The term “annuity,” as used in financial theory, is most closely related to what is today called an immediate annuity. This is an insurance policy which, in exchange for a sum of money, guarantees that the issuer will make a series of payments.
Annuities can actually trace their origins back to Roman times. Contracts during the roman empire were known as annua, or “annual stipends” in Latin. These annua enabled Roman citizens to make a one-time payment to the annua, in exchange for lifetime payments made once a year.
With today’s modern annuities, these payments can be either level or increasing periodic payments for a fixed term of years or until the ending of a life or two lives, or even whichever is longer. It is also possible to structure the payments under an immediate annuity so that they vary with the performance of a specified set of investments, usually bond and equity mutual funds. Such a contract is called a variable immediate annuity.
The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings with a tax-deferred growth factor. A common use for an immediate annuity might be to provide a pension income. In the U.S., the tax treatment of a non-qualified immediate annuity is that every payment is a combination of a return of principal (which part is not taxed) and income (which is taxed at ordinary income rates, not capital gain rates).
Immediate annuities funded as an IRA do not have any tax advantages, but typically the distribution satisfies the IRS “Required Minimum Distribution” requirement and may satisfy the RMD requirement for other IRA accounts of the owner (see IRS Sec 1.401(a)(9)-6.)
When a deferred annuity is annuitized, it works like an immediate annuity from that point on, but with a lower cost basis and thus more of the payment is taxed.
Period Certain Annuity
This type of immediate annuity pays the annuitant for a designated number of years (i.e., a period certain) and is used to fund a need that will end when the period is up (for example, it might be used to fund the premiums for a term life insurance policy). Thus this option is not necessarily suitable for an individual’s retirement income, as the person may outlive the number of years the annuity will pay.
A life or lifetime immediate annuity is used to provide an income for the life of the annuitant similar to a defined benefit or pension plan.
A lifetime annuity works somewhat like a loan in that is made by the purchaser (contract owner) to the issuing (insurance) company, which pays back the original capital or principal (which isn’t taxed) with interest and/or gains (which is taxed as ordinary income) to the annuitant on whose life the annuity is based.
The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the insurance company relies on a concept called the “law of large numbers”.
Because an annuity population can be expected to have a distribution of lifespans around the population’s average age, those dying earlier will give up income to support those living longer whose money would otherwise run out, hence, it is a form of longevity insurance.
A life annuity, ideally, can reduce the “problem” faced by a person that doesn’t know how long he or she will live, and so they don’t know the optimal speed at which to spend their savings. Lifetime annuities with indexed payments may be an acceptable solution to this problem.
Variations of Lifetime Annuities
For an additional expense (either by way of an increase in premiums or a decrease in benefits), an annuity or benefit rider can be purchased on another life such as a spouse, family member or friend for the duration of whose life the annuity is wholly or partly guaranteed.
For example, it is common to buy an annuity which will continue to pay out to the spouse of the annuitant after death, for so long as the spouse survives. The annuity paid to the spouse is called a survivorship annuity.
However, if the annuitant is in good health, it may be more advantageous to select the higher payout option on his or her life only and purchase a life insurance policy that would pay income to the survivor.
The pure life annuity can have harsh consequences for the annuitant who dies before recovering his or her investment in the contract. Such a situation, called a forfeiture, can be mitigated by the addition of a period-certain feature under which the annuity issuer is required to make annuity payments for at least a certain number of years; if the annuitant outlives the specified period certain, annuity payments continue until the annuitant’s death, and if the annuitant dies before the expiration of the period certain, the annuitant’s estate or beneficiary is entitled to the remaining payments certain.
The trade-off between the pure lifetime annuity and the life-with-period-certain annuity is that the annuity payment for the latter is smaller. A viable alternative to the life-with-period-certain annuity is to purchase a single-premium life policy that would cover the lost premium in the annuity.
Impaired-life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the annual payment to the purchaser is raised. Life annuities are priced based on the probability of the annuitant surviving to receive the payments.
Longevity insurance is a form of annuity that defers commencement of the payments until very late in life. A common longevity contract would be purchased at or before retirement but would not commence payments until 20 years after retirement. If the nominee dies before payments commence there is no payable benefit. This drastically reduces the cost of the annuity while still providing protection against outliving one’s resources.
A deferred annuity is chiefly a vehicle for accumulating savings with a view to eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment.
All varieties of deferred annuities owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.
A deferred annuity which grows by interest rate earnings alone is called a fixed deferred annuity. A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is called a variable annuity.
A new category of deferred annuity, called the fixed or equity indexed annuity emerged in 1995. These annuities may have features of both fixed and variable deferred annuities. The insurance company typically guarantees a minimum return for an equity indexed annuity. An investor can still lose money if he or she cancels (or surrenders) the policy early, before a “break even” period.
An oversimplified expression of a typical equity indexed annuity’s rate of return might be that it is equal to a stated “participation rate” multiplied by a linked index’s (such as the S&P 500) performance excluding dividends. Interest rate caps or an administrative fee may be applicable.
Deferred annuities have the advantage that taxation of all capital gains and ordinary income is deferred until withdrawn. In theory, such tax-deferred compounding allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when amounts held under a deferred annuity are withdrawn or inherited, the interest/gains are immediately taxed as ordinary income.
Attributes of Deferred Annuities
Deferred annuities are usually divided into two different kinds:
Fixed annuities offer some sort of guaranteed rate of return over the life of the contract. In general such contracts are often positioned to be somewhat like bank CDs and offer a rate of return competitive with those of CDs of similar time frames.
Many fixed annuities, however, do not have a fixed rate of return over the life of the contract, offering instead a guaranteed minimum rate and a first year introductory rate. The rate after the first year is often an amount that may be set at the insurance company’s discretion, subject however, to the minimum.
There are usually some provisions in the contract to allow a percentage of the interest and/or principal to be withdrawn early and without penalty (usually the interest earned in a 12-month period or 10%), unlike most CDs. Fixed annuities normally become fully liquid depending on the surrender schedule or upon the owner’s death.
Most equity index annuities are properly categorized as fixed annuities and their performance is typically tied to a stock market index (usually the S&P 500 or the Dow Jones Industrial Average). These products are guaranteed but are not as easy to understand as standard fixed annuities as there are usually caps, spreads, margins, and crediting methods that can reduce returns.
These products also don’t pay any of the participating market indices’ dividends; the trade-off is that contract holder can never earn less than 0% in a negative year.
Variable annuities allow money to be invested in “separate accounts” (which are sometimes referred to as “sub-accounts” and in any case are functionally similar to mutual funds) in a tax-deferred manner.
Their primary use is to allow an investor to engage in tax-deferred investing for retirement in amounts greater than permitted by individual retirement or 401(k) plans.
In addition, many variable annuity contracts offer a guaranteed minimum rate of return (either for a future withdrawal and/or in the case of the owner’s death), even if the underlying separate account investments perform poorly. This can be attractive to people uncomfortable investing in the equity markets without the guarantees. Of course, an investor will pay for each benefit provided by a variable annuity, since insurance companies must charge a premium to cover the insurance guarantees of such benefits.
Variable annuities are regulated both by the individual states (as insurance products) and by the Securities and Exchange Commission (as securities under the federal securities laws). The SEC requires that all of the charges under variable annuities be described in great detail in the prospectus that is offered to each variable annuity customer. Of course, potential customers should review these charges carefully, just as one would in purchasing mutual fund shares.
Planners or Advisors that sell variable annuities are usually regulated by FINRA, whose rules of conduct require a careful analysis of the suitability of variable annuities (as other securities products) to those to whom they recommend such products. Variable products are often criticized as being sold to the wrong people, who could have done better investing in a more suitable alternative.
There is even more scrutiny paid to these products since the commissions paid are often high relative to other investment products.
Performance Guarantees in Variable Annuities
There are several types of performance guarantees, and one may often choose them à la carte, with higher charges for guarantees that are riskier for the insurance companies. The first type is a guaranteed minimum death benefit, which can be received only if the owner of the annuity contract, or the covered annuitant, dies.
Guaranteed minimum death benefits come in various flavors, in order of increased risk to the insurance company:
Return of premium (a guarantee that you will not have a negative return).
Roll-up of premium at a particular rate (a guarantee that you will achieve a minimum rate of return).
Maximum anniversary value (looks back at account value on the anniversaries, and guarantees you
will get at least as much as the highest values upon death).
Greater of maximum anniversary value or particular roll-up.
Insurance companies provide even greater insurance coverage on guaranteed living benefits, which tend to be elective. Unlike death benefits, which the contract holder generally can’t time, living benefits pose significant risk for insurance companies as contract holders will likely exercise these benefits when they are worth the most.
Annuities with guaranteed living benefits tend to have high fees commensurate with the additional risks underwritten by the issuing insurer.
Some guaranteed living benefits examples, in no particular order:
Guaranteed minimum income benefit (a guarantee that one will get a minimum income stream upon
annuitization at a particular point in the future).
Guaranteed minimum accumulation benefit (a guarantee that the account value will be at a certain
amount at a certain point in the future).
Guaranteed minimum withdrawal benefit (a guarantee similar to the income benefit, but one that
doesn’t require annuitizing).
Guaranteed-for-life income benefit (a guarantee similar to a withdrawal benefit, where withdrawals
begin and continue until cash value becomes zero, withdrawals stop when cash value is zero and
then annuitization occurs on the guaranteed benefit amount for a payment amount that is not
determined until the annuitization date.)
Caution should be used in regard to guaranteed life benefit riders in non-qualified contracts as most of the products in the annuity marketplace today create a 100% taxable income benefit whereas income generated from an immediate annuity in a non-qualified contract would partially be a return of principal and therefore non-taxable.