Structure and Design of Annuities
There are many ways to describe annuities, based on different factors:
¨ How will money be added to the contract? The contractholder may pay a single premium or periodic payments to the annuity company.
¨ When will annuity payments be paid out of the contract? Some contracts begin annuity payments immediately; others will defer income payments into the future.
¨ How long will annuity payments last? Annuity contracts offer a number of payout options – for a stated period of years or, more commonly, for a lifetime.
¨ How does the annuity company invest the funds in the contract? In some contracts, the company will hold the funds in the general assets of the company and guarantee a fixed rate of return; in other contracts, the funds are invested in a separate account, and the "interest rate” varies based on the investment results of the separate account.
How will money be added to the contract?
An annuity begins with a sum of money, called the principal. Annuity principal is created or “funded” in one of two ways: all at once with a single premium or over time with a series of periodic premiums.
Annuities can be funded with a single, lump-sum premium, in which case the principal is created immediately. For example, an employee has been accumulating funds for retirement in his 401k plan. At retirement, the employee could use the accumulated value in that account to fund the purchase of an annuity to provide retirement income. Insurance companies commonly use a life insurance policy’s death benefits to purchase a single premium annuity as a life income settlement option.
Annuities can also be funded through a series of periodic premiums that, over time, will create the annuity principal fund. In the past, it was common for insurers to require fixed and level installment premiums, much like traditional life insurance premiums. This allowed the company to guarantee future values at the contract’s inception (just like traditional life insurance).
Today, insurers often allow annuity owners to make flexible premium payments. A certain minimum premium may be required to purchase the annuity, but after that, the owner can make premium deposits as often as he or she desires – this is analogous to the premium flexibility of universal life insurance.
When will annuity payments be paid out of the contract?
Annuities can be classified by the date the income payments to the annuitant begin. Depending on the contract, annuity payments can begin immediately or they can be deferred to a future date.
An immediate annuity makes its first benefit payment to the annuitant at one payment interval from the date of purchase. Most annuities make monthly payments, so an immediate annuity would typically pay its first payment one month from the purchase date. Immediate annuities have no real accumulation period – the annuity period begins at the inception of the contract.
Immediate annuities must be funded with a single payment, and are often called “single-premium immediate annuities”, or SPIAs. An annuity cannot simultaneously accept periodic funding payments by the contractholder and pay out annuity income.
Deferred annuities delay the start of income payments to some future date. Unlike immediate annuities, deferred annuities can be funded with periodic payments over time. Periodic payment annuities are commonly called flexible premium deferred annuities, or FPDAs. Deferred annuities can also be funded with single premiums, in which case they're called single-premium deferred annuities, SPDAs.
Deferred annuities have an accumulation period. As noted above, the contractholder retains important rights during the accumulation period – such as the ability to surrender the contract, withdraw funds from the contract and exchange the contract for a more suitable contract. The contract will outline what those rights are. Most insurers charge contractholders for withdrawal or surrender of deferred annuities in the early years of the contract. These surrender charges cover the costs associated with selling and issuing contracts as well as costs associated with the insurer's need to liquidate underlying investments at a possibly inappropriate time. Surrender charges for most annuities are of limited duration, applying only during the first five to eight years of the contract – and usually on a sliding scale, i.e., lower charges in later years. However, most contracts will waive those charges for small withdrawals, say, up to 10% of the annuity’s value annually. In addition to the contract’s surrender charges, the IRS imposes a penalty on withdrawals from deferred annuities prior to age 59˝. (This is similar to tax treatment of qualified retirement accounts such as a 401k plan. It is important to note that, unlike qualified retirement plans, withdrawals need not be taken from a deferred annuity at age 70˝.)
The contractholder has effective control over the deferred annuity until he or she decides to “annuitize” the account. Annuitization is simply the decision to start receiving periodic annuity payments from the contract. Once that decision has been made, the contractholder loses control of the contract and the company will simply pay the promised income payments. While some contracts, at their inception, specify the date annuity payments are to start, most deferred contracts leave the decision to “annuitize” up to the contractholder. Indeed, many annuity contracts continue in the accumulation (or investment) period indefinitely — that is, they never annuitize.