In my life insurance and pension administration career, I have received several questions from people relating to life insurance and annuities. I remember my days in a Pension Fund Administration company (PFA) when we had the arduous task of educating people on the Pension Reform Act that had just been enacted. It was confusion everywhere, even among the employees of some of the newly licensed PFAs. There was a particular presentation we attended one day and the team leader for one of our competitors was busy confusing the audience on annuity benefits. He was constantly repeating something like “if any of your staff dies, the insurance company will pay the annuity benefit under your group life insurance scheme…”
What actually prompted my writing this piece today was a radio phone-in program I listened to a few days ago. The program was about retirement and the new pension system in Nigeria. A pension expert was invited to the studio and listeners were asking him various questions on air. What surprised me was the low level of knowledge that people have on the subject. I heard people asking questions about annuity, yet what they were actually talking about was life insurance! So I have decided to look at the main differences between life insurance and annuity in this post, hoping that it will be of help to those who find it difficult to separate the two.
I will be using the two “pure” life insurance products comprising term assurance and whole life products to draw the relevant differences. In case you are not familiar with these two types of life insurance contracts, it will be helpful to take a quick look at another of my posts, Types of Life Insurance, first.
Basically, a term assurance policy provides for payment of the insurance benefit/payout (i.e. sum assured) in the event of death within the period of insurance cover, say 5 years. If the policyholder survives the period, no payment is made. On the other hand, a whole life cover pays the sum assured whenever death occurs. Unlike term assurance, the whole life policy builds up cash values so the policyholder can still receive some payments after a certain period of time. He can also obtain a loan under the policy because of this cash accumulation feature.
If you are not also familiar with the basic concepts of annuity, I have another blog on it which is titled Types of Annuities. You can check it out here.
With those housekeeping statements, I think we can now start to look at the key differences between life insurance (term/whole life) and annuities.
1.0 Reason for making a purchase
I think the first factor to start with is the reason for buying any of the products. What is the purpose of buying life insurance? And what does annuity do for the buyer? Basically, a term assurance or whole life insurance product provides income or inheritance benefit for the dependants in the event of death of the policyholder. Annuities, on the other hand, provide income to the annuitant (policyholder). With a deferred annuity product, for instance, the policyholder accumulates money over a period; following which the insurance company starts to pay him series of income (also called pension if it’s for retirement) at a future date. If it is an immediate annuity, the policyholder pays a lump sum of money to the insurance company and he starts receiving income from them “immediately” until a certain future date, or till death.
2.0 Payment by the insurance company
For life insurance (term and whole life), the insurance company typically pays a lump sum of money to the beneficiary. And who determines the lump sum? The policyholder does. At the time of buying a life insurance policy, the proposer (purchaser) states the amount that should be paid in the event of his death and the insurance company determines the cost (premium) of the benefit chosen. Although it is also possible for the proposer to state the maximum amount of premium he can afford to pay and the company works out the corresponding benefit for him; this is not a common practice.
An immediate annuity, on the other hand, usually pays out a lifetime income while a deferred annuity could provide a combination of both lump sum and income. Again, who determines the amount of income to be paid? For an immediate annuity, the policyholder pays a lump sum to the insurance company and, in return, the company tells him the amount of annuity income that his money can buy for him. Alternatively, he can tell the insurance company the amount of income he wants and the insurance company advises him of what it would cost (single premium).
In the case of a deferred annuity, the policyholder determines the premium he wants to be paying regularly and the insurance company advises him of the income (annuity) that these regular premiums will buy for him. As an alternative, the policyholder can indicate the level of income he wants from a future date, and the insurance company tells him what it would cost in terms of regular premium payment till the due date of the annuity payment.
3.0 When payment is made
The difference between life insurance and annuities can also be identified by looking at when payments are made under the two. As stated above, benefits are paid under a term assurance policy in the event of death of the policyholder within the period of cover. For a whole life insurance, the payout takes place whenever he dies, or when he surrenders or takes a loan under the policy.
Payment of annuity income, on the other hand, starts from the date the annuitant makes the first withdrawal under a deferred annuity plan. As for immediate annuity, payment starts immediately, i.e. one period (month/quarter) after the immediate annuity is purchased; and payment usually stops when the annuitant dies (see Types of Annuity for more details).
4.0 Death Benefits
I think this is one of the areas where the two types of contracts are often confused so I will try to explain it in simple terms.
As for term assurance/whole life, it is quite clear that benefits are primarily paid in the event of death as earlier explained. Payment of death benefits under annuity contracts requires a little bit of explanation. In doing this, I will be distinguishing between death that occurs during the period of funding the annuity (i.e. accumulation period), and death that occurs when the payment of annuity income has already started (i.e. annuity period).
As for immediate annuity, there is no accumulation period since the annuity is usually funded through a single premium payment to the life office. This therefore leaves us with the benefit that is paid when death occurs after the annuity has started. In this case, further payment of annuity stops because, ordinarily, annuity is a “living benefit” payable to someone who is alive. However, the annuitant could die shortly after the commencement of payment when he has not collected much from the insurance company. Imagine death occurring after receiving just three months’ annuities; having paid a huge purchase sum to the insurance company as a lump sum! For this reason, most immediate annuity contracts have guarantee-period clauses of say, five or 10 years. Assuming that the annuity is guaranteed for 5 years, the insurance company will pay to the deceased annuitant’s beneficiary the annuity benefits for the remaining unexpired period of five years from the date of death. If, for example, he had received annuity benefits for three years before his death, the insurance company will pay additional two years’ annuities to his beneficiary (usually as a lump sum).
Treatment of death benefits under a deferred annuity is a little different. And the difference is just for death occurring during the accumulation period. Since the annuitant was still paying towards his future annuity benefits before his death, it is logical to note that the responsibility of the insurance company for annuity payment has not commenced. The common practice is therefore to refund the premiums that the policyholder paid to date; which is fair enough. Let me however caution that the plan could be designed in such a way that a specific amount would be paid on death during this period. Where this is the case, the premium payment would be quite different, and such payment is usually arranged through an embedded term assurance cover.
Similar treatment to immediate annuity takes place if death occurs during the annuity payment period.
5.0 Tax treatments
The next point to look at is the way life insurance and annuities are treated for tax purposes.
Money is not accumulated under a term assurance policy, so no payment is made if the policyholder remains alive. Conversely, a whole life policy has cash values and policy loan attraction. However, the cash value is not taxed unless it exceeds the premiums paid when the policyholder is making a withdrawal. Similarly, death benefits under a whole life and term assurances are not taxed.
When someone buys a deferred annuity plan, he is actually accumulating cash towards future income benefits. The premiums paid during the accumulation period therefore serve as “tax deferred benefits.” When payment of annuity income commences later in the future, the annuitant pays tax only on the investment income aspect of the annuity; in which case the benefit is treated as an unearned income.
Similarly, immediate annuity is regarded as a tax deferred benefit, but only in the early payout years. It is also treated as an unearned income hence tax is imposed only on the investment income aspect of the annuity benefit.
6.0 When the plans are bought
Finally, we can differentiate life insurance and annuity policies by looking at the typical ages when they are bought. This differentiation should also help the insurance marketers out there who may be finding it difficult to identify the age brackets of those prospects who may be interested in life insurance or annuity products.
Generally, people between the ages of 20 and 34 years usually find term assurance to be attractive. This is the period when they are very young, active, and probably undertaking a number of risky ventures. The product is very cheap hence quite affordable for them. Tendency is for the people of this age brackets to take term assurance policy today and consider a more permanent product later in life. Old age or retirement doesn’t normally cross their minds at this stage so annuity may not be attractive to them or, if attractive, they may conclude that it can be purchased at a later date.
Whole life insurance would typically become attractive to those who are within the 35-60 age brackets because of their maturity and better appreciation of their responsibilities.
Deferred annuity is usually effected by those within the age band of 40-65, while immediate annuity often falls in the good books of those who are in 55-80 age brackets.
I should however point out that there is no hard and fast rule to this issue. Life insurance or annuity has to do with humans, and we all have our individual circumstances and preferences.