Annuities are complex financial instruments that can be difficult to understand.
Annuity jargon only further complicates the task of comprehending annuities. It is imperative for any annuitant to understand all the basic facets of an annuity, and especially important for them to know the provisions of their specific contract. The following key annuity terms provide a comprehensive resource that should offer a great foundational understanding of annuities for anyone interested in purchasing one.
Annuity: A contract issued by an insurance company with the main benefit of giving the annuitant a lifetime of income. Under the contract, the annuitant pays the insurance company in return for the guarantee that he or she will receive payments from the insurer in return. Annuities are an investment strategy most commonly used by retirees, or those approaching retirement. The annuitant can pay into the annuity periodically over time, but more often in a lump sum, to receive payouts on a monthly basis in return.
Annuitant: The owner of an annuity. The annuitant pays the insurance company that serves as the annuity provider in return for regularly scheduled payouts.
Principal: The amount of money invested into the annuity by the annuitant (the total amount of money paid to the insurer).
Single-Premium Immediate Annuity: A specific type of annuity contract whereby the annuitant pays the insurer a certain amount of money upfront in a lump sum, and then the annuity owner immediately starts receiving periodic payouts in return. The payouts begin right away once the investment is made.
Deferred Annuity: A type of annuity under which the annuitant invests the principal and then delays the payouts. Deferred annuities can be funded by the annuitant over time through a series of payments, or more commonly with one lump sum payment upfront. The annuitant decides exactly when to start receiving the payouts. This strategy allows the principal to grow in the annuity during the period of time that the payouts are delayed, resulting in larger payouts for the annuitant. Additionally, deferred annuities require a smaller principal to be laid out upfront from the annuitant.
Single-Premium Deferred Annuity: A deferred annuity that is paid for by the annuity owner in the form of one lump sum payment upfront. The annuitant makes one cumulative payment into the annuity and then waits to receive the payouts for however long they choose to delay them.
Longevity Annuity: This is a specific type of annuity which is guaranteed to make payments for the rest of one’s lifetime, with the payments set to begin at a future date. Longevity annuities generally pay out a much larger amount than the annuitant invested as principal. They are also referred to as deferred income annuities.
Fixed Annuity: Fixed annuities guarantee that the insurer will make payouts to the annuitant at a fixed interest rate for a specific period of time. Fixed annuities are the least risky type of annuity. They are the most straightforward annuity, and they provide the most predictable and reliable stream of income.
Variable Annuity: When you purchase a variable annuity, you choose from a selection of investments, usually mutual funds, and the payouts you receive from the insurer are contingent upon the performance of the investments you choose. Your account value will increase or decrease along with your underlying investment portfolio. There is more risk associated with variable annuities than any other type of annuity, however, it is not entirely risky because the insurance company provides features that protect your annuity in the event that your investments perform poorly.
Indexed Annuity (interchangeable with the terms fixed indexed annuity and equity-indexed annuity): An indexed annuity will pay you a guaranteed minimum amount, although a portion of your return is dependent upon the performance of a stock market index, like the S&P 500. You receive the low-risk appeal of having a guaranteed minimum return, but you also have the added opportunity to benefit when the financial markets perform well. Indexed annuities fall between fixed and variable annuities in terms of risk, and therefore they also fall in the middle in regard to potential payout amounts.
Ordinary Annuity: An ordinary annuity is an annuity that pays out at the end of each interval period that is chosen by the annuitant. In other words, the annuitant receives payments at the end of the month, or the end of the quarter, or the end of a specific interval schedule of payouts. Ordinary annuities are beneficial to the institution making the payouts because the money typically has a higher present value to the party making the payments and a lower present value to the receiver of the payments.
Straight Life Annuity: The annuity makes payouts on a regular basis for the remainder of one’s life, and does not include any further beneficiary payments upon the death of the annuity owner. There are no death benefits with straight life annuities, rather the payments stop when the annuitant dies and the financial institution that issued the annuity keeps the remaining money. Due to the fact that there is no death benefit, straight life annuities are often cheaper to purchase and may offer higher payouts than annuities that offer a death benefit.
Life with Cash Refund Annuity: This option allows the annuitant to designate a beneficiary to receive any leftover money in the event that the policyholder dies before the principal has been paid back to the annuitant. Choosing this feature results in lower monthly payments to the annuitant while that person remains alive.
Life and Period Certain Annuity: This kind of annuity is guaranteed to pay out for the remainder of one’s life, but also provides the additional security of adding a specified period during which the beneficiaries will receive the payments if the annuitant passes away before the end of the chosen period. For example, if the annuitant buys a life and 10-year certain annuity and passes away during the third year of the period. The beneficiaries will receive their payments for the remaining seven years of the 10-year period.
Joint and Survivor Annuity: The annuity applies to two people as opposed to just one. Joint life annuities continue to make payments as long as one of the two beneficiaries is alive. These are commonly purchased by spouses to ensure that both people will have guaranteed income if one of them passes away early.
Asset Allocation: This term refers to the distribution of assets within a variable annuity across multiple areas of investment, such as stocks, bonds, mutual funds, etc. The goal of asset allocation is to reduce investment risk.
Subaccount: A common term used to describe the investment options that are offered in a variable annuity. The annuitant invests in a collection of “subaccounts” to potentially increase the returns.
Yield Cap/ Rate Cap: An upper limit placed on some indexed annuities that sets a maximum that an annuitant will benefit from positive changes in the index used by that annuity. In other words, the annuitant will not necessarily obtain the entire benefit from any rise in the index because it is limited by the cap. If the index soars, the annuitant may only see a portion of that increase reflected in the annuity payouts.
Free-look Period: The period of time where the annuitant can cancel the annuity and get a full refund for the contract. The free-look period can range from 10 to 30 days and varies by state. After the free-look period, getting out of an annuity contract becomes much more complicated.
Accumulation Period: The first phase of an annuity; the period of time when the annuity is gathering and building up the money that will be paid out to the annuity owner. The accumulation period includes all payments that the annuitant makes into the account, and it also includes the interest that is accrued on the principal if the annuity is deferred.
Payout Period: The payout period is the second phase of the annuity process in which the annuitant receives payments from the insurer. The payout period either begins immediately after the principal investment is made or after a number of years predetermined in the contract.
Death Benefit: A provision in an annuity contract that allows the annuitant to designate a beneficiary to receive the remaining payouts upon his or her death. It is important to include death benefits in annuity contracts to ensure that the accumulated assets are not surrendered to a financial institution when the owner of the account passes away.
Beneficiary: The person chosen by the annuitant to be the recipient of the remaining payouts by the annuity upon the annuitant’s death. Beneficiaries are commonly surviving spouses, children or other loved ones.
Period Certain: The term period certain refers to a length of time specified by the annuitant in the annuity contract to receive regular payments. Instead of receiving payments for the rest of one’s life, a period certain annuity pays out for a specified amount of time that is chosen by the annuitant when the contract is structured, such as five or 10 years. Period certain also comes into play if one buys a “life and period certain” annuity. Life and period certain annuities are guaranteed to pay out for the remainder of one’s life, but also give the additional security of adding a specified period during which beneficiaries will receive payments if one passes away during the period. For example, if the annuitant buys a life and 10-year certain annuity and passes away during the third year of the period certain, the beneficiaries will receive their payments for the remaining seven years of the period.
Surrender Charge: A penalty issued by the insurer as a punishment for terminating or exceeding the penalty fee withdrawal provisions of an annuity contract during the surrender period.
Surrender Period: The period of time during which the annuity contract is subject to early surrender charges or penalties. The surrender period lasts for 7 to 10 years.
Qualified Annuity: The difference between qualified and nonqualified annuities are the way the annuitant chooses to fund the annuity, which consequently affects the way the annuity is taxed. A qualified annuity is one that is paid for with pre-tax money. Because the annuitant is funding the account with pre-tax dollars, the IRS will want to collect taxes eventually. In the case of a qualified annuity, the annuitant does not pay taxes on the money used to fund the account, but rather the payouts will be subject to ordinary income tax.
Nonqualified Annuity: Nonqualified annuities are funded by the annuitant with post-tax dollars. Since a nonqualified annuity is funded with earned income that’s already been taxed, only the portion of a withdrawal that is considered to be earnings is taxable. Thus, only the annuitant’s earnings are taxed as income; the principal is not taxed.
Exclusion Ratio: The exclusion ratio is a percentage associated with nonqualified annuities.
The exclusion ratio expresses the comparison of the taxable portion of a payout to the nontaxable portion. The ratio determines how much of each withdrawal should be taxed. The insurer should provide a monthly exclusion ratio.
Tax-Deferred: Annuities are a tax-deferred investment, meaning the principal accumulates interest and grows within the annuity without any taxes needing to be paid on it. There are no taxes to be paid while the principal is in the annuity, but the annuitant will need to pay taxes on the payouts they receive. Essentially, the taxes are delayed until the annuitant officially starts receiving them.
Lump Sum: A lump sum is a single cumulative payment made at a specific time, as opposed to a number of smaller payments. It is common for each annuitant to pay for an annuity with a lump sum payment. Annuitants can also opt to receive payouts as a lump sum, but it is a rare occurrence.
Annuitization Method: An annuity payout option that simply provides income payments to the annuitant for the rest of his or her life or for a specified period of time. When the annuitant decides to use this method, the amount of money received in each payment is determined by the insurance company based on one’s life expectancy or based on the period of time payments to the annuitant are supposed to be paid.
Systematic Withdrawal Schedule: The systematic withdrawal schedule is another payout option. When this is the chosen payment method, the annuitant must specify the frequency of payments and the amount of each. Funds are withdrawn from the annuity based on what the annuitant decides. With the systematic withdrawal schedule, one chooses to withdraw funds from the annuity until it is empty, thus creating the risk that the annuity will run out of money before the annuitant dies.
Early Withdrawal Penalty: A 10% penalty tax that is issued for the withdrawal of money from an annuity prior to the annuitant reaching age 59 ½.
Mortality and Expense Risk Charge (M&E): A fee charged by insurance companies to cover the cost of the death benefit (the “morality” charge), as well as any other insurance guarantees that the annuitant opts to add to the contract. The optional benefits that are normally added to a variable annuity are often subject to an M&E fee.
Annual Contract Fee: An annual fee paid to the insurer that allows the annuitant to maintain ownership of the contract. This fee essentially pays the company for administering the contract, and the fee is often waived if the account value exceeds that of a predetermined amount. The insurer may charge this fee as a percentage of an annuity’s total value (this percentage usually would not exceed .3%), or the insurer may use a flat fee anywhere from $50 to $100.
Prospectus: The prospectus is a document associated with variable annuities. The prospectus contains crucial information about the annuity contract, including payout options, death benefits and fees that the annuitant will have to pay. The prospectus will also serve as a very important source of information about the investment options offered by that particular variable annuity.
Charitable Gift Annuity: A charitable gift annuity is an arrangement between a donor and a charity in which the donor makes a sizable donation to the organization and receives regular payments for the rest of his or her life from the organization. The payouts are based on the value of the assets that the donor transferred to the charity. Once the donor dies, the assets are retained by the charity.
Charitable Remainder Annuity Trust: Charitable remainder annuity trusts are a form of gift transaction in which the donor allocates assets to a charitable trust, and subsequently fixed payouts are made to a beneficiary who is designated by the donor. The beneficiary is often a university, a non-profit organization, or another such association. Once the donor passes away, any funds that remain in the trust are donated to a preselected charity.
Grantor Retained Annuity Trust: A grantor retained annuity trust is a financial instrument that is commonly used when people are planning to pass down assets or large sums of money to the next generation upon death. A GRAT is an irrevocable trust that allows people to minimize or completely avoid the taxes incurred on assets when passed down to beneficiaries. When one decides to open a GRAT, the person establishes a trust and funds it with the cash and assets that should be passed down. Then, the annuitant is entitled to annuity payouts for a pre-selected period of time that usually is two to five years. Once the annuity period is over, the remaining value of the trust and all of the assets within the trust are passed on to the named beneficiary.
Reverse Annuity Mortgage: A reverse annuity mortgage is essentially a loan that can be secured by the borrower’s accumulated equity in a house. The borrower receives periodic payments in the form of an annuity from the lender, and the house is sold to pay off the loan upon the borrower’s death. This strategy is popular among older or retired couples who have paid off their original mortgage and continue to live on their property.
Structured Settlement Annuity: A structured settlement pays out money owed from a legal settlement in installments of periodic payments in the form of an annuity. Structured settlement annuities are usually arranged for very large sums of money instead of the recipient being paid one lump sum.
Tax Sheltered Annuity: A tax-sheltered annuity, also referred to as a 403(b) plan, is a retirement plan option that is exclusively offered by public schools and some charities. A 403(b) tax-sheltered annuity plan gives employees the option to defer some of their salaries into tax-deferred investment accounts. The funds for a tax-sheltered annuity are generally taken from an employee’s paycheck prior to federal or state income taxes being taken out by the employer. An employee will not pay any taxes on such funds and any gains earned by the funds until he or she begins making withdrawals from the plan after age 59 ½. When the money is withdrawn, it is taxed as regular income.
Special thanks in preparing this summary of “Annuities: A Glossary of Terms” goes to Bob Carlson, leader of the Retirement Watch advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.