Unit 12: Annuities
Single Premium
An annuity purchased by a single lump-sum payment is called a single premium annuity.
Groups Versus Individual Annuities
Small employers often purchase group annuities for employees during their working years. Larger employers often operate their own annuity pool, using a trust fund to hold investment assets and dispense benefits.
Variable Payout
The payout can fluctuate, reflecting the investment experience of the principal.
The Accumulation Period
The time between the purchase date and the date benefits begin. The owner has the ability to make changes during the accumulation period. If an individual owns the annuity, the interest generally is not taxed until it is paid out of the contract. This tax advantage is an important reason why people buy annuities.
Tax-Sheltered Annuities
A TSA is a pension plan for employees of nonprofit organization as specified by the IRS. The tax deferment allowed is much life that allowed for contributions a corporate employer makes to a qualified pension or profit-sharing plan.
Retirement Income Annuities
A retirement income annuity is an ordinary deferred annuity, but with a traditional feature - a decreasing term life insurance rider that provides term life insurance with a face amount that decreases each year the policy is in force. The effect is that if the annuitant reaches retirement age, say 65, the decreasing term insurance death benefit expires and annuity payments begin providing retirement income. If, however, the annuitant dies before retirement, the decreasing term insurance benefit is combined with the value of the annuity and then paid to the annuitant's beneficiary in any settlement option chosen.
Two-Tiered Annuities
A two-tiered Annuity is one that has different values available for distribution at maturity depending on whether the value is taken in a lump sum before annuitization or left with the issuer for periodic payments. These annuities offer relatively high rates, but only if the owner holds the contract for a certain number of years then annuitizes it.
Nonforfeiture Provisions
An annuity contract owner who stops making premium payments during the accumulation period does not lose the value accumulated in the annuity up to that point. Instead, the contract holder will have nonforfeiture options or rights to the cash value accumulation in the annuity. The contract may be SURRENDERED for its cash value in a lump sum payment. However, most companies will level some kind of surrender charge, which is higher in the early years of the contract and then scales downward as time goes on, called a 'back-end load'. An annuity can only be surrendered during the accumulation period. If the policy is surrendered for a lump sum prior to age 59 1/2, a 10% tax penalty will apply, in addition to the surrender charge. A BAIL OUT PROVISION allows the annuity owner to surrender the annuity without surrender charges if interest rates drop a specific amount within a specific time period.
Accumulation of Retirement Fund
An annuity contract provides for a series of periodic payments that begin on a specific date (such as when the annuitant reaches a certain age) or a contingent date (such as the death of another person), and continue for the duration of a person's life or for a fixed period. Usually, but not always, an annuity guarantees a lifetime income for the recipient.
How Annuities Work
An annuity is a contract between a purchaser and an insurance company. The purchaser pays the premium and generally is the contract owner. The contract owner has certain rights under the contract. With an annuity, the insurer is counting on the annuitant not outliving the principal and interest.
Purposes of Annuities
An annuity's principal function is the liquidation of an estate. Annuities are designed to protect against the risk of living too long. Annuities may be purchased on an individual or a group basis. Individual annuities are usually purchased to provide retirement income or to fund other specific needs. Group annuities are most often used to fund employer-sponsored retirement plans for employees.
Tax-Deferred Growth
Annuity benefit payments are a combination of principal and interest. The portion of the benefit payments that represents a return of principal is not taxed; the portion representing interest earned on the declining principal is taxed. Exclusion ratio is the portion of the return on investments that is income tax exempt. To discourage the use of deferred annuities as short-term investments, the Internal Revenue Code imposes a penalty as well as taxes on early withdrawals and loans from annuities. Partial withdrawals are treated first as earnings income; only after all earnings have been taxed are withdrawals considered a return of principal. Furthermore, a 10% penalty tax is imposed on withdrawals from a deferred annuity before age 59 1/2.
Variable Annuities
Designed to provide a hedge against inflation through investments in separate account of the insurer consisting primarily of common stock. Variable annuities are characterized by a variable rate of growth and a variable benefit payment to the annuitant.
Fixed Payout
For a fixed annuity, the cash value accumulation at the beginning of the annuity period is simply annuitized - that is, the accumulation is converted into a stream of periodic payments. The result is a fixed dollar amount payout that remains the same for the rest of the contract.
Lump Sum Settlements
If an annuitant dies before the annuity fund (the principal) is depleted, a lump-sum cash payment of the remainder is made to the beneficiary. Thus, the beneficiary receives an amount equal to the beginning annuity fund less the amount of income already paid to the deceased annuitant.
Indexed Annuities
Indexed Annuity is a fixed annuity (meaning the principal and interest are both guaranteed) with an equity-linked rate of return. The advantage of an indexed annuity is that it has a guaranteed minimum interest rate and can never decrease in value. It also gives the annuitant the opportunity to beat the rate of inflation.
Annuity Untis
When the annuity period begins, the accumulation units are converted to annuity units.
Owner Versus Annuitant Versus Beneficiary
The annuity company or insurer is most often a private insurance company because annuities are generally sold by life insurance companies. The annuitant is the insured, usually also the owner of the contract, and the intended recipient of the annuity payments and the person upon whose life expectancy the payments will be based. The owner can: change the beneficiary, make withdrawals, or surrender the annuity; pay the premium; and make changes to the contract during the accumulation period. A beneficiary may also be named in an annuity contract. The annuity payments begin or continue after the death of the annuitant, for the lifetime of the beneficiary, or for a specified number of years.
Distribution of Lifetime Income
The basic function of an annuity is to systematically liquidate a principal sum over a specified period of time. An annuity is usually purchased as a means to save for retirement. The benefit of purchasing an annuity is that the cash accumulation in the account grows tax deferred.
The Annuity Period
This is the period following the accumulation of the annuitant's payments which annuity benefits are received. During the annuitization period, the insurance company controls the funds in the annuity and disburses them according to the contract terms.
Fixed Annuities
General Account Assets: A fixed annuity is fully guaranteed contract, which is backed by funds invested in the insurer's general account. Principal, interest, and the amount of the benefit payments are guaranteed. Interest Rate Guarantees: There may be two levels of guaranteed interest: a current rate that is guaranteed at the beginning of each calendar year, and a minimum guaranteed rate that will be paid if the current rate falls below this level. Current Purchase Rate: Reflects the current interest rates based on current economic conditions. This rate is guaranteed at the beginning of each calendar year and could fluctuate from year to year. Guaranteed Purchase Rate: The minimum interest rate that is guaranteed for the life of the contract. Level Benefit Payment: When converted to a payment mode, fixed annuities provide a guaranteed fixed benefit amount to the annuitant. The amount and duration of the benefit payment are guaranteed. Because the benefit amount is fixed, annuitants may see the purchasing power of their income payments decline over the years due to inflation.
Guaranteed Minimum Payouts
Refund Life Annuity: A refund life annuity will pay the annuitant for life, but if the annuitant dies too soon after the annuity period begins, there will be a refund of any undistributed principal or cost of the annuity. Life Annuity Certain: An annuity certain is an option that does no guarantee a lifetime income to the annuitant. It provides an income for a guaranteed period (or for a fixed amount) regardless of whether the annuitant is alive or not. If the annuitant outlives the guaranteed period, the annuity payments cease. If the annuitant dies during the guaranteed period, the payments continue to a survivor until the guaranteed period of time ends. The LIFE ANNUITY WITH PERIOD CERTAIN guarantees a lifetime income, but if death occurs within the period certain, annuity payments will be continued to a survivor for the balance of the period certain. Joint Life and Survivorship and Joint Life Annuities: A joint and survivorship option provides benefits for the life of the annuitant and the life of a survivor. A stated monthly amount is paid to the annuitant, and upon the annuitant's death the same or a lesser amount will be paid for the lifetime of the survivor. A joint life annuity covers two or more annuitants and provides monthly income only until the first annuitant dies. Temporary Annuity Certain: A temporary annuity provides annuity payments for a specified period of time, or until death of the annuitant - whichever occurs first.
Flexible Premium
A flexible premium annuity is like the level premium annuity in that annuity premiums are made over time, usually years, until annuity benefits are scheduled to begin. The difference is that with a flexible premium annuity, the purchaser has the option to vary the amount of each premium payment, as long as it falls between a minimum and maximum amount. These can be advantageous to persons whose incomes may be subject to considerable fluctuation or who, for whatever reason, cannot pay for an annuity all at once or with periodic premiums that are the same amount each time. The actual amount of the annuity benefit cannot be determined in advance because there's no way to determine in advance the amount of each premium that will be paid or how much will be paid in total for the annuity. The purchaser must wait until the final premium payment has been made to determine the exact amount of the annuity benefit.
Immediate and Deferred Annuities
Immediate Annuity: The benefit payments begin within 12 months of purchase. Frequently, an immediate annuity is purchased with life insurance proceeds, an inheritance, or a settlement received for injuries. These can be single premium. Deferred Annuity: The benefit payments are postponed until a later date, such as a planned retirement age. These can be single premium or periodic payment.
Level Premium
Under this arrangement, the premiums are paid in periodic installments over the years before the annuity income begins.
Accumulation Units
During the accumulation period, an owner's units are identified as accumulation units. Value of Separate Account / (Annuity Owners/Number Of Accumulation Units Outstanding) = Value of One Accumulation Unit
Market Value-Adjusted Annuities
Individual deferred annuity contracts with underlying assets held in a different account. The values are guaranteed if held for a specific period of time, but the nonforfeiture values may fluctuate according to a market value adjustment formula if held for shorter periods. The interest rate on MVA annuities is guaranteed (fixed) for a specific period of time. An adjustment is only made if the annuity is surrendered.
Accumulation of Education Funds
An annuity can be used for other purposes such as to accumulate funds for a college education.
Premium Determination
Annuitant's Age: (IDEA) An annuitant who will begin to receive $300 per month for life beginning at age 60 will pay a higher premium than an annuitant who will begin to receive $300 per month for life beginning at age 65. Annuitant's Sex: Because statistically women live longer than men, a woman will pay higher premiums because she is likely to require more income payments than a man her own age. Assumed Interest Rate: When determining premiums, companies estimate an assumed interest rate for those premium dollars. Income Amount and Payment Guarantee: The higher the amount of periodic income and the longer the guarantee it must be paid, the higher the annuity premium will be. Loading for Company Expenses: As with life policies, the annuity purchaser helps pay the company's operating expenses.
Annuity Settlement Options
In a life annuity, the payout is guaranteed for life. Life Annuity - No Refund: A life only option provides for payment of annuity benefits for the life of the annuitant with no further payment following the death of the annuitant. This option will pay the highest amount of monthly income to the annuitant because it is based only on life expectancy.