The Basics of Annuity Part I : Different Types & Differences with Insurance

What is an annuity contract?

An annuity is a contract under which insurer promises to make a series of periodic payments to a named person in exchange for a premium or a series of premiums.

Historically, only insurance companies were allowed to issue, sell annuities because issuing annuities requires specialized expertise, and involve considerable financial risk. Today however banks, stockbrokers are allowed to sell annuities but only insurance companies can issue annuities.

Three Factors contributing to popularity of Annuities:

1. Concerns about future of Social Security
2. Increasing population in the age group of 50 also known as baby boomers.
3. Good performance of stock market prompted people to do financial planning using annuities.

Two major difference with Life Insurance:

1. Annuities protects against the risk of ‘living too long’ or living so long so as to deplete all the money that has been saved to serve for old age.
2. Annuities provide a simple method of providing retirement income. It is a very good retirement funding product.

Parties to an annuity contract: Insurer and Contract Owner

The contract owner can be a real person or maybe an entity such as a trust, partnership or corporation. A non-human contract owner is also known as non-natural owner.

Annuitant: Person whose lifetime is used to measure the length of time annuity payments are payable under the annuity contract. It has to be a person because his life is used to measure the life expectancy.

Payee: Person who receives the annuity payments.

Beneficiary: Person or legal entity that receives the death benefit.

Types of Annuities:

Based on when payments begin:

1. Immediate Annuities: Payments generally are scheduled to begin one annuity period after the date on which the annuity was issued. An annuity period is the time span between each of the payments in the series of periodic annuity payments. The period could be a month, quarter, half-yearly or annually.

2. Deferred Annuities: Periodic Payments are scheduled to begin more than 1 annuity period after the date on which annuity was purchased.

A contract owner can usually change the date on which payments will begin before the first payment is done.

Accumulation Period: Time period between the date that the contract owner purchases the annuity and the date the payments begin is known as the accumulation period.

Payout Period: Once payment begins, the annuity is said to be in payout period.

Based on how premiums are paid:

Single Premium Annuities: Purchased by the payment of one lump sum premium.

Single Premium Immediate Annuity (SPIA): Converts one lump some money say lottery win/ retirement money, into an income stream within one annuity period.

Single Premium Deferred Annuity (SPDA): Converts one lump some money which is held by insurer until when the insured decides of receiving payments. Most insurers accept additional premium or window premium during 1st contract year.

Flexible Premium Annuities: The contract owner pays premium periodically over a stated period of time. The premium is however is set between a maximum and minimum.

Contract owner may choose not to pay any in a year but if paying should follow the limit.

Based on Tax deductions:

Qualified Plans: Employee sponsored retirement plans that satisfy complex legal requirements of the Internal Revenue Code and ERISA and provide favorable tax benefits to employer and employees. Qualified Annuities are purchased to fund/ distribute funds from a tax-qualified plan and are exempt from taxation during accumulation period.

Non-Qualified Plans: Does not receive all tax advantages afforded qualified annuities.

Based on how the Annuity Premium is invested:

Fixed Annuity: Annuity premiums are deposited in insurer’s General account, the general fund of assets invested to support the insurer’s traditional insurance products. Insurer guarantees to pay a specified rate of interest on accumulated value – the net amount paid for the annuity plus interest less any withdrawal or fees.

Variable Annuity: Annuity premiums are deposited in a separate account, an investment account maintained separately from an insurer’s general account to help manage the funds placed in variable insurance products also known as segregated accounts in Canada. May include sub accounts, investment funds that allow the insurer to place variable annuity premiums in a wider variety of investments. Generally offers no guarantees and contract owner retains the risk associated with sub account investments. The amount of contract’s accumulated value and periodic annuity payments vary based on performance of pool of investments.

Based on Payout period options:

Straight Life: Periodic payments only as long as the annuitant lives.

Life Income with period certain: Guarantees that payments will be made throughout the lifetime of annuitant’s or a minimum stated period whichever is larger.

Joint and Survivor Annuity: Series of payments to one or more person and those payments continue until the death of last surviving annuitant.

The Basics of Annuity Articles

The Basics of Annuity Part I : Different Types & Differences with Insurance

The Basics of Annuity Part II : The Annuity Contract

The Basics of Annuity Part Three : Fixed and Equity Indexed Annuities

The Basics of Annuity – Part Four: Variable and Market Value Adjusted Annuities