WHAT IS AN ANNUITY?

An annuity has one basic purpose — to provide a series of payments over a period of time. Usually, this period of time is an individual’s lifetime. One highly-regarded insurance textbook offers this definition, “In its pure form, a whole life annuity may be defined as a contract whereby for a consideration (the premium), one party (the insurer) agrees to pay the other (the annuitant) a stipulated amount (the annuity) periodically throughout life.” Another textbook explains an annuity in these words, “... an annuity is a periodic payment to commence at a specified or contingent date and to continue throughout a fixed period or for the duration of a designated life or lives.”

Although textbook definitions are sometimes complex, what is clear is that for a purchase price or premium an annuity will pay an individual an income over a certain period of years, often over the individual’s lifetime.

For example, assume Mr. Green is age 50 and ready to begin planning for his retirement at age 65. As part of his financial plan, he purchases a nonqualified annuity and pays a monthly premium of $300 each month for 15 years. When he reaches age 65, Mr. Green will have accumulated a sum of about $95,000, assuming an interest rate of 7%. If he chooses, he can ask the insurance company to pay his annuity to him for life. He will receive a check each month for approximately $635 for the remainder of his life, whether it is three years or thirty years.

WHAT IS A “NONQUALIFIED” ANNUITY?

In the example concerning Mr. Green’s retirement planning, the annuity he purchased was referred to as a “nonqualified” annuity. To someone unfamiliar with the income taxation of retirement plans, purchasing something that is “not qualified” may not sound like a very good idea. However, the use of the term “nonqualified” has nothing to do with the qualifications of either the annuity or the insurance company. Instead, it refers to whether the annuity is part of an employee benefit plan that has met certain requirements, or become “qualified,” under the Internal Revenue Code. A “qualified” annuity is one which is used as part of or in connection with a qualified retirement plan. A “nonqualified” annuity is one which is not used as part of any qualified retirement plan. In very simplistic terms, a qualified retirement plan differs from a nonqualified arrangement in that the contributions made into a qualified plan are income tax deductible to the employer making the contributions and certain nondiscrimination requirements must be met. In other words, an employer must offer its qualified retirement plan to almost all of its employees. A nonqualified annuity may be purchased by any individual or entity and is not associated with an employer-provided plan.

THE ANNUITY’S UNIQUE FEATURE

Annuities offer many useful features. One feature of the annuity is unique and not to be found in any other investment or accumulation vehicle. The unique feature of an annuity is that it provides a stream of income that the annuitant cannot outlive. If the annuity benefits are to be paid over the annuitant’s lifetime, the monthly or annual benefit amount is guaranteed to come each and every month or year regardless of how long the annuitant lives.

It is often said that an annuity offers protection against living too long. At first impression, this may sound strange. How can a person live too long? In relation to an annuity, this statement about living too long refers only to the person’s financial situation. It is possible, from an income viewpoint, to live beyond the point where all of an individual’s savings, retirement plan benefits, and other financial means have been used up. An annuity paying benefits over the person’s lifetime offers protection against this possibility.

To illustrate the annuity’s unique feature, assume that Mr. White is now age 40 and wishes to retire at age 60. Toward this end, he can save about $300 per month in addition to the funds he is placing in the 401(k) plan offered by his employer. If he purchases a nonqualified annuity today and places the $300 each month into the contract, he will have accumulated approximately $123,000 in the annuity when he reaches age 60, assuming a 5% rate of return. At age 60, Mr. White’s life expectancy is approximately 24 years or until he reaches age 84. If he begins taking benefit payments from the annuity at age 60, he will receive about $720 per month, or $8,640 annually. This amount will be paid to him, assuming he elects a life only settlement option, every year of his life whether he lives to age 70, to age 80, to age 90 or beyond.

On the other hand, if Mr. White had placed the same $300 per month for 20 years into another financial vehicle, such as a mutual fund, and received a comparable rate of return he could begin withdrawing the same monthly amount of $720 when he reached age 60. Assuming a 4% interest rate after he begins making withdrawals, if Mr. White lived to age 70, he would still have about $78,000 left in his mutual fund. If he lived to age 80, he would still have about $12,000 left in his mutual fund. However, at about the time that Mr. White turns 82, he will have completely depleted his mutual fund.

Of course like all of us, Mr. White does not know how long his life will be. However, should he survive to age 82 and beyond, Mr. White would probably have a much easier time paying his monthly bills if he had purchased the annuity as his retirement planning vehicle rather than the mutual fund. On the other hand, if Mr. White survived only to age 75, the life only annuity would offer no further payments to his beneficiaries while the mutual fund would still contain approximately $48,000. (However, most annuity contracts offer methods of receiving benefit payments with certain refund and guarantee features.)

WHO PURCHASES ANNUITIES?

Many think that annuities are purchased only by the wealthy — individuals who have already accumulated a large estate and can place thousands at one time into a single annuity contract. Many purchases of this type are made, but it is not true that all annuities are purchased by the wealthy. Many nonqualified annuity contracts are purchased by persons of modest income to help accumulate an estate or provide financial income after retirement. Although the provisions vary from one annuity to another, many contracts accept monthly premium payments of as little as $50. Even this modest amount, over time and with the benefit of tax deferral, can grow into a significant sum. For example, if Ms. Brown, age 35, purchases an annuity today and pays a monthly premium of $50 until she reaches age 65, assuming a 6% interest rate, she will have accumulated approximately $50,225 in her annuity.

In looking ahead to their retirement years, most individuals plan on Social Security and pension plan benefits from their employers to finance their retirement. But, many experts agree that these items usually provide only about one-half of the average American’s pre-retirement income. Many individuals will want to supplement this retirement income and the purchase of nonqualified annuities is one way to do so.

There are others who benefit from the purchase of annuities. Included here are individuals whose occupation is one in which a majority of their life’s income is earned in a short amount of time. Professional sports figures and entertainers fall into this category. Even a small business owner who lands a big contract or, perhaps, sells a portion of his business and has a large influx of income may consider the purchase of an annuity with those funds.

Another way in which annuities are purchased involves the receipt of life insurance proceeds. If a surviving spouse or children receive a large lump sum payment of death proceeds from a life insurance policy, purchasing a single premium annuity with the funds and selecting some type of lifetime payout option is a good way to make sure the life insurance proceeds will last the survivor’s lifetime and not be frittered away in a few years. To illustrate, assume that Mrs. Smith, age 45, dies in a car accident. Her spouse receives a lump sum death benefit payment of $250,000 from one of Mrs. Smith’s life insurance policies. By using this lump sum to purchase an immediate annuity, Mr. Smith, age 47, will receive a monthly income of approximately $1,380 for the remainder of his life, assuming an interest rate of about 5%. If he elects a life and ten year certain annuity, his monthly payment from the immediate annuity would be about $1,365.

THE TIMELINE OF AN ANNUITY

An annuity contract passes through two distinct phases during its existence, the accumulation phase and the annuitization phase. The single exception to this is the immediate annuity which does not actually pass through an accumulation phase but moves immediately after it is purchased into the annuitization phase.

The Accumulation Phase

The accumulation phase is that period of time from the purchase of the annuity until the annuity holder decides to begin receiving benefit payments from the annuity. It is during this period that the annuity builds up or accumulates the funds that will provide the annuity holder with future benefits. One important item that permits a significant build-up of funds within the annuity is that the interest credited to the annuity’s premiums by the insurance company is not taxed each year to the holder of the annuity. Rather, payment of the tax on this income is delayed or deferred until the annuity holder begins drawing benefits from the contract. This deferral of taxation allows interest to be credited on every dollar of interest previously credited, resulting in a much larger accumulation of funds than if a portion of the interest was withdrawn each year to pay the income tax due currently.

With a nonqualified annuity, the accumulation phase can last from a few years to many years. Take the case of Mr. Black, age 60, who has just purchased an annuity. He plans to pay premiums for five years until he reaches age 65 and then receive benefit payments from the annuity for the remainder of his life. The accumulation phase of his annuity will be five years, a relatively short period of time. In contrast, take the case of Ms. Green, now age 55, who owns an annuity that she purchased at age 25 with funds inherited from her grandparents. The accumulation phase of her annuity is currently 30 years.

The Annuitization Phase

The second phase that an annuity contract passes through is the annuitization phase which begins with payment of the first benefit amount from the annuity to the annuity holder. The annuitization phase is sometimes referred to as the payout period or the benefit period. Most nonqualified annuity contracts allow the annuity holder to elect to begin receiving benefit payments at any time, so the annuitization phase can start at age 20 or age 100, under some annuity contracts.

Continuing with the example of Mr. Black, discussed above, the annuitization phase of his annuity will begin when he reaches age 65 and continue for the rest of his life. Since the life expectancy of a 65-year-old male is about 20 years, Mr. Black’s annuity will have an accumulation phase of five years and an annuitization phase of about 20 years, on average. Ms. Green’s annuity, discussed above, has already been in the accumulation phase for 30 years and is just now passing into the annuitization phase. It is possible that this annuity will have had a longer accumulation phase than an annuitization phase.

Earlier, the definition of a nonqualified annuity was discussed and contrasted with that of a qualified annuity. This course confines itself to a discussion of nonqualified annuities and, therefore, does not address in detail annuities purchased as part of a qualified retirement plan, Individual Retirement Annuities (IRAs) or Tax Sheltered Annuities (TSAs). While there are some similarities between the nonqualified annuity and these other types, there are also many differences. It is not safe to assume that a particular aspect of a nonqualified annuity works in the same manner as an IRA or TSA. More often than not, there is a difference.