The Advisor's Guide to Annuities, 4th Edition

John L. Olsen, Michael E. Kitces

• Publisher: The National Underwriter Company
• Year: 2014
• ISBN:
  9781939829788
• Topic: Business
• Subtopic: Finance
• Index: Business

The Advisor's Guide to Annuities provides objective, impartial guidance on what annuities can and cannot do, their costs, and what risk-management features annuities offer. All delivered in easy-to-read language.

Chapter

1

Basics of Annuities

What is an Annuity?

The term annuity simply means a series of regular payments over time. In popular usage, however, annuity generally refers to a contract or policy, issued by an insurance company, providing for payment of a regular income by the annuity issuer to the owner, over a specified period or for the life of an annuitant (see the section entitled “Parties to the Annuity Contract”). These contracts, called commercial annuities, are what we will be talking about throughout this book.

Types of Annuities

There are different types of annuities, which are generally classified according to three different parameters:

1. how the annuity is purchased;

2. when annuity payments are to begin; and

3. how the cash value in the annuity is invested.

How the Annuity is Purchased

There are generally two different ways an annuity is purchased. A Single Premium annuity is a contract purchased with a single payment, or premium. No further premiums are required, or even allowable. A Flexible Premium annuity is purchased with an initial payment (to establish the contract) and typically contains a series of premiums that may be paid whenever, and in whatever amount, the purchaser wishes, subject to policy minimums and maximums. While deferred annuities may be purchased on either a single premium or a flexible premium basis, immediate annuities are always purchased with a single premium.

There is very little difference, if any, in the important policy provisions, guarantees, and payout options of the two types, and their tax treatment is identical. The significant distinction is simply that in some instances, contracts offered as single premium cannot receive additional subsequent payments, and therefore do not allow additional contributions under the original contract’s terms—instead, additional money must be deposited to a new annuity contract.

When Annuity Payments Are to Begin

An immediate annuity is one in which regular income—or annuity—payments begin to be made to the owner¹ within one year of purchase. Another label sometimes used to describe an immediate annuity is payout annuity.

A deferred annuity is one in which annuity payments are deferred until later than one year after purchase—perhaps much later. The life of a deferred annuity is divided into two phases:

1. The accumulation phase. This is the period from purchase of the contract until annuitization, during which the annuity contract may grow in value for the crediting of interest (in the case of a fixed annuity) or the change in value of the subaccounts (with a variable annuity). Annuitization is the exercise, by the owner, of a contractual option to begin receiving regular annuity payments, in accordance with an annuity payout option (see the section entitled “Types of Annuity Payouts”). Deferred annuity contracts typically require annuitization by some specified date or age by specifying a maximum annuity starting date or maturity date (e.g., policy anniversary following annuitant’s age eighty-five, or annuitant’s age eighty-five). Newer contracts may permit further deferral of annuitization provided the request is received within a specified period of time prior to the maturity date.²

2. The distribution phase. This is the period from annuitization until the annuity payments cease, which may be at the end of the annuitant’s life or after a specified number of years (see the section entitled “Types of Annuity Payouts”).

Note: It is essential that the advisor understand the difference between an annuity contract’s required annuity starting date (i.e., the date by which annuity payments must commence, absent an election to defer annuitization) and when annuitization is permitted under that contract. In January, 2005, a class-action lawsuit was filed alleging unsuitability, asserting that the deferred annuity purchased by a senior citizen allegedly did not permit annuity payments to begin until the annuitant’s age was 115. However, it appears that age 115 was the contract maturity date, and annuity payments under the contract could start at any time the owner wished to annuitize. In fact, in some contracts a late maturity date is a benefit, allowing an owner to keep the contract in the accumulation phase as long as possible, if that is his/her wish.

There is no accumulation phase in the life of an immediate annuity, as annuity payments typically commence shortly after purchase, and must, by definition, commence within one year. Annuities that are in distribution phase (i.e., deferred annuities that have been annuitized and all immediate annuities) are said to be in payout status.

A third type of annuity, often called a longevity annuity, first appeared in the marketplace in 2007. It is similar to an immediate annuity in that it provides only for income (usually for life); there is no accumulation period. Unlike an immediate annuity, the longevity annuity income does not commence within one year of purchase; rather, it is deferred until a future date, which may be for many years after purchase. Currently, there are two types of longevity annuities: (a) “pure longevity annuities,” which provide no death benefit if the buyer does not live to the annuity starting age and often specify a set starting age and (b) “Deferred Income Annuities,” which often provide both a death benefit and a choice as to annuity starting ages. See Chapter 8 for a detailed discussion of longevity annuities.

How the Cash Value in the Annuity is Invested

A fixed annuity is an annuity in which the contract value is measured in dollars. A variable annuity is one in which the contract value is measured in terms of units—either accumulation units or annuity units, depending upon whether the contract is in the accumulation phase or the distribution phase. In both cases, the value of each unit can—and probably will—vary each business day, according to the investment performance of the separate accounts³ chosen by the contract owner. We will look at how accumulation units and annuity units work shortly. First, however, let’s understand the basic investment difference between fixed and variable annuities.

Fixed Annuities

A fixed annuity may be either immediate or deferred.

Fixed Immediate Annuities

All single premium immediate annuities (fixed or variable) provide an income (annual, semiannual, quarterly, or monthly), either for a specified period or for life. These payout options are described later in this chapter.

Fixed Deferred Annuities

In a fixed deferred annuity, the contract values are guaranteed by the issuing insurance company. These values (discussed below) are all measured, as we’ve noted, in dollars. There is a common misconception that fixed, in the term “fixed annuity,” refers to the rate of interest credited to the contract. This is not correct. While some fixed deferred annuities provide guarantees as to the period during which the current interest rate will be credited, and all deferred annuities provide a guaranteed minimum interest rate that will be credited during the entire accumulation period, the term fixed, when used in reference to fixed annuities, properly refers, not to the interest rate, but to the fact that the contract values are measured in fixed units—namely, dollars.

What are these contract values? In a fixed immediate annuity, or a fixed deferred annuity that has been annuitized, the contract value guaranteed by the issuing insurer is the dollar amount of the periodic annuity payment (which may be payable monthly, quarterly, semi-annually, or annually). In a fixed deferred annuity, there are several contract values:

1. Cash Value. The cash value, or accumulation value, of a fixed deferred annuity is the value on which interest is computed and to which interest is credited. It is generally the sum of all premium payments received, plus all prior interest credited, less any withdrawals (and, in the case of certain qualified annuities, unpaid loan interest). The cash value of fixed deferred annuities is always guaranteed. The cash value of variable annuities is not, except for monies deposited into the fixed account option of such contracts.

2. Annuity Value. The annuity value is the value to which an annuity payout factor will be applied if—and only if—the contract owner annuitizes the contract. In some deferred annuities, this value is identical to the cash value. In so-called tiered annuities (of the type where a higher interest rate is credited to the annuity value than is credited to the cash value) and in contracts providing for an annuitization bonus, the annuity value is higher than the cash value.

3. Surrender Value. The surrender value of a deferred annuity is the cash value, less any applicable surrender charge and market value adjustment (see Chapter 5: Basic Costs of Annuities) that will be paid to the contract owner upon surrender of the contract.

The basic investment difference between fixed and variable annuities is that in a fixed annuity, either immediate or deferred, the contract owner is offered no investment choices within the contract and assumes no investment risk. In a fixed deferred annuity, the cash value, which includes all premium payments and prior interest credited, is guaranteed against loss, as is a minimum interest rate. All fixed deferred annuities also offer a current—nonguaranteed—interest rate. Some, but not all, contracts guarantee the current declared rate for a certain period of time. By contrast, the contract owner of a variable annuity retains an investment risk. (See further discussion below regarding variable annuities.) In a variable immediate annuity, the amount of each year’s annuity payment will vary with the performance of the investment accounts chosen. In a deferred variable annuity, it is essential for the advisor to understand that the guarantees in fixed annuities are only as good as the ability of the issuing insurer to pay them.

Variable Annuities

A variable annuity may be either immediate or deferred.

Variable Immediate Annuities

Like fixed immediate annuities, variable immediate annuities provide regular annuity payments, commencing within one year of purchase. The annuity payout options are typically the same as with immediate fixed annuities. The chief difference is that the annual income in a variable annuity will vary with the performance of the investment accounts chosen. A second difference is that, unlike fixed immediate annuities, variable immediate annuities typically impose an asset management charge that is taken into account by the insurer in declaring the current year’s annuity payment.

Variable deferred annuities work very differently from fixed annuities, in both the accumulation phase and in the distribution phase.

Variable Deferred Annuities

The Accumulation Phase

In the accumulation phase of a variable deferred annuity,⁴ each premium payment purchases, after applicable contract charges are deducted, a number of accumulation units for each investment subaccount chosen by the contract holder. The cash value will vary with the performance of those investment subaccounts; there is no guarantee either of principal or of minimum interest, except for cash values placed in the so-called “fixe...