Introduction To Annuities: Basics of Annuities
In the introduction, we learned about the history and purpose of annuities. In this section, we will explore the mechanics of these contracts and the basic characteristics that apply to all forms of annuities: fixed, indexed and variable. Life Income With Refund (Or Cash Refund Annuity)
The Phases of an Annuity Contract
The life of a modern annuity contract consists of three separate phases: accumulation, annuitization and payout. However, not all of these phases apply to all types of annuities. The specifics of each phase are broken down as follows:
Accumulation Phase – This is always the first phase in the life of any annuity contract. It is the period of growth for the annuity that begins after the initial payment is made. This phase will last until payments are scheduled to begin from the contract. In some cases, the investor continues to make regular additional payments into the annuity during this phase.
Annuitization Phase– Annuitization is really more of a definitive event rather than a phase; it represents the point when the insurance company must begin making payments back to the investor. In the case of a variable annuity, annuitization is also the process in which all accumulation units purchased in the contract are converted into annuity units for payout.
Payout Phase – The final phase of an annuity in which payments are made to the investor. This phase can be very brief or quite long, depending upon various factors including payout amount and the total accrued during the accumulation phase.
It should be noted that annuities will continue to grow even after the accumulation phase is over. Interest or market gains will continue to accumulate inside the contract during all three phases, regardless of whether the contract is fixed, indexed or variable. For example, an investor who makes an initial $100,000 deposit into a fixed annuity contract may continue to invest another $1,000 per month for the next 10 years. The contract will pay the investor a guaranteed rate on the initial deposit and all subsequent additions, both during the accumulation phase and after the contract annuitizes. The balance of funds remaining inside the contract will also continue to earn the guaranteed rate until payout is complete and the contract is depleted. However, not all annuities have an accumulation phase (see below).
Methods of Premium Payment
As mentioned in the previous section, there is more than one way to fund an annuity contract. Most annuity carriers offer products that can be funded in one or all of the following ways:
Single Premium – A single, lump-sum payment that fully funds the contract.
Fixed Premium – A systematic investment program that requires the contract owner to make equal payments of a specific dollar amount at regular intervals over a given period of time until the contract is fully funded.
Flexible Premium – An arrangement that largely permits owners to make premium payments whenever and however they choose, above a certain minimum amount. Owners of flexible premium contracts may still opt to make a systematic investment, but they are free to amend the terms of this program at any time, provided the contract has or will exceed the required minimum investment amount. They are also free to add other money at any time as well.
Methods of Payout
There are several different options that the owner/annuitant can choose from when deciding on the method of income payment. These are:Straight Life –The contract pays out to the annuitant as long as he or she lives, regardless of whether the contract value is exhausted or not. If the contract is worth $50,000 and pays out $1,000 a month, then the annuitant can expect to receive that amount every month for life, even if he or she ends up collecting several times the contract value over the remainder of his or her life. This example demonstrates the purpose that annuities were created for: once the contract has annuitized, then the amount of the contract becomes, for all practical purposes, irrelevant to the annuitant, and he or she can simply count on receiving a set monthly or yearly amount for life, no matter what. If there is any principal remaining upon the annuitant's death, however, it goes back to the insurance company that issued the contract. Usually, a straight life payout will be higher than any other payout option, but it also has the highest risk of forfeiture upon death.
Life Income With Period Certain –The annuitant receives income for life but is guaranteed a certain number of payments regardless of whether the annuitant lives that long. For example, if the period certain is twenty years, and the annuitant dies after thirteen years, the beneficiary will receive the last seven years of payments. Again, the initial payout is less than with a straight life contract.
Joint Life –This arrangement is just like straight life, except that there are two annuitants, and payments will only continue as long as both of them are living. Upon the death of either, payments will cease. (This option is very seldom selected, for obvious reasons.)
Joint Survivor Life (Or Joint And Survivor Annuity) - This is a much more popular option as payments will continue as long as both annuitants are living. Only upon the death of the second annuitant does the contract pass to the beneficiary.
Period Certain –This is probably the simplest of all options. Payments simply continue for a certain period of time, then stop, at which point the contract value is exhausted.
Joint Survivor Life With Period Certain –A combination of the Joint Life and Joint Survivor Life options. Payments continue until both annuitants are dead, at which time the beneficiary will receive the remainder of the contract if the death of the second annuitant transpired within the period certain.
Fixed Amount –Also a very simple method, the annuitant simply receives a fixed payment until the contract value is exhausted, regardless of when that will be. If the annuitant dies before the contract is depleted, the beneficiary receives the remainder.
Interest Income Only – The annuitant receives all or part of the interest or gain from the contract without depleting the principal. Technically, this isn't an annuity option, but merely a systematic withdrawal.
Annuitants seldom choose any kind of straight payment option that has no period certain, but many insurance companies offer flexible payout options that can change even after annuitization to allow contract holders a greater freedom in how they receive their income streams. Annuitization is also not always required; some owners opt never to annuitize their contracts in order to retain greater freedom over the distribution.
Timing of Payout
All annuities can be divided into one of the following two categories when it comes to timing of annuity distributions:
1. Immediate Annuities – These contracts do not have an accumulation phase before payout. As their name implies, immediate annuities begin making payments back to the owner as soon as the contract is in force.
2. Deferred Annuities – The principal invested in these contracts will grow for a set period of time until annuitization or systematic withdrawal.
In Section 3, we'll explore the advantages, disadvantages, distributions and taxation of annuities, as well as the parties involved.
Life Income With Refund (Or Cash Refund Annuity)- As the name implies, the annuitant receives income for life, but if there is any principal remaining upon death, it goes to the beneficiary instead of back to the insurance company. This removal of forfeiture found in straight-life payout options results in a lower initial actuarial payout to the annuitant.
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