An Annuity is a financial vehicle that provides income at a future date in an individual’s life and is commonly used to save up for higher education costs or as a retirement savings fund. An annuity is considered to be a form of insurance that provides future income to an individual while still alive, instead of when he or she dies. As a financial product offered by financial institutions and insurance companies, money is deposited either as a lump sum or as a series of payments by the owner of the annuity to a financial institution which then invests the money, tax-deferred, in order to earn interest and accumulate value for the investment.
Later in the annuity owner’s life, payments are distributed back from the financial institution along with the investment’s earned interest. An insurance company is able to offer annuities because of its ability to guarantee annuity payments for the entirety of the annuitant’s life, regardless of the age of the individual.
4 Parties Involved in an Annuity
- Insurance company (or other financial institution)
- Owner of the annuity
- Annuitant
- Beneficiary
- Annuity Structure and Design
An annuity is a legally binding contract involving an insurance company (or other financial institution), the owner of the annuity, an annuitant, and the annuity’s beneficiary. Although the owner of the annuity contract is often the same individual as the annuitant, both roles are unique to the contract.
The annuity’s owner is responsible for depositing funds in the form of premium payments into the annuity as well as for all taxes owed from the annuity’s earned interest. In return, the insurer invests the owner’s premium payments in stocks, bonds or securities, depending on whether the annuity is ‘fixed’ or ‘variable,’ and over time the annuity builds value.
When the annuity matures it ‘annuitizes,’ meaning that the contract begins to distribute both the Invested Principal and Earned Interest to the annuitant to serve as future income. If the annuitant dies before the contract is annuitized, the contract’s beneficiary becomes the receiver of the contract’s payout.
Both the owner and insurer benefit from an annuity contract because both parties earn interest on the invested payments by the owner.
During the annuity’s growth period, known as the Accumulation Period, interest that is earned by the investment is ‘compounded,’ or reinvested on a tax-deferred basis, thus allowing for a greater accumulation of funds for the annuitant. By compounding the interest, each year’s returns are re-invested, thus providing the annuitant with an exponential growth rate.
Once the contract annuitizes, a second period, called the Annuity Period, or ‘payout’ period, begins. During this period, the interest that accumulates is taxed appropriately as ‘gains,’ or earnings, on the investment; however, since the invested funds paid into the annuity using after-tax dollars, only the earned interest, or gains, on the investment are taxed,
The invested funds and earned interest can be distributed back to the annuitant in a variety of ways such as over a certain period of time, at a specific monetary amount per payment, or it can even serve as a death benefit to an annuitant’s designated beneficiary.
Group vs. Individual Annuities
Similar to an individual annuity, a group annuity provides monthly income to members of the group. Each member of the group is provided with a certificate that defines his or her participation rights in the group annuity.
A group annuity is often purchased to fund ‘defined benefit’ pension plans in which an employer establishes to provide future pension to company employees. Likewise, individuals purchase annuities to provide a structured future stream of income.
Business and Personal Uses of Annuities
Business UsesOften set up by employers as part of a retirement compensation package, a qualified annuity is often used to fund pension plans, 401(k) plans, 403(b) plans, SEPs, and other retirement plans on a tax-deductible basis. Based on the tax-deferred eligibility of the group, funding into the plan by the employer is paid with pre-tax dollars
Personal Uses
On the individual level, an annuity is used to provide a future stream of income for the individual to serve as retirement income, or as a source of funding for higher education, such as through an Individual Retirement Annuity (IRA).
Annuity Riders
As with a life insurance policy, riders can be added to an annuity to provide additional benefits for the annuitant. While an annuity rider typically requires additional premium, the benefits provided by such rider can greatly benefit the annuitant in the future.
Annuity riders commonly added to an annuity include long-term care riders, guaranteed monthly income riders and death benefit riders, each providing extra benefits to the owner of the annuity as well as extra financial protection for the annuitant.
Insurance Aspects of an Annuity
Although an annuity contract is not the same as a life insurance policy, both contracts can create similar protection depending on the structure of the annuity. It is important to realize that an annuity is not life insurance, and each is treated and taxed differently.
Most commonly, an annuity provides living benefits for the contract’s owner, who is also the contract’s annuitant; however, some annuities are designed to be similar to the type of financial protection provided by a life insurance policy. An annuity owner can pay the contract’s premiums and taxes on earned interest and designate another individual as the contract’s annuitant, who receives the distributed funds during the contract’s designated annuity period.
Owner-Driven vs. Annuitant-Driven Structure
An example of when an annuity owner is not the annuitant is in an ‘owner-driven’ annuity structure. This type of annuity structure involves the owner and annuitant being two separate individuals and is designed to benefit the annuitant upon the death of the annuity’s owner.
In comparison, the more common ‘annuitant-driven’ annuity structure involves the owner and annuitant being the same individual, and at the point of annuitization, payments are made back to the owner/annuitant or the designated beneficiary in the event that the owner/annuitant dies within the contract’s annuity period.
Premium Payment Options
Single (Lump Sum)
The most common premium option is the single, lump-sum option. This single payment is invested by the contract owner initially and continues to grow as the insurer reinvests the annual earned interest back into the annuity.
Level
This type of premium structure allows an annuity contract owner to make equal premium payments to the insurer on a scheduled basis, such as on a monthly, quarterly, semi-annual, or annual basis. As premium deposits are made by the contract’s owner, both the invested principal and earned interest continue to build and grow the annuity.
Flexible
This type of premium structure allows an annuity contract owner to vary the annuity’s premium deposit amounts at his or her discretion to better follow his or her budget, although a minimum and maximum premium payment level are enforced by the insurer.
Annuitization Time Frames (Immediate vs. Deferred)
Single Premium Immediate Annuity (SPIA)
Designed as a means of spreading out a lump-sum of money over a specified period of time, an Immediate Annuity begins to distribute funds immediately after the first payment period (depending on payment frequency: monthly, quarterly, semi-annual, or annual), and is used when a single, lump-sum premium is deposited by the contract owner with the intent of distributing it over a specified period of time to the annuitant (again, the annuity owner and the annuitant can be the same person or two separate people).
Single Premium Deferred Annuity (SPDA)
A Deferred Annuity delays payout to allow interest to compound over a period of time. Again, an annuity is not taxed during the accumulation period to allow interest to build a quicker rate, thus providing a larger investment return for the annuitant. A deferred annuity can be paid with a single premium, known as a Single Premium Deferred Annuity (SPDA), or through multiple premium deposits.
Flexible Premium Deferred Annuity (FPDA)
Some insurers provide additional flexibility by offering a multiple premium, deferred annuity that allows the contract owner to control the premium deposit amounts and frequency within certain limits stated in the contract, known as a Flexible Premium Deferred Annuity (FPDA).
