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Annuity (US financial products)

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In the United States an annuity contract is created when an insured
party, usually an individual, pays a life insurance company a single
premium that will later be distributed back to the insured party over
time. Annuity contracts traditionally provide a guaranteed distribution
of income over time, such as via fixed payments, until the death of the
person or persons named in the contract or until a final date, whichever
comes first. However, the majority of modern annuity customers use
annuities only to accumulate funds free of income and capital gains taxes
and to later take lump-sum withdrawals without using the guaranteed-
income-for-life feature.

Although annuities have only existed in their present form for a few
decades, the idea of paying out a stream of income to an individual or
family dates back to the Roman Empire. The Latin word "annua" meant
annual stipends and during the reign of the emperors the word signified a
contract that made annual payments. Individuals would make a single large
payment into the annua and then receive an annual payment each year until
death, or for a specified period of time. The Roman speculator and jurist
Gnaeus Domitius Annius Ulpianis is cited as one of the earliest dealers
of these annuities, and he is also credited with creating the very first
actuarial life table. Roman soldiers were paid annuities as a form of
compensation for military service. During the Middle Ages, annuities were
used by feudal lords and kings to help cover the heavy costs of their
constant wars and conflicts with each other. At this time, annuities were
offered in the form of a tontine, or a large pool of cash from which
payments were made to investors.
One of the early recorded uses of annuities in the United States was by
the Presbyterian Church back in 1720. The purpose was to provide a secure
retirement to aging ministers and their families, and was later expanded
to assist widows and orphans. In 1912, Pennsylvania Company Insurance was
among the first to begin offering annuities to the general public in the
United States. Annuities have continued to grow in popularity and prove
their value over and over as individuals, organizations and businesses
look for secure ways to guarantee retirement income. Some prominent
figures who are noted for their use of annuities include: Benjamin
Franklin assisting the cities of Boston and Philadelphia; Babe Ruth
avoiding losses during the great depression, OJ Simpson protecting his
income from lawsuits and creditors. Ben Bernanke in 2006 disclosed that
his major financial assets are two annuities.


Annuity contracts in the United States are defined by the Internal
Revenue Code and regulated by the individual states. Variable annuities
have features of both life insurance and investment products. In the
U.S., annuity insurance may be issued only by life insurance companies,
although private annuity contracts may be arranged between donors to non-
profits to reduce taxes. Insurance companies are regulated by the states,
so contracts or options that may be available in some states may not be
available in others. Their federal tax treatment, however, is governed by
the Internal Revenue Code. Variable annuities are regulated by the
Securities and Exchange Commission and the sale of variable annuities is
overseen by the Financial Industry Regulatory Authority (FINRA) (the
largest non-governmental regulator for all securities firms doing
business in the United States).
There are two possible phases for an annuity, one phase in which the
customer deposits and accumulates money into an account (the deferral
phase), and another phase in which customers receive payments for some
period of time (the annuity or income phase). During this latter phase,
the insurance company makes income payments that may be set for a stated
period of time, such as five years, or continue until the death of the
customer(s) (the "annuitant(s)") named in the contract. Annuitization
over a lifetime can have a death benefit guarantee over a certain period
of time, such as ten years. Annuity contracts with a deferral phase
always have an annuity phase and are called deferred annuities. An
annuity contract may also be structured so that it has only the annuity
phase; such a contract is called an immediate annuity. Note this is not
always the case.

Immediate annuity

The term "annuity," as used in financial theory, is most closely related
to what is today called an immediate annuity. This is an insurance policy
which, in exchange for a sum of money, guarantees that the issuer will
make a series of payments. These payments may be either level or
increasing periodic payments for a fixed term of years or until the
ending of a life or two lives, or even whichever is longer. It is also
possible to structure the payments under an immediate annuity so that
they vary with the performance of a specified set of investments, usually
bond and equity mutual funds. Such a contract is called a variable
immediate annuity. See also life annuity, below.
The overarching characteristic of the immediate annuity is that it is a
vehicle for distributing savings with a tax-deferred growth factor. A
common use for an immediate annuity might be to provide a pension income.
In the U.S., the tax treatment of a non-qualified immediate annuity is
that every payment is a combination of a return of principal (which part
is not taxed) and income (which is taxed at ordinary income rates, not
capital gain rates). Immediate annuities funded as an IRA do not have any
tax advantages, but typically the distribution satisfies the IRS RMD
requirement and may satisfy the RMD requirement for other IRA accounts of
the owner (see IRS Sec 1.401(a)(9)-6.)
When a deferred annuity is annuitized, it works like an immediate annuity
from that point on, but with a lower cost basis and thus more of the
payment is taxed.

Annuity with period certain
This type of immediate annuity pays the annuitant for a designated number
of years (i.e., a period certain) and is used to fund a need that will
end when the period is up (for example, it might be used to fund the
premiums for a term life insurance policy). Thus this option is not
necessarily suitable for an individual's retirement income, as the person
may outlive the number of years the annuity will pay.

Life annuity
A life or lifetime immediate annuity is used to provide an income for the
life of the annuitant similar to a defined benefit or pension plan.
A life annuity works somewhat like a loan that is made by the purchaser
(contract owner) to the issuing (insurance) company, which pays back the
original capital or principal (which isn't taxed) with interest and/or
gains (which is taxed as ordinary income) 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 insurance company relies on a concept called
cross-subsidy or the "law of large numbers". Because an annuity
population can be expected to have a distribution of lifespans around the
population's mean (average) age, those dying earlier will give up income
to support those living longer whose money would otherwise run out. Thus
it is a form of longevity insurance (see also below).
A life annuity, ideally, can reduce the "problem" faced by a person when
they don't know how long they will live, and so they don't know the
optimal speed at which to spend their savings. Life annuities with
payments indexed to the Consumer Price Index might be an acceptable
solution to this problem, but there is only a thin market for them in
North America.

Life annuity variants
For an additional expense (either by way of an increase in payments
(premium) or a decrease in benefits), an annuity or benefit rider can be
purchased on another life such as a spouse, family member or friend for
the duration of 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 so long as the spouse
survives. The annuity paid to the spouse is called a reversionary annuity
or survivorship annuity. However, if the annuitant is in good health, it
may be more advantageous to select the higher payout option on his or her
life only and purchase a life insurance policy that would pay income to
the survivor.
The pure life annuity can have harsh consequences for the annuitant who
dies before recovering his or her investment in the contract. Such a
situation, called a forfeiture, can be mitigated by the addition of a
period-certain feature under which the annuity issuer is required to make
annuity payments for at least a certain number of years; if the annuitant
outlives the specified period certain, annuity payments continue until
the annuitant's death, and if the annuitant dies before the expiration of
the period certain, the annuitant's estate or beneficiary is entitled to
the remaining payments certain. The tradeoff between the pure life
annuity and the life-with-period-certain annuity is that the annuity
payment for the latter is smaller. A viable alternative to the life-with-
period-certain annuity is to purchase a single-premium life policy that
would cover the lost premium in the annuity.
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 annual payment to the purchaser is raised.
Life annuities are priced based on the probability of the annuitant
surviving to receive the payments. Longevity insurance is a form of
annuity that defers commencement of the payments until very late in life.
A common longevity contract would be purchased at or before retirement
but would not commence payments until 20 years after retirement. If the
nominee dies before payments commence there is no payable benefit. This
drastically reduces the cost of the annuity while still providing
protection against outliving one's resources.

Deferred annuity

The second usage for the term annuity came into being during the 1970s.
Such a contract is more properly referred to as a deferred annuity and is
chiefly a vehicle for accumulating savings with a view to eventually
distributing them either in the manner of an immediate annuity or as a
lump-sum payment.
All varieties of deferred annuities owned by individuals 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.
A deferred annuity which grows by interest rate earnings alone is called
a fixed deferred annuity (FA). 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 called a variable
annuity (VA).
A new category of deferred annuity, called the fixed indexed annuity
(FIA) emerged in 1995 (originally called an Equity-Indexed Annuity).
Fixed indexed annuities may have features of both fixed and variable
deferred annuities. The insurance company typically guarantees a minimum
return for EIA. An investor can still lose money if he or she cancels (or
surrenders) the policy early, before a "break even" period. An
oversimplified expression of a typical EIA's rate of return might be that
it is equal to a stated "participation rate" multiplied by a target stock
market index's performance excluding dividends. Interest rate caps or an
administrative fee may be applicable.
Deferred annuities in the United States have the advantage that taxation
of all capital gains and ordinary income is deferred until withdrawn. In
theory, such tax-deferred compounding allows more money to be put to work
while the savings are accumulating, leading to higher returns. A
disadvantage, however, is that when amounts held under a deferred annuity
are withdrawn or inherited, the interest/gains are immediately taxed as
ordinary income.


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A variety of features and guarantees have been developed by insurance
companies in order to make annuity products more attractive. These
include death and living benefit options, extra credit options, account
guarantees, spousal continuation benefits, reduced contingent deferred
sales charges (or surrender charges), and various combinations thereof.
Each feature or benefit added to a contract will typically be accompanied
by an additional expense either directly (billed to client) or indirectly
(inside product).
Deferred annuities are usually divided into two different kinds:
Fixed annuities offer some sort of guaranteed rate of return over the
life of the contract. In general such contracts are often positioned to
be somewhat like bank CDs and offer a rate of return competitive with
those of CDs of similar time frames. Many fixed annuities, however, do
not have a fixed rate of return over the life of the contract, offering
instead a guaranteed minimum rate and a first year introductory rate. The
rate after the first year is often an amount that may be set at the
insurance company's discretion subject, however, to the minimum amount
(typically 3%). There are usually some provisions in the contract to
allow a percentage of the interest and/or principal to be withdrawn early
and without penalty (usually the interest earned in a 12-month period or
10%), unlike most CDs. Fixed annuities normally become fully liquid
depending on the surrender schedule or upon the owner's death. Most
equity index annuities are properly categorized as fixed annuities and
their performance is typically tied to a stock market index (usually the
S&P 500 or the Dow Jones Industrial Average). These products are
guaranteed but are not as easy to understand as standard fixed annuities
as there are usually caps, spreads, margins, and crediting methods that
can reduce returns. These products also don't pay any of the
participating market indices' dividends; the trade-off is that contract
holder can never earn less than 0% in a negative year.
Variable annuities allow money to be invested in insurance company
"separate accounts" (which are sometimes referred to as "subaccounts" and
in any case are functionally similar to mutual funds) in a tax-deferred
manner. Their primary use is to allow an investor to engage in tax-
deferred investing for retirement in amounts greater than permitted by
individual retirement or 401(k) plans. In addition, many variable annuity
contracts offer a guaranteed minimum rate of return (either for a future
withdrawal and/or in the case of the owner's death), even if the
underlying separate account investments perform poorly. This can be
attractive to people uncomfortable investing in the equity markets
without the guarantees. Of course, an investor will pay for each benefit
provided by a variable annuity, since insurance companies must charge a
premium to cover the insurance guarantees of such benefits. Variable
annuities are regulated both by the individual states (as insurance
products) and by the Securities and Exchange Commission (as securities
under the federal securities laws). The SEC requires that all of the
charges under variable annuities be described in great detail in the
prospectus that is offered to each variable annuity customer. Of course,
potential customers should review these charges carefully, just as one
would in purchasing mutual fund shares. People who sell variable
annuities are usually regulated by FINRA, whose rules of conduct require
a careful analysis of the suitability of variable annuities (and other
securities products) to those to whom they recommend such products. These
products are often criticized as being sold to the wrong persons, who
could have done better investing in a more suitable alternative, since
the commissions paid under this product are often high relative to other
investment products.
There are several types of performance guarantees, and one may often
choose them à la carte, with higher risk charges for guarantees that are
riskier for the insurance companies. The first type is a guaranteed
minimum death benefit (GMDB), which can be received only if the owner of
the annuity contract, or the covered annuitant, dies.
GMDBs come in various flavors, in order of increasing risk to the
insurance company:
Return of premium (a guarantee that you will not have a negative return)
Roll-up of premium at a particular rate (a guarantee that you will
achieve a minimum rate of return, greater than 0)
Maximum anniversary value (looks back at account value on the
anniversaries, and guarantees you will get at least as much as the
highest values upon death)
Greater of maximum anniversary value or particular roll-up
Insurance companies provide even greater insurance coverage on guaranteed
living benefits, which tend to be elective. Unlike death benefits, which
the contractholder generally can't time, living benefits pose significant
risk for insurance companies as contractholders will likely exercise
these benefits when they are worth the most. Annuities with guaranteed
living benefits (GLBs) tend to have high fees commensurate with the
additional risks underwritten by the issuing insurer.
Some GLB examples, in no particular order:
Guaranteed minimum income benefit (GMIB, a guarantee that one will get a
minimum income stream upon annuitization at a particular point in the
Guaranteed minimum accumulation benefit (GMAB, a guarantee that the
account value will be at a certain amount at a certain point in the
Guaranteed minimum withdrawal benefit (GMWB, a guarantee similar to the
income benefit, but one that doesn't require annuitizing)
Guaranteed-for-life income benefit (a guarantee similar to a withdrawal
benefit, where withdrawals begin and continue until cash value becomes
zero, withdrawals stop when cash value is zero and then annuitization
occurs on the guaranteed benefit amount for a payment amount that is not
determined until annuitization date.)
Recently, insurance companies developed asset-transfer programs that
operate at the contract level or the fund level. In the former, a
percentage of client's account value will be transferred to a designated
low-risk fund when the contract has poor investment performance. On the
fund level, certain investment options have a target volatility built
within the fund (usually about 10%) and will re-balance to maintain that
target. In both cases, they are stated to help buffer poor investment
performance until markets perform better (where they will transition back
to normal allocations to catch an upswing). However, there are criticisms
of these programs including, but not limited to, often mandating these
programs on clients, restricting flexibility of investing, and not
catching the upswing of markets fast enough due to the underlying design
of such programs.
Be careful in regard to using GLB riders in non-qualified contracts as
most of the products in the annuity marketplace today create a 100%
taxable income benefit whereas income generated from an immediate annuity
in a non-qualified contract would partially be a return of principal and
therefore non-taxable.

Criticisms of deferred annuities
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Deferred annuities are generally sold by financial professionals, some of
whom may work directly for an insurance company. Most financial
professionals, however, are independent agents of the insurance company,
not employees. The financial professional who sells an annuity collects a
commission from the insurance company. This commission will be a
percentage of the total premium paid by the investor. This percentage can
be as little as 1% and as high as 12%; the average is 6%. Since these
commissions appear high and there are deferred sales charges on
annuities, many financial professionals have criticized annuity products.
The investor will, generally, not pay any of this commission directly to
the financial professional; the commission is paid by the insurance
company to the financial professional up front. The insurance company
will recapture the commission paid to the financial professional through
the fees charged to the customer (in a variable annuity) or the spread in
the interest rate market (for a fixed or fixed indexed annuity). There
are also deferred back-end charges that will be applied if the investor
closes out his or her contract before the agreed-upon time frame, usually
7–13 years. These charges can last for as little as 1 year or as many as
20 years, depending on the type of annuity and issuing company. These
back-end charges concern many financial professionals.
Some annuities do not have any deferred surrender charges and do not pay
the financial professional a commission, although the financial
professional may charge a fee for his or her advice. These contracts are
called "no-load" variable annuity products and are usually available from
a fee-based financial planner or directly from a no-load mutual fund
company. Of course various charges are still imposed on these contracts,
but they are less than those sold by commissioned brokers. It is
important that potential purchasers of annuities, mutual funds, tax-
exempt municipal bonds, commodities futures, interest rate swaps, in
short, any financial instrument understand the fees on the product and
the fees a financial planner may charge.
Variable annuities are controversial because many believe the extra fees
(i.e., the fees above and beyond those charged for similar retail mutual
funds that offer no principal protection or guarantees of any kind) may
reduce the rate of return compared to what the investor could make by
investing directly in similar investments outside of the variable
annuity. A big selling point for variable annuities is the guarantees
many have, such as the guarantee that the customer will not lose his or
her principal. Critics say that these guarantees are not necessary
because over the long term the market has always been positive, while
others say that with the uncertainty of the financial markets many
investors simply will not invest without guarantees. Past returns are no
guarantee of future performance, of course, and different investors have
different risk tolerances, different investment horizons, different
family situations, and so on. The sale of any security product should
involve a careful analysis of the suitability of the product for a given
A controversial practice of insurance sales is the selling of insurance
contracts within an IRA or 401(k) plan. Since these investment vehicles
are already tax deferred, investors do not receive additional tax
shelters from the annuities. Additionally, if the death benefit on a
variable annuity funded with IRA or 401(k) dollars exceeds the account
value, at the death of the policy owner, the beneficiary will be taxed on
the total amount of the death benefit received, thus forfeiting one of
the most significant benefits of a life insurance policy, which is a tax-
free death benefit. The benefit of the annuity contract is the guaranteed
lifetime income that all annuity contracts must have by state law.
Approximately 90% of annuitants, however, have not taken the life annuity
upon retirement. If an investor does not intend to take the life income
option from an annuity contract at retirement he or she may want to
consider a low-cost deferred annuity.
If an investor needs to take lifetime income at retirement, on the other
hand, he or she may want to try to buy an annuity upon retirement or
might consider selecting a 401(k) plan account with an option to buy the
annuity just before retirement.


In the U.S. Internal Revenue Code, the growth of the annuity value during
the accumulation phase is tax-deferred, that is, not subject to current
income tax, for annuities owned by individuals. The tax deferred status
of deferred annuities has led to their common usage in the United States.
Under the U.S. 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 annuity contracts are bought primarily for the
tax benefits rather than to receive a fixed stream of income. If an
annuity is used in a qualified pension plan or an IRA funding vehicle,
then 100% of the annuity payment is taxable as current income upon
distribution (because the taxpayer has no tax basis in any of the money
in the annuity). If the annuity contract is purchased with after-tax
dollars, then the contract holder upon annuitization recovers his basis
pro-rata in the ratio of basis divided by the expected value, according
to the tax regulation Section 1.72-5. (This is commonly referred to as
the exclusion ratio.) After the taxpayer has recovered all of his basis,
then 100% of the payments thereafter are subject to ordinary income tax.
Since the Jobs and Growth Tax Relief Reconciliation Act of 2003, the use
of variable annuities as a tax shelter has greatly diminished, because
the growth of mutual funds and now most of the dividends of the fund are
taxed at long term capital gains rates. This taxation, contrasted with
the taxation of all the growth of variable annuities at income rates,
means that in most cases, variable annuities shouldn't be used for tax
shelters unless very long holding periods apply (for example, more than
20 years).
Also, any withdrawals before an investor reaches the age of 59 are
generally subject to a 10% tax penalty in addition to any gain being
taxed as ordinary income.
In the October 2003 edition of Wealth Manager, an article titled "Photo
Finish" by W. McAfee, Jr. examined the effects of taxation on annuities
relative to other investment vehicles. The author found that annuities
are generally not effective as a tax deferral vehicle and that there are
significant flaws in the use of annuities for financial planning during
the accumulation phase.

Insurance company default risk and state guaranty associations
An investor should consider the financial strength of the insurance
company that writes annuity contracts. Major insolvencies have occurred
at least 62 times since the conspicuous collapse of the Executive Life
Insurance Company in 1991.
Insurance company defaults are governed by state law. The laws are,
however, broadly similar in most states. Annuity contracts are protected
against insurance company insolvency up to a specific dollar limit, often
$100,000, but as high as $500,000 in New York, New Jersey, and the state
of Washington. This protection is not insurance and is not provided by a
government agency. It is provided by an entity called the state Guaranty
Association. When an insolvency occurs, the Guaranty Association steps in
to protect annuity holders, and decides what to do on a case-by-case
basis. Sometimes the contracts will be taken over and fulfilled by a
solvent insurance company.
The state Guaranty Association is not a government agency, but states
usually require insurance companies to belong to it as a condition of
being licensed to do business. The Guaranty Associations of the fifty
states are members of a national umbrella association, the National
Organization of Life and Health Insurance Guaranty Associations (NOLHGA).
The NOLHGA website provides a description of the organization, links to
websites for the individual state organizations, and links to the actual
text of the governing state laws.
A difference between guaranty association protection and the protection
e.g. of bank accounts by FDIC, credit union accounts by NCUA, and
brokerage accounts by SIPC, is that it is difficult for consumers to
learn about this protection. Usually, state law prohibits insurance
agents and companies from using the guaranty association in any
advertising and agents are prohibited by statute from using this Web site
or the existence of the guaranty association as an inducement to purchase
insurance. Presumably this is a response to concerns by stronger
insurance companies about moral hazard.