Annuity

The term annuity (from Latin annus, a year), in current use in the insurance industry, refers to two very different types of legal contracts with very different purposes. Traditionally, for at least four hundred years, the term annuity referred to what is more correctly called today an immediate annuity. This is an insurance policy which makes a series of either level or fluctuating periodical payments, made annually, or at more frequent intervals, either for a fixed term of years, or during the continuance of a given life, or a combination of lives. The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings. A common use for an immediate annuity might be to provide a pension income to a person who is about to retire.

Payment options

In technical language an annuity is said to be payable for an assigned status, this being a general word chosen in preference to such words as "time", "term" or "period," because it may include more readily either a term of years certain, or a life or combination of lives. The magnitude of the annuity is the sum to be paid (and received) in the course of each year. Thus, if £100 is to be received each year by a person, he is said to have "an annuity of £100." If the payments are made half-yearly, it is sometimes said that he has "a half-yearly annuity of £100"; but to avoid ambiguity, it is more commonly said he has an annuity of £100, payable by half-yearly instalments. The former expression, if clearly understood, is preferable on account of its brevity. So we may have quarterly, monthly, weekly, daily annuities, when the annuity is payable by quarterly, monthly, weekly or daily instalments. An annuity is considered as accruing during each instant of the status for which it is enjoyed, although it is only payable at fixed intervals. If the enjoyment of an annuity is postponed until after the lapse of a certain number of years, the annuity is said to be deferred. If an annuity, instead of being payable at the end of each year, half-year, &c., is payable in advance, it is called an annuity-due. The holder of an annuity is called

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an annuitant, and the person on whose life the annuity depends is called the nominee.

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Upon immediate annuitization, a wide variety of options are available in the way the stream of payments is paid. If the annuity is paid over a fixed period independent of any contingency, it is known as an "annuity with period certain", or just annuity certain; if it is to continue for ever, it is called a perpetuity; and if in the latter case it is not to commence until after a term of years, it is called a deferred perpetuity. An annuity depending on the continuance of an assigned life or lives would commonly be called a life annuity, but also known as a life-contingent annuity or simply lifetime annuity; but more commonly the simple term "annuity" is understood to mean a life annuity, unless the contrary is stated. The payments can also be paid over the lifetime of the nominee(s) or for a fixed period, whichever is longer. This is known as "life with period certain".

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A hybrid of these is when the payments stop at death, but also after a predetermined number of payments, if this is earlier: known as a temporary life annuity. The difference with the period certain annuity is that the period certain annuity will keep paying after the death of the nominee until the period is completed.

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If not otherwise stated, it is always understood that an annuity is payable yearly, and that the annual payment (or rent, as it is sometimes called) is £1. It is, however, customary to consider the annual payment to be, not £1, but simply 1, the reader supplying whatever monetary unit he pleases, whether pound, dollar, franc, Thaler, &c.

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The annuity is the totality of the payments to be made (and received), and is so understood by all writers on the subject; but some have also used the word to denote an individual payment (or rent), speaking, for instance, of the first or second year's annuity,--a practice which is calculated to introduce confusion and should therefore be carefully avoided.

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Instances of perpetuities are the dividends upon the public stocks in England, France and some other countries. Thus, although it is usual to speak of £100 consols, the reality is the yearly dividend which the government pays by quarterly instalments. The practice of the French in this, as in many other matters, is more logical. In speaking of their public funds (rentes) they do not mention the ideal capital sum, but speak of the annuity or annual payment that is received by the public creditor. Other instances of perpetuities are the incomes derived from the debenture stocks of railway companies, also the feu-duties commonly payable on house property in Scotland. The number of years' purchase which the perpetual annuities granted by a government or a railway company realize in the open market, forms a very simple test of the credit of the various governments or railways.

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Life annuities

A life or lifetime immediate annuity is most often used to provide an income in old age, i.e. a pension. This type of annuity may be purchased from an insurance company.

Related Topics:
Pension - Insurance

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This annuity works somewhat like a loan that is made by the purchaser to the issuing company, who then pay back the original capital with interest to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the investment relies on cross-subsidy. Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will support those living longer.

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Cross-Subsidy remains one of the most effective ways of spreading a given amount of capital and investment return over a life time without the risk of funds running out.

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Life annuity variants

At a cost to the payments, an annuity can be purchased with addition of another life such as a spouse on whose life the annuity is wholly or partly guaranteed. For example, it is common to buy an annuity which will continue to pay out to the spouse of the annuitant after death, for as long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity.

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Other features such as a minimum guaranteed payment period irrespective of death, known as period certain, or escalation where the payment rises by inflation or a fixed rate annually can also be purchased.

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Life with period certain annuities are more palatable to people who have accumulated money and would not like to lose all of it if they were to die soon after annuitization. At least the period certain payments will be made to their beneficiary.

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Impaired life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the payment for the purchaser is raised.

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Deferred Annuities

There are two phases to a deferred annuity. The accumulation phase is the time between initial purchase and annuitization. The annuitization phase starts when the annuity is turned into a stream of payments. Before annuitization, additional purchase payments, known as premiums, may be made. In a deferred annuity, the goal is to invest the premium payments in either guaranteed accounts or variable accounts and earn investment returns. These returns can then be withdrawn when desired depending on the features of the contract.

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A wide variety of features have been developed by annuity companies in order to make their products more attractive. These include death benefit options and living benefit options.

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Deferred annuities in the United States have an advantage that all capital gains are tax deferred until withdrawn. In theory, this allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when a variable annuity is inherited the beneficiary must pay capital gains tax. This is not required for any other kind of investment.

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Deferred annuities are criticized and controversial, because they often generate a higher commission then other forms of investment, leading to suspicions or actual cases of conflict of interest. Of particular controversy are surrender charges, in which a certain percentage of the account value is taken by the insurance company as a fee in the case of early withdrawal. The charges may be applicable over a long time frame, say 7 or 10 years. Many of the deferred annuity controversies have come from these products being sold to rather old people, who find their money has been locked up for 7 years, which is inappropriate.

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Deferred annuities are usually divided into two different kinds:

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• Fixed Annuities offer some sort of guaranteed rate of return over the life of the contract. In general these are often positioned to be somewhat like bank CDs, and offer a rate of return competitive to CD's of similar time frames (with different tax treatments as previously mentioned). However, many fixed annuities do not have a completely fixed rate of return over the life of the contract, but rather a guaranteed minimum rate and a first year "teaser rate". The rate after the first year is often any amount that the insurance company wants to pay, but at least the minimum amount. Unlike most CD's, there are usually some clauses in the contract to allow a percentage of the interest and/or principal to be withdrawn early and without penalty. Normally fixed annuities become fully liquid upon death.
• Variable Annuities allow money to be invested in separate accounts (similar to mutual funds) in a tax deferred manner. Overall their primary use is to allow someone to engage in tax deferred investing for retirement at amounts greater then permitted by individual retirement or 401(k) plans. In addition, many variable annuity contracts offer a guaranteed minimum rate of return (either for a future withdrawal and/or in the case of the owners death), even if the underlying separate account investments perform poorly. These features can be thought of as "buying insurance against the stock market doing poorly". These features attract investors. These products are often heavily criticized as being sold to the wrong persons, who could have done better doing something else, since the commissions paid by this product are often very high relative to other investment products.

There are several types of these performance guarantees, and many times one can choose them a la carte, with higher charges for guarantees that are riskier for the insurance companies. There are guaranteed minimum death benefits (GMDBs), which can be received only if the owner of the annuity contract, or the covered annuitant, dies.

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These GMDBs come in various flavors, in order of increasing risk to the insurance company:

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• Return of premium (a guarantee that you will not have a negative return)
• Roll-up of premium at a particular rate (a guarantee that you will achieve a minimum rate of return, greater than 0)
• Maximum anniversary value (looks back at account value on the anniversaries, and guarantees you will get at least as much as the highest values upon death)
• Greater of MAV and particular roll-up

Even riskier for insurance companies are the guaranteed living benefits, which tend to be elective. Unlike death benefits, which the contractholder generally can't time, living benefits have significant risk for the insurance companies as contractholders will likely exercise these benefits when they are worth the most. Annuities with guaranteed living benefits (GLBs) tend to have very high fees.

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Some GLB examples, in no particular order:

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• Guaranteed minimum income benefit (a guarantee that one will get a minimum income stream upon annuitization at a particular point in the future.)
• Guaranteed minimum accumulation benefit (a guarantee that the account value will be at a certain amount at a certain point in the future)
• Guaranteed minimum withdrawal benefit (a guarantee similar to the income benefit, but one that doesn't require annuitizing)