The term annuity, in current use in the insurance industry, refers to two very different types of legal contracts with very different purposes. Traditionally, for at least four hundred years, the term annuity referred to what is more correctly called today an immediate annuity. This is an insurance policy which makes a series of either level or fluctuating payments, paid out over a fixed number of years or during the lifetime(s) of one or two individuals, or in any combination of lifetime plus period certain guarantees. The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings. A common use for an immediate annuity might be to provide a pension income to a person who is about to retire.
The second usage for the term annuity came into its own during the 1970s. This contract is more correctly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings. Note, this is different from the immediate and is the cause of much confusion when people discuss annuities without carefully defining which type of annuity they have in mind.
Under the heading of deferred annuities are contracts which may be similar to bank certificates of deposit (CD) in that they offer the buyer a safe interest rate return on their money; to stock index funds or other stock funds, where the growth of the account is dependent upon the performance of the market. All varieties of deferred annuities have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.
To complete the definitions here, a deferred annuity which grows by interest rate earnings alone is correctly called a fixed deferred annuity. A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is correctly called a variable annuity. In the last ten years a new category of deferred annuities have emerged, called equity indexed annuities (EIAs). These policies are a hybrid of the two types of deferred annuities just described. The EIA offers a guarantee that the account value will never drop below the initial amount invested while also offering a chance to participate in the upside potential of any increase in the value of a major stock index, such as the S&P500 or Dow Jones Industrial Average.
By law an annuity contract can only be "manufactured" by an insurance company. They are distributed by, and available for purchase from, duly licensed bank, stock brokerage, and insurance company representatives. Some annuities may also be purchased directly from the "manufacturer," i.e., the insurance company writing the contract.
In a typical immediate annuity contract, an individual would pay a lump sum or a series of payments (called premiums) to an insurance company, and in return receive a fixed income payable for the rest of their life. The exact terms of an annuity product are drawn up in legal terms in a contract.
As well as referring to insurance products, it is common in finance theory to call any stream of fixed payments over a specified period of time an annuity. This usage is most commonly seen in academic discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money concepts.
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Upon immediate annuitization, a wide variety of options are available in the way the stream of payments is paid. If it is paid over the life of the annuitant (the person receiving the annuity payments), it would commonly be called a life annuity, but also known as a life-contingent annuity or simply lifetime annuity. If the annuity is paid over a fixed period it is known as an "annuity with period certain". The payments can also be paid over the lifetime of the annuitant(s) or for a fixed period, whichever is longer. This is known as "life with period certain".
A hybrid of these is when the payments stop at death, but also after a predetermined number of payments, if this is earlier: known as a temporary life annuity. The difference with the period certain annuity is that the period certain annuity will keep paying after the death of the annuitant until the period is completed.
This annuity works somewhat like a loan that is made by the purchaser to the issuing company, who then pay back the original capital with interest to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the investment relies on cross-subsidy. Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will support those living longer.
Cross-Subsidy remains one of the most effective ways of spreading a given amount of capital and investment return over a life time without the risk of funds running out.
Life annuity variants
At a cost to the payments, an annuity can be purchased with addition of another life such as a spouse on whose life the annuity is wholly or partly guaranteed. For example, it is common to buy an annuity which will continue to pay out to the spouse of the annuitant after death, for as long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity.
Other features such as a minimum guaranteed payment period irrespective of death, known as period certain, or escalation where the payment rises by inflation or a fixed rate annually can also be purchased.
Life with period certain annuities are more palatable to people who have accumulated money and would not like to lose all of it if they were to die soon after annuitization. At least the period certain payments will be made to their beneficiary.
Impaired life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the payment for the purchaser is raised.
In the case of a deferred annuity there are two phases of the annuity. The accumulation phase is the time between initial purchase and annuitization. When the annuity is turned into a stream of payments, academically it is known as the annuitization phase. Before annuitization, additional purchase payments, known as premiums may be made. In a deferred annuity, the goal is to invest the premium payments in either guaranteed accounts or variable accounts and earn investment returns. These returns can then be withdrawn when desired based on the features of the contract.
A wide variety of features have been developed by annuity companies in order to make their products more attractive. These include death benefit options and living benefit options.
Because immediate annuities generally give a series of guaranteed payments, they are priced consistently with other guaranteed investments, such as government bonds. These are less risky than other investments, such as the stock market, and offer a lower expected return. Sometimes annuities are based on investments expected to give a better return, and the risk of these may vary from funds that incorporate some form of protection (for example by purchasing derivatives) through to pure equity funds based on shares alone. At the riskiest end of the market where the fund is not held in trust, the annuity provider risks going bankrupt and possibly defaulting on the policy, as happened in Japan in the 1990s.
A collection of algebraic shortcuts known as annuity functions are used to model annuities, as well as a variety of other financial arrangements.
In the USA tax code, the growth of the premium during the accumulation phase is not subject to current income tax. This is referred to as being tax deferred. Perhaps the tax deferred status of deferred annuities has led to their common usage in the United States. Under the US tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments (annuitization), and many of the contracts are bought primarily for the tax benefits rather than to get a fixed stream of income.
In the United Kingdom, the income from Compulsory Purchase Annuties purchased with pension funds or by an employer immediately on retirement (a 'Hancock annuity) is treated as taxable income. The income from Purchased Life Annuities, bought by any other means, has an element which is considered return of capital, and only the excess over this is considered a gain that is subject to income tax. The element considered capital return is based on life expectancy and will therefore increase with age.
Because of cross-subsidy and the guarantees an annuity can give against running out of income and becoming dependent on state welfare in old age, annuities often have a favourable tax treatment, which may affect how attractive they are relative to other investments.
Immediate annuities are a compulsory feature of certain pension saving schemes in some countries, where the government grants tax deductions, provided that savings are paid into a fund which can only (or mainly) be withdrawn as an annuity. The United Kingdom and the Netherlands have such schemes. From 2003 the tax deduction in the Netherlands is only allowed if, without additional savings, the old age income would be less than 70% of the current income.
In the UK contributions into pension savings are generally free of income tax, up to certain limits. Although a number of different regimes exist, personal pension funds taken out since 1988 must use at least 75% of the fund to purchase an annuity by the 75th birthday of the annuitant. If an annuity is not immediately purchased retirement income up until this age can be drawn from the fund by using Pension Income Withdrawal formerly (and still frequently called) Income Drawdown. This operates under a strict code of rules and limits according to age and figures said by the Government Actuarial Department to prevent the fund being eroded too fast. Individuals may vary withdrawals between 35% and 100% of a maximum limit, that is reset every three years – known as the triennial review. Income Drawdown carries both the investment risk of the invested pension fund and mortality drag that occurs from the loss of cross subsidy and advancing average age expectancy that occurs in the time over which annuity purchase is delayed.
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