I don't expect to do additional research on this topic in the near future.
An annuity is a financial contract by which a company pays to an individual (annuitant) a stream of regular payments in exchange for funds paid to the company in advance (either as a lump sum or a stream of payments). A close conceptual equivalent is a self-funded pension, in which an individual pays into a program during their working years, then receives a fixed income upon their retirement.
Historically, annuities are an offshoot of life insurance, and are often offered by firms and governed by laws that pertain to the life insurance industry. However, the product has evolved over time such that there are various species of annuity, so what follows is necessarily a generalization that will certainly omit the odd instances.
Since an annuity is a contract, there may be a wide array of possible arrangements and stipulations to the basic agreement. There are conventions, but the parties may agree on any arrangement they desire.
The contractual nature also provides for any modifications to the terms, or may require a new contract to be written if modifications exceed the stipulated scope, and the discretion of both parties.
There is also a risk involved, in that annuities are a contract with a specific company, and hold no inherent value in the market - though it would seem that the contract could be treated as an investment and traded among holders, there is no evidence to indicate that this is a common practice.
Of special note: should the company go bankrupt, the contract is void and the annuitant must seek to recollect the present value of the contract from the remnants of the bankrupted firm, just like any creditor to whom the firm owes money. There are clauses and stipulations in the contract to address this risk, and laws in place to ensure that companies safeguard funds, though I haven't researched them as yet.
An annuity can be funded all at once as a lump sum(a "single premium" annuity), or the annuitant can make a series of payments over time to build up to a set value. It is not uncommon for a single-premium to be bought with the proceeds of a life insurance contract or an inheritance as a method of managing the funds, and there may be tax benefits to doing so.
Once funds are deposited into an annuity, they cannot be withdrawn except under certain terms (specified by the annuity contract), and generally at a significant penalty.
Some annuities (generally, variable ones) give the annuitant decision-making authority over how their principal is to be invested. In this way, the annuitant can influence the performance of their funds, with a goal of increasing the payment amount they will receive, but additional fees (similar to mutual fund fees) may apply. More commonly, investment decisions are either stipulated in advance or actively managed by the firm.
Some companies offer "bonus credit" features that add a bonus to the value equal to a percentage of deposits. The SEC warns that firms that do this to attract customers often get that money back, and then some, by means of other modifications to the contract (increased fees and charges, decreased payments, etc.), so in the end it is a bad deal for the investor.
An annuity may commence payments to the annuitant immediately, or the funds may lie fallow for a time with payments commencing at a future date. The latter arrangement is termed a "deferred annuity," the former an "immediate annuity." The value proposition of a deferred annuity is that it gains in value while the funds lie fallow, resulting in a larger payout.
The annuitant generally receives these payments monthly, but other arrangements (weekly, bimonthly, quarterly, annually) can also be made. The exact amount of payment, fixed or variable, is determined by the amount deposited and the duration of the annuity.
Generally, but not necessarily, funds held in an annuity draw interest, such that withdrawals are come combination of the principal amount and accumulated interest.
The payout can be a fixed amount, or it can be variable. Variable annuities have payments that may fluctuate according to the performance of specific investments, such as a bond portfolio, mutual fund, or market interest rates. Some variable annuities are tied to the performance of a specific equity, and are this called "equity-indexed annuities."
Annuities are often described in terms of their payout option: immediate fixed, immediate variable, deferred fixed, and deferred variable.
Inherent in the annuity contract is that the funds will remain with the institution for an extended period of time, and the annuitant may have signed away some or all of their rights to access the funds on demand.
Most commonly, there is a stipulated surrender charge, a penalty expressed as a percentage of withdrawals, that the annuitant must pay for early withdrawal of funds (not to mention that this decreases the amount of future payments, if only a portion of funds are withdrawn). This charge generally decreases over time.
There are also stipulations under which surrender charges may be waived or decreases (medial expenses are a common stipulation). However, such stipulations are part of the contract, not required by law.
The duration of the annuity will vary: they can be for a fixed number of years or for the "life" of the annuitant. This is generally part of the contract, agreed to in advance, and is generally not mutable afterward.
Generally, annuities that pay for a fixed number of years can be passed along to heirs if the annuitant passes away before the annuity expires. An annuity that is tied to the life of the annuitant expires when they do, and cannot be passed on to heirs (though a payment, called a "death benefit," is a common option).
Note that annuities tied to the life of the annuitant often carry a "mortality risk charge," that is assessed each year, which is similar in nature to a life insurance premium, covering the company's risk that the annuitant wil exceed life expectations.
The contract will stipulate the exact terms, so a wide array of arrangements can be made between the institution and the annuitant.
An annuity may be owned by an individual, or there may be multiple annuitants - most often, a married couple, but it can be any number for any reason (an inheritance may be annualized and split among the heirs with a survivorship clause among them). The line between a joint annuity and a joint life insurance policy is blurry.
FEES AND EXPENSES
Common fees and expenses are:
- Sales Load - Annuities may charge a base fee at the onset for providing the service. These are less common now, as the market is more competitive.
- Mortality and Expense Charges - A fee charged on an annuity tied to the lifespan of the annuitant to insure the company against the loss they will occur if the annuitant lives too long
- Surrender charges - Punitive fees charged for early withdrawal of funds from an annuity
- Administrative Fees - Fees charged by the company for managing a variable annuity, which may be termed management fees, administrative fees, records maintenance fees, etc., or some combination thereof.
- Indirect Fees - When an annuity invests funds in securities, there are fees associated with buying, selling, and holding those securities. These are not directly related to the annuity, but affect the balance of the annuity (hence the amount of payments).
One source notes that the fees charged by annuities ranges between 2.3% and 3.5% per year over the lifetime of the annuity, not including surrender charges or the proportion withheld from heirs when an annuity is inheritable.
There are no standards for performance, and performance will vary according to the type, terms, duration, etc. of the specific annuity. However, the general consensus seems to be that the return on an annuity is extremely low, often on par with certificates of deposit (Bank CDs).
As an investment, it is often conceded that an annuity is inferior in performance to virtually any other kind of long-term investment (a bond or mutual fund), but offers security in its stead, in that the firm assumes the risk of market performance.
The interest earned on an annuity is not taxable until such time as it is withdrawn. It is worth mentioning that interest on annuities is taxed at the same rate as ordinary income (it is not treated as a capital gain, which is often discounted).
In fixed annuities, each payment is considered to be earned interest (taxable) plus some portion of the principal deposited (non-taxable). The math seems a little odd, so I'll skip the calculations as to what portion is taxed and what portion is tax-free, as it will vary according to the return anyway.
With variable annuities, interest and earnings can be accumulated in the account and withdrawn separately from principal - in this way, funds that that would have been paid as taxes on earnings can remain in the account, accumulating compound interest, until such time as they are withdrawn.
According to the SEC, individuals who hold a tax-advantaged retirement plan (IRA, 401K, etc.) will receive no additional tax advantage from a variable annuity. They don't go into detail as to the reasons.
There is a law (Section 1035 of the US Tax Code) that allows an annuitant to exchange a variable annuity contract for another one without paying taxes on investment income.
Annuities have been in existence for centuries. One example (from 1740) indicates that churches managed them for widows and orphans of wealthy men. Naturally, there was corruption (churches paying out far less than was due), and the state stepped in with legislation and requirement of a writ, which facilitated the transition of annuities from a charitable service of the church to a commercial product.
With the emergence of the middle class and corporations, the annuity model was used to provide pensions for workers. The same model was adapted by governments providing income to the elderly (state pensions, such as Social Security), and there arose a market demand for private pensions among individuals whose access to or faith in company or state pensions motivated them to seek separate arrangements.
Most commonly, annuities are created by life insurance policies, which pay out the settlement as a stream of income rather than a lump sum. Even when this is not a provision of the insurance policy, firms generally guide the beneficiaries toward using the settlement to purchase an annuity.
Annuities are also created by individuals for their own benefit, as a method of establishing a private pension fund. It is possible to establish an annuity at any time: a person who has had a windfall (lottery winning, lawsuit settlement, etc.) may find themselves with a pile of cash and wish to convert it into regular income and remove the temptation to spend their newfound wealth irresponsibly.
There are other methods of managing a lump sum of cash and taking regular withdrawals, and an annuity has a handful of disadvantages for the consumer: the return is generally less over time than other investment options and the decision to buy is a firm commitment (the terms are fixed, it cannot be managed, and early withdrawal has significant penalties).
One advantage is that an annuity can be set up as an insurance product, such that its payment term is the life of the annuitant (the company loses money if the insured lives longer than expected, reaps substantial profit for an early death). These annuities often offer better "returns" than other low-risk investments (such as CDs), provided the annuitant outlives expectations.
Also, the payments from an annuity are not tied to any investment, and can be locked at a certain level, so regardless of the fluctuations in the market, the annuitant will receive a set amount. This is an advantage to those living close to the bone, and who cannot tolerate any fluctuation in income.
Also, the interest earned by an annuity is tax-free until withdrawn, which increases the earnings over time. Instead of paying taxes immediately, all interest remains in the account, compounding interest upon interest.
An annuity also an be used as a source of income, enabling the annuitant to obtain credit (loans), whereas the future earnings of securities are seen as less certain. (Arguably, the person could borrow from their nest egg and pay it back rather than borrowing from a third-party and paying interest to someone else, but I think it all depends on how the math works out).
Much of the material that markets or explains annuities is dodgy: firms happily explain the benefits to the consumer, but are a reluctant to disclose the details of their own interest in the product. This is not uncommon, but the degree to which the language is purposefully vague and evasive raises a red flag.
There is a significant amount of disinformation considering annuities:
- Annuities are not considered as assets under Medicare
- Annuities are exempt from estate taxes
- Annuity income cannot be garnished by creditors or collectors
- Annuities are more secure than other investments
Each of the above statements is entirely false and entirely fabricated (it is not covered in the information above). There are also many instances where information is slightly represented (something may be true in specific cases, benefits are exaggerated, drawbacks underemphasized, conditions ignored, etc.).
A "reverse mortgage," depending on its specific conditions, can be considered a form of annuity in which the annuitant signs over their real estate in lieu of cash and receives a monthly payment. The company allows the annuitant to remain in their home for the duration of the annuity (generally their lifespan) and takes possession of the property upon their death.
From all I've read, annuities seem to be a very bad choice as compared to other alternatives for managing a large sum of cash with an eye toward providing a future stream of income, and would not be appealing at all to most investors.
One exception would be those investors who have not saved sufficient funds for their retirement, and as such are highly sensitive to fluctuations in market returns (even a slight decrease in the return for safe investments would mean that they are unable to cover their expenses).
One source suggests the only time an annuity might be desirable is when an individual meets all of the following requirements:
- They have contributed the maximum to 401K/IRA plans
- They will keep the annuity at least 20 years
- They are presently in a 28% or higher tax bracket
- They expect to be in tax bracket lower than the tax rate on long-term capital gains after retirement
- They do not need the annuity proceeds prior to age 59.5
- They are in good health
- They are unconcerned about the tax disadvantages to their heirs
Even when all of those conditions are true about the investor, it remains to example the terms of the annuity contract in detail, in order to ensure that the hidden fees do not exceed the economic benefits.
In all, annuities are an excellent profit-maker for the companies that sell them, but a very bad deal for the annuitants. One source candidly concluded that annuities are "a scam perpetrated on the elderly," who are not very financially savvy and are fearful of the future, and suggested the practice of selling them should be outlawed.