CHAPTER ONE - 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 a 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 guarantee 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.

 

OWNERSHIP OF AN ANNUITY

 

When the owner of an annuity enters into an agreement they must always understand all of the terms to the best of their ability.  If there are additions, withdrawals, or a complete liquidation to be made, there may be restrictions or penalties.

 

The contract owner can be an individual, couple, trust, corporation, or partnership.  The only requirement is that the owner must be an adult or legal entity.  A minor can be the owner as long as the policy lists the minor's custodian (example:  “James Jones, as custodian for the benefit of Johnny Jones").  Since the contract owner controls this investment, the owner has total control, and can give the contract to anyone, or will part or all of the contract to anyone or any entity at any time.

 

THE ANNUITANT

 

The most difficult party to an annuity for a person to fully understand, is the annuitant.  The best way to understand this party to an annuity would be to compare it to the functions of a life insurance policy.  When a life insurance policy is issued, the person insured is named on the contract and continues as the insured until the owner of the policy either terminates the contract or does not make any required premium payments - or, of course the insured dies.

 

With the annuity, the terms remain in force until the contract owner makes a change or the annuitant (the person named in the contract as annuitant) dies.  Therefore, the annuitant resembles the insured in a life insurance policy.  But with an annuity, the death of the annuitant does not necessarily mean the contract is about to terminate.  Even though every annuity contract must designate an annuitant, the annuitant has no voice or control over the investment or its disposition, unless the annuitant is also the contract owner.   If the contract is a Variable Annuity, and if the annuitant dies, this may create certain insurance company guarantees.

 

Annuitants are often called the "measuring life."  This means that the length of time that the contract covers must have a specific time frame.  The annuitant is then used as the time frame that is considered and referred to by the contract.  Just like in life insurance, the annuitant has no voice or control over the contract. The annuitant can benefit from an annuity ONLY when it “annuitizes.”

 

The person named as annuitant can be any person so designated by the annuity, with the only restriction being that is must be an actual living person under a specified age, and not a trust, business, corporation, etc.  The maximum age of the proposed annuitant depends on the requirements of the insurance company – usually the annuitant must be under age of 75 when the contract is first executed.  It is of prime importance that the investment (contract) stay in force after the annuitant reaches this maximum age.

 

Generally, the contract owner may change the annuitant at any time provided the annuitant is alive when the contact was originally executed.  Some contracts allow for the contract owner to name a co-annuitant.  By naming a co-annuitant, the contract could last longer because any “forced” annuitization or the termination of the contract, could possibly be postponed until the death of the second annuitant.  The co-annuitant can be compared to a “second-to-die” life insurance policy, as the death of one annuitant will not force distribution of the annuity.  Naming a co-annuitant means the death of one annuitant will not trigger a possible forced distribution. 

Only a small number of insurers include a co-annuitant option as part of the annuity application.

 

Some annuity contracts require a distribution or “orderly liquidation” of the funds, once the annuitant reaches a certain specified age - typically 80 or 85.  The death of an annuitant may require liquidation within a specified period, usually five years.

 

THE BENEFICIARY

 

To use an analogy, in a life insurance policy, the beneficiary has no “status” until the death of the named insured.  In an annuity, the beneficiary has no “status” until the death of the annuitant.  Similarly, the beneficiary of an annuity has no control of the policy and has no say in the management of the policy.  The beneficiary benefits from an annuity only when the annuitant dies.

 

The beneficiary can be either an individual, or a trust, corporation or partnership.  There does not have to be any relationship between the beneficiary and the annuitant – indeed, they could conceivably be (but highly unlikely) total strangers.  The application form used for an annuity allows the owner to state multiple beneficiaries, and to designate the percentage of each beneficiary if so desired.

 

Frequently, one spouse would be the owner of the contract, and the other spouse would be the beneficiary.  With some companies, co-ownership is allowed, thereby allowing both spouses to be owners.  This can be quite valuable in case the annuitant dies as the annuity proceeds would not go to a beneficiary as long as one of the spouses was still alive.

 

Generally, a single person (or widow or widower) will designate themselves as the owner of the contract and also the annuitant, naming another party as the beneficiary (such as a church, charity, etc.).  By doing this, the person has complete control over the investment during their lifetime, and upon their death, the annuity proceeds will automatically pass to the intended heir.

 

Since the owner of the contract can change the beneficiary at any time, they do not need to notify a listed beneficiary that they have been so designated, or indeed, even tell them if they are removed as beneficiary.

 

MULTIPLE TITLES

 

When the original investment(s) is/are made, the owner(s), annuitant, and beneficiary(s) must be so stated.  As stated above, only the annuitant has to be a natural person.  The person can hold more than one “title.”  For instance, they could be the contract owner and beneficiary of the same contract.  It is also possible that the annuity owner, annuitant and beneficiary are the same person.  It should always be remembered that a non-person entity (such as a corporation, partnership, living trust, etc.) can only be specified as contract owner and/or beneficiary.  The annuitant must be a living individual under a certain age.

 

HOW THE CONTRACT IS "DRIVEN"

 

Most annuities are considered as "annuitant-driven," i.e., if the annuitant reaches a certain age, died, or became disabled, certain provisions of the annuity would govern.  Some of these provisions could waiver any penalties enacted by the insurer, or the death benefit, IRS penalty, and/or the required annuitization or distribution of the contract would go into effect, depending upon the situation of the annuitant (such as the contract owner dying, reaching a certain age, or becoming disabled).  Some, but few, annuities state that certain provision can come into being if either the owner, co-owner, or annuitant dies, reaches the age of annuitization, or becomes disabled.  This flexibility makes the annuity more appealing in some circumstances.

 

WHEN DO BENEFITS BEGIN?

 

There are two basic types of annuities in respect to when benefits start (when the annuity “annuitizes”).

 

IMMEDIATE ANNUITY –START PAYING NOW

With an immediate annuity, annuity payments will commence after a predetermined “period.”  The period can be one year, for instance, in which case the first benefit payment will be one year after the purchase of the immediate annuity.  Payments can be monthly, quarterly, semi-annual or annual.  If the period is one month, annuity payments start one month after purchase.

 

DEFERRED ANNUITY-START PAYING LATER.

 

With annuitization, the payment period is scheduled to begin at some future date.  The period when the contract annuitizes, is called the maturity date.  Conversely, for definition purposes, the period prior to the maturity date is called the accumulation period.  Further, the period following the maturity date during which payments are made is the liquidation or distribution period.

 

If death occurs before the annuitization period as stated in the contract, the cash value paid to the annuitant’s beneficiary would equal the amount of premiums paid in.  However, most contacts provide for payment to the beneficiary of at least the amounts paid in  - plus interest and regardless of sales charges.

 

The owner of a Deferred Annuity is permitted to alter the date that payments are scheduled to begin but within certain conditions that are plainly stated in the annuity.

 

HOW ARE ANNUITIES PURCHASED?

 

PREMIUM PAYMENTS.

 

The specific premium amount depends on several factors, primarily the length of the guaranteed benefit payment period.  The “Straight life” (discussed later) annuity offers maximum income per dollar of outlay.  Obviously, the reason for this is that some annuitants will die prematurely, or in the early part of the annuitization, thereby restricting the total amount of payout.  Period certain and refund options provide less income per dollar of outlay, as the element of mortality does not enter the equation.

 

The interest the company earns on investments is an important factor in determining annuity premiums.  The higher the interest, the more income per dollar of outlay.  During the discussion of Equity Indexed Annuities, the effect of the company’s investment portfolio is extremely important.  Obviously, the higher the investment return the lower the premiums to the annuitants.

 

The third factor is the expenses of the insurer.  If the insurer has high expenses (such as high commissions and overrides), the higher the premium to the policyholder.  In other words, the lower the expenses, the lower the premiums paid to the insurer which are required by the insurer to pay all claims and satisfy their stockholders.

 

 

HOW ARE ANNUITY PREMIUMS PAID?

 

Single Premium immediate annuity premiums are paid when the contract is signed, hence the term “lump sum payments.”  The funds for the payment of premiums can come from a variety of sources such as Employee profit-sharing plan, Savings Accounts, Cash Value of life insurance policy or sale of home or property, etc.

 

In today’s market, many annuities are purchased as the result of an IRA, 401(k) or 403(b) rollover.  When this is done, it is extremely important that it be a “Section 1035” exchange, i.e. that it not be a taxable exchange unless, for some reason, the customer wants to pay taxes on the amount of the rollover at that time.  The insurance company will furnish the papers that must be executed for such a rollover to exist and as discussed elsewhere in this text, the funds must be automatically transferred to the new annuity.

 

Periodic Level Premiums is a typical payment method of deferred annuities.  The annuitant pays equal premium amounts at regular intervals, until the benefits are scheduled to begin.  Some individuals choose this option, as it is similar to making deposits into a regular savings type account.

 

Periodic Flexible Premiums is a premium payment method that is more “in tune” with today’s investment world.  The annuitant pays the premiums over a period of time, until they are paid off.  Since the premiums are flexible, they appeal to those who want flexibility in the timing and amount of premium payments and is particularly attractive to those who want a program in which they can vary the amounts they save each year.  This also appeals to those who earn commissions, or other types of irregular income such as actors, truck drivers, artists, etc., not to mention families with growing children.  As long as the annuity remains in effect, funds will continue to accrue interest.  The principal disadvantage is that the actual amount of annuity benefit cannot be determined in advance, which may be essential in financial planning.

 

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.

 

 

“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)

 

LIFE ANNUITIES (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 die soon after annuitization, the 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. 

 

 

LIFE INCOME WITH PERIOD CERTAIN

 

The Life Income with Period Certain 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.

 

 

 

 

LIFE INCOME WITH REFUND ANNUITY

 

The Life Income with Refund type of Annuity states that in the 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 payments 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.

 

 

TEMPORARY LIFE ANNUITY

 

The Temporary Life Annuity is a “combination” plan.  Annuity payments will be made until either (a) the end of a pre-determined number of years, or  (b) until the death of the annuitant, whichever comes first.

JOINT AND SURVIVOR ANNUITIES

 

Under this arrangement, two people are annuitants, usually husband and wife.  Beginning on the date set in the contract, payments are paid to the annuitants.  Payments are guaranteed to continue to the surviving spouse upon the other spouse’s death.  Depending on the terms, the continuing payments will either be in the same amount as when both annuitants were alive, or be reduced.  Obviously, the premiums are higher than those for life income annuities are since the likelihood of a long annuity payment period is greater when more than one life is covered.

 

Two types are commonly used. 

 

1.  Joint and 2/3 survivor, the surviving spouse receives two thirds of the income paid to the original annuitant.

           

2.  Joint and one-half survivor, surviving spouse receives half of the income.

 

COMPARISON OF ANNUITY vs CD NET RETURNS

 

Because of the tax treatment, the net return of an annuity will always exceed that of a Certificate of Deposit.  The following chart shows this difference quite dramatically.

COMPARISON OF ANNUITY vs CD NET RETURNS

 

 

From this bar chart, it is obvious that one is much better putting assets into annuities, instead of CD’s, and the longer the period of time that funds remain in annuities, the better performance.

 

WITHDRAWAL OPTIONS

 

Receiving the funds from an annuity, either fixed-rate or variable, is a double-edged sword.  The owner can always take out part or all of his/her money at any time.  However, any withdrawal may be subject to a penalty. 

 

Generally, an annuity will allow withdrawals of up to 10 percent per year without any penalty or other cost.  The “free” withdrawal is usually based on a percentage of the principal (not the current value).  If, for example, an annuity owner invests $25,000 into an annuity, and then later adds another $25,000, the owner may withdraw up to $5,000 every year, without penalty.  Even with investment growth, this would be the maximum that they could withdraw without penalty.  However, some annuities do allow a free withdrawal which is based upon the greater of  (a) the current value, or (b) the principal contribution(s).

 

The contracts must be read carefully, as some companies will allow withdrawals of up to 15% per year, and others will allow free withdrawals of the growth at any time – or based upon the current value of the annuity (principal plus growth).

 

In respect to the withdrawals, recent statistics indicate that nearly three/fourths of those who invest in annuities, never take any money out of the annuities.  It should also be kept in mind that those restrictions on withdrawals eventually disappear.

 

Those restrictions on withdrawals, usually lasting about 5 to 7 years, do not apply to certain no-load annuities.  A “true” no-load annuity will usually allow withdrawals of any amount, at any time, without cost or penalty.

 

These restrictions do not mean that the owner cannot take out more than the specified amount – such as 10% - but if funds are taken out, a penalty will apply.  The amount of the penalty depends upon the type of annuity and the insurer.

 

 

ANNUITIZATION

 

Annuitization is the even distribution of both principal and interest, or growth of the annuity, over a specified period of time.  There is a distinct advantage to annuitization inasmuch as the disbursements are tax-favored.  Those situations where funds are sporadic, the tax-favorable status does not apply.

 

Annuitization is allowed under nearly all annuity contracts.  When the annuity is annuitized, the owner of the contract makes the decision as to how to receive the funds, i.e. what will be the mode of payment (monthly, semi-annually, annually, quarterly, etc.).  Variable contracts and fixed rate contracts may be annuitized. 

 

There is a disadvantage to annuitization.  Once the annuitization procedure has been

 

 

 

 

established, it cannot be changed (except for a very few exceptions).  There can also be a disadvantage if a Variable Annuity is annuitized.  In those cases, the amount of the check will vary, depending upon the results of the sub-accounts selected and the amount of money allocated to these sub-accounts.  With a Variable Annuity, the investment “ups-or-downs” are risks of the person receiving the checks, which is usually the contract owner/annuitant, and is not that of the insurer.

 

Obviously, and as discussed in more detail later, the more “aggressively” the money is invested, the less predictable is the payout stream.  On the flip-side, if the annuity funds are invested in short-term bonds, utilities or money market sub-accounts, the more predictable the income will be from time to time.

 

Another possible disadvantage for annuitizing a fixed rate annuity is that the amount of each check depends upon the competitiveness of the insurer, what the current rates happen to be at that time, the duration of the withdrawals, and of course, the principal amount annuitized.

 

 

 

CHAPTER 1

1. If the annuitant dies before the annuity period starts, the cash value paid to the beneficiary:

A. will equal the face amount.

B. will equal the anticipated annuitized amount.

C. will equal the amount of premiums paid in.

2. The Annuity period is

A. the time the contract owner makes payments.

B. the time period during which the insurance company will make payments.

C. the time between, when the contract ends, and payments begin.

3. The annuity owner

A. can be a trust.

B. cannot give the contract to another person.

C. must be the annuitant.

4. __________________are often called the “measuring life”

A. Annuitants.

B. Contract owners.

C. Corporations.

5. The person named as an annuitant can be any person so designated by the annuity

A. and it may be a trust or corporation.

B. and it must be an actual living person under a specified age.

C. who may be of any age.

6. An annuity that starts paying benefits after a period of time, usually at least a year, is called

A. an annual annuity.

B. a deferred annuity.

C. an immediate annuity.

7. The premium for an annuity depends primarily on

A. the length of the benefit period.

B. the commissions paid to the agent.

C. the interest the insurance company makes on the investment.

 

8. With a Cash Refund Annuity the company agrees

A. to pay until the annuitant dies, then all payments stop.

B. that if the annuitant dies, it will refund in cash the difference the annuitant
received and the premiums paid plus interest.

C. that if the annuitant dies it will refund in cash all the premiums paid plus interest.

9. The ________________________annuity provides the maximum income per dollar
for the annuitant.

A. Life Certain.

B. Life income with refund.

C. Straight Life.

 

10. An annuity that allows withdrawals of up to 10% per year without penalties, usually bases the percentage on

A. the present value of the annuity, including growth.

B. the principal.

C. the growth portion of the annuity only.

 

 

 

ANSWERS:  1 A   2B  3A   4A   5B  6C   7A  8B  9C  10B