In a typical scenario, an investor (usually the annuitant) will make a single cash premium to own an annuity.
After the policy is issued the owner may elect to annuitize the contract (start receiving payments) for a chosen period of time (e.g., 5, 10, 20 years, a lifetime).
Alternatively, an investor can defer annuitizing their contract to get larger payments later, hedge long-term care cost increases, or maximize a lump sum death benefit for a named beneficiary.
[1] The idea of paying out a stream of income to an individual or family dates back to the Roman Empire.
The Roman speculator and jurist Gnaeus Domitius Annius Ulpianus is cited as one of the earliest dealers of these annuities, and he is also credited with creating the first actuarial life table.
During the Middle Ages, annuities were used by feudal lords and kings to help raise capital to cover the heavy costs of their constant wars and conflicts with each other.
The purpose was to provide a secure retirement to aging ministers and their families, and was later expanded to assist widows and orphans.
In 1812, Pennsylvania Company Insurance was among the first to begin offering annuities to the general public in the United States.
Some prominent figures who are noted for their use of annuities include: Benjamin Franklin assisting the cities of Boston and Philadelphia; Babe Ruth avoiding losses during the great depression, O. J. Simpson protecting his income from lawsuits and creditors.
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.
This is an insurance policy which, in exchange for a sum of money, guarantees that the issuer will make a series of payments.
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.
The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings with a tax-deferred growth factor.
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.
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".
All varieties of deferred annuities owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn.
In theory, such tax-deferred compounding allows more money to be put to work while the savings are accumulating, leading to higher returns.
A disadvantage, however, is that when amounts held under a deferred annuity are withdrawn or inherited, the interest/gains are immediately taxed as ordinary income.
A variety of features and guarantees have been developed by insurance companies in order to make annuity products more attractive.
Each feature or benefit added to a contract will typically be accompanied by an additional expense either directly (billed to client) or indirectly (inside product).
The first type is a guaranteed minimum death benefit (GMDB), which can be received only if the owner of the annuity contract, or the covered annuitant, dies.
Annuities with guaranteed living benefits (GLBs) tend to have high fees commensurate with the additional risks underwritten by the issuing insurer.
In the former, a percentage of client's account value will be transferred to a designated low-risk fund when the contract has poor investment performance.
Be careful in regard to using GLB riders in non-qualified contracts as most of the products in the annuity marketplace today create a 100% taxable income benefit whereas income generated from an immediate annuity in a non-qualified contract would partially be a return of principal and therefore non-taxable.
Variable annuities are controversial because many believe the extra fees (i.e., the fees above and beyond those charged for similar retail mutual funds that offer no principal protection or guarantees of any kind) may reduce the rate of return compared to what the investor could make by investing directly in similar investments outside of the variable annuity.
Annuity contracts are protected against insurance company insolvency up to a specific dollar limit, often $100,000, but as high as $500,000 in New York [2], New Jersey [3], and the state of Washington [4].
When an insolvency occurs, the guaranty association steps in to protect annuity holders, and decides what to do on a case-by-case basis.
Some firms allow an investor to pick an annuity share class, which determines the salesperson's commission schedule.