Annuities
The mechanics
An annuity is a contract that liquidates a sum of money over time, protecting against the risk of outliving income (longevity risk). During the accumulation period value builds; during the annuitization (payout) period the insurer makes payments. The owner holds all rights; the annuitant is the measuring life; the beneficiary receives any remaining value.
Types
- Immediate - purchased with a lump sum and payouts begin within one payment period. Deferred - payouts begin later.
- Fixed - guaranteed interest rate, insurer bears investment risk. Variable - funds in a separate account, the owner bears investment risk, requires a securities registration and a prospectus. Indexed - interest linked to an index with caps, floors, and participation rates.
- Qualified (funded with pre-tax dollars, e.g., IRA/403(b)) vs. nonqualified (after-tax dollars).
- Premium structures: single premium or flexible premium.
Payout options
Straight life (highest income, no survivor benefit), life with period certain, installment/refund (guarantees return of the unpaid balance to a beneficiary), joint and survivor, and annuity certain (a set period with no life contingency).
Features and charges
Surrender charges commonly decline over 7–10 years; many contracts allow a free withdrawal percentage each year. Fixed deferred annuities may apply a market value adjustment. A free-look period applies to new contracts.
Traps: a question about the death of the annuitant during accumulation is answered with the contract value paid to the beneficiary; a question about the death of the owner involves ownership transfer. Also remember that the risk of outliving income is what an annuity solves - not dying too soon (that is life insurance).
Worked example: a retiree with $200,000 wants guaranteed lifetime income starting next month - that is a single premium immediate annuity; the payment amount depends chiefly on age, sex (where permitted), assumed interest rate, and payout option selected.