Two Types, Three Varieties

Annuities come in several types and varieties and some are extremely complex; unfortunately, the more complex they are the more opportunity for abuse there is. So, following is a simple breakdown on the Two Types and Three Varieties of annuity contracts.

Type 1. Immediate Annuity

An immediate annuity is one in which regular income payments from the insurance company start within twelve months of the payment of premiums to the insurance company. The immediate annuity is not sold as often as the deferred annuity. There is usually less commission for the insurance agent and consumers are generally unwilling to give up access to their principal.

Type 2. Deferred Annuity

A deferred annuity is one in which premium payments are made and income payments from the insurance company are delayed for more than 12 months from the premium payment date. This could be a single payment or a series of payments over time. More often than not, purchasers of deferred annuities die without ever turning the annuity into an income stream . In other words, it is never actually used as an annuity (a monthly or other regular income payment from an insurance company). It is used as a tax deferred savings account and after the saver has died the income taxes wind up being paid by the beneficiaries at ordinary income rates. Taxation of the growth of the capital is deferred until the income is distributed to the annuitant or beneficiaries. This is the most popular type of annuity, largely due to the fact that it is a way of saving without paying current taxation. It is also more popular with insurance agents because this type typically pays a much higher commission than an immediate annuity according to James P. Pedigo writing in a National Underwriter article, “”Making Income Annuities Irresistible” Feb. 5, 2006 (Immediate annuities) do pay about half the percentage of commission that deferred annuities pay.

Variety 1. Fixed Annuity

A fixed deferred annuity always pays a fixed interest rate that is declared by the Board of Directors of the insurance company, typically on an annual basis although some contracts guarantee the interest rate for longer periods of time. These are known as multi-year contracts. The guaranteed interest will fluctuate based on the frequency of Board actions to reset the interest rate which is stated in the contract. The value of the annuity will not fluctuate with the stock market, only the rate of interest earnings will vary over the life of the contract.

A fixed immediate annuity will make its periodic payments determined by the initial value, the age of the annuitant or the period certain and an interest rate determined at the beginning, the time of annuitization. The payments will be constant over the life of the payout period. A portion of each payment is treated as a return of principal and the other portion is treated as interest on the principal which is taxed as ordinary income. The proportions of each payment are determined by a formula based on the age of the annuitant, the current interest rate environment and the amount of tax deferred accumulations. The proportion between principal and interest will, therefore vary from contract to contract.

There is a quite rare form of fixed immediate annuity that has payments that increase in order to keep up with inflation. If you compare an inflation-adjusted immediate annuity to a plain fixed-rate immediate annuity you would find that for a certain premium payment, the initial income payment will be greater for the plain fixed annuity than for the inflation-adjusted annuity. Due to the time-value of money, the insurance company has to earn more over time to pay you the future increasing monthly check.

Variety 2. Variable Annuity

The account value of a Variable Annuity will fluctuate based on the performance of the underlying investments referred to as separate accounts or sub-accounts. Separate Accounts are essentially the same as mutual funds that are dedicated to providing investment opportunities for variable life insurance and variable annuity contracts. They are not sold outside of the insurance contract. A variable annuity is designed for the investor who is willing to accept financial market risks and expects to receive the higher market returns.

A deferred variable annuity grows income tax deferred the same as a fixed deferred annuity. A potential drawback is that all income from an annuity is taxed as ordinary income (generally a higher rate) and the investor looses the advantage of capital gains treatment (generally a lower income tax rate).

An immediate variable annuity makes regular income payments based on the value of the underlying investments which are unitized. A unit is essentially the equivalent of a share in a mutual fund. The number of units is guaranteed and the distribution from those units is based on the investment performance of the investment units. If they rise in value, so do the income distributions. If, however, they decline in value so will the income distributions. The expectation of a variable immediate annuity is that over time it will go up more than down and the income stream will therefore be able to keep up and maybe out-perform inflation thus maintaining the investors purchasing power over time. That is getting harder to do since annuity companies are raising their fees, which of course, come out of investment performance. This is according to a review by Symetra Life Insurance released this month which says 9 of the 10 largest issuers of variable annuities are raising their fees.

Variety 3. Equity Indexed Annuity

The Equity Indexed Annuity (EIA) is a relatively recent development (the 1990s) and is an extremely complicated contract. The EIA has more moving parts than any of the other annuity varieties. It is, for the present time at least, considered a fixed annuity because it has certain minimum guarantees that dont exist with a variable annuity. A variable annuity, while an insurance contract, is regulated as a security. The SEC has just released an announcement of a new definition that will deem virtually all EIAs securities rather than insurance contracts. This will result in these EIA contracts being subject to the SECs oversight rather than the State Insurance Departments. The new definition will go into effective January 12, 2011. (http://www.sec.gov/news/press/2008/2008-298.htm ) If it is more likely than not that the value of an EIA at maturity will exceed the guaranteed value, it will be considered a security. At present, these contracts can be sold by agents only licensed to sell insurance products. If the change takes place, it will require a securities license to be able to sell these EIAs.

The Equity-Indexed Annuity is a deferred annuity. The EIA’s performance is tied to one or more securities indices like the S&P 500 Index or the NASDAQ Index or several others. In oversimplified terms, if the index goes up during the measuring period (which could be a month or a year or more depending on the contract) more than the guaranteed amount, the contract is credited with a percentage of that excess performance (the investor will never be credited with all of the outperformance). If the index loses money during the measuring period, the investor is credited with whatever the guaranteed amount is in the contract. In theory, this is a pretty good sounding deal ” get more if the markets go up and, supposedly, dont lose any if the markets go down. If it were that simple it would be a good deal. But remember, I as I previously wrote, these are extremely complicated contracts. It has been my observation that many of the people selling them dont understand them, let alone the people buying them.

A Very Brief History

In modern history, the annuity contract was designed to allow an individual to purchase or create their own pension plan if their employer didnt provide one as a part of their employee benefits. The annuity could be purchased by either a single payment or a series of payments. An individual traded some of their savings for a guaranteed income for life, regardless of how long they lived. Of course, in those days, it was typical that a retirement time frame was a very few years. Life expectancy did not go much beyond the retirement age of 65, so a person didnt need to buy a pension that would last for 30 years or so. Those early contracts were strictly fixed annuities. Variable annuities were not invented until 1952.

Today, annuities are primarily tax deferred savings vehicles. With the advancement of the Baby Boomers onto the retirement scene, it looks like annuities are changing again, this time back to something more akin to their original form. These annuities will be driven by the income goals rather than the accumulation goals. The new twist is that they will also have more options because Baby Boomers are accustomed to personalized treatment and the ability to demand certain benefits from the providers of services and get what they want. Insurance companies will have to at least appear to give them that.