The first thing to understand about an annuity is that it is, indeed, a contract, a formal, written agreement between an individual and a life insurance company that obligates both to a long term commitment. In return for a commitment by the annuity owner to keep a lump sum of money on deposit for a minimum period of time, the insurer is obligated to secure the deposit, credit it with a rate of interest, guarantee its return at the death of the individual, and then guarantee an income over the life of the annuitant or for a specified period of time.
The idea of a “contract” may scare some people, but, with the depth of obligation skewed toward the life insurer, it tends to work more in favor of the annuity contract holder which is why life insurers continue to experience record inflows to their annuity products. To understand how an annuity contract works is to understand just how much the life insurer is obligated to the annuity contract holder and how they provide such unique benefits. Essentially, an annuity contract is comprised of two phases, an accumulation phase and a distribution phase.
For investors with a longer retirement time horizon, and no need for current investment income, a fixed or deferred annuity can be used to accumulate funds until they are needed. The contract includes an accumulation account to which the insurer assigns a fixed rate of interest. The contract spells out the details of the accumulation phase and all of the requirements and restrictions for the annuity owner.
This establishes how the annuity is to be titled as an asset. In the event of the death of the annuity owner it will also dictate how and to whom the annuity contract is to be transferred .
Each contract specifies a minimum deposit amount that is accepted. Some annuities allow for additional periodic payments.
The terms for crediting interest are outlined including the length of time a rate is guaranteed and how future rates are determined. Annuity rates are usually based on the investment performance of the insurer’s portfolio and credited annually.
Minimum Rate Guarantee:
Specifies the minimum rate of interest that will be credited to the accumulation account. While insurers strive to credit account with competitive rates, a declining interest rate environment could push yields down severely, however, the insurer cannot credit a rate below the minimum guarantee.
These provisions allow for withdrawals to be made from the annuity at any time, however, if done so within a prescribed timeframe known as the Surrender Period, any amount withdrawn in excess of 10% of the value of the accumulation account will be charged a surrender fee. At the end of the surrender period, typically 7 to 10 years, there are no longer any surrender fees.
Aside from the fact that contributions to annuities are made with after-tax dollars, they are treated in the IRC much in the same way as qualified retirement plans. All interest earnings within the accumulation account are allowed to grow without current taxation and will be taxed as ordinary income when they are withdrawn. Also, any withdrawals made prior to the age of 59 ½ are subject to a 10% penalty by the IRS.
The contract includes a death benefit payable to a designated beneficiary. The benefit amount is, at a minimum, equal to the annuity owner’s principal investment.
This part of the contract details the process by which the insurer annuitizes the accumulation account and the requirements and options for the annuity owner. Once a contract is annuitized, the accumulation balance is irrevocably committed to the insurer.
An income option is selected as single life or joint life. If a joint life option is selected, the surviving annuitant will continue to receive payments based on the selected payment terms and payout rate.
This is the length of time, as specified by the annuity owner, that the insurer is obligated to make income payments. It could be for the lifetime of the annuitant or for a specific period of time.
This is the formula that determines the amount of income that will be generated each month and it is based on several factors including the age of the annuitant, the life expectancy of the annuitant (which determines the number of payments), and a minimum rate of interest.
In the event the annuitant dies before life expectancy, a selected refund option will determine the method and the amount of refund of the annuity owners balance will be paid to the beneficiary. Options no refund, cash refund, installment refund, or period certain refund.
Perhaps the most important element of the annuity contract is the financial ability of the insurer to fulfill its contract obligations. Simply put, an annuity contract is only as solid as the financial strength and integrity of the insurer. While an annuity owner has yet to lose any money from an annuity contract, which, in the 150 year history of annuities in this country, is a testament to their safety, companies with the highest ratings have the strongest balance sheets and reserves should be considered before others.