An annuity can be defined as a contract which provides an income stream in return for an initial payment.
Immediate annuity
An immediate annuity is an annuity for which the time between the contract date and the date of the first payment is not longer than the time interval between payments. A common use for an immediate annuity is to provide a pension to a retired person or persons.
It is a financial contract which makes a series of payments with certain characteristics:
- either level or fluctuating periodical payments
- made annually, or at more frequent intervals
- in advance or arrears
- duration may be:
- fixed (annuity certain)
- during the lifetime or one or more persons, possibly reduced after death of one person
- during the lifetime but not longer than a maximum number of years
- during the lifetime but not shorter than a minimum number of years
Annuity certain
An annuity certain pays the annuitant for a number of years designated. This option is not suitable for retirement income, as the person may outlive the number of years the annuity will pay.
Life annuity
A life annuity or lifetime immediate annuity is most often used to provide an income in old age (i.e., a pension). This type of annuity may be purchased from an insurance (UK and Republic of Ireland, Life Assurance) company.
This annuity can be compared to a loan which is made by the purchaser to the issuing company, who then pay back the original capital with interest to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant but life annuities are payable until the death of the last surviving annuitant. In order to guarantee that the income continues for life, the investment relies on cross-subsidy. Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will support those living longer (longevity insurance).
Cross-subsidy remains one of the most effective ways of spreading a given amount of capital and investment return over a life time without the risk of funds running out.
Life annuity options
Although this will reduce the available payments, an annuity can be arranged to continue until the death of the last survivor of two or more people. For example, many annuities continue to pay out (perhaps at a reduced rate) to the spouse of the main annuitant after his or her death, for as long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity or survivorship annuity. However, if the annuitant is in good health, it may be more beneficial to select the higher payout option on their life only and purchase a life insurance policy that would pay income to the survivor.
Other features such as a minimum guaranteed payment period irrespective of death, known as life with period certain, or escalation where the payment rises by inflation or a fixed rate annually can also be purchased.
Annuities with guaranteed periods are available from most providers. In such a product, if death takes place within the guaranteed period, payments continue to be made to a nominated beneficiary.
Impaired life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the annuity rate is better (i.e. a higher annuity for the same initial payment).
Life annuities are priced based on the probability of the nominee surviving to receive the payments. Longevity insurance is a form of annuity that defers commencement of the payments until very late in life. A common longevity contract would be purchased at or before retirement but would not commence payments until 20 years after retirement. If the nominee dies before payments commence there is no payable benefit. This drastically reduces the cost of the annuity while still providing protection against outliving one's resources.
Deferred annuity
The second usage for the term annuity came into its own during the 1970s. This is a deferred annuity and is a vehicle for accumulating savings, and eventually distributing them either as an immediate annuity or as a lump-sum payment. Note that this is different from an immediate annuity.
Under the heading of deferred annuities, there are contracts which may be similar to
- bank deposits in that they offer the buyer interest on their money and a guaranteed return of capital, or
- stock index funds or other stock funds, where the growth or shrinkage of the account depends on the performance of the market.
Contracts may also be linked to other investments such as property (real estate) or government bonds, or any combination of the above selected by the investor or his advisors. All varieties of deferred annuities owned by individuals have one thing in common in many jurisdictions: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.
To complete the definitions here, a deferred annuity where the benefits are fixed at outside, either in terms of a lump sum or an annuity, can be called a fixed deferred annuity . A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is called a variable annuity .
By law, an annuity contract can only be issued by an insurance company. They are distributed by, and available for purchase from, duly licensed bank, stock brokerage, and insurance company representatives. Some annuities may also be purchased directly from the issuer, i.e., the insurance company writing the contract.
In a typical immediate annuity contract, an individual would pay a lump sum or a series of payments (sometimes called annuity considerations ) to an insurance company, and in return receive a fixed income payable for the rest of their life. The exact terms of an annuity product are set out in the contract.
In common with other types of insurance contract, both immediate and deferred annuities will typically pay commission to the sales person (or advisor ).
A wide variety of features have been developed by annuity companies in order to make their products more attractive. These include death benefit options and living benefit options.
Investment Considerations
Immediate Annuities
Because immediate annuities generally provide a series of guaranteed payments, the annuity company normally matches its liabilities with government bonds and other high grade bonds, and the market yield available on these bonds largely determines the retail pricing of the annuities. (The companies are usually required by law to invest their funds in this way, to reduce the risk of default.)
These investments are generally regarded as less risky than other investments, such as those linked to the stock market, and probably offer a lower expected return. However fixed annuities do not protect the purchaser against the effects of inflation, which is a material risk.
For many elderly people, the financial risk of living longer than expected and running out of money is a bigger risk than investment risks such as exposure to a falling stock market. Immediate annuities protect against this risk.
Deferred Annuities
Deferred pensions are often used as a savings vehicle by higher rate taxpayers, as in some jurisdictions they get higher rate tax relief on their pension contributions and their fund accumulates without investment returns being subject to tax. The proceeds will be taxed when they are taken as benefits, but maybe at a lower rate. Those in lower tax brackets may be told to avoid deferred pensions because they may not be able to recoup the charges made by the annuity company. (In some jurisdictions, some or all of the proceeds must by law be applied to purchase a pension.) Arguably it is particularly inappropriate to pay pension contributions at a point when one has outstanding debts, eg a mortgage.
Actuarial Considerations
Actuarial Formulae are used to model annuities and determine their price.
Payment options for Immediate Annuities
In technical language an annuity is said to be payable for an assigned status , this being a general word chosen in preference to such words as "time", "term" or "period," because it may include more readily either a term of years certain, or a life or combination of lives. The magnitude of the annuity is the sum to be paid (and received) in the course of each year. Thus, if £100 is to be received each year by a person, he is said to have " an annuity of £100. " If the payments are made half-yearly, it is sometimes said that he has " a half-yearly annuity of £100 "; but to avoid ambiguity, it is more commonly said he has an annuity of £100, payable by half-yearly instalments . An annuity is considered as accruing during each instant of the status for which it is enjoyed, although it is only payable at fixed intervals. If the enjoyment of an annuity is postponed until after the lapse of a certain number of years, the annuity is said to be deferred . If an annuity, instead of being payable at the end of each year, half-year, &c., is payable in advance, it i
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