Annuity Basics: What are the different kinds of annuities
and how are they different?
By John L. Olsen, CLU, ChFC, AEP
If you’re like most people, you find the subject of annuities confusing. Just the terminology would befuddle anyone – “exclusion ratio”, “annuitization”, “indexed”, “cap rate”, “participation rate”, etc. As if that weren’t enough, the terms are not applied uniformly. Some writers about annuities refer to the kind that produces an income immediately after purchase as an “immediate annuity”; others call it a “payout annuity”. “Equity index annuity” and “fixed indexed annuity” are used almost interchangeably to refer to the same type of contract. And some writers use “hybrid annuity” to describe a fixed index annuity while others use that term to denote an annuity that includes long term care benefits.
One of the biggest sources of confusion about annuities is the fact that some writers on the subject make broad, sweeping statements about “annuities” without specifying the types of annuities they’re talking about. Example: “Annuities have high fees”. This statement is at least arguably true when applied to variable immediate or deferred annuities, but is false if applied to immediate or deferred fixed annuities, because fixed annuities typically impose no annual fees.
In this article, we’ll attempt to dispel the confusion by arranging the annuity types in a logical format, using industry standard definitions, and describing them in terms of how they work. But first, we need to clarify what is meant by the word “annuity”.
What does “annuity” mean?
Strictly speaking, the word "annuity" refers to a series of payments over time in which both principal and interest are spread over the payout period. That’s what is meant in tax law by the phrase “amounts received as an annuity”. But there are also annuity contracts – legal agreements between an insurance company and a buyer to guarantee an income, either immediately (an “immediate annuity”) or at some future date (“deferred annuity”). It is these annuity contracts that most people are thinking of when they use the word “annuity” and it’s these annuity contracts that we’ll be talking about in this article.
Parties to the annuity contract
Issuer – The insurance company that issues the contract (Commercial annuities are always issued by insurance companies).
Owner – The person or entity that owns the contract, may exercise all rights to it (e.g.: changing the beneficiary, and surrendering or making distributions from it), and bears the income tax liability for taxable distributions.
Beneficiary – The person or entity who will receive any death benefit upon the death of the owner (or, in the case of “annuitant-driven” annuities, the annuitant).
Annuitant – The person (it must be a human being) whose age and sex (for non-Period Certain annuities) determines the amount of each annuity payment. Annuity payments may be payable to the annuitant if the owner requests it, but the tax liability will be that of the owner.
Types of annuities
An Immediate Annuity is a contract for income. The income must commence within one year of purchase and will persist for either a specified period or for the life or lives of the annuitant(s).
The Period Certain annuity pays an income for a period selected by the owner. If the annuitant dies before the end of the Period Certain, payments will continue, to the beneficiary, for the remainder of that period.
A Life Annuity pays an income for the lifetime of the annuitant, or, in the case of two annuitants (a “Joint and Survivor” annuity), so long as either annuitant is alive.
A Life Annuity with No Refund (“Life Only annuity”) pays an income until the annuitant (or surviving annuitant) dies, at which point the annuity expires without value, even if death occurs shortly after issue.
A Life Annuity with Refund pays an income for the greater of the annuitant’s lifetime or the expiry of the refund feature. The refund feature may be either a Period Certain (e.g.: 10 years) or a Cash or Installment Refund (where payments will persist for the greater of the annuitant’s lifetime or until the entire purchase payment has been paid out.
A Deferred Annuity is so named because payout may be deferred, at the option of the owner, often to as late as annuitant’s age 90 or 95. Deferred annuities have two phases:
The Accumulation Phase - from contract issue until “annuitization” (the point at which the contract owner elects to take payout under an annuity payout option, such as “Life Only” or “Life and 10 Year Certain”).
The Payout (or Annuity) Phase – from annuitization until the death of the annuitant (or expiry of the refund feature, if any). In this phase, the contract acts like, and is taxed exactly as, an immediate annuity.
“Annuitant-Driven” and “Owner-Driven” annuities
Deferred annuities may be either “annuitant-driven” or “owner-driven”. (Neither has any applicability to immediate annuities). An “annuitant-driven” contract will pay a death benefit upon the death of the annuitant. An “owner-driven” contract pays a death benefit upon the death of the owner. But a contract is not either one or the other, because all contracts issued since January 18, 1985 must be “owner-driven” because Internal Revenue Code (IRC) Section 72(s) requires that deferred annuities issued after that date must pay out upon the death of the owner. Some deferred annuities are also “annuitant-driven. That is, they will pay a death benefit if either the owner or the annuitant dies. Some annuitant-driven contracts (especially variable ones) offer a guaranteed minimum death benefit, which may be greater than the annuity’s cash value. In such cases, that guaranteed minimum benefit is payable upon the death of the annuitant. At the death of the owner, the death benefit is typically the contract’s cash value.
Immediate vs. Deferred Annuities
Annuities, either immediate or deferred, may be variable or fixed.
Variable Immediate Annuities provide for an annuity payment (annually or more frequently) for the life of the annuitant (variable “period certain” annuities are rarely purchased). The amount of each year’s payment varies with the investment performance of the investment accounts chosen by the owner. Investment accounts are similar to mutual funds, and may be invested in stocks, bonds, real estate, and other investment types.
Fixed immediate annuities differ from variable immediate annuities because the amount of each annual payment is fixed, either level or increasing by a set percentage each year. As with variable immediate annuities, most fixed immediate annuities are life annuities (paying out for the annuitant’s lifetime), but few are life only (where payments cease at annuitant’s death, even if that occurs shortly after purchase); the most common type is “life and 10 year certain”, paying for the greater of the annuitant’s lifetime or ten years.
Variable deferred annuities are similar to mutual funds “wrapped” inside a deferred annuity contract. During the accumulation period, contributions to the annuity are placed in “separate accounts” chosen by the purchaser. These accounts may be invested in stocks, bonds, real estate or other types of investments. The value of each separate account can, and usually does, vary from day to day. There is no guarantee of principal or of minimum investment return.
At any time after the first contract year, the owner may elect to receive the contract value in regular annuity payments. (This election is called “annuitization”). The payments may be fixed in amount (under any of the regular annuity payment options, such as “life only”, “life & 10 year certain”, etc.) or may vary with the investment performance of the separate accounts chosen (under any of annuity payment options available under this “variable annuitization”). Variable deferred annuities typically assess annual fees that may range from less than 1% to more than 2.5% per year, or more if an optional “guaranteed lifetime income” rider is chosen.
Fixed deferred annuities, like variable deferred annuities, have two phases (“accumulation” and “payout”), but in the accumulation phase, the two types are very different. Fixed deferred annuities guarantee both principal and a minimum interest crediting rate. They rarely impose any annual fees unless an optional “guaranteed lifetime income” rider is elected. Although up-front sales charges are rare in both fixed and variable deferred annuities, both types usually impose surrender charges. There are two types of fixed deferred annuities:
“Declared Rate” fixed deferred annuities guarantee both principal and a minimum annual interest crediting rate for the life of the contract; nearly all of them offer in addition, a current, non-guaranteed, interest. Typically, this current rate is declared annually, although some “multi-year guaranteed annuities” (“MYGAs”) guarantee the current rate for 2 or more years. MYGAs often impose surrender charges only for the same period of time as the current interest rate guarantee.
“Indexed” deferred annuities differ from “declared rate” contracts only in how current interest is calculated and credited. In an index annuity, interest is calculated based on the positive performance (growth) of an external equity index (often, the S&P500®). Because it’s a fixed annuity, an indexed annuity guarantees principal, except to the extent that principal may be invaded by surrender charges (discussed below); thus, only the upward movement of the equity index or indices chosen will affect contract value. A decline in that index (or indices) will not cause a decline in the annuity’s cash value.
Consumers should not expect that an index annuity will capture all of the gain in the underlying index; the amount of such gain that will be recognized and credited to the annuity varies from contract to contract. Obviously, no insurance company can afford to pass to its annuity contract holders 100% of index gain while guaranteeing that they will not suffer any loss when the value of that index declines. Typically, insurers limit the amount of index-linked interest they will credit (and their own liability to pay such interest) by the use of several mechanisms (often called “moving parts”). The most common are “participation rate” and “interest rate cap”.
The participation rate is the percentage of gain (usually, but not always, annual gain) that will be paid in the form of interest. Example: An index annuity has a current participation rate of 60%. If the index gains 15% in a given year, the annuity will be credited with 9% (15% x 0.60 = 9).
The cap rate is the maximum amount of index-linked interest that will be credited in a given period. Example: The annuity has a cap rate of 5%. The annuity will be credited with interest equal to the percentage of growth in the index over the crediting period (often, but not always, a contract year), not to exceed 5%.
Often, these two mechanisms will be used in combination. Example: An annuity has a 60% participation rate and a cap rate of 5%. The index advances by 10% in the crediting period. The annuity will be credited with 5% (10% x 0.60 = 6%, but the cap of 5% applies.
The actual interest crediting formulas used by issuers of index annuities can be a lot more complicated than these examples. Readers who are thinking about purchasing an index annuity should do so only when they fully understand how that annuity works, how it credits interest, and – most especially – the surrender charges (if any) that it imposes, and when those charges are waived.
Surrender charges are imposed by most, but not all, deferred annuities (Immediate annuities generally impose no surrender charges because most immediate annuities cannot be surrendered for cash). It is vitally important that prospective buyers fully understand the impact of these charges on the deferred annuity’s cash surrender value, when they’re imposed, and when they’re waived. Some critics of annuities assert that surrender charges are wholly unattractive, that they always work to the buyer’s disadvantage. This is neither accurate nor fair. Let’s look, now, at how they work, and then why they exist in the first place.
Surrender charges are a penalty for withdrawing from or surrendering a deferred annuity early. They are applied according to a schedule. Most, but not all, surrender charges decline over time. Example: Year 1 = 10%, Year 2=9%, etc. until Year 11 = 0%. Usually, the charge is imposed on a surrender or withdrawal exceeding a certain “penalty free” percentage of contract value (most commonly, 10%). Thus under the schedule above, a withdrawal of $25,000, representing 25% of the annuity’s value in year 5 would be subject to a surrender charge of $13,770 (6% of 90% of $25,000). That same withdrawal, if made in year 8, would be $6,750 (3% of 90% of $25,000). Often, the surrender charge is waived if the contract owner is confined to a nursing home. Usually (but not always), the surrender charge is waived at death.
Why do these charges even exist? They exist to reimburse the insurance company for the loss it sustains if a deferred annuity is surrendered (either partially or fully) before it has recouped the “acquisition costs” of that annuity. It costs money for an insurance company to put an annuity (or life insurance policy, for that matter) into force. It must pay a commission to the selling agent and costs of processing the annuity application and issue. In addition, the insurance company must set aside statutorily required “reserves” (to ensure that it has the funds to redeem the contracts that it sells), which must be invested very conservatively, at very conservative (low) interest rates. Over time, the insurance company will recoup these costs from its “interest rate spread” (the difference between what the company earns from investing the annuity premium and what it credits to the contract owner). This is why surrender charges generally declines over time.
In the absence of surrender charges, the insurance company would have to find some other way of recouping losses from contracts surrendered early. It could impose a front-end sales charge; most consumers are unwilling to pay sales charges, which is why contracts imposing them are rarely sold. Alternatively, it could impose annual fees or credit interest at a less than competitive rate. Neither alternative is attractive to buyers. Or, recognizing that its losses from early surrenders come only from contracts surrendered early, it could recoup those losses only from those very contracts (which are surrendered early). By choosing this last alternative, the insurance company is free to invest the annuity premium at longer-duration bonds paying higher interest than shorter-duration bonds, from which profit it can credit interest at a competitive rate.
Thus, surrender charges may be seen as benefits to the buyer, resulting in a higher rate of interest than would be possible without those surrender charges. But they’re also serious restrictions on the liquidity of the money invested (how readily the annuity cash value can be converted to actual cash). Buyers of deferred annuities should not put money into those contracts if that money may be needed within the surrender charge period. Some agents will object to that last sentence, pointing to the “penalty-free surrender amount” (typically, 10% of the cash value). But the author’s experience (more than forty years in the annuity business) tells him that even when a consumer knows that he may need early access to the money he invested in an annuity, he’s unlikely to know the exact amount. Consequently, I suggest that one should never put money into a deferred annuity that may be needed within the surrender charge period. A deferred annuity is a long term savings instrument and that’s how it should be used. (One notable exception is the “MYGA” (multi-year guaranteed annuity). These contracts usually have short surrender charge periods and typically guarantee a rate of interest for that entire period.
But what about taxes?
In the workshops and classes I teach, I often remark that “one good thing about deferred annuities is that they get tax deferral (that the interest earned is not taxed until it is distributed in a withdrawal or surrender); one bad thing about them is that they get tax deferral”.
That’s not merely a lame joke. It’s a recognition that tax advantages always come with a cost. In the case of deferred annuities, the “cost” of tax deferral is twofold:
- All distributions from any annuity, whether taken during lifetime or after death, to the extent that they’re taxable, are always taxed as “Ordinary Income” (just like interest on a Certificate of Deposit); no annuity distribution is ever eligible for capital gains treatment.
- Distributions taken prior to the annuity owner’s age 59 ½ will be subject to a 10% penalty tax (10% of the distribution that is includible in income) unless an exception applies. You can find the exceptions at
What does this mean? It means that, in this author’s opinion, if your goal is long term wealth accumulation, such as saving for retirement, a deferred annuity can be a very useful and powerful tool; but it’s a very poor instrument for short term savings (with the possible exception of those MYGAs).