5.1 Annuity Principles and Concepts
Concept of an Annuity
An annuity is a financial product primarily used to provide a consistent stream of income to an individual, most commonly during retirement. In principle, annuities are designed to help protect individuals from the risk of outliving their retirement savings by offering income payments that can continue for life.
One of the key functions of an annuity is to distribute or liquidate accumulated funds by making periodic payments that continue until the death of the annuitant or for a specified period of time. When compared to life insurance, an annuity can be considered the opposite of a life insurance policy—life insurance protects against dying too soon, while an annuity protects against living too long.
Annuities are issued and funded through life insurance companies, and a producer must hold at least a life insurance license in order to sell annuity products.
Life Insurance vs. Annuities
| Life Insurance | Annuity |
|---|---|
| Provides a benefit upon death of the insured | Provides steady income until death of the annuitant |
| Creates an estate | Liquidates an estate |
| Pays a death benefit | Pays a living benefit |
| Protects against premature death | Protects against living too long |
| Owner, insured, beneficiary | Owner, annuitant, beneficiary |
| Policy | Contract |
Control of the Contract
Owner: The owner is the individual who controls the annuity contract. The owner is responsible for making the required payments into the contract and holds all contractual rights associated with the policy.
Annuitant: The annuitant is the individual on whose life the annuity contract is based. If the annuity is annuitized for lifetime payments, the income payments are calculated using factors such as the annuitant's age, gender, the selected payout option, and the amount used to fund the annuity.
Beneficiary: The beneficiary is the person designated in the contract to receive benefits if the owner and/or annuitant dies before annuitization occurs, or if the selected settlement option provides a residual benefit after the annuitant's death.
Similar to life insurance, annuity contracts allow the owner to designate beneficiaries prior to the annuitization or guaranteed payout period. A beneficiary may be named when the first purchase payment is made and can only be changed by the owner.
The owner's contractual rights begin when the annuity is purchased. The owner—who may also be the annuitant—has the authority to change the annuity starting date, designate or change beneficiaries, and select or modify payout options.
During the accumulation period, if the owner and annuitant are the same person and the named beneficiary is the annuitant's spouse, the Internal Revenue Code allows the spouse to assume ownership of the annuity upon the annuitant's death. This transfer allows the spouse to continue the contract with all ownership rights, including the continuation of tax-deferred growth.
Insurance Aspects of an Annuity
Annuities are insurance products that rely on mortality tables to determine payment structures and risks. When a life-contingent settlement option is selected—such as life only or joint and survivor—the insurance company guarantees income payments for as long as the annuitant lives.
This guarantee is made possible through actuarial calculations based on the law of large numbers. Individuals who live shorter-than-expected lifespans leave reserves that help fund payments for those who live longer than average. By pooling risk across many annuity contracts, the insurer is able to provide guaranteed lifetime income to annuitants who outlive their projected life expectancy.
Death Benefits
In addition to offering the potential for guaranteed lifetime income, annuities also provide a death benefit if the annuitant dies before the contract is annuitized. In this situation, the contract will have a designated beneficiary, similar to a life insurance policy.
The insurer will generally pay the beneficiary an amount equal to either the total premiums paid into the contract or the current account value, whichever is greater, according to the terms of the annuity contract.
Quiz
1. What is the primary purpose of an annuity?
A. To provide a death benefit to beneficiaries
B. To accumulate funds for business insurance
C. To provide a steady stream of income, typically during retirement
D. To protect against property loss
Correct Answer: C
Rationale: An annuity is designed primarily to provide a regular stream of income, most often during retirement. Its key purpose is to help protect individuals from the financial risk of outliving their savings.
2. Which statement best describes the relationship between life insurance and annuities?
A. Both primarily provide death benefits
B. Life insurance protects against living too long, while annuities protect against dying too soon
C. Life insurance protects against dying too soon, while annuities protect against living too long
D. Both only provide benefits after retirement
Correct Answer: C
Rationale: Life insurance provides protection against premature death by paying a death benefit, while annuities provide protection against longevity risk by providing income that may last for life.
3. In an annuity contract, who is the individual whose life expectancy is used to determine income payments?
A. Owner
B. Beneficiary
C. Insurer
D. Annuitant
Correct Answer: D
Rationale: The annuitant is the person on whose life the annuity payments are based. Factors such as the annuitant's age, gender, and payout option help determine the amount and duration of income payments.
4. Which individual controls the annuity contract and has the authority to change beneficiaries or payout options?
A. Beneficiary
B. Owner
C. Annuitant
D. Producer
Correct Answer: B
Rationale: The owner controls the annuity contract. The owner has the authority to make decisions such as changing beneficiaries, selecting payout options, and adjusting the annuity start date.
5. What death benefit is typically paid if the annuitant dies before the contract is annuitized?
A. Only the interest earned on the account
B. The lesser of premiums paid or account value
C. The greater of the total premiums paid or the account value
D. Only the last premium paid
Correct Answer: C
Rationale: If the annuitant dies before annuitization, the beneficiary generally receives a death benefit equal to the greater of the total premiums paid or the current account value, depending on the contract terms.