Annuity contracts in the United States are defined by the Internal Revenue Code and regulated by the individual states. Annuities have features of both life insurance and investment products. In the U.S., annuity contracts may be issued only by life insurance companies, although private annuity contracts may be arranged between donors to non-profits to reduce taxes. Insurance companies are regulated by the states, so contracts or options that may be available in some states may not be available in others. However, their federal tax treatment is governed by the Internal Revenue Code.
There are two possible phases for an annuity, one phase in which the customer deposits and accumulates money into an account (the deferral phase), and the annuity phase in which the insurance company makes income payments until the death of the customers (the "annuitants") named in the contract. Annuity contracts with a deferrral phase always have an annuity phase and are called deferred annuities. It is possible to structure an annuity contract so that it has only the annuity phase; such a contract is called an immediate annuity.
The term "annuity," as used in financial theory, is most closely related to what is today called an immediate annuity. This is an insurance policy which, in exchange for a sum of money, guarantees that the issuer will make a series of payments. These payments may be either level or increasing periodic payments for a fixed term of years or until the ending of a life or two lives, or even whichever is longer. It is also possible to structure the payments under an immediate annuity so that they vary with the performance of a specified set of investments, usually bond and equity mutual funds. Such a contract is called a variable immediate annuity. See also life annuity.
The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings with a tax-deferred growth factor. A common use for an immediate annuity might be to provide a pension income. In the U.S., the tax treatment of an immediate annuity is that every payment is a combination of a return of principal (which part is not taxed) and income (which is taxed at ordinary income rates, not capital gain rates). When a deferred annuity is annuitized, it works like an immediate annuity from that point on, but with a lower cost basis and thus more of the payment is taxed.
Annuity with Period Certain
This type of immediate annuity pays the annuitant for a designated number of years (i.e., a period certain) and is used to fund a need that will end when the period is up (for example, it might be used to fund the premiums for a term life insurance policy). Thus this option is not necessarily suitable for an individual's retirement income, as the person may outlive the number of years the annuity will pay.
A life or lifetime immediate annuity is used to provide an income for the life of the annuitant similar to a defined benefit or pension plan.
A life annuity works somewhat like a loan that is made by the purchaser (contract owner) to the issuing (insurance) company, which pays back the original capital or principal (which isn't taxed) with interest and/or gains (which is taxed as ordinary income) 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 insurance company relies on a concept called cross-subsidy or the "law of large numbers". Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will give up income to support those living longer whose money may otherwise run out.
A life annuity, ideally, can reduce the "problem" faced by a wealthy person that he/she doesn't know how long he/she will live, and so he/she doesn't know the optimal speed at which to spend his/her savings. Life annuities with payments indexed to the Consumer Price Index might be an acceptable solution to this problem, but there is only a thin market for them in North America.
Life annuity variants
For an additional expense (either by way of an increase in payments (premium) or a decrease in benefits), an annuity or benefit rider can be purchased on another life such as a spouse, family member or friend for the duration of 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 so long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity or survivorship annuity. However, if the annuitant is in good health, it may be more advantageous to select the higher payout option on his or her life only and purchase a life insurance policy that would pay income to the survivor.
The pure life annuity can have harsh consequences for the annnuitant who dies before recovering his or her investment in the contract. Such a situation, called a forfeiture, can be mitigated by the addition of a period-certain feature under which the annuity issuer is required to make annuity payments for a least a certain number of years; if the annuitant outlives the specified period certain, annuity payments continue until the annnuitant's death, and if the annnuitant dies before the expiration of the period certain, the annuitant's estate or beneficiary is entitled to the remaining payments certain. The tradeoff between the pure life annuity and the life-with-period-certain annuity is that the annuity payment for the latter is smaller. A viable alternative to the life-with-period-certain annuity is to purchase a single-premium life policy that would cover the lost premium in the annuity.
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 annual payment to the purchaser is raised.
Life annuities are priced based on the probability of the annuitant surviving to receive the payments. Longevity insurance is a form of annuity that defers commencement of the payments until very late in life. A common longevity contract would be purchased at or before retirement but would not commence payments until 20 years after retirement. If the nominee dies before payments commence there is no payable benefit. This drastically reduces the cost of the annuity while still providing protection against outliving one's resources.
The second usage for the term annuity came into being during the 1970s. Such a contract is more properly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings with a view to eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment.
All varieties of deferred annuities owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.
A deferred annuity which grows by interest rate earnings alone is called a fixed deferred annuity (FA). A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is called a variable annuity (VA).
A new category of deferred annuity, called the equity indexed annuity (EIA) emerged in 1995. Equity indexed annuities may have features of both fixed and variable deferred annuities. The insurance company typically guarantees a minimum return for EIA. An investor can still lose money if he or she cancels (or surrenders) the policy early, before a "break even" period. An oversimplified expression of a typical EIA's rate of return might be that it is equal to a stated "participation rate" multiplied by a target stock market index's performance excluding dividends. Interest rate caps or an administrative fee may be applicable.
Deferred annuities in the United States have the advantage that taxation of all capital gains and ordinary income is deferred until withdrawn. In theory, such tax-deferred compounding allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when amounts held under a deferred annuity are withdrawn or inherited, the interest/gains are immediately taxed as ordinary income.
A wide variety of features and guarantees have been developed by insurance companies in order to make annuity products more attractive. These include death and living benefit options, extra credit options, account balance guarantees, spousal continuation benefits, reduced contingent deferred sales charges (or surrender charges), and various combinations thereof. Each feature or benefit added to a contract will typically be accompanied by an additional expense either directly (billed to client) or indirectly (inside product).
Deferred annuities are usually divided into two different kinds:
* Fixed annuities offer some sort of guaranteed rate of return over the life of the contract. In general such contracts are often positioned to be somewhat like bank CDs and offer a rate of return competitive with those of CDs of similar time frames. However, many fixed annuities do not have a completely fixed rate of return over the life of the contract, but have rather a guaranteed minimum rate and a first year introductory rate. The rate after the first year is often an amount that may be set in the insurance company's discretion, subject, however, to the minimum amount (typically 3%). Unlike most CDs, there are usually some provisions in the contract to allow a percentage of the interest and/or principal to be withdrawn early and without penalty (usually the interest earned in a 12-month period or 10%). Normally, fixed annuities become fully liquid upon the owner's death. Most equity index annuities are properly categorized as fixed annuities, and their performance is typically tied to a stock market index (usually the S&P 500 or the Dow Jones Industrial Average). These products are guaranteed but are not as easy to understand as standard fixed annuities, as there are usually caps, spreads, margains and crediting methods that can hinder returns. These products also don't pay any of the participating market indices' dividends; however, the trade-off is that contractholder can never earn less than 0% in a negative year.
* Variable annuities allow money to be invested in insurance company "separate accounts" (which are sometimes referred to as "subaccounts" and in any case are functionally similar to mutual funds) in a tax-deferred manner. Their primary use is to allow an investor to engage in tax-deferred investing for retirement in amounts greater than 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 owner's death), even if the underlying separate account investments perform poorly. This can be attractive to people uncomfortable investing in the equity markets without the guarantees. Of course, an investor will pay for each benefit provided by a variable annuity, since insurance companies must charge a premium to cover the insurance guarantees of such benefits. Variable annuities are regulated both by the individual states (as insurance products) and by the Securities and Exchange Commission (as securities under the federal securities laws). The SEC requires that all of the charges under variable annuities be described in great detail in the prospectus that is offered to each variable annuity customer. Of course, potential customers should review these charges carefully, just as one would in purchasing mutual fund shares. People who sell variable annuities are usually regulated by the NASD, whose rules of conduct require a careful analysis of the suitability of variable annuities (and other securities products) to those to whom they recommend such products. These products are often criticized as being sold to the wrong persons, who could have done better investing in a more suitable alternative, since the commissions paid under this product are often high relative to other investment products.
There are several types of performance guarantees, and one may often choose them a la carte, with higher risk charges for guarantees that are riskier for the insurance companies. The first type is comprised of guaranteed minimum death benefits (GMDBs), which can be received only if the owner of the annuity contract, or the covered annuitant, dies.
GMDBs come in various flavors, in order of increasing risk to the insurance company:
* 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 maximum anniversary value or particular roll-up
Insurance companies provide even greater insurance coverage on guaranteed living benefits, which tend to be elective. Unlike death benefits, which the contractholder generally can't time, living benefits pose significant risk for insurance companies as contractholders will likely exercise these benefits when they are worth the most. Annuities with guaranteed living benefits (GLBs) tend to have high fees commensurate with the additional risks underwritten by the issuing insurer.
Some GLB examples, in no particular order:
* 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)
* Guaranteed-for-life income benefit (a guarantee similar to a withdrawal benefit, but will pay you for as long as you live and does not require annuitization)
Criticisms of deferred annuities
Deferred annuities are generally sold by financial professionals, some of whom might work directly for an insurance company, although most financial professionals are independent agents of the insurance company and do not work directly for the companies. The financial professional who sells an annuity collects a commission from the insurance company. This commission will be a percentage of the total premium paid by the investor. This percentage can be as little as 1% and as high as 12% and on average is 6%. Since these commissions appear high and there are deferred sales charges on annuities, many financial gurus have criticized annuity products.
The investor will, generally, not pay any of this commission directly to the financial professional; the commission is paid by the insurance company to the financial professional up front. The insurance company will recapture the commission paid to the financial professional through the fees charged to the customer (in a variable or equity indexed annuity) or the spread in the interest rate market (for a fixed annuity). There are also deferred back-end charges that will be applied if the investor closes out his or her contract before the agreed-upon time frame, usually 8 years. These charges can last for as little as 1 year or as many as 20 years, depending on the type of annuity and issuing company. These back-end charges are of concern to many financial professionals and financial gurus.
Some annuities do not have any deferred surrender charges and do not pay the financial professional any commission, although the financial professional may charge a fee for his or her advice. These contracts are called "no-load" variable annuity products and are usually available from a fee-based financial planner or directly from a no-load mutual fund company. Of course various charges are still imposed on these contracts, but they are less than those sold by commissioned brokers. It is of course important that potential purchasers -- of annuities, mutual funds, tax-exempt municipal bonds, commodities futures, interest-rate swaps, in short, any financial instrument -- understand the fees on the product and the fees a financial planner may be charging.
Variable annuities are controversial because many believe the extra fees (i.e., the fees above and beyond those charged for similar retail mutual funds that offer no principal protection or guarantees of any kind) involved with them may reduce the rate of return compared to what the investor could make by investing directly in similar investments outside of the variable annuity. A big selling point for variable annuities is the guarantees many have, such as the guarantee that the customer will not lose his or her principal. Critics say that these guarantees are not necessary because over the long term the market has always been positive, while others say that with the uncertainty of the financial markets many investors simply will not invest without guarantees. Of course, past returns are no guarantee of future performance, and different investors have different risk tolerances, different investment horizons, different family situations, and so on. The sale of any security product should involve a careful analysis of the suitability of the product for a given individual, in light of all relevant facts and circumstances.
A controversial practice of insurance sales is the selling of insurance contracts within an IRA or 401(k) plan. Since these investment vehicles are already tax deferred, investors do not receive additional tax shelters from the annuities. The benefit of the annuity contract is the guaranteed lifetime income that all annuity contracts must have by state law. However, approximately 90% of annuitants have not taken the life annuity upon retirement. If an investor does not intend to take the life income option from an annuity contract at retirement, he or she may want to consider a low-cost deferred annuity.
On the other hand, if an investor needs to take lifetime income at retirement, he or she may want to try to buy an annuity upon retirement or might consider selecting a 401(k) plan account with an option to buy the annuity just before retirement.
In the U.S. Internal Revenue Code, the growth of the annuity value during the accumulation phase is tax-deferred, that is, not subject to current income tax, for annuities owned by individuals. The tax deferred status of deferred annuities has led to their common usage in the United States. Under the U.S. tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments (annuitization), and many of annuity contracts are bought primarily for the tax benefits rather than to receive a fixed stream of income. If an annuity is used in a qualified pension plan or an IRA funding vehicle, then 100% of the annuity payment is taxable as current income upon distribution (because the taxpayer has no tax basis in any of the money in the annuity). If the annuity contract is purchased with after-tax dollars, then the contractholder upon annuitization recovers his basis pro-rata in the ratio of basis divided by the expected value, according to the tax regulation Section 1.72-5. (This is commonly referred to as the exclusion ratio.) After the taxpayer has recovered all of his basis, then 100% of the payments thereafter are subject to ordinary income tax.
Since the Jobs and Growth Tax Relief Reconciliation Act of 2003, the use of variable annuities as a tax shelter has greatly diminished, because the growth of mutual funds and now most of the dividends of the fund are taxed at long term capital gains rates. This taxation, contrasted with the taxation of all the growth of variable annuities at income rates, means that in most cases, variable annuities shouldn't be used for tax shelters unless very long holding periods apply (for example, more than 20 years).