Types of Annuities

Annuity is a financial product which has the enhancement of retirement security as its sole objective. Indeed, some experts have argued that annuities should not be seen as life insurance products, but as pure investment contracts, owing to the fact that their sale is not restricted to life insurance companies. This may not be an appropriate position to take because life offices are, indeed, the largest supplier of annuities, and the various forms of guarantees given under the products can only be best offered by insurance companies.

What, then, in a very simple term, is annuity? “An annuity is a contract between an individual and a life insurance company whereby in return for a sum of money, the latter undertakes to provide an income for the individual from retirement to death.” That is one definition. It can also be described as an agreement between a life office and a person, whereby the life office agrees to make a series of regular payments to that person, in return for an advance payment received (premium) from him.

As usual, let me give a quick example. Someone may have some cash available right now and be desirous of providing for his retirement period. Let’s say this man is 50 years old and he plans to retire at age 60. All he needs do is to give that lump sum to an insurance company which will then promise to pay him income from that retirement age of 60 till he dies. That’s a single premium deferred annuity. He can, alternatively, say to the insurance company, “I want you to start paying me annuity from now on.” It then becomes a single premium immediate annuity. This man could end up getting much more than he paid to the company if he is lucky to live long.

Our man can actually start to pay regular premiums to the insurance company from now till age 60. On attainment of that age of 60, it becomes the turn of the insurance company to start “returning” payments to him. You will notice that the word “returning” is in quotes because the company is not simply returning what the man has paid over the years. Rather, it uses the premiums paid by our man to buy annuity benefits for him. These annuity payments would continue to be paid until the man dies. That is regular or flexible premium deferred annuity.

But what if the man dies shortly after the commencement of annuity payments? Well, strictly speaking, annuity is paid to someone who is alive. If he becomes rather unlucky to die too soon, no further payments ought to be made. But life insurance people are good people. They are not cheaters. That is why most annuity payments are guaranteed for a certain period of say, five or 10 years, in any event. Assuming an annuity is guaranteed for five years and the man (annuitant) dies after collecting income for just two years, the balance for the remaining guaranteed period (in this case, the remaining three years) is paid to his dependants (usually as a lump sum). 

Annuity classifications

The annuity market is very wide, but I will again try to give you the basics; starting with the key categories into which the products can fall.  

An annuity can be classified in terms of:

a. Its primary purpose which could be accumulation (for deferred payment starting at a future date) or payout (immediate payment from now)

b.  Nature of its underlying investment – which could be fixed or variable;

c. Nature of commitment given for payout – which could be fixed income, fixed period, or lifetime.

d. Premium payment arrangement – single payment to the insurance company or flexible/regular premium

e. Tax status of the annuity – which could be a qualified or unqualified one.

Getting confused already? I don’t think so. These five classifications are quite easy to understand. But let me expatiate.

 a.       Fixed Annuities

These are the annuities that pay a fixed amount of income. Pure and simple! The insurance company collects your premium and guarantees to pay X amount from a specific date. Irrespective of whatever may happen, from good investment experience to terrible inflation, that X amount is paid periodically as agreed. Who then wins? Well, it depends on where the pendulum swings. If the company’s investment experience is so good that they make more from your premiums than they have promised to pay you as annuity income, kudos to them. You can’t complain. What if inflation renders your fixed income useless? Again, you’ve signed a code of silence.  

If things were so bad that your insurance company lost money compared to what they have promised to pay you; they must still fulfill their promise to you. That’s why the word “insurance” is part of the company’s name. You may also live so long that you eventually get multiples of what you paid as premiums. That’s your good luck. 

What a simple description of fixed annuities! I can go further to talk about indexed fixed annuities, market value adjusted annuities etc. But you may not need those information here. Just get the basics from me. That’s all. 

b.      Variable Annuities

These are annuities that vary in line with the underlying investments into which the company had put your premiums. As an example, if your money had been invested in a specific mutual fund, the amount of annuity you get at the end of the day will depend on the performance of that fund (net of expenses). Most variable annuities do offer different alternative funds so the choice is yours.  

c.       Immediate or deferred annuity

The examples given above should make these two quite clear. For an immediate annuity, you start to receive your annuity income immediately (actually one month after payment of premium to the company). For a deferred annuity, the insurance company starts to pay you at a future date (say, from your retirement date). 

d.      Fixed Period Annuities

Fixed period annuities are paid for a specific period of time, say 10 years. Their payments are not contingent on life or age of the annuitant. Instead, annuity payment becomes a function of the period chosen, the amount of premium paid to the insurance company, and the interest rate the insurance company is comfortable with for that period (i.e. if it is a fixed annuity product). Once payment is made for the agreed period, the flow of income payment to you will stop. Let the annuitant continue to live forever thereafter, the contract would not come to his rescue. That’s a drawback for this type of annuity. 

e.      Lifetime Annuities

The name speaks for itself. A lifetime annuity pays a series of income to the annuitant until he dies. It is the basic traditional form of annuity.  

There can also be a Joint Life annuity covering two annuitants (e.g. husband and wife) where annuity payment continues until the second one of the annuitants dies. Who else can provide this kind of financial product other than an insurance company! 

The amount of income paid to the annuitant (or annuitants) would depend on the age (or ages, if more than one annuitant), the amount of premium paid to the insurance company, and the rate of interest used by the company (if fixed annuity). 

f.        Single Premium Annuities

For single premium annuities, a lump sum is paid to the insurance company which, in turn, promises payment of annuities. Once the lump sum (single premium) is paid, it becomes the responsibility of the insurance company to continue to pay the income to the annuitant as agreed. As can be observed from the examples earlier given, there could be single premium immediate annuity or single premium deferred annuity.

 g.       Flexible Premium Annuities

Flexible or regular premium annuities are those annuities funded over a period of time by periodic premium payments. Periodic premium is paid to the life office for a period of time; say 10 years, following which the company begins to pay annuity income to the annuitant. These series of income are funded from the premiums earlier received together with the accumulated investment returns earned on them. It therefore follows logically that there can only be flexible or regular premium deferred annuities. 

h.      Qualified Annuities

I will simply describe these types of annuities as those that are qualified to enjoy certain tax advantages as prescribed by the laws of the applicable country.

 i.        Nonqualified Annuities

It should be clear from (h) above that nonqualified annuities are the ones that do not enjoy certain tax advantages like their qualified counterparts.

It would be observed from the last two classifications above (h and i) that I’ve tried not to go deeply into the issues of taxation of annuities. This is in recognition of the fact that practice differs from country to country and it would be impracticable to cover every territory here. Suffice to state, however, that annuities generally (whether qualified or nonqualified) enjoy tax advantages on their investment income. The investment earnings of annuities are either treated as tax-exempt or tax-deferred until they are withdrawn.

Key Features.

You will notice that annuity has taken a considerable space in this article. Yes, I told you; it is a wide subject. And don’t forget that I have skipped quite a number of things. But let’s quickly round up by looking at some key features of annuities.

a.       Tax treatment

As earlier hinted, the investment income on annuities enjoys a favorable tax treatment. In addition, you do not pay tax on your annuity investment until the time the insurance company starts to pay you the promised annuities. At that time, your annuity income is treated as earned income and taxed accordingly. The implication of this is that one can put any amount into an annuity plan and it would not be taxed year in year out like some other investments. You only pay tax when you start drawing income.

 b.      Wide investment

A wide array of investment is made available through annuities. You have different investment options that you can exercise most especially if you opt for variable annuities where your money could be invested in mutual funds, real estate, money market etc – depending on what the insurance company is offering. 

c.       Protection

Annuity is usually non-assignable, most especially when you make a single premium payment to the insurance company. Once you pay the premium, it becomes the “property” of your insurance company, so none of your creditors can lay claim to it as part of your investment. The worst they can do is to attack the annuity income that is paid to you, not the amount you have invested. In any case, some countries also have laws that ward creditors off the annuity income too, so you are doubly protected. 

Similarly, you cannot assign your annuity plan to someone else. It is for you, and for you only to enjoy.

 d.      Payment for life

When you buy a lifetime annuity, you have the assurance of regular income throughout your life. Even if you become a Methuselah, you continue to receive income! How come? You may want to know. Well, the concept is very simple. Your lifetime income comes from the amount you paid to the insurance company as premiums, the investment returns they have earned on the money, and the “savings” they have made from the premiums of those who did not live long. These three combined together makes it possible for the company to confidently guarantee to pay you income forever. Don’t forget that there are other thousands, rather millions, of people who have contributed into the common “pot of fund” of the insurance company. Just imagine how much is available to make payments to you. That “pot of fund,” of course, continues to get bigger as more people contribute into it and as the company keeps investing the fund.

 e.      Inheritance money

Can you remember what I said earlier about the guaranteed period of annuities? Good. In the event of death, the balance of annuity payments for the remaining period of guarantee is paid to the beneficiary/dependant, so it becomes part of the inheritance. The beauty of this is that such payment goes directly to the beneficiary. It does not pass through the probate or fall under the purview of the annuitant’s will.

 

 

 

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