Annuities Explained - Indexed, Fixed, Variable, etc

Aside from selling life insurance policies, many insurance companies also offer annuity products.  The annuity is simply a promise the insurance company makes to pay the annuity beneficiary a set stream of income for a length of time.  The annuity owner pays the insurance company a set premium amount, and makes payments either in one lump-sum or spread out across a number of years.  At the creation of the account, the distribution start date is determined.  Different annuity types will have different starts dates, with the needs of the annuity owner determining which annuity is pursued.

One of the primary advantages of annuities, and the main reason for many annuity sales, is the tax-deferred build-up of income inside of the annuity.  Annuities are not taxed until withdrawals are taken from the account, allowing the owner to compound their earnings tax-free.  It should be noted that fees associated with annuity accounts can sometimes offset the tax-advantages of the account, so having the details of the annuity explained to you is important before you commit to the contract.

Major Categories Of Annuities Explained

Fixed Annuity - fixed annuities are the oldest form of annuity available on the market today, and are considered one of the safer annuity types.  A conventional fixed annuity refers to the account providing a fixed dollar amount over a specified period or throughout the lifetime of the annuitant.  This stream of income provides the beneficiary a consistent and dependable source of funding that they can be certain remains constant.

  • Fixed rate annuities - another form of fixed annuity product is the fixed rate annuity.  This defers slightly in the sense that it provides a fixed interest rate on the account value.  This fixed rate then translates into a fixed growth and fixed income for the duration of the distributions.
  • Fixed income annuities - simply refers to the conventional form of fixed annuity contract.  The income returned to the beneficiary is a fixed dollar amount.
  • Retirement annuity - this variation mostly references the annuity's ability to provide a dependable income stream for the retiree using the product.  With the lifetime option applied to the account, the retiree can depend on a stream of income that cannot run out before they pass away.  This has become a fall-back income planning tool for many retirees.

Variable Annuity - if there is a single annuity product that garners the most bad press, it would be variable annuities.  One of the limitations of a fixed payment account is that it is subject to decreasing purchase power caused by inflation.  This decreasing purchasing power can greatly dilute the value of the account, and endanger the solvency of the annuity owner in the future.  Intended to combat this problem and offset the effects of inflation, the variable annuity contract was created.

Variable annuities tie the value of the account to a common stock investment program offered by the insurance companies.  The theory being that the markets have been the best vehicle to balance the rise or fall of the dollar.  Because the account value of the variable annuity is tied to performance of the underlying portfolio, there is a degree of risk involved.  Unless minimum guarantees are built into the contract, the annuity owner runs the risk of losing account value during poor performance of their portfolios.  It should also be noted that a traditional life insurance agent cannot sell variable annuities without first obtaining their securities license.

Indexed Annuity - introduced in the mid-1990s, the equity indexed annuity was created as a variation of the traditional, fixed-interest, deferred annuity contract.  As the name suggest, the indexed annuity ties the performance of the account to the performance of the market index associated with it.

These fixed index annuities provide a minimum fixed interests rate and then allow a portion of the growth of the underlying markets during upswings.  During these market uptrends, the annuity account is credited with higher interest rates and increased account values.  During down markets, the annuity owner does not have to worry about losing principle in the account, as the contract provides a minimum guaranteed return.  In essence, this type of annuity provides the user a nice hybrid of fixed annuities and variable annuities.

Distribution Types Of Annuities Explained

Annuities can be classified into one of two categories:

Immediate Annuity -  an immediate annuity makes the first benefit payment one payment interval after the date of purchase of the contract.  If the payment interval is monthly, the first payment beings one month after the date of purchase.  If the payment interval is annual, the payments begin one year from the purchase date.  Immediate fixed annuities are always purchase with one single lump-sum premium payment.

Deferred Annuity - in order for an annuity to be defined as deferred, the payment period must occur more than at least one payment period after the date of purchase.  This is most often deferred for multiple years, and allows for the accumulation of funds to occur during this period of time.

Special Features Of Annuities Explained

Annuity Certain vs. Lifetime Annuities - if the payments of the product are to be paid for the duration of a specified period of time, the contract is referred to as annuity certain.  In contrast, if the payments are to be made for the duration of the lifetime of an annuitant, then the contract is referred to as a life annuity, or single-life annuity.

Joint Annuities - when an annuity covers the life of more than one individual, it is referred to as a joint annuity.  The joint lives on the contract determine when the distribution payments end.  A joint annuity terminates the contract on the date of the first death of those covered.  For this reason it is seldom used.

Joint and Survivorship Annuities - a more common type of joint life annuity is the joint and last survivor annuity.  The primary difference with this type of annuity is that it continues to make payments until the last surviving life covered on the contract dies.  This is a much more favorable contract type for couples needing retirement income.

Key Phrases -

Accumulation Phase - period in which premiums are paid to the insurer

Annuitant - the life in which the annuity contract is based.

Cap - a cap is most often associated with an indexed annuity and provides an upper cap on the interest rate that the insurer will credit the account during any market uptrend.

Distribution or Liquidation Phase - period in which income payments are paid from the insurer to the annuity's beneficiary.

Participation Rate - similar to a cap, the participation rate refers to the amount of participation in the growth of market indexes the annuity owner is credited.  A participation rate of 65% indicates the account will be credited with 65% of the growth.