In the United States, an annuity is a financial product which offers tax-deferred growth and which usually offers benefits such as an income for life. Typically these are offered as structured (insurance) products that each state approves and regulates in which case they are designed using a mortality table and mainly guaranteed by a life insurer. There are many different varieties of annuities sold by carriers. In a typical scenario, an investor (usually the annuitant) will make a single cash premium to own an annuity. After the policy is issued the owner may elect to annuitize the contract (start receiving payments) for a chosen period of time (e.g., 5, 10, 20 years, a lifetime). This process is called annuitization and can also provide a predictable, guaranteed stream of future income during retirement until the death of the annuitant (or joint annuitants). Alternatively, an investor can defer annuitizing their contract to get larger payments later, hedge long-term care cost increases, or maximize a lump sum death benefit for a named beneficiary..
History 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 Ulpianus is cited as one of the earliest dealers of these annuities, and he is also credited with creating the 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 raise capital to cover the heavy costs of their constant wars and conflicts with each other. At this time, the most popular form of annuities were those offered in the form of a tontine, where the fixed annual payments were shared amongst a dwindling number of surviving members leading to ever increasing payments to the longest lived investors.
One of the early recorded uses of annuities in the United States was by the Presbyterian Church 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 1812, Pennsylvania Company Insurance was among the first to begin offering annuities to the general public in the United States. 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, O. J. Simpson protecting his income from lawsuits and creditors. Ben Bernanke in 2006 disclosed that his major financial assets are two annuities.
General
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 willing parties although typically the intent of these is 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 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).US SEC Answers on Equity-Indexed Annuities 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 FIA'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.