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In the U.S. an annuity
contract is created when an individual gives a life insurance company money
which may grow on a tax-deferred basis and then can be distributed back to the
owner in several ways. The defining characteristic of all annuity contracts is
the option for a guaranteed distribution of income until the death of the person
or persons named in the contract. Perhaps confusingly, the majority of modern
annuity customers use annuities only to accumulate funds and to take lump-sum
withdrawals without using the guaranteed-income-for-life feature.
Annuity contracts in the United States are defined by the Internal Revenue Code
and regulated by the individual states. Variable annuities have features of both
life insurance and investment products.[1] In the U.S., annuity contracts may be
issued only by life insurance companies, although private annuity contracts may
be arranged between donors to non-profits to reduce taxes. Insurance companies
are regulated by the states, so contracts or options that may be available in
some states may not be available in others. Their federal tax treatment,
however, is governed by the Internal Revenue Code. Variable annuities are
regulated by the Securities and Exchange Commission and the sale of variable
annuities is overseen by FINRA (the largest non-governmental regulator for all
securities firms doing business in the United States).
There are two possible phases for an annuity, one phase in which the customer
deposits and accumulates money into an account (the deferral phase), and another
phase in which customers receive payments for some period of time (the annuity
or income phase). During this latter phase, the insurance company makes income
payments that may be set for a stated period of time, such as five years, or
continue until the death of the customer(s) (the "annuitant(s)") named in the
contract. Annuitization over a lifetime can have a death benefit guarantee over
a certain period of time, such as ten years. Annuity contracts with a deferral
phase always have an annuity phase and are called deferred annuities. An annuity
contract may also be structured so that it has only the annuity phase; such a
contract is called an immediate annuity.
The term "annuity," as used in financial theory, is most closely related to what
is today called an immediate annuity. This is an insurance policy which, in
exchange for a sum of money, guarantees that the issuer will make a series of
payments. These payments may be either level or increasing periodic payments for
a fixed term of years or until the ending of a life or two lives, or even
whichever is longer. It is also possible to structure the payments under an
immediate annuity so that they vary with the performance of a specified set of
investments, usually bond and equity mutual funds. Such a contract is called a
variable immediate annuity. See also life annuity, below.
The overarching characteristic of the immediate annuity is that it is a vehicle
for distributing savings with a tax-deferred growth factor. A common use for an
immediate annuity might be to provide a pension income. In the U.S., the tax
treatment of an immediate annuity is that every payment is a combination of a
return of principal (which part is not taxed) and income (which is taxed at
ordinary income rates, not capital gain rates). When a deferred annuity is
annuitized, it works like an immediate annuity from that point on, but with a
lower cost basis and thus more of the payment is taxed.
A life or lifetime immediate annuity is used to provide an income for the life
of the annuitant similar to a defined benefit or pension plan.
A life annuity works somewhat like a loan that is made by the purchaser
(contract owner) to the issuing (insurance) company, which pays back the
original capital or principal (which isn't taxed) with interest and/or gains
(which is taxed as ordinary income) to the annuitant on whose life the annuity
is based. The assumed period of the loan is based on the life expectancy of the
annuitant. In order to guarantee that the income continues for life, the
insurance company relies on a concept called cross-subsidy or the "law of large
numbers".
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