Structured Settlements:

Deferred Annuity

The second usage for the term annuity came into being during the 1970s. This contract is more correctly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings, and eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment.

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owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.
A deferred annuity which grows by interest rate earnings alone is correctly called a fixed deferred annuity (FAs). A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is correctly called a variable annuity (VAs).

A new category of deferred annuities has emerged in 1995, called equity indexed annuity (EIA). Equity indexed annuities are a hybrid of the two types of deferred annuities just described. The insurance company typically guarantees a minimum return for EIA. An investor can still lose money if he or she cancels the policy early, before a "break even" period. An EIA's rate of return is equal to the "participation rate" multiplied by a target stock market index's performance excluding dividends. Interest rate caps, or administrative fee may be applicable.

There are two phases to a deferred annuity. The accumulation phase is the time between initial purchase and annuitization. The annuitization phase starts when the annuity is turned into a stream of payments. Before annuitization, the defered annuity contract may allow additional purchase premium payments to be added, increasing the contract's value.

A wide variety of features and guarantees have been developed by insurance companies in order to make their annuity products more attractive. These include death benefit options and living benefit options.

Deferred annuities in the United States have an advantage that all capital gains and income are tax deferred until withdrawn. In theory, this allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when a variable annuity is inherited or received as income the beneficiary must pay regular income tax on the gains above the invested cost basis.

Deferred annuities are usually divided into two different kinds:
Fixed Annuities offer some sort of guaranteed rate of return over the life of the contract. In general these are often positioned to be somewhat like bank CDs, and offer a rate of return competitive to CD's of similar time frames (with different tax treatments as previously mentioned). However, many fixed annuities do not have a completely fixed rate of return over the life of the contract, but rather a guaranteed minimum rate and a first year "teaser rate". The rate after the first year is often any amount that the insurance company wants to pay, but at least the minimum amount. Unlike most CD's, there are usually some clauses in the contract to allow a percentage of the interest and/or principal to be withdrawn early and without penalty. Normally, fixed annuities become fully liquid upon death.

Variable Annuities allow money to be invested in separate accounts (similar to mutual funds) in a tax deferred manner. Overall their primary use is to allow someone to engage in tax deferred investing for retirement at amounts greater than permitted by individual retirement or 401(k) plans. In addition, many variable annuity contracts offer a guaranteed minimum rate of return (either for a future withdrawal and/or in the case of the owners death), even if the underlying separate account investments perform poorly. This can be attractive to people uncomfortable investing in the equity markets without the guarantees. However, an investor will pay for each benefit provided by a variable annuity, since insurance companies in general do not write money losing contracts; look at the charges carefully. These products are often heavily criticized as being sold to the wrong persons, who could have done better doing something else, since the commissions paid by this product are often very high relative to other investment products.

There are several types of these performance guarantees, and many times one can choose them a la carte, with higher charges for guarantees that are riskier for the insurance companies. There are guaranteed minimum death benefits (GMDBs), which can be received only if the owner of the annuity contract, or the covered annuitant, dies.

These GMDBs come in various flavors, in order of increasing risk to the insurance company:
• Return of premium (a guarantee that you will not have a negative return)
• Roll-up of premium at a particular rate (a guarantee that you will achieve a minimum rate of return, greater than 0)
• Maximum anniversary value (looks back at account value on the anniversaries, and guarantees you will get at least as much as the highest values upon death)
• Greater of maximum anniversary value or particular roll-up

Even riskier for insurance companies are the guaranteed living benefits, which tend to be elective. Unlike death benefits, which the contractholder generally can't time, living benefits have significant risk for the insurance companies as contractholders will likely exercise these benefits when they are worth the most. Annuities with guaranteed living benefits (GLBs) tend to have very high fees.

Some GLB examples, in no particular order:

• Guaranteed minimum income benefit (a guarantee that one will get a minimum income stream upon annuitization at a particular point in the future.)
• Guaranteed minimum accumulation benefit (a guarantee that the account value will be at a certain amount at a certain point in the future)
• Guaranteed minimum withdrawal benefit (a guarantee similar to the income benefit, but one that doesn't require annuitizing).

Criticisms of deferred annuities
Deferred annuities are criticized by financial gurus, because they often generate a higher commission than other forms of investment and they also typically have surrender charges, in which a certain percentage of the account value is taken by the insurance company as a fee in the case of early withdrawal of too much money. However, as most contracts allow you to take out up to 10% per year with no penalty, this point is moot for individuals who are taking an income below this amount from the annuity.

An abusive practice of insurance sales is the selling of insurance contracts within an IRA or 401(k) plan in the US. Since these investment vehicles are already tax defered, investors do not receive additional tax shelters from the annuities.

Taxation

In the U.S. Internal Revenue Code, the growth of the annuity value during the accumulation phase is tax deferred, that is, not subject to current income tax for annuities owned by individuals. The tax deferred status of deferred annuities has led to their common usage in the United States. Under the US tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments (annuitization), and many of the contracts are bought primarily for the tax benefits rather than to get a fixed stream of income. If an annuity was used in a qualified pension plan or an IRA funding vehicle, then 100% of the annuity payment is taxable as current income upon distribution. If the annuity contract is purchased with after-tax dollars, then the policyholder upon annuitization recoves his basis pro-rata in the ratio of basis divided by the expected value according to the IRS regulations from Section 1.72-5. After the taxpayer has recovered all his basis, then 100% of the payments thereafter are subject to ordinary income tax.

See:
• Annuity
• best fixed annuities
• best fixed annuity rates
• fixed indexed annuities
• Life Annuity
• credit shelter trusts
• Tort
• California structured settlement companies
• Colorado settlement companies
• Cashing in on a Structured Settlement
• Texas Structured Settlement
• Cash for Structured Settlements

This article is licensed under the GNU Free Documentation License.
It uses material from the Wikipedia article "Annuity (US financial products)".