ANNUITIES

Identification

• Annuities are a form of contracted financial obligation. They are offered by financial institutions and either accumulate value, or take an existing value and pay it out over a number of years. The exact definition of an annuity depends on the law of a given country.

Function

• Under Federal law, annuities can only be issued by life insurance companies. However, it is important to realize that insurance regulation is a matter of state law in the U.S., so annuity products available in one state may not be available in another.

  These financial products typically take the form of a payment made in exchange for a string of guaranteed payments to be made after a future date. This model typically includes two phases. The first phase (deferral) features the initial deposit and accumulation of funds into the annuity. The second phase (income) is when the set payments are made, at set intervals and for a set period of time.

Life Annuity

• A life annuity functions like a loan between the purchaser to the insurance company, which pays back the original capital (typically tax-free) with interest/investment returns (this is taxed as ordinary income). The loan period is based on the life expectancy of the purchaser. In order to guarantee that payments continue for the life of every purchaser, the insurance company uses a concept called "the law of large numbers." Simply put, because a given purchaser population can be anticipated to have a statistical distribution of lifetimes around the population's average age, those dying earlier will functionally give up income to support those living longer whose money would otherwise run out. In other words, the math can be arranged so that the balance tilts towards more people dying early, thus creating a profit for the insurance company while guaranteeing that all purchasers receive their guaranteed income. Common variants include payments to be made to a spouse or offspring in the event of death.

Deferred Annuity

• A deferred annuity is a financial product used to accumulate savings for a future pay-out, either as set payments in the form of a more typical annuity, or as a lump sum. There are a plethora of deferred annuity products, but they all have one thing in common: taxes on growth in the annuity are deferred until the pay-out begins. These annuities can either grow based on a fixed interest rate, or based upon investment returns that are variable. The latter type is usually called a Variable Annuity, and will be expanded upon below. This type of financial product has the advantage of allowing capital gains to be compounded before taxation, which is more efficient for long-term growth. This annuities are often sold by an independent salesperson working on behalf of the issuing insurance company, who collects a substantial commission for his participation.

Annuity within a Fixed Period

• Some annuity products guarantee a set series of payments for a fixed, limited period of time. These are useful for people who anticipate having to make a set of payments at a future date. Unlike a Life Annuity, they are for a finite, defined period of time rather than set to a condition (5 years, for example, instead of an event like death). Whereas a Life Annuity is a good choice to fund a private pension, these forms of annuities are more useful in making payments on an education or for funding a different insurance policy.

Variable Annuities and GMWB

• Variable annuities are also known as "mutual funds in an insurance wrapper." It combines some of the characteristics of a fixed annuity with some of the benefits of owning mutual funds. Investor pay a premium to the insurance company, similar to the one that they pay for an annuity, and the insurance company then invests the premium in sub-accounts.

  The Guaranteed Minimum Withdrawal Benefit (GMWB) is the insurance wrapper. A common feature for variable annuities, the GMWB protects the investment against market risk by guaranteeing the annuitant the right to withdraw a percentage of their entire investment each year until entire the initial investment amount has been recovered. For example, if you purchase a variable annuity for $100,000, and a slump in the stock market reduces the value of the investment to $85,000, with a GMWB of 10 percent, you will be able to withdraw $8,500 (10 percent of the actual value of the account) each year until the entire $100,000 (the guaranteed investment) is recovered.