An annuity is a contract that guarantees to provide you with periodic income payments for your lifetime and/or for a fixed period of time. Annuities may be purchased with a single lump sum of money, with fixed periodic premium payments, or with premium payments made at your discretion.
Periodic income payments may begin almost immediately (called an immediate annuity) or may be deferred until a specified time (called a deferred annuity). The person who receives income payments under an annuity is called the annuitant.
Immediate annuities are purchased with a single lump sum of money (premium). Income payments begin within one payment interval from the date the premium was paid. For example, if you are to receive annual payments under the annuity contract, you will receive your first periodic income payment one year after paying the premium.
The following are common types of immediate annuities.
Joint and last-survivor annuities provide periodic income payments for as long as any of the people insured under the contract are alive. These annuities are commonly used in husband and wife relationships.
Life income annuities are also called straight life annuities and provide periodic income payments for as long as the annuitant lives and terminate on the annuitant's death. This type of annuity provides the largest payment of all the immediate annuities, because no matter how few income payments have been made when the annuitant dies, no refund of the premium is made.
Installment refund annuities provide a periodic income payment for as long as the annuitant lives and then continue payments to the annuitant's beneficiary after the annuitant's death until the total of all income payments made equals the premium.
Cash refund annuities provide a periodic income payment for as long as the annuitant lives. Upon the death of the annuitant, they provide a lump sum payment to the beneficiary equal to the difference between the premium and the total of all income payments made prior to the annuitant's death.
Certain and life annuities provide a periodic income payment for as long as the annuitant lives or for a specified (certain) period of time, whichever is longer. The certain periods are usually 5, 10, 15, or 20 years. The longer the certain period, the lower the periodic income payments.
Deferred annuities may be purchased with a single premium or with periodic or flexible premiums. Periodic income payments begin at a specified date, often age 65.
The period between the purchase date and the date the income payments begin is called the deferral or accumulation period. During this period the insurance company treats your premium payments much like deposits to a savings account. Premium payments are reduced for expenses and any withdrawals you may make and are credited at an interest rate declared by the insurance company.
The balance in the account is called the account value. At the end of the accumulation period, the insurance company purchases an immediate annuity using the account value less any expense charges. A deferred annuity contract provides a guarantee that a minimum income payment per dollar of account value will be paid.
The interest rate credited during the accumulation period of a deferred annuity is subject to a stated minimum range as required by state law, usually between 1% and 3% per year. Insurance companies determine the actual rate of interest to be credited on a periodic basis.
The method of determining this crediting rate varies among different annuity contracts and insurance companies but is generally based on the company's investment experience and competition.
It is important to remember that current crediting rates are generally guaranteed only for a short period of time, often one year.
Upon death or surrender (cancellation) of a deferred annuity, the insurance company is required to provide you with the cash value remaining in the annuity contract. Immediate annuities do not develop cash values.
The cash value is generally the account value less the surrender charge. Surrender charges are often waived if the policy is terminated due to the death of the annuitant. Surrender charges are usually a percentage of the account value and decrease with time. State law establishes minimum cash values.
Most deferred annuity contracts allow you to withdraw a portion, usually 10%, of the account value without a surrender charge. This is called a free partial withdrawal. The amount that is withdrawn is deducted from the account value.
Many single premium deferred annuity contracts have bailout provisions. This is a provision that allows you to withdraw the account value without a surrender charge, if the interest rate credited falls below a set rate.
Insurers frequently offer bonus interest as an incentive to purchase an annuity or to retain an annuity to the end of the term of the annuity or maturity.
In some cases, a bonus may only be credited if the annuity is retained for a minimum number of years.
It is important to carefully review how any bonus feature impacts other features of the annuity, particularly the interest rate credited to the annuity.
For example, the interest rate for annuities with a bonus may actually be lower than the interest rate credited to an annuity without a bonus. The result may be that the annuity without the bonus feature provides a greater benefit than the annuity with the bonus feature.
Annuity contracts contain an important tax benefit. Federal income taxes on interest earnings that accumulate during the deferral period are deferred until the annuity is paid out. This can result in a significant saving over a long period of time relative to other methods of saving.
If a deferred annuity is surrendered before age 59 1/2, the amount of the cash value that is larger than the total premiums paid is subject to a 10% federal tax penalty in addition to the required income taxes. The tax penalty generally does not apply if the annuity is surrendered due to death or disability or to equal periodic payments made over the lifetime of the annuitant. Consult a tax advisor before you purchase or surrender an annuity in order to thoroughly understand the tax consequences.
Market value adjusted annuities guarantee a crediting rate over a specified period above the state minimum guaranteed rate.
However, if you decide to surrender the annuity, the account value is subject to both surrender charges and an adjustment based on current interest rates. This adjustment is intended to protect the insurance company from the tendency of annuitants to surrender during periods of increasing interest rates.
Unlike the annuities described above, a variable annuity contract does not guarantee a minimum interest crediting rate, nor does it guarantee the amount of income payments per dollar of cash value.
A variable annuity generally offers you the option to invest your premium payments in many different investment funds such as money market funds, common stock funds, bond funds, and others.
During the accumulation period of the variable annuity, premium payments less expense charges are used to purchase units in a selected fund. The number of units purchased depends on the value of a unit in that fund, much like purchasing shares in a mutual fund.
Cash values and income payments then depend on the number of units purchased and the value of each unit at the time the payments are made. Variable annuities are more appropriate for people looking for an investment product without the long-term guarantees provided by other annuity products.
Equity-indexed annuities provide benefits that are linked to an external equity index such as Standard & Poor's 500 Composite Stock Price Index (S&P 500).
Interest credits are determined using a formula based on changes in the index. Two significant features of the formula are the indexing method and the participation rate. The indexing method determines how the amount of change in the index is determined.
The change in the index value from the beginning of a contract year to the index value at the end of the contract year. Interest is added to the annuity each year to reflect the change.
The change in the index value from the beginning of the term of the contract to the end of the term of the contract. Interest is added to the annuity at the end of the term of the contract to reflect the change.
Index values at various points during the term of the contract are compared with the index value at the start of the term of the contract. Interest added to the annuity at the end of the term of the contract is based on the difference between the highest index value and the index value at the start of the term of the contract.
Index values at various points during the term of the contracts are compared with the index value at the end of the term of the contract. Interest added to the annuity at the end of the term of the contract is based on the difference between the lowest index value and the index value at the end of the term of the contract.
The participation rate is the percentage of the change in the index that will be used to credit interest to the annuity. Insurers generally guarantee the participation rate for a specified period of time and after this period, a new participation rate will be applicable.