Annuity

The term annuity (from Latin annus, a year), in current use in the insurance industry, refers to two very different types of legal contracts with very different purposes. Traditionally, for at least four hundred years, the term annuity referred to what is more correctly called today an immediate anuity. This is an insurance policy which makes a series of either level or fluctuating periodical payments, made annually, or at more frequent intervals, either for a fixed term of years, or during the continuance of a given life, or a combination of lives. The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings. A common use for an immediate annuity might be to provide a pension income to a person who is about to retire.

Deferred Annuities
The second usage for the term annuity came into its own during the 1970s. This contract is more correctly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings. Note, this is different from the immediate and is the cause of much confusion when people discuss annuities without carefully defining which type of annuity they have in mind.

Under the heading of deferred annuities are contracts which may be similar to bank certificates of deposit (CD) in that they offer the buyer a safe interest rate of return on their money, or to stock index funds or other stock funds, where the growth of the account is dependent upon the performance of the market. All varieties of deferred annuities have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.

To complete the definitions here, a deferred annuity which grows by interest rate earnings alone is correctly called a fixed deferred annuity. A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is correctly called a variable annuity. In the last ten years a new category of deferred annuities have emerged, called equity indexed annuities (EIAs). These policies are a hybrid of the two types of deferred annuities just described. The EIA offers a guarantee that the account value will never drop below the initial amount invested while also offering a chance to participate in the upside potential of any increase in the value of a major stock market index, such as the S&P500 or Dow Jones Industrial Average.

By law an annuity contract can only be "manufactured" by an insurance company. They are distributed by, and available for purchase from, duly licensed bank, stock brokerage, and insurance company representatives. Some annuities may also be purchased directly from the "manufacturer," i.e., the insurance company writing the contract.

In a typical immediate annuity contract, an individual would pay a lump sum or a series of payments (called premiums) to an insurance company, and in return receive a fixed income payable for the rest of their life. The exact terms of an annuity product are drawn up in legal terms in a contract. We should mention that the term "annuity" is also used in finance theory to refer to any stream of fixed payments over a specified period of time. This usage is most commonly seen in academic discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money concepts.

Payment options
In technical language an annuity is said to be payable for an assigned status, this being a general word chosen in preference to such words as "time", "term" or "period," because it may include more readily either a term of years certain, or a life or combination of lives. The magnitude of the annuity is the sum to be paid (and received) in the course of each year. Thus, if £100 is to be received each year by a person, he is said to have "an annuity of £100." If the payments are made half-yearly, it is sometimes said that he has "a half-yearly annuity of £100"; but to avoid ambiguity, it is more commonly said he has an annuity of £100, payable by half-yearly instalments. The former expression, if clearly understood, is preferable on account of its brevity. So we may have quarterly, monthly, weekly, daily annuities, when the annuity is payable by quarterly, monthly, weekly or daily instalments. An annuity is considered as accruing during each instant of the status for which it is enjoyed, although it is only payable at fixed intervals. If the enjoyment of an annuity is postponed until after the lapse of a certain number of years, the annuity is said to be deferred. If an annuity, instead of being payable at the end of each year, half-year, &c., is payable in advance, it is called an annuity-due. The holder of an annuity is called an annuitant, and the person on whose life the annuity depends is called the nominee.

Upon immediate annuitization, a wide variety of options are available in the way the stream of payments is paid. If the annuity is paid over a fixed period independent of any contingency, it is known as an "annuity with period certain", or just annuity certain; if it is to continue for ever, it is called a perpetuity; and if in the latter case it is not to commence until after a term of years, it is called a deferred perpetuity. An annuity depending on the continuance of an assigned life or lives would commonly be called a life annuity, but also known as a life-contingent annuity or simply lifetime annuity; but more commonly the simple term "annuity" is understood to mean a life annuity, unless the contrary is stated. The payments can also be paid over the lifetime of the nominee(s) or for a fixed period, whichever is longer. This is known as "life with period certain".

A hybrid of these is when the payments stop at death, but also after a predetermined number of payments, if this is earlier: known as a temporary life annuity. The difference with the period certain annuity is that the period certain annuity will keep paying after the death of the nominee until the period is completed.

Life annuities
A life or lifetime immediate annuity is most often used to provide an income in old age, i.e. a pension. This type of annuity may be purchased from an insurance company.

This annuity works somewhat like a loan that is made by the purchaser to the issuing company, who then pay back the original capital with interest to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the investment relies on cross-subsidy. Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will support those living longer.

Deferred Annuity
There are two phases to a deferred annuity. The accumulation phase is the time between initial purchase and annuitization. The annuitization phase starts when the annuity is turned into a stream of payments. Before annuitization, additional purchase payments, known as premiums, may be made. In a deferred annuity, the goal is to invest the premium payments in either guaranteed accounts or variable accounts and earn investment returns. These returns can then be withdrawn when desired depending on the features of the contract.

A wide variety of features have been developed by annuity companies in order to make their products more attractive. These include death benefit options and living benefit options.

Deferred annuities in the United States have an advantage that all capital gains are tax deferred until withdrawn. In theory, this allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when a variable annuity is inherited the beneficiary must pay capital gains tax. This is not required for any other kind of investment.

Deferred annuities are criticized and controversial, because they often generate a higher commission then other forms of investment, leading to suspicions or actual cases of conflict of interest. Of particular controversy are surrender charges, in which a certain percentage of the account value is taken by the insurance company as a fee in the case of early withdrawal. The charges may be applicable over a long time frame, say 7 or 10 years. Many of the deferred annuity controversies have come from these products being sold to rather old people, who find their money has been locked up for 7 years, which is inappropriate.

Deferred annuities are usually divided into two different kinds:

* Fixed Annuities offer some sort of guaranteed rate of return over the life of the contract. In general these are often positioned to be somewhat like bank CDs, and offer a rate of return competitive to CD's of similar time frames (with different tax treatments as previously mentioned). However, many fixed annuities do not have a completely fixed rate of return over the life of the contract, but rather a guaranteed minimum rate and a first year "teaser rate". The rate after the first year is often any amount that the insurance company wants to pay, but at least the minimum amount. Unlike most CD's, there are usually some clauses in the contract to allow a percentage of the interest and/or principal to be withdrawn early and without penalty. Normally fixed annuities become fully liquid upon death.

* Variable Annuities allow money to be invested in separate accounts (similar to mutual funds) in a tax deferred manner. Overall their primary use is to allow someone to engage in tax deferred investing for retirement at amounts greater then permitted by individual retirement or 401(k) plans. In addition, many variable annuity contracts offer a guaranteed minimum rate of return (either for a future withdrawal and/or in the case of the owners death), even if the underlying separate account investments perform poorly. These features can be thought of as "buying insurance against the stock market doing poorly". These features attract investors. These products are often heavily criticized as being sold to the wrong persons, who could have done better doing something else, since the commissions paid by this product are often very high relative to other investment products.

There are several types of these performance guarantees, and many times one can choose them a la carte, with higher charges for guarantees that are riskier for the insurance companies. There are guaranteed minimum death benefits (GMDBs), which can be received only if the owner of the annuity contract, or the covered annuitant, dies.

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Also see:
• Debt
• Unclaimed Money
• Structured Settlement
• Creditworthiness
• What is a Loan
• Annual Percentage Rate
• Origination Fee
• Point in a Mortgage
• Bankruptcy

This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Annuity".