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Annuity classification and payout options

Lesson 52 of 105 · All lessons · Up next: Personal uses of annuities: tax deferral, retirement income, education funds, and guaranteed minimum withdrawal benefits →

Three ways to classify an annuity

An annuity is a contract in which a purchaser pays an insurer a lump sum or a series of payments in exchange for regular disbursements, beginning either immediately or at some future date. Its main job is to provide income for a specified period or for the rest of one or more lives. The person whose life the payments depend on is the annuitant. Exam questions classify annuities three ways.

1. How the premium is paid.

  • Single premium: one lump sum buys the contract.
  • Periodic or flexible premium: the owner pays over time, in level or varying amounts.

2. When income begins.

  • Immediate annuity: payments start within 12 months of purchase. An immediate annuity is always bought with a single premium (a single premium immediate annuity, or SPIA).
  • Deferred annuity: income payments are not scheduled to start for at least 12 months. A deferred annuity may be bought with a single premium or with periodic premiums.

3. How the value is credited.

  • Fixed annuity: the insurer guarantees a minimum interest rate and bears the investment risk. Fixed income payments do not rise with inflation unless the contract adds an inflation adjustment.
  • Variable annuity: premiums go into separate accounts (sub-accounts), and the contract holder bears the investment risk. Once annuitized, payments rise when investment performance beats the assumed investment return (AIR), stay level when they match it, and fall when they lag it.
  • Indexed annuity: interest is credited by a formula tied to an external index such as the S&P 500, subject to caps, participation rates and spreads. A traditional equity indexed annuity has a guaranteed floor. A non-guaranteed index annuity (also called a registered index-linked, buffer or structured annuity) can lose principal.

Two phases of a deferred annuity

During the accumulation phase, an accumulation annuity keeps an account value that grows tax-deferred and can be withdrawn, subject to surrender charges. At annuitization, the owner converts that account into an income stream, and the payout (annuity) phase begins. A paid-up deferred annuity, or deferred income annuity, works differently: each premium buys a fixed future income amount, and the contract keeps no account value.

Annuity payout options for the same premium, shown in two columns with a separate box beneath them. The left column covers one life. At the top is straight life, or life only, which pays the higher amount but stops at the annuitant's death with nothing for a beneficiary. An arrow points down to life with period certain or refund, which pays less because a beneficiary receives the rest of the guaranteed period or the unpaid premium. The right column covers two lives. At the top is joint life, which pays the higher amount but stops at the first death. An arrow points down to joint and survivor, which pays less because payments continue, in full or reduced to, for example, three quarters, two thirds or one half, until both annuitants have died. A note between the columns and the bottom box says that moving down, adding a guarantee lowers each payment. The bottom box, drawn with a dashed border, is period certain. It is not tied to anyone's life: it pays for a fixed number of years, such as five, ten or twenty, whether or not the annuitant lives, and then stops, so it gives no protection against outliving your money.
Payout options: adding a guarantee lowers the payment

Payout (settlement) options

  • Straight life (life only): payments for the annuitant's lifetime, then nothing. Of the options on one life, it pays the highest periodic amount for a given premium. The annuitant cannot outlive the income, but if they die soon after payments start, little of the premium comes back.
  • Life with period certain: payments for life, but for no less than a stated period, such as 10 or 20 years. If the annuitant dies early, a beneficiary receives the rest of the certain period.
  • Life with refund: payments for life. If the annuitant dies before the payments received equal the premium, the beneficiary receives the difference, either in a lump sum (cash refund) or in continuing payments (installment refund).
  • Joint and survivor: two annuitants, usually spouses. Payments continue until both have died, either at 100% to the survivor or reduced, for example to 50%, two-thirds or 75%. This option suits someone with a dependent spouse.
  • Joint life: payments to two annuitants that stop at the first death. Because nothing continues to the survivor, it pays more than a joint and survivor option.
  • Period certain: payments for a fixed period, such as 5, 10 or 20 years, whether or not the annuitant lives. This option is not life contingent, so it gives no longevity protection.

Each guarantee you add, whether a certain period, a refund or a survivor benefit, lowers the periodic payment, because the insurer may have to pay out more in total.

Tax note: Federal law includes annuity payments in gross income, except for an exclusion ratio: the share of each payment that bears the same ratio to the payment as the investment in the contract bears to the expected return. That share is a tax-free return of premium. Earnings grow tax-deferred, and a withdrawal before age 59½ is generally subject to a 10% tax penalty.

Key terms

Sample questions

An annuity is classified as an immediate annuity when its income payments begin within what period after purchase?

  • 30 days
  • 12 months
  • 5 years
  • The date the owner reaches age 59½
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