Those who watch daytime television may be all too familiar with scenes of people leaning their heads outside their windows, shaking their fists at the sky, and shouting the phrase, “It’s my money, and I need it now!” Others may be familiar with the more recently portrayed scene of everyday citizens breaking out into an opera song about having a “structured settlement” and needing cash now. As these totally normal, everyday scenarios play out on their screens, viewers may find themselves wondering, what are these “structured settlements,” and why can’t these people get their money?
The “structured settlements” being referenced by the actors in these commercials are better known as annuities. While these commercials are part of a clever marketing campaign, they highlight a few important characteristics of these often complicated and misunderstood financial products. In our first of three blog posts dedicated to demystifying annuities, we will explore the definitions of some common annuity terminology.
An annuity is a contractual agreement between an insurance company and the buyer of the contract for the insurance company to provide the buyer with a steady stream of payments over a predetermined period of time (hence the term “structured settlement”). The amount and duration of these payments can vary, as each annuity contract can have several different terms and conditions associated with it than another annuity contract, even if those contracts are issued by the same financial institution.
Fixed vs. Variable
Annuities can be structured as either fixed or variable. A fixed annuity, as the name suggests, provides the annuity owner with consistent, fixed payments determined. A variable annuity, on the other hand, provides irregular, variable payments based on the performance of underlying sub-accounts (stocks, bonds, money market funds, etc.) into which the annuitant’s assets are invested.
Immediate vs. Deferred
An immediate annuity allows the annuity owner to receive payments almost right away, typically within one month of purchase. This type of annuity can generally only be purchased with a lump sum, as opposed to smaller payments made over time. With a deferred annuity, on the other hand, the insurance company invests the money contributed by the contract owner until the owner decides to begin taking regular payments, a process known as “annuitization.” Deferred annuities typically have a clause stating the annuity owner can cancel the annuity early and receive a lump sum, though there are often early withdrawal penalties involved that need to be considered and understood.
Pure Life vs. Period Certain
A pure life annuity, also known as a lifetime annuity, pays a benefit to the annuitant until the annuitant’s death. The contract owner’s estate or beneficiary receives no benefits following this death. With a period certain annuity, the contract owner can specify when the benefit will start and how long it will last, typically a period of 10, 15, or 20 years. If the annuitant dies before the end of this period, their estate or beneficiary receives the remainder of the payments.
Riders are special provisions that can be added to an annuity contract, giving the annuitant—or their beneficiaries—certain benefits that are not attached to the original contract. Each of these provisions increase the complexity and overall cost of the annuity, adding as much as 1 percent or more to the annual cost. Examples of annuity riders include guaranteed minimum living benefits, such as a guaranteed minimum withdrawal benefit (GMWB) or cost of living adjustment (COLA), and guaranteed minimum death benefits, such as a death benefit rider, which provides an annuity owner’s heirs with at least the amount of the premium paid into the annuity (or the amount of the premiums paid that are remaining).
Using the definitions above, we can begin to explore the types of annuity contracts available to consumers, such as:
- Immediate fixed annuity with 10 years certain – In this annuity contract, the annuitant provides the insurance company with a lump sum upon purchasing the annuity. The insurance company provides the annuitant a fixed monthly payment, which is guaranteed for the longer of the annuitant’s life or 10 years. If the annuitant dies before the 10-year period is completed, the annuitant’s estate or beneficiary receives the remainder of the payments.
- Deferred fixed pure life annuity with a COLA rider – In this annuity contract, the annuitant makes a single payment (or series of payments) to the insurance company. The annuitant receives fixed payments sometime in the future, and the payments increase if there is an increase in the cost of living. Payments cease upon the death of the annuitant.
In our next article in the series, we will look at some of the advantages and disadvantages of annuities.
The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.