
deposited. It is not necessary to make
additional payments, but the contract allows the policyowner to do so if he or
she so desires.
There is a simple difference between a
single premium and a flexible premium annuity: the single premium annuity
allows only a single one-time premium to be made. The flexible premium annuity allows more than one payment to be
made but does not necessarily dictate that more than one must be made. Rather it offers the availability to do so.
Variable, Fixed, and
Indexed Annuities
Variable Annuities
A variable annuity is similar to a mutual
fund family in that the investor has the ability to select from one or more
different investment portfolios, called sub-accounts. There is no set rate of return promised in a
variable annuity (thus the name, variable). Simply stated, a variable annuity is an insurance contract
joined with an investment product.
Annuities function as tax-deferred savings vehicles with insurance-like
properties; they use an insurance policy to provide the tax deferral. The insurance contract and investment
product combine to offer the following features:
1. Tax
deferral on earnings.
2. Ability
to name specified beneficiaries.
3. Annuitization
(the ability to receive payments for life based on life expectancy).
4. The
guarantees provided in the insurance component.
A variable annuity invests in stocks or
bonds, has no predetermined rate of return, and offers a possibly higher rate
of return when compared to a fixed annuity.
A variable annuity is an investment vehicle
designed primarily for retirement savings.
They have become a part of the retirement and investment plans of many
Americans. Before an agent markets
these products, it is important to know the basics. A variable annuity is not right for everyone.
A variable annuity is a contract between the
policyowner, who may or may not be the insured, and an insurance company. The insurer agrees to make periodic
payments, beginning at some agreed upon date.
The annuity may be purchased by a lump sum payment or through a series
of deposits (payments).
A variable annuity offers a range of
investment options. The value of the investment
will vary depending upon the performance of the investment options that have
been selected. Usually the investment
in a variable annuity is mutual funds that invest in stocks, bonds, money
market instruments, or some combination thereof.
Even though variable annuities invest in
mutual funds, they are not the same as mutual funds. They differ in some important ways:
1. Variable
annuities let the owner receive periodic payments for the rest of their life if
they so choose. They may choose payout
options other than payment for life, enabling a spouse or beneficiary to also
collect from the annuity.
2. Variable
annuities have a death benefit. If the annuity owner dies before the insurer
has started making payments to them, their beneficiary is guaranteed to receive
a specified amount, typically at least the principal. The beneficiary will get a benefit from this feature if, at the
time of the owners death, the account value is less than the guaranteed amount.
3. Variable
annuities are tax-deferred. That means
the owner pays no taxes on the income and investment gains from the annuity
until the money is withdrawn. Then they
will pay only on the gains. The money
may be transferred from one investment option to another within a variable
annuity without paying tax at the time of transfer. When the money is withdrawn the earnings will be taxed at
ordinary income tax rates rather than lower capital gains rates.
Most professionals feel the benefits of tax
deferral will outweigh the costs of a variable annuity if you hold it as a
long-term investment to meet retirement and other long-range goals. Most professionals do not recommend
annuities, fixed or variable, for short-term goals.
Of course, annuities are not the only
financial vehicle that offers tax-deferral.
Individual Retirement Accounts (IRAs), and employer-sponsored 401(k)
plans also provide tax deferral.
Financial experts usually recommend that these two vehicles be used to
their limits prior to considering annuities for retirement.
Fixed Annuities
A fixed annuity provides a fixed rate of
return (thus, the name fixed).
The idea of a fixed annuity is that you give a sum of money to an
insurance company and in exchange receive a fixed monthly amount (payout) for a
specified period of time, either a fixed period or for life. Essentially, one is converting a lump sum of
money into an income stream. Whether
one chooses period certain or annuitization for life, payment does not change,
even to account for inflation trends.
If a fixed-period is chosen, also called a
period-certain annuity, the annuity continues to pay until that specified time
period is reached, either to the original investor or to the investors estate
or beneficiaries. Alternatively, if the
investor chooses to annuitize, then payments continue for a variable period;
namely until the investors death. For
an investor who annuitized, the insurance company pays nothing more after the
investors death to the estate or to the beneficiaries. This means neither interest nor principal
will continue on after the investors death even if the principal was not used
up.
Fixed annuities allow an individual access
to the investment prior to annuitization, usually ten percent of the account
value once per year. This can vary by contract
so it is important to read the contract terms.
An annuity may also have some type of hardship clause that allows
withdrawal with no surrender charges in specified situations. When considering a fixed annuity, compare
the annuity with a ladder of high-grade bonds that allow the owner to keep
principal with minimal restrictions on accessing the money.
Annuitization can work well for a long-lived
retiree. In fact, a fixed annuity can
be thought of as a kind of reverse life insurance policy. Life insurance is primarily designed as
financial protection against premature death, whereas the annuity is designed
as financial protection against longevity of life.
The fixed annuity might also have an
advantage for those who wish to generate monthly income and have worries about
someone being able to steal away their capital. If this is the case, then giving the capital to an insurance
company for management might be attractive.
Children and grandchildren often prefer their parents and grandparents
deposit into an annuity to protect them from those who would try to swindle
them out of their money.
Equity Indexed Annuities (EIA)
Equity Indexed Annuities (often referred to
simply as Indexed Annuities) are simply fixed annuities that employ a formula linked
to an independent index to arrive at a credited interest rate. This type of annuity provides the investor
with participation in the stock market without any downside market risk. This means that there is no such thing as a
losing or negative period. In the
traditional fixed annuity-pricing model, credited rate represents one variable,
but this has been split into four or more variables in equity indexed
pricing. Interest rate has become a
function of (1) participation rate, (2) spread, (3) cap, and (4) index method.[2]
Equity Indexed annuities have been offered
in Europe for a number of years but have been available in the United States
only since the middle 1990s. For
American investors, stock market participation is usually linked to the S&P
500. As a result, one might think that
such an equity instrument would be classified as a variable annuity, but
equity-indexed annuities are, in fact, fixed-rate contracts.
In a fixed-rate annuity, the insurer
offering the product guarantees a rate of return for a specified period of
time. They further guarantee a minimum
rate of return for a given period and guarantee the investors principal at all
times. As a result, the insurer bears
any risk involved in the annuity.
In a variable product, all investment risk
is assumed by the investor (annuity contract owner). The money deposited is put in one or more sub-accounts, similar
to the choices found in a mutual fund family.
The investment choices typically range from very conservative to
aggressive. In a variable product, the
investor bears any risk involved rather than the insurer.
Equity-indexed annuities have all of the
features of most fixed-rate annuity contracts except the interest credited to
the investors account is linked to some well-known market index. It may be the S&P 500, for example, and
often is.
An EIA that is held for its contracted
period of time cannot decrease in value.
A variable annuity, even when held for the contracted period, can
decrease in value since the risk lies with the investor, not the insurer. The EIA has a fixed minimum guarantee
similar to the fixed-rate annuity. The
value of the investors account can only increase due to stock market
appreciation, but it can never decline in value when a flat or declining market
exists.
Equity Indexed annuities, like all deferred
annuities, have the following 15 features:
1) There is
an annuity contract.
2) There
are four parties to each contract: the contract owner, the beneficiary, the
annuitant (who is not necessarily the contract owner), and the contract
issuer. The contract issuer is the
insurance company.
3) Growth
is tax-deferred, meaning the earnings are not taxed until withdrawn.
4) Free
partial withdrawals may be made at any time, as long as annuitization has not
occurred.
5) Withdrawals
in excess of the free withdrawal privilege are usually subject to an insurance
company penalty.
6) The
insurance company penalty usually ranges from eight or nine years declining
eventually down to zero.
7) Withdrawals
are considered to be ordinary income and do not qualify for the more favorable
capital gains tax rates.
8) Only
withdrawals of growth and interest are subject to taxation.
9) Withdrawals
of principal are not taxable, because the principal was previously taxed prior
to deposit.
10) All
income or growth (interest earnings) must be withdrawn first.
11) Income
and growth withdrawn prior to the contract owner reaching age 59 is subject to
a ten percent IRS penalty unless the contract owner has died, become disabled,
or annuitized the contract.
12) Tax-favored
income is possible if the contract is annuitized.
13) Annuitization
means that part of each check received is considered principal, and therefore
not taxed, and the remainder is considered interest or growth, which would be
taxable.
14) There is
a guarantee of principal at all times for a fixed rate annuity or a guaranteed
death benefit for a variable annuity.
15) There is
a probate-free death benefit, unless the contract owner names his or her estate
(rather than a person) as the beneficiary.
As in all contracts, it is important to
fully read the annuity offered, regardless of the type that it happens to
be. Agents are expected to fully
understand the contract terminology, know how returns are calculated, and
understand what type of product is being offered to the consumer.
End of Chapter Two
United Insurance Educators, Inc.