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Annuities can be classified along several dimensions at once: how premiums are paid in, how those premiums are invested, and when and how benefits are eventually paid out.
Ways to classify an annuity: Premium payment method (single vs. periodic) • When income payments begin (immediate vs. deferred) • How premiums are invested (fixed vs. variable) • How proceeds are distributed (pure life, annuity certain, or life refund)
An annuity can be funded with a single premium — one lump-sum payment — or through periodic payments, made in installments over time. Periodic-payment annuities may use a level premium, where the owner or annuitant pays a fixed installment each time, or a flexible premium, where both the amount and timing of each installment can vary.
Annuities can also be classified by when income payments actually start. An immediate annuity is purchased with a single lump-sum payment and begins making income payments within one year of purchase — often as soon as one month afterward. This structure is commonly referred to as a Single Premium Immediate Annuity, or SPIA.
A deferred annuity, by contrast, is one in which income payments do not begin until after one year has passed from the date of purchase. Deferred annuities can be funded either with a single lump sum (a Single Premium Deferred Annuity, or SPDA) or through periodic payments (a Flexible Premium Deferred Annuity, or FPDA); with periodic funding, the amount contributed can vary from year to year, and the longer the annuity remains deferred, the more flexibility the owner typically has in paying premiums.
An immediate annuity is always funded with a single premium. A deferred annuity's income payments begin sometime after one year from purchase.
Nonforfeiture rules require that a deferred annuity carry a guaranteed surrender value the owner can claim if the contract is surrendered before annuitization. A 10% penalty may apply to withdrawals taken before the owner reaches age 59½.
A surrender charge helps the insurer recover the investment value it loses when a deferred annuity is surrendered early. The charge is levied against the cash value and generally declines the longer the contract has been in force — for example, a schedule might charge 7% in the first year, 6% in the second, and then 5%, 4%, 3%, 2%, and 1% in the years that follow, reaching 0% from the eighth year onward. At surrender, the owner receives the premium paid, plus any interest earned, minus whatever surrender charge still applies.
An annuity owner paid $900 in premium, which has accumulated $45 in interest, and the applicable surrender charge is $90. If the annuity is surrendered at this point, the value paid out is ($900 premium + $45 interest) − $90 surrender charge = $855.
Annuities may also be classified as fixed or variable, based on how the underlying premium payments are invested.
A fixed annuity offers a guaranteed minimum interest rate on the funds paid in, and pays a level, unvarying income once annuitized. The insurer guarantees both the dollar amount of each payment and how long payments will last, based on the settlement option the annuitant selects.
Because the payment amount is fixed and known in advance, this is called a level benefit payment amount. The tradeoff is that a fixed annuity's purchasing power can be eroded by inflation over time, since the payment never increases to keep pace with rising costs.
Premiums paid into a fixed annuity are deposited into the insurer's general account, which is invested conservatively — largely in bonds — so the company can safely guarantee both a rate of return and its future payment obligations.
In a fixed annuity, premiums are held in the insurer's general account.
With a fixed annuity, the insurer bears the investment risk. The interest actually credited depends on how well the insurer's general account performs, but that rate can never fall below the contract's guaranteed minimum, typically around 3%. During accumulation, the annuity is credited at whichever is higher: the guaranteed minimum rate, or the insurer's current interest rate. The guaranteed minimum is simply the lowest rate the contract can ever earn.
An equity indexed annuity is a fixed annuity that aims for somewhat more aggressive growth than an ordinary fixed annuity. Like other fixed annuities, it carries a guaranteed minimum interest rate, typically 3% to 4%, but at the end of the contract term it is credited with whichever is greater: that guaranteed minimum, or a current indexed rate tied to a widely followed market index, such as the S&P 500.
Insurers typically retain the first portion of any index gain for themselves, crediting only the excess to the annuitant.
Suppose an insurer retains the first 4% of index gains and credits any amount above that to the annuitant. If the index earns 13% in a given year, the company keeps 4% and credits the annuitant's account with the remaining 9%.
Equity indexed annuities are considered less risky than a variable annuity or a mutual fund, but are expected to outperform an ordinary fixed annuity over time.
| Feature | Fixed Annuity | Variable Annuity |
|---|---|---|
| Interest Rate | Guaranteed by insurer | Not guaranteed |
| Underlying Investment | General account (conservative) | Separate account (equities, not guaranteed) |
| License Needed | Life insurance | Life insurance plus securities |
| Expenses | Guaranteed | Guaranteed |
| Income Payment | Guaranteed | Not guaranteed |
Fixed vs. Variable Annuities
A variable annuity is designed as a hedge against inflation: because the annuitant may earn different rates of return on the funds paid in, its value has room to grow along with the cost of living. Three characteristics define a variable annuity:
Premiums paid into a variable annuity purchase accumulation units in the separate account, much like buying shares of a mutual fund; these units represent an ownership interest in the account. Once the contract is annuitized, accumulation units convert into annuity units, and income is paid based on the value of those units — the number of annuity units received stays level, but the value of each unit continues to fluctuate until it is actually paid out.
A market value adjusted annuity (MVA), also called a modified guaranteed annuity (MGA), is a single-premium deferred annuity that lets the owner lock in a guaranteed interest rate over a set maturity period, typically ranging from 3 to 10 years. In an MVA, the penalty for surrendering the contract early depends on how current interest rates compare to the rate locked in at purchase.
Suppose an owner purchases a 10-year fixed annuity locked in at a 6% rate, tied to a widely used bond-index benchmark. If the owner withdraws the funds after 5 years and the benchmark rate at that time is still 6%, no adjustment applies. If the benchmark rate has since risen to 8%, a penalty is assessed against the owner. If it has instead fallen to 4%, the insurer may actually pay the owner a bonus. The size of the market value adjustment is generally a percentage of the difference between the annuity's contracted rate and the benchmark rate at the time of surrender — the owner shares in the risk of changing interest rates if the contract is surrendered early.
Annuity payment options describe how the funds in an annuity are to be paid out, and closely mirror the settlement options available under a life insurance policy.
A life annuity pays a set amount for as long as the annuitant lives. Under pure life — also called life-only or straight life — payments stop the moment the annuitant dies, no matter how early in the payout period that occurs. This option produces the highest possible monthly payment of any life contingency option, but carries no guarantee that the full amount paid into the contract will ever be paid back out.
Under the life with guaranteed minimum option, if the annuitant dies before the full principal amount has been paid out, the remaining balance is refunded to the beneficiary. This option is also known as refund life, and it guarantees that the entire principal amount will eventually be paid.
Pure life produces the highest monthly benefit, but offers no guarantee that the full principal will be paid out.
Any annuity benefits still unpaid at the annuitant's death are taxable to the beneficiary when received.
A life with period (term) certain option is another life contingency payout: payments are guaranteed for the annuitant's entire remaining lifetime, and also guaranteed to continue to a beneficiary for a specified period if the annuitant does not live that long.
Under a life income with a 15-year period certain option, the annuitant is paid for as long as they live. If the annuitant dies shortly after payments begin, the remaining payments in that 15-year window continue to a named beneficiary for the balance of the period.
A single life annuity covers only one life, with payments made solely with reference to that individual; contributions can be made as a single premium or through periodic premiums, accumulating until the contract is annuitized.
A multiple life annuity covers two or more lives at once. The two most common multiple-life arrangements are joint life and joint and survivor.
Under a joint life arrangement, two or more annuitants receive payments until the first of them dies, at which point payments stop entirely.
The joint and survivor arrangement modifies the life income option by guaranteeing income to two recipients for as long as either one is living. While it is possible for the survivor to keep receiving the same payment amount, most contracts instead reduce the payment once the first recipient dies. This is commonly written as "joint and ½ survivor" or "joint and ⅔ survivor," meaning the surviving recipient receives one-half or two-thirds of the amount that was paid while both recipients were alive. This option is frequently chosen by a couple planning for retirement; as with any life income option, there is no guarantee that the full proceeds will be paid out if both recipients die shortly after payments begin.
In contrast to the life contingency options above, annuities certain are short-term annuities that pay a fixed amount for a fixed period, or until a fixed total sum has been paid out — entirely independent of whether the annuitant is still living.
With the fixed-period option, the annuitant selects the length of time payments will run, and the insurer calculates the size of each payment based on the account's value and its projected future earnings. This option pays for the chosen period only, whether or not the annuitant is alive to receive it.
The fixed-period option pays only for the specific time period selected, regardless of whether the annuitant is living.
With the fixed-amount option, the annuitant instead selects the dollar amount of each payment, and the insurer determines how long that amount can be sustained based on the account's value and projected earnings. This option pays the chosen amount until the funds are exhausted, whether or not the annuitant is alive to receive it.