An annuity is simply a stream of periodic payments. Start with a lump sum of money, pay it out in equal installments over a period of time until the original fund is exhausted, and you have created an annuity. An annuity is simply a vehicle for liquidating a sum of money. Of course, in practice the concept is more complex. An important factor not mentioned above is interest. The sum of money that has not yet been paid out is earning interest, and that interest will eventually pass on to the recipient.
Individuals may purchase annuities with a single sum amount or through a series of periodic payments. The insurer credits the annuity fund with a certain rate of interest, which is not currently taxable. Over time, the value of the annuity grows. The ultimate amount that will be available for payout is a reflection of the amount the investor pays into the contract and the interest the insurance company credits to the contract.
With any annuity, there are two distinct time periods involved: the accumulation period and the payout or annuity period:
The accumulation period is that time during which the contractholder pays premiums into the annuity and the insurer credits interest earnings to the contract. During the accumulation period, the contractholder retains some control over the contract. For example, the contractholder may withdraw funds from the contract, surrender the contract, exchange the contract for a different type of annuity or for a contract issued by another company. The contract will detail what rights the contractholder has during this period and any limitations on those rights. In addition, the IRS may impose limitations or penalties in some circumstances. The accumulation period can last for years, or may be a momentary point in time, depending on how the contract is funded.
During the annuity period, the insurer pays periodic payments to the recipient. The conversion from the accumulation period to the annuity period is referred to as “annuitization”. At this point the contract turns from an investment vehicle to an income-paying device. During that process, the contractholder chooses how he or she would like the annuity payments to be paid out of the contract. Typically, benefits are paid out monthly — though a quarterly, semiannual or annual payouts are possible. There are a number of payout options the contractholder may choose. The amount of an annuity payment is dependent upon three factors: the accumulated principal, interest rate and payment period. Life insurance companies, because of their experience with mortality tables, are uniquely qualified to combine an extra factor – called the survivorship factor — into the standard annuity calculation. Only life insurance companies can guarantee annuity payouts lasting a lifetime.
In some contracts there is no requirement that the contract ever be annuitized, i.e., the accumulation period may continue indefinitely. Other contracts may require annuitization by a certain date or age — this is often called the contract's starting date or maturity date. Some contracts may impose a maturity date, but allow the owner to extend the accumulation period (i.e., delay annuity payments) by giving the annuity company written notice. Regardless of the terms of the contract, once it is annuitized the contractholder loses control over the account, and the company will simply pay the income payments selected by the contractholder.
The distinction between the accumulation period and the annuity period is key to understanding contract provisions and tax treatment.
This course focuses the suitability of an agent’s annuity recommendations and assumes that the student has a basic understanding of annuity contracts. If you would like a more thorough review of annuity contracts, click here for a Annuities Primer.
The rest of this chapter will explore the differences between the interest crediting methods of fixed, variable and indexed annuities, fees annuities charge and the tax consequences of an annuity investment.