Define Annuity Contracts
An annuity contract involves one or more people and an insurance company. The universal common feature of annuity contracts is the option of the holder or holders to receive assured lifelong income in the form of regular payments from the insurance company. The source of these payments is investments made by the holder(s), either in a lump sum or in a series of contributions to the insurance company. The investment proceeds grow tax-deferred prior to disbursal. When the proceeds are distributed to the holder, investment gains are taxed as ordinary income.
Certain features are common to all annuities, or at least all deferred annuities. These can be summarized and discussed without differentiating between fixed, variable or indexed annuities. They include:
- Accumulation period – The length of time during which the holder’s investment grows tax-deferred prior to being distributed is specified in the contract. This time period ranges from one to 10 years.
- Surrender charges – Insurance companies need to be able to predict how much money they will have to return to customers prematurely – that is, prior to contractually-specified dates. One means of achieving this is to penalize early withdrawals of annuity investments by imposing charges for doing so, which typically range from 5-10% in the first year and fall to zero within 4-10 years.
- Penalty-free withdrawal feature – Annuities commonly build in a limited measure of liquidity by allowing the holder to withdraw a certain percentage of annuity assets each year. This percentage is often 10%; frequently, it is limited to interest earned on the account.
- Death-benefit feature – Except for an immediate annuity with a simple lifetime distribution feature, annuities have death-benefit clauses insuring that undistributed funds in the account do not revert to the insurance company but are instead passed on to a beneficiary or beneficiaries. (Alternatively, the beneficiary may have the option to accept the terms and ownership of the annuity.) The minimum death benefit will normally be the value of all payments made to the company, minus any partial withdrawals made by the holder prior to death. Various options exist for enhancing the value of the death-benefit.
- Free-look period – As with other insurance contracts, state law typically specifies a time period within which the annuity holder can reverse the purchase decision without penalty. The time period varies between states but periods range from 10 to 30 days.
- Privilege of annuitization – The right to lifelong income is a defining feature of an annuity, but contracts often specify alternative choices. Within the context of annuitization, a wide range of possible distribution options exists. For an immediate annuity, which has no accumulation period and whose distributions begin soon after the contract is signed, this consideration is dominant.
- Means of payment – Holders of deferred annuities agree to make regular payments to the insurance company over time. The contract may allow these to be made by direct debit or salary purchase.
- Cash surrender option – The holder may have the right to surrender the policy for a cash value, the calculation of which will be described in the annuity contract.
- Additional payments – The holder may have the right to make additional payments in order to augment the value of later distributions; the contract will define annuity payments in both timing and magnitude.
- Sales commissions – Commissions paid to sales personnel must be disclosed.
- Underwriting responsibility – Guarantees help define annuity value, but they are only as good as the payout ability of the issuer. The contract names the entity with this specific responsibility.
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Other typical annuity features are specific to the type of annuity under review.
Important contract features of fixed annuities include:
- Size and duration of the guaranteed interest rate – Sometimes insurance companies will offer an unusually-attractive credited interest rate but guarantee the rate only for the first year of the accumulation period. Since the term of the accumulation period will often exceed the length of the initial rate-guarantee period, these provisions are of special interest to holders.
- Bailout provision – A common provision allows holders to cash in the annuity without penalty if the guaranteed rate falls below the initial credited interest rate by more than 1%.
The variable annuity is considered a security. As such, the Securities and Exchange Commission requires information about it to be disclosed in a document called a prospectus. Important features of the prospectus and the variable annuity contract include:
- Enumeration of investment options – The holder is managing the investment account, not the insurance company. Accordingly, it must be important to know what investment options are available and the degree of relative risk they entail.
- Guaranteed minimum interest or accumulation features – In order to put a floor under retirement savings, variable annuities have typically included guaranteed minima, either as part of the contract or as optional riders. The recent evolution of Living Benefit riders has increased the scope and magnitude of these features to include guaranteed lifetime withdrawals and the ability to meld withdrawal and annuitization programs.
- Limitation on the annual number of portfolio alterations – Since active management is a key element of variable annuities, holders should be aware of limitations of the number of free changes they can make in the composition of their portfolios.
- Tax-reimbursement charges – In some states, insurance companies are taxed on the sale of variable annuities and pass those taxes along to holders. Details are included in the annuity contract.
- Management fees – The subaccounts in a variable annuity are the functional equivalent of mutual funds. Like mutual funds, they are costly to manage and administer. The annualized costs are listed in the prospectus, but sometimes labeled vaguely as mortality and expense charges. As with mutual funds, these expenses reduce the holder’s annual return on the account.
Important contract features of indexed annuities include:
- Applicable index – The annuity contract specifies the particular index, such as the Standard & Poor’s 500, used in indexing the investment performance of the accumulation account.
- Participation rate – This feature determines the percentage weighting of the index number in the indexation process, with the maximum being 100%.
- Minimum guaranteed rate – Even though the index might decline over time, the annuity will guarantee this minimum positive return to the holder.
- Administration fees – Although index funds themselves are known for their low fees, the insurance company incurs additional administration costs in massaging the index number and providing guarantees to the holder, which are reflected in these fees and described in the contract.
- Vesting schedule – This schedule describes the timing of possible penalty-free withdrawals by the holder.
- Cap rate – If gains in the index are capped at a maximum percentage rate rather than fully realized in the credited interest rate, this provision explains the process.
- Index-change calculation method – Different methods of calculating the change in the index number, such as the point-to-point, annual reset and high-water mark methods, will yield different index numbers. This will affect the credited interest rate the holder receives. The method used will be stated and explained in the contract.
While not exhaustive, the foregoing features, provisions and options serve to define annuity contracts fairly well in the operational sense.
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