Life Annuity Guide
The Life annuity hearkens back to the days before annuities were investment vehicles, when the word annuity simply meant a stream of income payments whose duration matched the lifetime of the recipient.
In traditional financial theory, an annuity is a level stream of payments extending indefinitely into the future. In the 19th century, insurance companies began accepting lump-sum payments in exchange for the promise to make lifelong annuity payments to the payee. These contracts eventually took on the name of the payment stream that was the object of the contract. When specialized forms of annuity began to limit the payment period, the traditional form was renamed a life annuity to distinguish it from those newer varieties.
Life Annuity Distribution
A life annuity is a plan for distributing funds provided to the insurance company by the annuity holder(s). In its classic form, a life annuity provides level, regular, lifelong payments to the holder. The contract terminates with the holder’s death and any undistributed funds revert to the insurance company. Since the annuity payout is geared to the life expectancy of the holder, the insurance company bears the risk that the holder’s life will exceed expectancy and reaps the reward of early death; the law of large numbers guarantees that the former and latter will cancel out over long periods. (Improving technology and increasing life expectancy requires frequent actuarial updating to maintain this balance.)
Numerous variations on this basic model have taken precedence over it. Most annuities now have death-benefit provisions allowing the holder to designate one or more beneficiaries. In the event of the holder’s death, the beneficiary would receive a minimum of all undistributed premiums, less any partial withdrawals. Various ways of sweetening the death benefit all carry a price tag in the form of higher annuity-expense charges. A period-certain annuity requires payment of annuity benefits for a designated time period; the beneficiary (or the estate) receives the payments if the holder dies.
Another variation involves multiple annuitants. A Joint-and-life annuity pays until the first annuitant dies; a joint-and-survivors annuity pays until both annuitants die. An impaired-life annuity is potentially important for a holder whose life expectancy drops dramatically during the life of the annuity contract; the terms allow for a commensurate increase in payout as compensation.
Buyers of a Life Annuity
Security is uppermost in the mind of the life annuity buyer. This is only logical. Consider the classic case of an immediate life annuity. The buyer owns a capital sum sufficient to support annuity payments for the remainder of his or her life expectancy and pays that money to the insurance company in exchange for the promise of lifetime annuity payments. The insurance company is contractually obligated for those payments and must therefore invest the money safely. The company chooses to invest in high-grade corporate or government securities. The annuity payments the buyer receives cannot embody a greater return than that provided by fixed-income securities. Since the buyer originally had the option of buying individual stocks, mutual funds or bond funds, what will make him or her satisfied with this lesser yield? Only a strong preference for the greater safety, security, and stability that the annuity will provide.
Not surprisingly, provision for retirement is the main purpose behind purchase of a life annuity. The internal investment logic of the previous paragraph supports this, because somebody with no source of employment income will be willing to trade the possibility of a higher return for the security of a stable, certain income. The external incentives facing annuity buyers also favor retirement saving as the number one motivation. Withdrawals by holders younger than age 59 ½ are subject to 10% penalty under the IRS code. Surrender charges imposed by insurance companies on early withdrawals from deferred annuities are another incentive to delay annuity distribution until retirement.
Immediate-annuity purchasers are excellent candidates for the life annuity distribution. These may be recent retirees whose private savings comprise the purchase payment for the annuity, company employees who choose to roll over their qualified plan into an immediate life annuity, employers who elect to fund their company pension using immediate annuities for their employees, or even governments who transform unfunded retirement-system liabilities into private pensions via purchase of immediate life annuities. (Immediate life annuities are very popular in Chile, a country that has privatized its public retirement system. In the U.K., individuals are required to annuitize company pensions by age 75.)
With the introduction of deferred annuities, the life annuity principle has been broadened to encompass fixed, variable and indexed varieties as well. This jibes with fixed annuities, which are relatively conservative investment vehicles, analogous to fixed-income investments; and also with indexed annuities, which are close to fixed annuities in their protection of investor principal. Indeed, many indexed annuities are also single-premium, immediate annuities.
Variable annuities, which are a growth-oriented, higher-risk investment vehicle, may seem oddly juxtaposed with life annuities. Actually, it is reasonable that risk tolerance should vary with age and wealth, so that the same investor might hold high-risk equities until retirement, then opt to annuitize in retirement.
Don't Just Shop, Implement a Solid Retirement Strategy
Purchasing an annuity is a big decision. Online research is a good start, but prudent investors should discuss all their options and risks with an independent financial advisor. Request a free, no-obligation consultation today, along with a report of current rates on brand-name annuities.Speak with an advisor over the phone about annuities for FREE.
Tax Consequences of Life Annuities
Annuities allow for tax-deferred growth of investment proceeds, which can be a significant benefit to holders of deferred annuities during the accumulation phase. During distribution, however, the worm turns. Annuity distributions are taxed as ordinary income. A distribution will usually consist partly of (untaxed) return of principal and partly of taxed investment gain. Although it is often true that individuals occupy lower income-tax brackets in retirement than while employed, tax rates on earned income are currently much higher than those on (say) capital gains. Thus, the enhanced security of a life annuity may have a price tag in the form of higher taxation during retirement than would be true with some alternative investments, such as mutual funds.
Guarantee and Regulation of Life Annuities
The fact that life annuities provide guaranteed income for life does not relieve buyers of the necessity to investigate the soundness of the guarantee, which rests of the financial soundness of the issuing insurance company. At least four major rating agencies regularly provide evaluations of life-insurance companies for the convenience of annuity buyers.
The regulatory status of annuities depends on whether the investment risk of the annuity is assumed by the insurance company (making the annuity exempt from securities regulation under the “safe harbor” provision of the Securities Act of 1933) or by the annuity holder (making the annuity a security, subject to federal securities regulation under the 1933 Act and required to provide a prospectus). Seemingly, this is determined by the contract provisions governing the investment or accumulation phase of the annuity, if there is one. Thus, variable annuities and some indexed annuities (all of them after January, 2011) are securities, while other annuities are not.
Click Here to start a detailed comparision to determine if life annuities are the best instrument to meet your retirement goals. A licensed specialist will provide a free consultation and quote report.