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What are annuities? "An annuity is a contract sold by insurance companies that pays a monthly (or quarterly, semiannual, or annual) income benefit for the life of a person (the annuitant), for the lives of two or more persons, or for a specified period of time. The annuitant can never outlive the income from the annuity. While the basic purpose of life insurance is to provide an income for the beneficiary at the death of the insured, the annuity is intended to provide an income for life for the annuitant. There are variations in both the way that payments are made by a buyer during the accumulation period, and in the way payments are made to the annuitant during the liquidation period. An annuity may be bought by means of installments, with benefits scheduled to begin at a specified age such as 65; or, it may be bought by means of a single lump sum, with benefits scheduled to begin immediately or at a later date. No physical examination is required." (Dictionary of Insurance Terms, Third Edition) Simply put, an annuity is defined as a policy contract that agrees to pay the insured a regular income over a specified number of years. Often called "life insurance in reverse" because while life insurance protects against loss by premature death. Annuities, on the other hand, protect against "living too long." However, most annuities have some sort of death benefit. By assuring continued payments for a specified or unlimited number of years, annuities guaranteed that the insured will not deplete his or her source of income. The time period over which the insurance company promises to provide income varies by type of contract is logically called the Annuity Period. The contract may specify an exact number of years or the individual's lifetime (an unspecified number). The person who purchases the annuity is the owner. The person who received payments from the annuity is the annuitant. The annuitant may or may not be the contract owner. Annuities may be written on an individual, joint or group basis. The most common is the individual annuity that is usually purchased for retirement purposes. The "Joint and Survivor" annuity is also a common form for married persons. With this type of annuity, there are two persons insured and payments are guaranteed to continue to the surviving spouse upon the other's death. Annuity payments can be either the same or different amount, usually designated as a percentage of the original amount (discussed in more detail later). Group annuities are generally part of a group pension or similar employee benefit plan. Back to top How Long Will Benefit Payments Continue? Annuity Certain (Period Certain): An Annuity Certain specifies the number of benefits payments of a set amount. This option will guarantee a minimum amount that the insurance company will pay on an annuity. The annuity has a Death Benefit that provides for payment to be made to the designated beneficiary upon the annuitant's death and will continue as long as the beneficiary lives. In effect, this annuity says that it will pay the benefits remaining of the period certain to the beneficiary. However, if the annuitant should survive the period certain, then the annuity performs as a Life Annuity. Consumer Application: Cecil dies 3 years after taking out an Annuity with a 5-year period certain. The Annuity Company will continue to make payments to his beneficiary for next two years. Insurance companies usually pay the present value of the remaining payments in a lump sum, so Cecil's beneficiary will receive 2 annual payments. If Cecil had survived the first five years of annuitization (liquidation period), the annuity would have continued to be paid out in the normal manner, ceasing upon the annuitant's death. "A Life Annuity Certain is an annuity that ... guarantees a given number of income payments whether or not the annuitant is alive to receive them. If the annuitant is living after the guaranteed number of payments have been made, the income continues for life. If the annuitant dies within the guarantee period, the balance is paid to a beneficiary. For example, under one common contract, a life annuity certain for 10 years, income payments are guaranteed for a minimum of 10 years. If the annuitant dies after receiving two years of payments, the beneficiary would receive the remaining eight years of income. An annuitant who lives out the 10 years would receive income payments for life, but there would be none available to a beneficiary." (Dictionary of Insurance Terms, Third Edition) Back to top Straight Life Annuities: This is the most common type of annuity. The simple "Straight Life Annuity" provides for guaranteed periodic payments that terminate upon the death of the annuitant. Once the annuitant dies, the contract is fulfilled and no payments are made. This type of annuity does not guarantee that the annuitant will receive payments equal to the amount paid as premiums on the contract. If the annuitant lives a long time, they will recover more than all of the premiums they have paid; if they dies soon after annuitization, the in insurance company will only pay the benefits up until the time of death. In the event the annuitant dies during the accumulation period (i.e. the time that payments are being made on the annuity, but prior to annuitization) proceeds will revert to the beneficiary, or if none is named, to the estate. Because this limits potential payouts, it will provide a higher return than other plans. The Straight Life Annuity provides the maximum income per dollar of outlay . Back to top Life Income With Period Certain: The Life Income with Period Certain (why don't they call it "Certain Period" - Period Certain seems backwards. Maybe a dyslexic Actuary named it?) - guarantees that annuity payments to a beneficiary will be made for a specific number of years, even if the annuitant dies before the end of this period. Payments to the annuitant will continue as long as he or she lives. Back to top Life Income With Refund Annuity: The Life Income with Refund type of Annuity states that in event of the annuitant's death, the company will pay an amount at least equal to the total dollars paid in as premiums. The company will continue to pay the guaranteed amount of monthly income for as long as the annuitant lives. There are two types of this annuity: Cash Refund: The Company agrees that if the annuitant dies, it will refund in cash the difference between the income that annuitant received and the amount that was paid in premiums plus interest earned. Installment Refund: The Company agrees to continue to make payment to the beneficiary until the total of the payments made to the annuitant and to the beneficiary equals the amount the owner paid for the annuity plus the interest earned. The longer the payout is to continue after the annuitant's death, the smaller will be the periodic payments. Back to top Using Annuities: Basic Considerations Obviously, Annuities are important for a person who needs a vehicle to meet their financial needs. The financial needs of corporations that provide group benefits also benefit from annuities. Financial planners use annuities for a variety of reasons, and in today's market, annuities must compete with other investment vehicles. Back to top Long-Term Investment Strategies As a general rule, annuities should be considered part of a long-term investment strategy rather than as a short-term liquid savings account (with one notable exception - the immediate annuity). This statement will be repeated in one form or another throughout this text, as it underlies the entire subject of annuities used as an investment. One of the primary benefits of annuities, the tax deferral on interest, applies only as long as the funds deposited in the annuity are not withdrawn. When discussing the precise tax consequences, it is apparent that Internal Revenue Service tax penalties can be quite severe. As discussed elsewhere also, it be noted that the insurance company imposes its own penalties in the form of surrender charges or interest rate adjustments when annuity funds are withdrawn under certain circumstances. The exceptions to long-term investment strategy is the use of a single premium immediate annuity to begin providing income payments as soon as possible. In this case, of course, the purpose is to pay an immediate stream of income, not to build up funds for the future. Generally annuities are purchased with flexible premiums so as to defer the income return until some future date and to reap the tax benefits in the meantime. Annuitants who adhere to the long-term strategy are thus "rewarded" and annuitants who do not are "penalized." At the same time, the flexibility and withdrawal privileges of newer annuities are more sensitive to changing financial circumstances, therefore annuity owners who encounter large, unexpected, immediate financial needs are able to access their annuity funds to some extent. In particular, Variable Annuities are best perceived as long-term investments. When the stock market is a "bull" market, that also means that the investments underlying a Variable Annuity will also perform well over the long term. Back to top What is an EIA? An Equity Indexed Annuity is, simply put: a fixed deferred annuity. It is not a new type of annuity, it is not a security, it is not a Variable Annuity - it is a fixed deferred annuity with all of the guarantees and features. The biggest difference between an EIA and a "regular" fixed deferred annuity is how interest is credited to the contract. Traditionally on a fixed annuity, the interest rate credited to the annuity is based on existing and current interest rates which is guaranteed by the insurance company and is guaranteed payable for the term of the annuity. Since most fixed annuities use a one-year period, they are renewed for another year, one year at a time. While it may have a guaranteed interest rate of, typically, 3 percent, it will use current rates each year, but never less than the guaranteed rate. With an EIA, the interest rate is based on a formula linked to an independent stock market index - usually Standard & Poor's Composite Stock Price Index (S&P 500). So, to summarize: an Equity Indexed Annuity is a fixed deferred annuity that uses an external index that reflects the fluctuations of the stock market to determine the interest earned. The EIA is not a security, indexed mutual fund, nor an investment in the stock market, nor a Variable Annuity: it is also NOT a substitute for any of these investment vehicles. However: The conservation of the principal of the Equity Indexed Annuity is GUARANTEED! (Blaring of trumpets, rolling of drums, resounding applause of thousands of investors.) Remember that it is a fixed annuity. A fixed annuity protects the annuitant from the risk of losing their invested money (principal) because of the vagaries of the stock market. This is the safety factor that has made fixed annuities attractive throughout the years and which are then used for "safe" investments that will not be accessed for a period of years. Remember also, as stressed throughout this text, risk and return work in tandem - as the risk increases, the return increases. Therefore, the security of a fixed annuity would indicate that the return would be provided at a low rate of return. With an EIA, the investor is provided with an opportunity to share in increasing rates because of increasing values in the stock market, and still do so with a guarantee that the principal will not be touched. It can be used to provide the annuitant with a steady stream of income, and can be used to supplement other income like Social Security, pension plans and income from savings. Back to top |