Annuity Purposes and Contract Parties

Understanding the Purpose and Phases of an Annuity

An annuity is an insurance contract designed to accumulate funds, provide income, or both. While life insurance can provide money at an insured person's death, an annuity operates differently by providing income over time, including income that lasts for life. The primary risk an annuity protects against is longevity risk, which is the risk of outliving one's financial resources. From a legal standpoint, the annuity contract operates as a legally binding unilateral agreement where only the insurer makes an enforceable promise.

An annuity moves through distinct phases depending on its design. A deferred annuity has an accumulation period before its payout period. The accumulation period is also referred to as the pay-in phase of the annuity contract. Many deferred annuities have an accumulation value before payout, but some deferred income annuities do not provide an accessible cash value. For a nonqualified annuity owned by an individual, earnings generally grow tax-deferred, although growth is not guaranteed; an annuity owned by a corporation or another non-natural person may not qualify for tax deferral.

The payout phase is called the annuity period, also known as the liquidation period, payout period, or annuitization phase. During the annuity period, the accumulated funds are converted into a stream of regular income payments. While a deferred annuity postpones the start of income payments to allow an accumulation period, an immediate annuity generally begins with the payout period, has no accumulation period, and begins paying out income within one year of the premium payment.

Annuitization converts an annuity's value into periodic payments under a selected payout option and is generally irrevocable. Once annuitization occurs, the contract owner generally cannot surrender the contract or change the payout option. For a life-contingent payout option, the annuitant's life expectancy is one factor used to calculate payments.

The Four Parties to an Annuity Contract

There are four potential parties to an annuity contract: the insurer, the owner, the annuitant, and the beneficiary. The insurer issues the contract and is responsible for its contractual payment obligations, subject to its claims-paying ability. The other three roles involve the individuals or entities that hold rights, measure life expectancy, or receive proceeds.

The owner holds the contractual rights and is generally the person or entity that purchases the annuity, although someone else may provide the premium. The owner can be an individual, a trust, a corporation, or another legal entity. Subject to the contract's terms, the owner holds significant authority: the owner can name or change the beneficiary (subject to any irrevocable beneficiary designation), choose the settlement or payout option, and surrender the annuity or make partial withdrawals during accumulation.

The annuitant is the natural person whose life is used to calculate life-contingent income payments. Because annuity payout calculations rely on human mortality tables, an annuitant must always be a natural person. A corporation or trust can own an annuity, but it cannot serve as the annuitant. The owner and the annuitant are very frequently the same individual, but they can be two different individuals under the same contract. An annuitant does not have ownership rights in the contract unless that annuitant is also named as the owner.

The beneficiary is designated to receive any benefits payable after an owner's or annuitant's death, depending on the contract and payout option. A beneficiary generally cannot manage or surrender the annuity while the owner is alive, although an irrevocable beneficiary may have rights that restrict changes to the contract. Annuity benefits paid directly to a named beneficiary generally avoid probate. If no beneficiary is eligible to receive the proceeds, the contract's default provisions determine who receives them, which may be the owner's estate.

Contract Surrenders and Withdrawals During Accumulation

If the contract permits surrender during accumulation, the owner can terminate it and receive any cash surrender value available under its terms. This completely ends the contract prior to annuitization.

To discourage early liquidation and recover issuance costs, insurers often establish surrender charges. A surrender charge is an amount the insurer deducts under the contract when the owner surrenders or withdraws funds during a specified charge period. Some deferred annuities permit limited withdrawals without an insurer surrender charge; the exact amount and conditions depend on the contract, and taxes may still apply.

For example, imagine a client purchases a deferred annuity and needs money three years later during the contract's stated charge period. If the owner surrenders the entire contract, the insurer applies a surrender charge against the accumulation value before disbursing the remaining cash surrender value. If the contract permits limited penalty-free withdrawals, the owner may take that allowed amount without an insurer deduction, though income tax obligations may still arise.

Death Benefits and Payout Settlements

If the owner dies during accumulation, the contract generally provides for payment or distribution to a designated beneficiary, subject to its terms and federal tax rules. For a nonqualified annuity, accumulated earnings included in death proceeds are generally taxable to the beneficiary as ordinary income. Federal tax rules generally require distributions after the owner's death, even if the owner and annuitant are different people. If an annuitant who is not the owner dies during accumulation, contract terms and applicable federal tax rules determine whether benefits must be distributed or a successor annuitant may be named.

Tax rules establish different treatment for surviving spouses compared to nonspouse beneficiaries. For a nonqualified annuity, a surviving spouse who is the designated beneficiary may generally elect spousal continuation. Spousal continuation generally lets the surviving spouse treat the contract as their own, continuing the contract as its owner and deferring income tax until distributions are taken. In contrast, a nonspouse beneficiary of a nonqualified annuity generally must take distributions under federal tax deadlines rather than continue the contract as their own.

What happens upon death during the payout phase depends on the selected settlement option, the contract's terms, and whose death triggers a benefit. If the annuitant dies during the payout stage under a straight life income option, all payments cease immediately with no residual benefit to a beneficiary. Under a life annuity with period certain, income is guaranteed for the annuitant's life, and payments are provided to a beneficiary if the annuitant dies before the specified period ends.

Refund options offer another layer of protection if the annuitant dies early in the payout phase. Under a cash refund option, if the annuitant dies before receiving payments equal to the amount used to purchase the income stream, the beneficiary receives the difference in a lump sum. Under refund or period certain options, any remaining guaranteed benefit is paid to the beneficiary in the form specified by the option, which may be installments or a lump sum.