Understanding Annuities

There are many different annuity products on the market. The key step in understanding annuities is in grasping the underlying principles of the annuity concept.  Annuity products can be divided into three groups. The three basic types of annuity share a common structure: the holder makes periodic payments that are invested and accumulate tax-free over time until a specified future date, at which point the accumulated proceeds are distributed to the holder.

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The Accumulation Phase: How Annuities Generate Income

The important difference between the three different types of annuity is the way in which they generate the bulk of their income. Income generation in the accumulation phase is discussed below for each type.

Fixed Annuity

The fixed annuity is the oldest and most popular type of tax deferred annuity. It gets its name from the provision in the annuity contract that specifies a fixed rate of investment return on the holder’s investment contributions. (This rate of return will normally be guaranteed, but not for the entire duration of the accumulation period.) The contract also specifies the length of the accumulation period, during which the contributions grow and compound tax free. At its conclusion, the distribution period begins and payments to the holder commence.  The amount of these payments is also specified in the annuity contract.

Fixed annuities also offer a death benefit to a beneficiary or beneficiaries named by the holder of the annuity.  The minimum death benefit is the sum of all purchase payments minus any partial withdrawals. Because this feature is analogous to life insurance, annuities are offered by insurance companies.

An important principle of financial management is the matching of assets and liabilities.  Because the annuity creates liabilities of known size and time placement, the insurance company will strive to accumulate assets whose returns match up with those liabilities. It knows when the distribution phase of the annuity will begin and exactly how much it will be liable for at that time. Its actuaries can accurately estimate the death rate for its annuitants in order to estimate its future liabilities in death benefits. By following the course of the economy, it can predict its future liabilities for guaranteed minima in interest rate returns and annuity values with fair accuracy.

In order to create assets that meet these known or estimated future liabilities, the insurance company will invest in securities whose returns are both known and safe.  These securities are mostly government bonds and high-grade corporate debt securities, which offer guaranteed rates of return when held to maturity – barring default. The returns on these investments are what funds the accumulation accounts of annuity holders. By matching the duration of their assets and liabilities, the companies can minimize their risk of operation.

Annuities are notorious for the high surrender charges levied by issuing insurance companies.  These charges exist not only to discourage premature withdrawals of money from the accumulation process but also to improve the predictability of those withdrawals.  Making withdrawals a last resort makes them more predictable by the insurance companies, which enables company planners to meet the demand for withdrawals.

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Variable Annuities

The variable annuity is so-named because the investment returns earned by the holder in the accumulation period are not contractually fixed. Instead, they are tied to investments selected by the holder and whose returns vary according to their marketplace performance. Variable annuities were created in order to allow holders to seek higher rates of return by willingly bearing the risk of greater fluctuation in investment performance.

The three major investment vehicles patronized within variable annuities are stock mutual funds, bond funds and money-market funds. Stock mutual funds purchase the stock of companies and create diversified portfolios; fund shareholders purchase units of these portfolios rather than shares of individual stock per se.  Bonds are debt securities issued by governments and corporations.  Because the bond funds usually don’t hold the bonds to maturity, bond-fund shares fluctuate in value as interest rates change.  Money-market funds hold very short-term commercial securities of banks and corporations; their shares are a good temporary parking place for investment funds.

The distribution phase of the variable annuity operates the same as in a fixed annuity.  The gains of the accumulation period are paid out and taxed as ordinary income.

Even though annuity customers themselves select the investment vehicles whose performance determines the rate of return credited to their accumulation account, insurance companies still help to generate income during accumulation.  In common with fixed annuities, variable annuities offer death benefits and guaranteed minima, which require the insurance company to hold reserves to meet those obligations.  Consequently, the company charges expenses to variable-annuity holders over and above the usual expenses charged to shareholders of mutual funds and money-market funds.

Indexed Annuities

The investment performance of the indexed annuity is linked to fluctuations in some index of financial-market performance, such as the Standard & Poor’s 500. The interest rate credited during the accumulation period will vary according to the market performance of the index. There are, however, several features designed to confine this variation within certain preset boundaries. On the risk-return spectrum, the indexed annuity falls in between fixed and variable annuities.

A contractual formula determines the precise way in which interest is credited to the holder’s account during accumulation. The formula sets a floor underneath the credited interest rate; it guarantees a specified minimum rate even during periods in which the index’s performance falls below that minimum. (Similarly, the guaranteed minimum concept can also apply to the value of the annuity principal itself.) There is a tradeoff in exchange for this benefit - the account does not receive the full benefit of index values during periods of high market performance. A key parameter, the participation rate, determines the percentage of change in index performance that translates into change in the value of the interest rate and annuity value. For example, a participation rate of 75% would permit 75% of the change in the value of the index to be reflected in the interest rate credited to the account. (The participation rate can be changed by the insurance company, but both its upper and lower bounds are fixed by the annuity contract, with the usual lower bound being zero percent.)

Contractually speaking, even the calculation of the index itself is subject to formula. Different methods of computing the index value – such as the point-to-point, high-water-mark or annual-reset methods – will result in different index numbers and different credited interest rates. This choice provides another opportunity to fine-tune the indexed annuity to better reflect the risk preferences of holders.

Once again, understanding annuities is not possible without an appreciation of the purpose served by the expenses charged to the annuity holder by the insurance company. The guaranteed minimum interest rate and account value are a valuable consideration to the holder, but they impose a burden on the insurance company, which must hold reserves to meet these contingencies. The expenses charged to the holder are, in part, invested by the insurance company for this purpose. Similarly, the creation of the special provisions of the indexed annuity is a costly process, as is maintenance of sales and service staff to explain and implement those provisions.  Expenses pay the freight for those services.

Understanding Annuities – Expenses

A final word about expenses is in order. Annuities are so numerous and complex in their features that it is inefficient to allow the lay public to buy annuities without guidance. Insurance companies have a legal, moral and commercial duty to provide qualified personnel to assist in this choice. Compensation to this personnel forms a big part of the expenses for which annuities are justly famous.

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