How Annuities Work

Financial institutions and their agents advertise annuities as a means to provide future income. An annuity is a contract with an annuity provider that promises a deferred payment in exchange for a single premium or a series of premiums. Whereas life insurance helps to create an estate, an annuity helps you to liquidate it. The benefits of annuities make them attractive to investors and those wishing to save for retirement. However, to get something to work properly, one usually needs to understand how it works in order to maximize benefits. That also applies to annuities.

♦ Purpose

To understand how annuities work, their purpose should be appreciated. Most annuities are designed to protect annuity investors against longevity risk – the risk of outliving their life savings. In exchange for a payment or series of payments, the provider promises to provide income for as long as you live. In addition, annuities are also used as tax shelters and medium-term income options.

♦ Annuity guarantees and protection

As an income option, annuities typically operate with base guaranteed interest rates – a safety net for the annuity investor. Variable annuities are regarded as the riskiest of the annuity family, but even they normally have base guaranteed rates. In addition, in the event that the annuity fund fails, annuity providers are required to use money set aside in a reserve fund to satisfy their liability to policyholders.

♦ Factors that affect the accumulated fund (yield) of annuities

• Size of payment/ contributions

• Frequency of contributions

• The accumulation rate

• Fees and expenses (for annuities with mutual funds primarily)

• Surrender charges and taxes

♦ The payment and payout phases

Annuities generally have a payment/ contribution or accumulation phase and a payout or “annuitization” phase. The payout phase only occurs when the annuity matures (in the case of a deferred annuity) – after the accumulation phase. In the accumulation phase, annuity investors make premium payments that compound according to the prevailing rate of return or accumulation rate. When an annuity matures, actuaries use an annuitization rate to determine the payouts. This rate is based on factors such as gender and age. The settlement options selected also determine the size of the distributed payout.

♦ Different annuity plans

Annuities, like insurance products, are quite diverse. There are three main dichotomies for annuity products. These determine how a particular annuity contract works. For example, registered deferred fixed annuities exist, as well as immediate variable annuities.

• Immediate vs. deferred

An immediate annuity has no accumulation phase. The insurer accepts a payment and begins the payout phase within one month, according to terms of the contract. The deferred annuity has an accumulation phase and usually requires the annuity investor to stipulate a maturity date.

• Registered/qualified vs. unregistered

Some annuities offer tax benefits because they are registered with the relevant tax authorities. Such annuities are registered or qualified.

• Fixed vs. variable

This dichotomy describes the behaviour of the accumulation rate during the contribution phase. A fixed annuity has a declared interest rate, while a variable annuity’s accumulation rate regularly fluctuates according to fund performance.

♦ Settlement options

When an annuity matures, the annuitization rate and the settlement option chosen affect the payout. Apart from influencing the size of your payouts, the settlement options determine what happens when the annuitant passes away. Those without beneficiaries usually take the straight life option, which yields the highest payout. If a spouse or dependent exists, then the joint and last survivor option would be beneficial. The four main options are:

a) Straight life option

b) Straight life with refund option

c) Straight life option with period certain

d) Joint and last survivor option

Although options b, c and d offer lower payouts than the straight life option, they partially protect the income streams of annuitants for beneficiaries and contingent beneficiaries.

♦ Structured settlements

Sometimes an annuitant has already started receiving payments, but needs a lumpsum now. Instead of waiting for the series of annuity payments, the annuitant and the insurer or annuity provider can agree to a structured settlement. The annuitant would receive a lumpsum less than the accumulated expected payout based on life expectancy.

♦ What annuity providers do not want you to know about how annuities work

While annuities have several benefits, sales representatives tend to de-emphasise certain points about how they work. An annuity provider essentially takes the annuity owner’s after-tax money, invests it and gives him a portion of the return that they get from it. When the annuity matures, they use the accumulated fund, which includes the investor’s accumulated returns, to pay him. However, they retain ownership of a significant portion of the fund if it is used to purchase an immediate annuity. With variable annuities, the providers de-emphasise the impact of the fees and charges on the fund accumulation.

Banks, in particular, have to sell annuities to insurers at the end of the accumulation period. What happens in this case is that annuity investors get low accumulation rates from financial institutions, which have to sell it to an insurer anyway. The annuity investors are the ones who lose most, because they essentially pay the financial institution a hefty, unnecessary middle-man fee.

• Conclusion •

How annuities work is a function of the type of annuity; factors affecting fund accumulation; and the stipulations of the annuity contract. Having a good idea of the options available can help annuity investors to resist annuity peddlers and choose plans that work best for them.