An annuity is a contract that promises to pay you an income on a regular basis for a period of time you choose, or you may decide to leave your premiums and accumulated values in the contract until a future date, your death, or the contract maturity date (usually age 100). Benefits from an annuity may be distributed in the form of periodic payments, withdrawals, a lump sum, or a death benefit, depending on the contract provisions.
Annuities must be sold by a licensed insurance agent. The agent is your best source for explanation of any contract terms or provisions you do not understand. If you are uncertain of the recommendations made by an insurance agent, or are not sure an annuity is right for you, do not be pressured into signing an application. You may wish to get a second opinion from another licensed agent who does not have a vested interest in your investment decision. If your financial decision will affect other family members, you may also want to include them in your decision process.
An annuity may be classified as immediate, or deferred. An immediate annuity is purchased with a single premium payment and begins income payments at one pay interval (monthly, quarterly, semi-annually or annually) within one year of the purchase date. A deferred annuity may be purchased with periodic premium payments, or a single premium payment, and benefits are distributed at a future time selected by the policyowner, which may include a lump sum payment.
Annuities can also be defined according to their investment configuration, which affects the income benefits they pay. They may be classified as fixed, variable, or indexed annuities.
A fixed annuity guarantees the principle investment and also provides an interest rate that is guaranteed by the contract. The company may pay a higher or current interest rate, but it will never fall below the guaranteed rate. The interest grows on a tax-deferred basis until annuity payments begin or the accumulated fund is otherwise distributed. Premium payments to a fixed annuity may be made in a single lump sum, or in periodic payments.
A variable annuity provides a choice of investment portfolios similar to mutual funds and some may include a fixed interest account. Premiums are usually paid in periodic payments (but can be a single lump sum) and may be allocated to one or more of the investment portfolios, or to the fixed interest rate account. Premiums allocated to the investment options are held in a separate account, as opposed to the fixed interest account where funds are held in the general account of the insurer.
Accumulation values of the investment portfolios are expressed in dollars per unit, and the value of each unit goes up or down depending on the performance of the underlying investments. The contract owner has the opportunity to experience market based gains, but also bears the risks associated with market declines.
Variable annuities are recognized by the Securities and Exchange Commission as an investment. Agents who sell variable annuities must be licensed and registered with the Financial Industry Regulatory Authority (FINRA), in addition to having a life insurance license with the state. The insurance agent is required to provide you with a summary, or a prospectus containing a policy summary, before or at the time the policy is delivered.
An indexed annuity (often referred to as fixed indexed annuities or equity indexed annuities) are deferred annuities that earn interest or provide benefits that are linked to an external equity index, such as Standard and Poor’s 500 Composite Stock Price Index. These annuities pay interest by tracking the performance of the index and paying an interest rate based on the gains in the index. An indexed annuity pays interest based only on the upward movement of a market index - losses in the index are ignored. This means there is no market risk with an indexed annuity.
When the owner of the annuity decides to annuitize the values of his or her annuity, there are several payment options. These include:
Lump Sum - the balance of the annuity account is paid in a lump sum.
Straight Life Income - pays the annuitant a guaranteed income for the annuitant’s lifetime. Upon death of the annuitant no further payments are made.
Life Annuity with Period Certain - guaranteed to pay the annuitant for life, or for a certain period of time, whichever is longer. Period Certain terms are usually 10, 15, or 20 years.
Joint and Full Survivor - provides payment of the annuity to two people. If either of them dies payments continue to the survivor for life. Similar arrangements are Joint and Two Thirds Survivor, and Joint and One Half Survivor.
Cash Refund - provides for a guaranteed income to the annuitant for life. If the annuitant dies before the principal is depleted, the balance is paid to the beneficiary in a single lump sum.
Installment Refund - the same as a Cash Refund except it provides for the funds remaining at the annuitant’s death to be paid to the beneficiary in the form of continued annuity payments - not as a single lump sum.
Income tax on non-qualified annuities is deferred, which means you aren’t taxed on the interest your money earns while it stays in the annuity. During the annuitization or payout period, part of the payments you receive will be considered a return of premium and the other part will be considered interest you’ve earned. You must pay taxes on the part that is considered interest when you withdraw the money. When you die, your beneficiaries may owe income taxes on any death benefit they receive from an annuity that represents interest earned.
Income tax on qualified annuities (i.e. Traditional IRA) is deferred, until withdrawals are taken from the annuity. All proceeds from a qualified taxable annuity are taxable. There is no distinction between principle and interest. When you die, your beneficiaries may owe income tax on their share of the annuity.
Income tax on a qualified Roth IRA is tax deferred and all proceeds are tax free to the annuity owner, annuitant and all beneficiaries upon withdrawal.
Annuities may also be used to fund certain employee pension benefit plans that will defer taxation on plan contributions as well as interest or investment income. Traditional and Roth IRAs may also be funded with annuities. You should consult with a professional tax advisor to determine if these options are right for you.
A 1035 exchange refers to Section 1035 of the Internal Revenue Code which provides that the values of an existing life insurance policy or annuity can be rolled over into a new annuity without incurring income taxation of the proceeds. Your insurance company and agent are familiar with the forms and process to complete a 1035 exchange. If an existing annuity is surrendered, and you or your bank receives the check, and then a new annuity is purchased, you may be in constructive receipt of the annuity assets and subject to taxation.
Funds withdrawn from a deferred annuity before age 59 ½ may be subject to a 10% income tax penalty.
Most annuities allow an annual withdrawal of a percentage of the accumulated value (usually 10%) that is not subject to the surrender penalty, depending on contract provisions.
When replacing an existing annuity or other investment, you should consider all of the advantages and disadvantages of the replacement purchase. These include, but are not limited to: surrender charges, interest rates, riders, management fees, administrative costs, and all other fees. Please ask your agent to explain any fees or costs associated with the purchase of your annuity.
If an agent makes a recommendation that you purchase, replace, or exchange an annuity, the agent must complete a suitability questionnaire before the contract is purchased. The suitability questionnaire form must be signed by the applicant and the agent, and a copy of the form must be presented to the applicant no later than the date the contract is delivered.
Insurance companies selling annuities must allow a “free-look” period during which time you may return the policy for a refund. Fixed annuities must provide an unconditional refund (including any contract fees or charges), for at least 21 days from the date of policy delivery. A 21-day “free look” is also required for variable or market value annuities. The refund is equal to the cash surrender value provided in the contract, plus any fees or charges deducted from the premiums or imposed by the contract, or a refund of all premiums paid. Please review your contract again after it is delivered and ask your agent to clarify any provisions or terms you do not understand.
The cover page of your annuity must contain the following disclosures, if applicable, in bold print and at least 12 point type:
“Please be aware that the purchase of an annuity contract is a long-term commitment and may restrict access to your money.”
“It is important that you understand how the bonus feature of your contract works. Please refer to your contract for further details.”
The interest rate applied to your contract may be subject to change periodically and may increase or decrease, subject to certain interest rate guarantees described in your contract.”
A Prospectus and Contract Summary (for variable annuities) and a Buyer’s Guide are required to be given to you.”
The cover page must also provide contact information for the issuing company, and the selling agent, and the toll-free help line for the Department of Financial Services.
Annuitant - the person upon whose life the annuity contract is payable. The annuitant may or may not be the owner of the annuity.
Accumulation Period - the period between the time a premium or premium payments are made, and income payments start.
Accumulation Units - pertains to variable annuity contracts. Premiums paid to the company, less a deduction for any expenses, are converted to accumulation units and credited to the individual’s account. The value of each unit purchased will go up or down with the market.
Annuity Units - before a variable annuity can be paid out the accumulation units are converted to annuity units. Annuity units are the basic measure and method by which a purchaser’s annuity income is determined. Once the annuitization or payout period begins, the number of annuity units does not change. However, the value of the annuity units will go up or down with the market.
Annuitization or Income Date - a date or age named in the annuity at which time the company begins making annuity payments.
Annuitization Period - the period of time periodic income payments are made.
Beneficiary - the person (named by the policy owner) entitled to receive benefits, if any, upon the death of the annuitant.
Bonus Annuity - pays a premium bonus amount when you buy the annuity or pay a premium, or an interest bonus added to the interest your annuity would normally earn. The bonus or increased interest is usually contingent on a policy condition such as remaining in force for a certain number of years, or annuitization (setting up periodic income payments). Please ask your agent to explain any conditions that must be satisfied to receive the bonus.
Buyer’s Guide - a document prepared by the National Association of Insurance Commissioners that provides information about annuities. The insurer is required to provide a buyer’s guide to each prospective purchaser for fixed and indexed annuities. For variable annuities, the insurer is required to provide a buyer’s guide (if available) or a policy summary, or a prospectus containing a policy summary.
Churning - Using the policy values in an existing life insurance or annuity policy to purchase another life or annuity policy with the same insurer for the primary purpose of generating additional commissions, without a reasonable assumption that the new policy will be much better.
Charitable Gift Annuity - the annuity contract between the insurer, the annuity owner, and the charity. A charitable gift annuity is intended to serve as a gift to a charity rather than income. The policy owner agrees to donate cash, stock, or other assets to a charity. In return, the owner receives a fixed payment (annuity) for life, plus tax benefits. Charitable annuities are not protected by FLHIGA and the donation is irreversible.
Longevity Annuity - also known as a “paid-up” annuity. This type of annuity provides protection against outliving your money late in life. They are usually purchased as a supplemental retirement investment. Once the payout begins, the annuity provides a regular amount of income for the rest of your life. If you die before you begin to receive payments, your heirs would not receive any benefits.
Maturity Date - the date on which the company must repay the principal. This term is most often used with life insurance policies and refers to the date the guaranteed cash value of the policy equals the face amount.
Policyowner - the person or entity that has the right to make changes in the contract. These include the right to surrender the policy and a change the beneficiary. The policy owner may or may not be the annuitant.
Prospectus - this document is prepared by the insurance company and reviewed by the Securities and Exchange Commission. It contains information about the purpose of the annuity, the separate account, the company’s investments and investment strategies. Purchasers of a variable annuity are required to receive a prospectus containing a policy summary, and entitled to a buyer’s guide.
Rider - Annuities may contain riders which add benefits to the contract, usually for an additional cost. An example may be a guaranteed income rider which guarantees a lifetime income regardless of the accumulated value of the annuity.
Twisting - is the practice of inducing a policy owner with one company to lapse, forfeit, or surrender a life or annuity policy for the purpose of taking out a policy in another company.
Surrender Charge - most annuity contracts charge a surrender penalty for withdrawals or surrenders that exceed the penalty free amount available, made during the early years of the contract. Usually the surrender penalty is a percentage of the amount withdrawn. The percentage declines each year until it reaches zero. Your annuity policy will contain a surrender schedule.
You should buy your annuity from an insurance company that is financially sound. There are various ways you can research an insurance company’s financial strength, such as visiting the insurance company’s website or asking your annuity salesperson for more information. You can also review a company’s financial strength rating from an independent rating agency such as A.M. Best Company, Standard and Poor’s Corporation, Moody’s Investor Service, and Fitch Ratings.
If an annuity owner is a Florida resident and the insurance company licensed to sell annuities in Florida becomes insolvent, a fixed deferred annuity will be guaranteed by the Florida Life & Health Insurance Guaranty Association (FLHIGA) for up to an aggregate amount of $250,000. If the contract has been annuitized before liquidation of the company, then the maximum guarantee would be $300,000.
The Guaranty Association covers only policyholders and certificate holders that were valid Florida residents on the date the insurer is declared insolvent and is liquidated. If you are a Florida resident on that date, you may be covered by FLHIGA even if you have subsequently moved to another state.
Portions of a variable annuity that are guaranteed by insurer (fixed interest accounts) are covered by FLHIGA. However portions of a variable annuity that are not guaranteed by the insurer (underlying investment portfolio options) are not covered by FLAHIGA.
You may check to see if your agent is licensed by contacting the Department of Financial Services/Division of Consumer Services.
Agents may have professional designations that indicate they have received additional education or training in areas such as life insurance, annuities, estate planning, and senior benefits. Some of the most common are: Chartered Life Underwriter (CLU); Chartered Financial Consultant (ChFC); FLMI (Fellow Life Management Institute), LUTCF (Life Underwriters Training Council Fellow), and CFP (Certified Financial Planner).