Single Premium Deferred Annuity
A single premium deferred annuity is a contract between an individual and an insurance company in which the individual provides funds that are invested and later used as the basis for lifelong distributions to the annuity holder. Along with the single premium immediate annuity, the single premium deferred annuity is among the oldest of annuities. Its salient features are deferral of distributions and singularity of payment.
It is very common to defer annuity distributions. There are two reasons behind this: to allow the holder to reach retirement age and to allow funds to accumulate and grow.
Aside from certain specialized uses, annuities are a retirement-oriented investment vehicle. Withdrawals by individuals younger than age 59 ½ are subject to a 10% penalty, as well as taxation at ordinary income rates. Early withdrawals commonly incur surrender charges on a declining scale, with a schedule lasting up to 10 years. Avoidance of these penalties is a powerful inducement to defer distribution of annuity funds. Time allows invested funds to grow at compound rates - another inducement to defer consumption until the future.
The other common rationale for deferral is to allow funds to accumulate; the holder does not possess accumulated funds to purchase a sufficiently generous annuity but can afford regular, periodic contributions over time. By definition, this rationale does not apply to the case of the single premium deferred annuity because the holder has sufficient funds to purchase the annuity in a single payment.
The purchaser of a single-payment annuity has the funds necessary to purchase an annuity possessing a payout of sufficient size. This criterion suggests various sources of demand for this product. On balance, the purchaser is more likely to have a high net worth, if only because this correlates more highly with possession of the aforementioned funds. Asset sales (houses, boats, autos, appliances, etc.) often generate sizable sums, which can be invested tax-deferred in a single premium deferred annuity. Retiring employees may wish to roll over large accumulations into an investment offering conservative growth, protection of principal and the privilege of annuitization. Heirs, suddenly in possession of a significant sum, may use the windfall to secure a guaranteed lifetime income.
Not all single-payment annuities are also deferred annuities. Immediate annuities are purchased in one payment because distributions are intended to follow quickly upon purchase; these annuities are often purchased at retirement using proceeds from qualified plans. The need for immediate income is what distinguishes this case from the preceding ones.
Putting it All Together
Combining the criteria of deferral and singularity produces the profile of a purchaser of a single premium deferred annuity: somebody with a sizable chunk of cash but a desire to spend it later, not now. That person will frequently be in late middle age, but not always – maybe he or she just sold a house or inherited money. That person will probably not be well into retirement, when deferral is both questionable and unnecessary, but might conceivably be recently retired and seeking protected, conservative growth for a limited time, followed by annuitization. That person will definitely not be a young wage-earner with a low net worth and few liquid assets, who would be better advised to split a sudden inheritance between equities, bonds and money-market funds.
Third parties can also be suitable purchasers of the single premium deferred annuity. An employer may find it ideal to meet pension liability funding requirements. Governments, staggering under the burden of unfunded public-retirement-system liabilities, should consider this option carefully.
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One way to appreciate the benefit of the single premium deferred annuity is to visualize it as a qualified plan with no contribution limit. Qualified plans are an excellent way to achieve tax deferred, compounded growth, but contributions are restricted to earned income and severely limited in size. An individual who comes into a large inheritance couldn’t place the money in a qualified plan but could use it to purchase a single premium deferred annuity, thereby shielding future growth from taxation until withdrawal at retirement. An important dissimilarity between the annuity and the qualified plan is that the premium itself will not automatically escape taxation as would earned income deposited into a qualified plan.
Fixed, Variable or Indexed?
Single premium deferred annuities are usually fixed or indexed annuities because the risk-return profiles and preferences of their buyers are likely to dictate these types. For example, consider the profile of an indexed-annuity purchaser: a person who is looking for growth but so anxious to protect principal as to limit upside growth potential. This tends to rule out the young and the very old, who are also the ones least likely to be looking for single premium deferred annuities. It is possible, however, to purchase a single premium deferred annuity with a variable investment portfolio. This would be a good choice for a younger member of the profile group identified above, who also possessed a strong tolerance for risk.
Because the single premium deferred annuity represents a substantial commitment of cash, the annuity contract usually includes a provision allowing withdrawal from or modification of the contract with no penalty, should the holder’s circumstances change drastically. For example, such a provision might allow annuity funds to be used to pay expenses for long-term care or premiums for a life-insurance policy.
The single premium deferred annuity allows an individual to immediately invest a large sum of money for retirement purposes and achieve tax-deferred compound growth, without facing the contribution limitations inherent in qualified plans. This makes it a vital part of the product market for investments.
Its very uniqueness makes it suitable only for some categories of investors, but it also enlarges the degree of benefit received by those individuals.
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