If you’re like most people, you find the subject of annuities confusing. Just the terminology would befuddle anyone – “exclusion ratio”, “annuitization”, “indexed”, “cap rate”, “participation rate”, etc. As if that weren’t enough, the terms are not applied uniformly. Some writers about annuities refer to the kind that produces an income immediately after purchase as an “immediate annuity”; others call it a “payout annuity”. “Equity index annuity” and “fixed indexed annuity” are used almost interchangeably to refer to the same type of contract. And some writers use “hybrid annuity” to describe a fixed index annuity while others use that term to denote an annuity that includes long term care benefits.
One of the biggest sources of confusion about annuities is the fact that some writers on the subject make broad, sweeping statements about “annuities” without specifying the types of annuities they’re talking about. Example: “Annuities have high fees”. This statement is at least arguably true when applied to variable immediate or deferred annuities, but is false if applied to immediate or deferred fixed annuities, because fixed annuities typically impose no annual fees.
In this article, we’ll attempt to dispel the confusion by arranging the annuity types in a logical format, using industry standard definitions, and describing them in terms of how they work. But first, we need to clarify what is meant by the word “annuity”.
What does “annuity” mean?
Strictly speaking, the word “annuity” refers to a series of payments over time in which both principal and interest are spread over the payout period. That’s what is meant in tax law by the phrase “amounts received as an annuity”. But there are also annuity contracts – legal agreements between an insurance company and a buyer to guarantee an income, either immediately (an “immediate annuity”) or at some future date (“deferred annuity”). It is these annuity contracts that most people are thinking of when they use the word “annuity” and it’s these annuity contracts that we’ll be talking about in this article.
Parties to the annuity contract
Issuer – The insurance company that issues the contract (Commercial annuities are always issued by insurance companies).
Owner – The person or entity that owns the contract, may exercise all rights to it (e.g.: changing the beneficiary, and surrendering or making distributions from it), and bears the income tax liability for taxable distributions.
Beneficiary – The person or entity who will receive any death benefit upon the death of the owner (or, in the case of “annuitant-driven” annuities, the annuitant).
Annuitant – The person (it must be a human being) whose age and sex (for non-Period Certain annuities) determines the amount of each annuity payment. Annuity payments may be payable to the annuitant if the owner requests it, but the tax liability will be that of the owner.
Types of annuities
An Immediate Annuity is a contract for income. The income must commence within one year of purchase and will persist for either a specified period or for the life or lives of the annuitant(s).
- The Period Certain annuity pays an income for a period selected by the owner. If the annuitant dies before the end of the Period Certain, payments will continue, to the beneficiary, for the remainder of that period.
- A Life Annuity pays an income for the lifetime of the annuitant, or, in the case of two annuitants (a “Joint and Survivor” annuity), so long as either annuitant is alive.
- A Life Annuity with No Refund (“Life Only annuity”) pays an income until the annuitant (or surviving annuitant) dies, at which point the annuity expires without value, even if death occurs shortly after issue.
- A Life Annuity with Refund pays an income for the greater of the annuitant’s lifetime or the expiry of the refund feature. The refund feature may be either a Period Certain (e.g.: 10 years) or a Cash or Installment Refund (where payments will persist for the greater of the annuitant’s lifetime or until the entire purchase payment has been paid out.
A Deferred Annuity is so named because payout may be deferred, at the option of the owner, often to as late as annuitant’s age 90 or 95. Deferred annuities have two phases:
- The Accumulation Phase – from contract issue until “annuitization” (the point at which the contract owner elects to take payout under an annuity payout option, such as “Life Only” or “Life and 10 Year Certain”).
- The Payout (or Annuity) Phase – from annuitization until the death of the annuitant (or expiry of the refund feature, if any). In this phase, the contract acts like, and is taxed exactly as, an immediate annuity.
“Annuitant-Driven” and “Owner-Driven” annuities
Deferred annuities may be either “annuitant-driven” or “owner-driven”. (Neither has any applicability to immediate annuities). An “annuitant-driven” contract will pay a death benefit upon the death of the annuitant. An “owner-driven” contract pays a death benefit upon the death of the owner. But a contract is not either one or the other, because all contracts issued since January 18, 1985 must be “owner-driven” because Internal Revenue Code (IRC) Section 72(s) requires that deferred annuities issued after that date must pay out upon the death of the owner. Some deferred annuities are also “annuitant-driven. That is, they will pay a death benefit if either the owner or the annuitant dies. Some annuitant-driven contracts (especially variable ones) offer a guaranteed minimum death benefit, which may be greater than the annuity’s cash value. In such cases, that guaranteed minimum benefit is payable upon the death of the annuitant. At the death of the owner, the death benefit is typically the contract’s cash value.
Immediate vs. Deferred Annuities
Annuities, either immediate or deferred, may be variable or fixed.
Variable Immediate Annuities provide for an annuity payment (annually or more frequently) for the life of the annuitant (variable “period certain” annuities are rarely purchased). The amount of each year’s payment varies with the investment performance of the investment accounts chosen by the owner. Investment accounts are similar to mutual funds, and may be invested in stocks, bonds, real estate, and other investment types.
Fixed immediate annuities differ from variable immediate annuities because the amount of each annual payment is fixed, either level or increasing by a set percentage each year. As with variable immediate annuities, most fixed immediate annuities are life annuities (paying out for the annuitant’s lifetime), but few are life only (where payments cease at annuitant’s death, even if that occurs shortly after purchase); the most common type is “life and 10 year certain”, paying for the greater of the annuitant’s lifetime or ten years.
Variable deferred annuities are similar to mutual funds “wrapped” inside a deferred annuity contract. During the accumulation period, contributions to the annuity are placed in “separate accounts” chosen by the purchaser. These accounts may be invested in stocks, bonds, real estate or other types of investments. The value of each separate account can, and usually does, vary from day to day. There is no guarantee of principal or of minimum investment return.
At any time after the first contract year, the owner may elect to receive the contract value in regular annuity payments. (This election is called “annuitization”). The payments may be fixed in amount (under any of the regular annuity payment options, such as “life only”, “life & 10 year certain”, etc.) or may vary with the investment performance of the separate accounts chosen (under any of annuity payment options available under this “variable annuitization”). Variable deferred annuities typically assess annual fees that may range from less than 1% to more than 2.5% per year, or more if an optional “guaranteed lifetime income” rider is chosen.
Fixed deferred annuities, like variable deferred annuities, have two phases (“accumulation” and “payout”), but in the accumulation phase, the two types are very different. Fixed deferred annuities guarantee both principal and a minimum interest crediting rate. They rarely impose any annual fees unless an optional “guaranteed lifetime income” rider is elected. Although up-front sales charges are rare in both fixed and variable deferred annuities, both types usually impose surrender charges. There are two types of fixed deferred annuities:
“Declared Rate” fixed deferred annuities guarantee both principal and a minimum annual interest crediting rate for the life of the contract; nearly all of them offer in addition, a current, non-guaranteed, interest. Typically, this current rate is declared annually, although some “multi-year guaranteed annuities” (“MYGAs”) guarantee the current rate for 2 or more years. MYGAs often impose surrender charges only for the same period of time as the current interest rate guarantee.
“Indexed” deferred annuities differ from “declared rate” contracts only in how current interest is calculated and credited. In an index annuity, interest is calculated based on the positive performance (growth) of an external equity index (often, the S&P500®). Because it’s a fixed annuity, an indexed annuity guarantees principal, except to the extent that principal may be invaded by surrender charges (discussed below); thus, only the upward movement of the equity index or indices chosen will affect contract value. A decline in that index (or indices) will not cause a decline in the annuity’s cash value.
Consumers should not expect that an index annuity will capture all of the gain in the underlying index; the amount of such gain that will be recognized and credited to the annuity varies from contract to contract. Obviously, no insurance company can afford to pass to its annuity contract holders 100% of index gain while guaranteeing that they will not suffer any loss when the value of that index declines. Typically, insurers limit the amount of index-linked interest they will credit (and their own liability to pay such interest) by the use of several mechanisms (often called “moving parts”). The most common are “participation rate” and “interest rate cap”.
The participation rate is the percentage of gain (usually, but not always, annual gain) that will be paid in the form of interest. Example: An index annuity has a current participation rate of 60%. If the index gains 15% in a given year, the annuity will be credited with 9% (15% x 0.60 = 9).
The cap rate is the maximum amount of index-linked interest that will be credited in a given period. Example: The annuity has a cap rate of 5%. The annuity will be credited with interest equal to the percentage of growth in the index over the crediting period (often, but not always, a contract year), not to exceed 5%.
Often, these two mechanisms will be used in combination. Example: An annuity has a 60% participation rate and a cap rate of 5%. The index advances by 10% in the crediting period. The annuity will be credited with 5% (10% x 0.60 = 6%, but the cap of 5% applies.
The actual interest crediting formulas used by issuers of index annuities can be a lot more complicated than these examples. Readers who are thinking about purchasing an index annuity should do so only when they fully understand how that annuity works, how it credits interest, and – most especially – the surrender charges (if any) that it imposes, and when those charges are waived.
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