At McCarthy Stevenot Agency, Inc., we can help answer your questions about annuities, and provide you with access to a wide variety of fixed annuity products.
  • An annuity is a financial device that pays an income stream to an “annuitant” or insured individual for a specified period of time.
  • Payments may be for as long as an annuitant’s lifetime or for a shorter fixed period of time.
  • Annuities are used in a variety of situations. Commonly annuities are used by retirees to establish a foundation of income during retirement.
  • Annuities are also often used in legal cases that require structured settlements.

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Learn More About Annuities

As stated above, an annuity is a financial device that pays an income stream to an “annuitant” or insured individual for a specified period of time. Payments may be for as long as an annuitant’s lifetime or for a shorter fixed period of time.

Annuities are used in a variety of situations. Commonly annuities are used by retirees to establish foundation of income during retirement. Annuities are also often used in legal cases that require structured settlements. A structured settlement can be required when an individual receives an funds from a lawsuit or legal settlement for the purpose of meeting long term financial obligations. For example, a court may award $1,000,000 to a plaintiff to cover medical expenses throughout the plaintiff’s lifetime. In such case, the defendant will not necessarily have to pay $1,000,000 at the settlement of the case. Instead, the defendant may be directed by the court to purchase an annuity that will provide the required income to the plaintiff over time, but at a much lower total cost to the defendant.

Another common use of annuities is in lotteries. People who buy lottery tickets choose the option of a “cash payout” or a “lifetime payout.” In either case, lottery winnings are expressed in terms of annuitized values. The moment a $20,000,000 lottery winner turns in his or her winning ticket, the winner doesn’t actually get a check for $20,000,000. Instead, the winner will either receive the $20,000,000 paid out over a fixed period of time (i.e. 20 years), or the winner will receive a reduced cash settlement that is (roughly) equal to what it would have cost the lottery commission to purchase an equivalent annuity.

How Annuities Work

The basic concept of an annuity is simple. Consider these two different scenarios to help understand how annuities work.

Scenario One:

Imagine a grandparent wants to provide $100 per year to a grandchild attending college to help the grandchild pay living expenses for each of four years of college. One option the grandparent has to fund this obligation is to go down to the bank and put four $100 bills in a safe deposit box. Each year, when the promised payment is due, the grandparent can go to the bank, open the safe deposit box, take out a $100 bill and hand it directly to the grandchild. At the end of four years, the grandparent will have paid out exactly $400 as promised, and the safe deposit box will be empty.

Scenario Two:

This example modifies the story above using some of the concepts of an annuity. This time, the same grandparent, instead of putting $400 in a safe deposit box, decides to put money into a savings account that pays 3% interest annually. By calculating the future impact of the 3% interest on the funds in the account, the grandparent will now only have to deposit $372.00 into the account in order to make the $100 in payments to the grandchild for each of the four years. After each $100 payment is made, the funds remaining in the account continue to earn interest and provide the additional funds necessary to make the complete payments. Just like the example above, $100 is paid out each of the four years and the ending balance is zero, but the initial investment required is $372 instead of $400.

As in the second scenario, fixed annuities apply a combination of principal and interest (and where possible tax advantages), in order to create a financial vehicle that can meet future and ongoing funding obligations. The goal of an annuity is to provide a fixed payment to a beneficiary for a specified period of time with a reduced upfront expense.

Taxation of Annuities

Annuities may contain a combination of pre-tax and after tax dollars depending on how they are funded. If an individual puts $10,000 of after tax dollars in an annuity and over time the annuity value grows to $20,000, the annuity now contains a combination of before tax and after tax dollars. Depending on the payout option selected, annuity beneficiaries may receive what is called an “exclusion ratio.” This ratio determines the ratio of pre-tax and after-tax dollars involved in the annuity payout.

Early Withdrawals

Annuities are intended for retirement funding, and individuals are not expected to withdraw funds from annuities before the age of 59 ½. If funds are withdrawn, there is a 10% penalty in addition to any regular income taxes that may otherwise be due on funds inside the annuity. If the annuity was purchased prior to 1982, the funds from the annuity will be taxed on a “FIFO” basis. FIFO means “first-in-first-out.” If the annuity was purchased after August 13, 1982, funds from the annuity will be taxed on a “LIFO” basis. LIFO means “last-in-first-out.”

Payout Options on Annuities

The second stage of a annuity, after the accumulation stage, is the payout or annuitization stage. Once a person reaches 59.5 years of age, he or she can begin withdrawing funds from an annuity. Funds can be withdrawn in a lump sum, on a fixed period basis, or on an annuitized basis. There are many structures for withdrawal of funds from an annuity.

Here are several possibilities:

Life Annuity Option

In this option an individual receives an annual benefit based on his or her age. This option generally provides the highest income option for an individual. Payments continue throughout the individual’s lifetime. This option protects a person from outliving his or her retirement funds because, as long as the individual is living, the funds keep coming. The downside of this option is that annuity payments will cease upon the death of the individual beneficiary. If an individual is married and both parties depend on income from the annuity, a life annuity can be a very risky option. This is because when the individual upon whose life the annuity is based dies, there are no additional funds made available to the surviving party.

Joint and Survivor Annuity Option

Also called a Joint Life Option, this annuity option structures payments at a lower level than a Life Annuity option, but it allows for payments to continue to a spouse upon the death of the primary annuitant. Payout benefits are lower than a Life Annuity because they take into account the life expectancy of both individuals involved.

Period Certain Annuity Option

With this option the annuity will pay out all of its value over a specified period of time. For example, if an individual selects a “ten year period certain” annuity, all benefits will be paid out over a ten year period. Even if the annuity recipient dies within the ten year time frame, the remaining benefits can be designated to a surviving beneficiary (or to the individual’s estate). The downside of a period certain annuity is in the risk of living too long. If a retiree lives beyond the ten year (or other specified) time frame, funds will be depleted.

Life with Guaranteed Period Annuity Option

This option gives an individual the ability to select a life option, so that an individual can be assured of income for the rest of his or her lifetime, but this option also includes a guaranteed payout provision, so that if the annuitant dies before the guarantee period has expired (say 10 years) , a guaranteed amount will still be paid to a beneficiary. Generally, this option will provide a lower benefit amount than would a standard Life Annuity.

Systematic Withdrawal Annuity Option

A systematic withdrawal annuity option is similar in some ways to a Period Certain Option. In this option a person can customize the number of payments received and when over a pre-set period of time.

Lump Sum Annuity Option

In a lump sum annuity option, an individual receives a “lump sum” check that cashes out the value of the annuity all at one time. If substantial funds are involved, this can create a higher tax liability as all of the income is received in one year. One benefit of longer term payout options is that they trickle out the annuity’s value over several years, thereby potentially lowering the annuity recipient’s tax liability.

Life Expectancy and Annuities

When insurers calculate the amounts they are willing to pay out for annuity benefits, many factors come into play. One of these factors is the life expectancy of the annuitant.

  • Assuming two individuals with the same size annuity and the same age, a female annuitant will receive a lower yearly benefit amount due to the fact that women have a longer life expectancy than men.
  • A 70 year old man who chooses a Life Annuity payout option will receive a higher benefit amount than a 60 year old man who has the same size annuity.

Other factors contributing to the amount of benefit paid out by an annuity are company expenses and investment returns. One insurance company’s investment portfolio may outperform (or underperform another company) thereby affecting payout amounts. Further, operating expenses can play a part in calculating benefit amounts. An insurer with higher operating expenses may yield lower benefit amounts to annuity beneficiaries.

Recently, many insurance companies have become exposed to other forms of adverse risk due to the types of investments they have made in the past. Many insurers are invested in mortgages, commercial real estate and other equities that have experienced compressed value in recent years. All of these factors combined can have an effect on the amount of benefit an insurer is willing to pay for a given annuity at a given starting date.

Immediate and Deferred Annuities

An annuity may be an “immediate” annuity or a “deferred” annuity. In the case of an immediate annuity, a person deposits funds with an insurer and a payout option begins “immediately” (may take 30 to 45 days). With a deferred annuity, an individual deposits funds (in a lump sum or through contributions over time) and “defers” annuity benefits until a later date, such as retirement.

Deferred annuities have two phases, an “accumulation” stage and an “annuitization” stage. The first phase is the accumulation stage in which funds are built up inside the annuity. During this stage funds are added to the annuity by various means. Funds may be transferred from one annuity to another via a 1035 exchange. Interest earned on funds inside an annuity grow at on a tax deferred basis. Tax deferred generally means that no taxes are due on earnings until funds are withdrawn. During the annuitization stage (or payout stage), a variety of payout options are available.

Filed under: Annuity Buyer's Guides

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