Parties to an Annuity

The person or entity that purchases an annuity is the ownerThe person or entity that purchases an annuity.. The person on whose life expectancy payments are based is known as the annuitantThe person on whose life expectancy payments are based.. For annuities sold directly to individuals, the owner and annuitant are usually the same person. The beneficiaryThe person or entity who receives any death benefits due at the death of the annuitant. is the person or entity who receives any death benefits due at the death of the annuitant.

Mechanics of Annuities

Settlement Options

Generally, an annuity owner does not set a precise retirement income goal in advance. The retirement benefit is whatever amount has accumulated by retirement time. Further, the amount accumulated is a function of the amount of contributions, their timing, and the rates of investment return credited to the account over time. This concept is illustrated in Figure 21.3 "Hypothetical Values for the Flexible Premium, Deferred Annuity Concept". If the annuitant dies before beginning the annuity payments, the accumulation value is returned to the beneficiary. When the annuitant lives until the liquidation period and selects an income option based on the life expectancy of the annuitant alone, it is considered a single life annuityWhen the income option is based on the life expectancy of the annuitant alone, assuming the annuitant lives until the liquidation period..

Figure 21.3 Hypothetical Values for the Flexible Premium, Deferred Annuity Concept

The originally specified retirement date can be changed after the annuity is purchased. Upon retirement, there are several options for settlement, similar to the ones shown in Chapter 19 "Mortality Risk Management: Individual Life Insurance and Group Life Insurance" for life insurance proceeds:

• Lump-sum cash payment
• Fixed period payment
• Fixed amount payment
• Life annuity
• Refund annuity
• Temporary life annuity
• Period-certain life annuity
• Joint life annuity
• Joint-and-survivor annuity

The typical options include taking cash in a lump sum equal to the accumulation value of the contract. A fixed period annuityMakes payments for a specified period, such as twenty years, and then ceases. makes payments for a specified period, such as twenty years, and then ceases. A fixed amount annuityPays benefits of a set amount per period until the accumulation value at the time benefits begin plus investment earning during the liquidation period are exhausted. pays benefits of a set amount per period until the accumulation value at the time benefits begin plus investment earning during the liquidation period are exhausted. The amount paid under these three options is not influenced by anyone’s life expectancy.

As with whole life or universal life policies, there are mortality factors and investment return factors that are guaranteed. The mortality guarantee is in case a person lives longer than expected. Unlike a regular savings account, where the recipient of the money gets only the total amount in the account, in annuities, the payments are promised for the duration of the annuitant’s life. The insurance company is taking the risk of paying more to someone who lives longer than expected according to mortality tables. This is the mortality guarantee.

An annuity in which benefit payments are guaranteed for life but then cease and the premium is considered fully earned upon the death of the annuitant is known as a life annuity. In this case, no beneficiary will receive any more payments even if the annuitant dies very early. While this annuity pays the maximum periodic benefit per dollar accumulated at the time benefits begin (or per immediate single premium), far more common is the selection of a payment option that provides continuation of payments to beneficiaries for a certain amount of time, such as ten or twenty years following the death of the annuitant. Most people do not like the idea that they might die shortly after beginning to receive benefit payments from an annuity in which they have made a large investment. Therefore, insurers have made available refund annuities, period-certain life annuities, and annuities like joint-and-survivor that reflect the life expectancies of more than one person.

A temporary life annuityCombination of a fixed period annuity and a life annuity; payments stop at the end of a specified period or at the death of the annuitant, whichever comes first. is a combination of a fixed period annuity and a life annuity. Payments stop at the end of a specified period or at the death of the annuitant, whichever comes first. A period-certain optionGuarantees a minimum number of annuity payments whether the annuitant lives or dies. guarantees a minimum number of annuity payments whether the annuitant lives or dies. Thus, a person can purchase a life annuity with five years certain, ten years certain, or some other period certain. If the annuitant dies before the end of the specified period, payments continue to a beneficiary for at least the period specified. A cash payment may be available to the beneficiary equal to the present value of the remaining payments. If the annuitant lives through the period certain, payments continue until death.

A refund annuityGuarantees that the annuitant and/or beneficiary will receive, during the liquidation period, minimum payments equal to the single premium in an immediate annuity or the accumulation value in a deferred annuity. guarantees that the annuitant and/or beneficiary will receive, during the liquidation period, minimum payments equal to the single premium in an immediate annuity or the accumulation value in a deferred annuity. For example, assume an accumulation value of $250,000 at the time of annuitization and that the annuitant receives $100,000 before death. The beneficiary would receive a lump-sum payment of $150,000. The annuitant is also promised lifetime benefits. Consequently, benefits can far exceed the accumulation value of $250,000 at the time of annuitization plus future investment earnings on this amount. The annuitant pays for the refund feature by taking a reduced amount of periodic benefit compared to what he or she would receive for a life annuity. He or she would also pay for any other options to guarantee certain payments to beneficiaries are paid with a reduced amount of periodic payments.

With a joint annuityNames two annuitants and payments stop when the first joint annuitant dies., two people are named, and payments stop when the first joint annuitant dies. In contrast to the joint annuity, a joint-and-survivor annuityNames two annuitants and continues payments as long as at least one annuitant is alive. continues payments as long as at least one annuitant is alive. You may recall that the joint-and-survivor annuity is the mode required in pensions unless the spouse relinquishes this benefit. In annuities sold by insurers, husbands and wives are the typical users of the joint-and-survivor option. They can decide at the time of annuitization whether payments should continue at the same amount after one spouse dies or if the amount should be reduced (perhaps to one-half or two-thirds of the original amount). Some annuitants want the full refund guaranteed by the refund option, while others are satisfied with a period-certain guaranteed. Others select a joint or joint-and-survivor option because of concern for another person, possibly over their lifetime. The effect of such guarantees is to reduce the monthly installments that can be purchased with any given sum of money. The option selected depends on one’s situation and viewpoint.

Types of Contracts

Annuities commonly used to help fund retirement include the following:

• Flexible premium annuity
• Single premium deferred annuity
• Single premium immediate annuity

All are available with fixed-dollar guarantees, as a variable or as index annuities.

The flexible premium deferred annuityAllows owners to change the amount of contributions, stop contributions, and resume them at will. allows you to change the amount of contributions, stop contributions, and resume them at will. For example, you may use a payroll deduction plan in which you authorize your employer to transfer $100 per pay period to the insurer. For a period of time, you may want to discontinue these contributions and later resume them at $200 per pay period. Without payroll deductions, you might prefer to submit premiums on a monthly, quarterly, annual, or some other basis. Earlier in the chapter, we referred to this as the installment plan.

For fixed-dollar annuities, the insurer guarantees a minimum rate of interest. Initially, a current rate of return is promised on funds in your account for a certain time (e.g., two years) during the accumulation period. Returns vary over time on your insurer’s investments that support fixed-dollar annuities, so the guarantee for future periods is likely to change. The degree of change may, in part, reflect the need for your insurer to remain competitive with annuity returns offered by other insurers, bank certificates of deposit, and other competing investment vehicles. Often, two or more interest guarantees are made by the insurer. One set of guarantees applies to funds contributed to the account in past periods. The other rate applies to funds contributed during a future period.

The single premium deferred annuityRequires payment of a single premium and a stipulates a longer period to which a current rate of interest is guaranteed. differs from a flexible premium deferred annuity primarily in the manner of premium payments. As the name implies, only one premium is paid. The motivation for purchase usually is driven more by the tax deferral of interest on earnings than by the promise of lifetime income during retirement. Another difference between the single premium deferred annuity and its flexible premium cousin is the longer period to which the current rate of interest is guaranteed

Many insurers have either a low or no sales load, which is basically a surrender charge (a percentage attached to withdrawals) that applies during the first five or more years. For example, 7 percent of the amount withdrawn can be retained by the insurer if the contract is surrendered for its cash value in the first year. The penalty decreases 1 percent per year, disappearing at the end of the seventh year. The surrender charge has two purposes. First, it discourages withdrawals. Second, it allows the insurer to recover some of its costs if the contract is terminated early.

The agent or broker may receive a normal level of sales commission on no-load and low-load annuities, but the commission is not deducted directly from the contributions. Annual expense charges levied on all assets are usually around 2 percent. Part of this charge is used to pay marketing expenses.

The single premium immediate annuityBegins benefit payments to the annuitant on the next payment date following the premium payment, usually as a large sum. is best understood by emphasizing the word immediate. Benefit payments to the annuitant begin on the next payment date following the premium payment, usually a large sum. The primary purchase motive would typically be interest in lifetime income. A primary source of funds for these annuities is lump-sum distributions from corporate retirement plans, as discussed in the next section. Other sources of funds include various forms of personal investment and life insurance death benefits.

Another use of annuities arises out of legal liability judgments. Liability insurers are increasingly interested in making periodic payments to the plaintiff, to lower the total cost of the liability. A structured settlement annuityMakes periodic payments to a plaintiff in a legal liability judgment to lower the total cost of liability. is a special type of single premium immediate annuity that achieves the goal. Issued by a life insurer, its terms are negotiated by the plaintiff, the defendant, their attorneys, and a structured settlement specialist. The market for structured settlement annuities is highly competitive. Consequently, the successful insurer in this market is likely to have a high rating for financial soundness, a competitive assumed rate of investment return, and a mortality assumption that reflects the plaintiff’s life expectancy.

Taxation of Annuities

The first major tax question is, Can individuals deduct annuity contributions (premiums) from adjusted gross income each year? Generally, premiums are not deductible. The exception is when annuities are invested in any of the pension plans described in this chapter.

When an annuity is purchased separately from any pension plan by individuals, the premiums paid are from after-tax income. During the accumulation period with these annuities, no income taxes are due on the returns unless the annuitant is making withdrawals or surrenders. When the annuity is distributed to the annuitant, only the earnings (not the premiums) are subject to income tax. When annuities are used as investment instruments in pensions or in IRAs, they are considered tax-deferred annuities. The premiums are paid with before-tax income. Distributions from tax-deferred annuities are subject to income taxation on the whole account. All payments from a tax-deferred annuity are subject to ordinary income taxes during the liquidation period.

For annuities that are bought with after-tax money by individuals, ordinary income taxes are paid on the return of (previously untaxed) investment earnings. The amount of each payment returned during the distribution of the annuity represents previously taxed contributions. These are not taxed again. Therefore, each payment is divided between taxable and nontaxable amounts at the beginning of the payout period by calculating an exclusion ratioExpression of annuity payments during distribution as taxable and nontaxable portions and calculated as investment in contract divided by expected return.. The ratio is then multiplied by each periodic payment to determine the amount of each annuity payment that is excluded from gross income. The exclusion ratio is the following: