Video: Annuities Explained
Dec. 23, 2016
What is an 'Annuity'
An annuity is a contractual financial product sold by financial
institutions that is designed to accept and grow funds from an
individual and then, upon annuitization,
pay out a stream of payments to the individual at a later point in time. The
period of time when an annuity is being funded and before payouts begin is
referred to as the accumulation
phase. Once payments commence, the contract is in the annuitization
BREAKING DOWN 'Annuity'
Annuities can also be created to turn a substantial lump sum into a steady cash flow, such as for winners of large cash settlements from a lawsuit or from winning the lottery.
Types of Annuities
Annuities can be structured according to a wide array of
details and factors, such as the duration of time that payments from the
annuity can be guaranteed to continue. Annuities can be created so that, upon
annuitization, payments will continue so long as either the annuitant or
their spouse (if survivorship benefit is elected) is alive. Alternatively,
annuities can be structured to pay out funds for a fixed amount of time, such
as 20 years, regardless of how long the annuitant lives. Furthermore, annuities
can begin immediately upon deposit of a lump sum, or they can be structured as
Annuities can be structured generally as either fixed or
annuities provide regular periodic payments to the annuitant. Variable
annuities allow the owner to receive greater future cash flows
if investments of the annuity fund do well and smaller payments if its
investments do poorly. This provides for a less stable cash flow than a fixed
annuity, but allows the annuitant to reap the benefits of strong returns from
their fund's investments.
One criticism of annuities is that they are illiquid.
Deposits into annuity contracts are typically locked up for a period of time,
known as the surrender
period, where the annuitant would incur a penalty if all or part of
that money were touched. These surrender periods can last anywhere from 2 to
more than 10 years, depending on the particular product. Surrender
fees can start out at 10% or more and the penalty typically
declines annually over the surrender period.
While variable annuities carry some market risk and
the potential to lose principal, riders and features
can be added to annuity contracts (usually for some extra cost) which allow
them to function as hybrid fixed-variable annuities. Contract owners can
benefit from upside portfoliopotential
while enjoying the protection of a guaranteed lifetime minimum withdrawal
benefit if the portfolio drops in value. Other riders may be purchased to add a death benefit to
the contract or accelerate payouts if the annuity holder is diagnosed with a
terminal illness. Cost of
livingriders are common to adjust the annual base cash flows for
inflation based on changes in the CPI.
Who Sells Annuities
Life insurance companies and investment companies are the two sorts of financial institutions offering annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk – that is, the risk of dying prematurely. Policyholders pay an annual premium to the insurance company who will pay out a lump sum upon their death. If policyholders die prematurely, the insurer will pay out the death benefit at a net loss to the company. Actuarial science and claims experience allows these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit. Annuities, on the other hand, deal with longevity risk, or the risk of outliving ones assets. The risk to the issuer of the annuity is that annuity holders will live outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.
Agents or brokers selling
annuities need to hold a state-issued life insurance license, and also a
securities license in the case of variable annuities. These agents or brokers
typically earn a commission based on the notional
value of the annuity
Who Buys Annuities
Annuities are appropriate financial products for individuals
seeking stable, guaranteed retirement income. Because the lump sum put into the
annuity is illiquid and subject to withdrawal
penalties, it is not recommended for younger individuals or for
those with liquidity needs.
Annuity holders cannot outlive their income stream, which hedges longevity
risk. So long as the purchaser understands that he or she is trading a liquid
lump sum for a guaranteed series of cash flows, the product is appropriate.
Some purchasers hope to cash out an annuity in the future at a profit, however
this is not the intended use of the product.
Immediate annuities are often purchased by people of any age
who have received a large lump sum of money and who prefer to exchange it for
cash flows in to the future. The lottery winner's
curse is the fact that many lottery winners who take the lump sum windfall
often spend all of that money in a relatively short period of time.
CASH REFUND ANNUITY
DEFINITION of 'Cash Refund Annuity'
An annuity contract that
returns funds back to a beneficiary in
the event that the annuitant dies
too early. A cash refund annuity
has a provision which stipulates that if the annuitant passes away before the
annuity payments received
equal the annuity
payments made, the insurance company will pay the difference to
the beneficiary. Some variations might include the addition of interest earned
on top of the difference.
BREAKING DOWN 'Cash Refund Annuity'
Annuities are used to guarantee a constant stream of income
over a specified period of time. Depending on the annuity features, the
payments will either continue or stop when you die. In a cash refund annuity,
your beneficiary receives a lump sum. For example, assume a retiree purchases
an annuity for $100,000, and receives $60,000 in annuity payments before
passing away. The beneficiary, in this case, would receive $40,000 as a lump
sum cash refund from the insurance company. An installment refund annuity would
return the $40,000 in payments over a period of time instead of a lump sum.
IMMEDIATE VARIABLE ANNUITY
An immediate variable annuity is an insurance product where
an individual pays a lump sum upfront for payments that begin right away. The
payments from an immediate variable annuity continue for the lifetime of the
annuity holder, but the amounts fluctuate based on the performance of an
BREAKING DOWN 'Immediate Variable Annuity'
The immediate variable annuity is unique in that most annuities have payouts that begin after an accumulation phase and that end when a specified age limit is reached. The immediate variable annuity skips the accumulation phase by having the holder contribute a lump sum, and then starts in the annuitization phase. Immediate variable annuities are less common, but can make sense particularly when the investor is older and worried about outliving his or her savings.
WHOLE LIFE ANNUITY DUE
A financial product sold by insurance companies that
requires annuity payments at the beginning of each monthly, quarterly or annual
period, as opposed to at the end of the period. A whole life annuity due is a
type of annuity that will provide the annuitant with payments during the
distribution period for as long as he or she lives. After the annuitant passes
on, the insurance company retains and funds remaining. Annuities are usually
purchased by investors who want to secure some type of income stream during
retirement. The accumulation period occurs as payments are being made by the
buyer of the contract to the insurance company; the liquidation period occurs
when the insurance company makes payments to the annuitant. Also called annuity
BREAKING DOWN 'Whole Life Annuity Due'
Annuities are financial products that are often purchased as part of a retirement plan to ensure income during the retirement years. Investors make payments into the annuity, and then, upon annuitzation, the annuitant will receive regular payments. Annuities can be structures to make payments for a fixed amount of time, commonly 20 years, or make payments for as long as the annuitant and his or her spouse is alive. Actuaries work with the insurance companies to apply mathematical and statistical models to assess risk when determining policies and rates.
The time between the end of the business day of the first
business day and the end of the business day of the second business day. The
valuation period refers to variable annuities. Annuities are financial products
that provide an income source in retirement. Variable annuities are annuity
products that provide annuity payouts based on the current value of the
BREAKING DOWN 'Valuation Period'
The contract value of a variable annuity depends on the performance of the investments. The owner of the annuity can choose the investment vehicles and allocate certain percentages or amounts towards various investment products. A variable annuity offers the potential for greater earnings (and larger payouts) but at the same time involves more risk than other annuity products such as fixed deferred annuities.
YEARS CERTAIN ANNUITY
An insurance product that pays the holder a monthly income
for a specified number of years. A years certain annuity is similar to other
annuities because they are generally used to provide a steady income during
retirement, but differ by providing income for a predetermined amount of time
regardless of how long the annuitant lives. This differs from a life annuity
which provides payouts for the remainder of the annuitant's life and, in
certain cases, the life of the annuitant's spouse.
BREAKING DOWN 'Years Certain Annuity'
A years certain annuity typically involves larger monthly payouts, but this type of annuity is less common than a life annuity. A years certain annuity may be more appealing to individual who will have another source of income during retirement (such as another annuity or other retirement plan). A years certain annuity would be risky if it were the only retirement income because the annuitant could outlive the monthly payment period and be forced to spend the remaining retirement years on a reduced income.
MORTALITY AND EXPENSE RISK CHARGE
BREAKING DOWN 'Mortality And Expense Risk Charge'
Any time an insurance company offers an annuity to someone, it must make assumptions about uncertain factors (such as the life expectancy of the annuitant) and the likelihood of uncertain events actually occurring; it must also provide the annuitant with peace of mind via lifetime payout options for the future and fixed insurance premiums. The insurance company prices these risks inherent to the structure of an annuity as accurately as possible and packages it into a dollar value charge for the annuitant.
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