How does an Annuity Work

An annuity contract is an exchange of a single premium or a series of premiums for a single payout or series of payouts. All annuities have a payment period and a payout period. The nature of the payment and payout periods is where the differences reside. The payment period is also known as the ‘accumulation phase’ where deferred annuities are concerned. Since fixed annuities do not allow for accumulation, there is just an initial-payment period.

Annuities are so varied that addressing how they work in a general sense is no easy task. Variable annuities have a different structure from fixed annuities. The difference between deferred and immediate annuities is also significant. However, there are basic similarities that can be addressed in discussing how annuities work.

A very important feature of how annuities work is the size of the contribution. Whether an annuity is fixed or deferred, the cash value at maturity is used to determine the payment or payments that the annuity provider or insurer makes. With deferred annuities, the contributions are allowed to accumulate with an interest rate (fixed or variable) over time. The greater the investment horizon is; the better the accumulation.

With immediate annuities (Single Premium Immediate Annuity or SPIA), the primary determinant is the size of the single premium. In general, annuity payouts are hinged on the size of the contribution(s), the length of the period, the accumulation rate and the number of premium payments made (in cases where the plan is not flexible).

A deferred annuity is a revocable contract whereas an immediate annuity is not. However, deferred annuities normally have either upfront charges (front-end) or surrender charges (back end) or both. Therefore, there may be stiff penalties for either non-payment or surrender of deferred annuities in the accumulation phase.

Once the annuity reaches maturity, the payout phase becomes relevant. At maturity, the insurer determines the payout on the basis of the cash value at maturity, the age and sex of the annuitant and the settlement options that are selected by the policy owner. The payout may be higher or lower with a change in any one of these variables.

The policy owner can choose to take a fraction of the cash value and use the rest to purchase an immediate annuity. Even when a deferred annuity reaches maturity, its cash value is then used to purchase a single-premium annuity. The policy owner has some discretion over whether the full amount is used to purchase the immediate annuity or just part of it. In the payout phase, the deferred annuity becomes irrevocable as well.

The settlement options for an annuity are important in specifying the terms and condition of the payout as it refers to contingent beneficiaries. They include the following:

a) Straight life option
b) Straight life with refund option
c) Straight life option with period certain
d) Joint and last survivor option

Another important feature of how annuities work is the notion of fixed and variable annuities. Fixed or variable annuities could be either deferred or immediate. Both types can have minimum guaranteed interest rates as well. However, fixed annuities offer higher base-guaranteed rates and also a more stable accumulation rate (or declared interest rate) that is premised on prevailing market conditions. Fixed immediate annuities offer stable payouts based on an ‘annuitization rate’.

Variable annuities operate in the manner of a mutual fund, with the pool of funds determined by the contributions to the variable annuity. Sometimes, insurers offer different fund options for policy owners to select. There is supposed to be a greater element of risk and a higher reward with variable annuities. Often, it is the case that policy owners face the higher risk without the promised higher reward. Variable immediate annuities do not fix a payment based on a payout rate but offer fluctuating payouts based on market conditions.

In acquiring knowledge of how an annuity works, it is important to realise that you may not know or discover everything. What you need to focus on is getting adequate amounts of the right information. Knowing the basics of how annuities work can help you to make them work even better for you. If you don’t know how to apply and use the information, you’ll be at the mercy of insurers, annuity providers and their representatives.