What are annuities? Basic structure and function

Camarda Wealth Advisory Group

Basic annuity anatomy – built on life insurance

Let’s begin with a basic premise:

Annuities are life insurance contracts. Annuities are life insurance contracts.

Those are just words, even with the repetition and the emphasis. So what does it mean?

It means that instead of a direct investment in an investment vehicle, annuity owners exchange their dollars for promises (with a lot of stipulations) made by life insurance companies. These promises may be straightforward or convoluted, indeed.

Annuity investment is actually in a life insurance company’s promise

But instead of having direct claim over specific assets (like shares of stock, or dollars in a bank) you have accepted a promise, which means that you are at least one more step removed from what you had thought you were buying.

These promises can often appear to be thin shadows of the property you thought you were purchasing, for a variety of reasons, which we will explore.

It is very important to realize that while all annuities have certain aspects in common, each one is a unique contract written by the insurance company’s legal staff, and can vary tremendously from other annuities contracts, even those issued by the same company! It is important to read and understand to see just what you may have.

The two basic annuity features

As “permanent” life insurance contracts, all annuities have two basic elements: a cash feature and an insurance feature.

The cash feature is ultimately an income one designed to pay income to the owner for some specified period, usually life. The insurance feature is some permutation of a death benefit, usually very watered-down, and usually very overpriced. We’ll look at some hard examples in just a bit.

Since we are talking about a life insurance contract, these are things that you have to apply for, though in reality not too many applicants are turned down, since state of health really plays no role in issuing the veneer of life insurance. In fact, in the annuity world, poor health should equal better rates, but hardly ever does.

The three critical annuity parties

On the application, besides the insurance company, there are three parties who apply, though they can all be the same person, and often are.

  1. Annuity Owner – The first party is the owner. This is the person who has the right to all the benefits of the property, which is the annuity contract, and can access the cash value within the constraints of the contract, and can change those things the contract will permit, such as the beneficiary.
  2. Annuity Beneficiary – The beneficiary is the person or entity who gets the value of the annuity contract, if any remains, at the death of . . . you’ll never guess . . . the annuitant. There is more on the annuitant in the next paragraph. In this, an annuity is like a life insurance contract, except that the beneficiary gets the bundle on the death of the annuitant instead of on the death of the insured.
  3. Annuity Annuitant – So what is an annuitant? As we will see in a bit, annuities are really designed to payout an income for a term which is usually based on someone’s lifetime. Even the word annuity is heavy on the “annual.” If you think of a pension where the pensioner gets so much for life or a little bit less for their and their spouse’s combined life, you will have a good idea of the basic premise of an annuity.

I know, I know, most of us think of annuities as accumulation products, and maybe the agent never told you about the automatic conversion to lifetime income provisions on page 46b of the contract. But trust me, they’re there.

Annuities as life insurance in reverse – lifetime income

Now, since the whole basic premise of an annuity is to generate lifetime income for someone, it matters who that person is that the contract’s payout features are to revolve about. How old they are—and how long they might live and collect—is a big one, for instance.

The person whose life determines the annuity’s payout behavior is called the annuitant. Insurance companies often describe the annuitant as the “measuring life,” but that doesn’t really tell us much by itself. So now you know: the annuitant is the one whose life determines the payout of the annuity.

For instance, if a “pure life,” or payout only for the annuitant’s lifetime option is selected, then income stops at the death of the annuitant and who also is the life which acts as the insured so long as there is some life insurance benefit to the annuity. The annuitant has no rights by virtue of being the annuitant; the life of the annuitant is simply a yardstick.

Annuitization – an irrevocable step

Permanent conversion of an annuity’s accumulation value into regular income—a process that cannot be undone—is called annuitization. Annuity contracts specify some future age at which this will happen automatically, but most folks die or clean the contracts out long before automatic annuitization.

The owner controls the contract, and gets to pick the parties at inception; usually, once the contract is issued, the annuitant can never be changed. The beneficiary gets whatever life insurance value may be left at the death of the annuitant. The same individual can (and often does) play all three roles. Groups of people can also play any or all roles: Jim and Jack can own a contract measured by the joint lives of Jane and Jill, with John and Joan to split the proceeds if the annuitants die. And we are not even into contingent beneficiaries yet. But there still are only three basic parties, even if each party really looks like a party!

Choose the annuitant wisely…

It is interesting to note that many insurance companies specify a maximum age allowed for annuitants and actually cut the commission rates that they will pay salespeople for older annuitants.

It is for this reason that unscrupulous agents may sometimes suggest that a younger spouse or child be specified as the annuitant, but this can be a very poor move for the annuity owner, for both tax and liquidity reasons.

The reason that life companies prefer younger annuitant ages is twofold: most contracts will waive the surrender charges—fees to access principal in early years—at the death of the annuitant, and the older the annuitant, the sooner that will be, statistically speaking, and the shorter the insurance company will have the money available to recover sales commissions and profit on; the other reason is that the older the annuitant, the sooner the contract will automatically annuitize, and the sooner the company will have start paying out an income, which can also cut into profitability.


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