An annuity is a cash contract between an individual and insurance company designed to systematically liquidate tax deferred capital.  Usually, there are three parties involved in the contract; contract owner, annuitant and the beneficiary.  The contract owner funds and controls the contract.  The annuitant receives the payments during the payout phase.  Many times, the contract owner and the annuitant are the same person.  However, they do not necessarily have to be the same party.  The beneficiary is the party that will receive the proceeds from the contract if the owner dies.  Annuities were created by the insurance industry to help clients receive lifetime retirement income, obtain protection against death and utilize professional money management and expertise.

 

Annuities are also a means by which an individual can manage risk of living too long and running out of money.  This has become a serious problem during modern times because of medical advances and better health awareness.  People are outliving their financial resources.

 

Annuities are contracts purchased by an individual in which an insurance company pays out monthly payments based on the total value of the client’s account to be disbursed by an agreed upon date.  The insurance company guarantees the individual that the payments will fill the need to protect against living too long.  Life insurance protects against dying too soon, annuities protect against living too long.

 

There are two phases to an annuity.  The wealth accumulation phase is the period when the client is depositing money into the account.  The second phase is the annuitization or payout phase during which the client withdrawals income from the account.

 

An Annuity pays either a fixed return or a variable return.  During the payout phase, if a client chooses a fixed guaranteed monthly income payment, the insurance company invests in securities based on the period of time that they will be paying out the funds to the client.  The performance risk is assumed by the insurance company.  Fixed annuities are the traditional choice of retirees because of their predictability, stability and guaranteed return.

 

If a client chooses a contract in which their money will grow at a rate based upon the performance of a specified portfolio of securities with no guaranteed, predetermined returns, this contract is known as a variable annuity.  During the accumulation phase, a variable annuity’s value is determined by the market value of the securities in its portfolio.  Most variable annuities offer a general account which pays a fixed rate as well.

 

The client can receive money from the insurance company in several different ways:

 

Life Annuity (Lifetime Income)

The annuitant is guaranteed a lifetime income.  At the death of the annuity, all payments cease and the annuity has no value.  No minimum number of payments is guaranteed.

 

Life Annuity with Period Certain

The annuitant receives a lifetime income but a minimum number of payments are made whether the annuitant lives or dies.  The annuitant receives two guarantees:

  • A certain amount will be paid periodically for the lifetime of the annuitant
  • Should the annuitant die prior to the period certain guarantee being satisfied (usually 5-20 years) the annuitant’s beneficiary will receive the remaining number of guaranteed payments

 

Joint and last Survivor

Periodic payments are guaranteed for the lifetime of two or more annuitants.  Payments continue until the death of the last annuitant.  The joint and survivor option is typically used for a husband and wife seeking a guaranteed joint lifetime income and then a guaranteed life income for the surviving spouse.  Periodic payments are made for the life of one person until his/her death.  Then the survivor becomes the annuitant and payments are made until the death of the survivor.  The periodic payments are usually less to the surviving annuitant.

 

Period Certain

The annuitant chooses a specific period in which they will receive payments.  At the end of the period chosen, payments cease.  A period certain annuitization is sometimes used if a client has a need that can be funded over a predetermined number of years.

 

Lump Sum Payment

The annuitant has the option of receiving the entire value of an annuity in a lump sum or in predetermined periodic amounts.  This allows the annuitant to maintain control of the annuity value, distribution(s), and tax liabilities.

 

Once a payout option is selected, it is irrevocable.  Payments depend on a variety of factors including amount invested, age and income option selected.  Assume a couple both age 70, has $100,000 to annuitize.  Their monthly payments would be as follows:

 

Payout Option                                  Monthly Payment

Lifetime Income (one life)                              $739

Life with 10 Period Certain                             $702

Joint and last Survivor                                    $620

10 Year Period Certain                                     $720

Lump Sum                                                          $0

 

There is no requirement that the payout begin at age 65 or some other age set for retirement programs.  Payouts can be done at any time the client chooses, but always after age 59 ½ to avoid the 10% IRS premature withdrawal penalty.  If the client surrenders the account and the annuity was purchased with after tax dollars, taxes would have to be paid on any earnings at ordinary income tax rates.  If the annuity was purchased with pre-tax dollars (IRA, 401k, 403b, etc) then the client would owe taxes on the entire value.   Annuities are structured to be a retirement income vehicle and withdrawing funds prior to retirement will cause tax consequences.  The money is accessible; however it should be only be withdrawn in cases of severe hardship.