Annuity terms every investor should know
Annuities can be a powerful tool for retirement planning, but they can easily feel complex and overwhelming if you’re unfamiliar with the terminology.
Here’s a breakdown of the most common annuity terms so you can make informed decisions as you navigate the annuity marketplace.
What is an annuity?
An annuity is a financial contract between you and an insurance company. You make a lump sum payment or a series of payments to the insurance company, and in return, the insurance company agrees to pay you a regular income stream, either for a fixed period or for life.
Common annuity terms explained
Here are some of the most common annuity terms and definitions.
1035 exchange
A provision in Section 1035 of the Internal Revenue Code that allows for a tax-free exchange of one annuity contract for a more suitable annuity.
Annuitant
An annuitant is the person who is entitled to receive regular payments from an annuity. They receive the income stream generated by the annuity, typically in exchange for a lump sum payment or a series of payments made to the insurance company.
Accumulation phase
The accumulation phase is the period during which the annuitant makes payments to the insurance company. These payments are invested and grow over time.
Annuity contract
The annuity contract is the legal document that outlines the terms of the annuity, including its payout schedule, surrender fees and other costs. It’s important to read the contract carefully before signing.
Annuitization phase
The annuitization phase begins when the annuitant chooses to receive income payments from the insurance company. The accumulated value of the annuity is converted into a guaranteed income stream. Withdrawing money from an annuity contract after annuitization begins is difficult, if not impossible.
Death benefit
Many annuities offer a death benefit, which pays a lump sum to the beneficiary if the annuitant dies before receiving all of the guaranteed payments.
Deferred annuity
A deferred annuity provides income payments at a later date, often years in the future. This is a popular option for individuals who want to save for retirement and defer the income payments until they need them.
Distribution phase
The point when you start receiving income (distributions) from your annuity.
Fixed annuity
A fixed annuity offers a guaranteed rate of return, and often functions similarly to a certificate of deposit (CD). This means that the income payments will be fixed and predictable. Fixed annuities are generally considered less risky than other types of annuities.
Fixed indexed annuity
Free-look period
The free-look period is a specific time frame during which an annuity contract can be canceled without penalty. If you decide the annuity isn’t right for you, you can cancel it during this period and receive a full refund of your premium. The length of the free-look period can vary by state, but it’s typically between 10 and 30 days.
Guaranty association
A guaranty association is a state-mandated organization that protects policyholders in the event of an insurance company’s insolvency. It acts as a safety net, ensuring that policyholders can still receive compensation for their claims, even if the original insurer goes bust. These associations are funded by assessments levied on all insurance companies operating within a state.
Guaranteed minimum income benefit (GMIB)
A GMIB is a rider that guarantees a minimum level of income payments, even if the underlying investments perform poorly.
Immediate annuity
An immediate annuity provides income payments within 12 months or less after the purchase. Immediate annuities require a large, up-front lump sum to fund the annuity contract. This is a popular option for retirees who need a steady income stream right away.
Indexed annuity
An indexed annuity offers a return based on a market index, like the S&P 500. An indexed annuity provides principal protection and may offer a guaranteed minimum interest rate, while also offering potential for growth.
Joint and survivor annuity
An annuity that provides income payment for the life of the annuitant, with smaller payments made to the surviving spouse for their life after the annuitant dies.
Longevity annuity
Also known as a deferred income annuity, this product is designed to provide a guaranteed income stream starting at a specific future date. This is a popular option for individuals who are concerned about outliving their savings.
Longevity risk
The risk of outliving your retirement savings.
Margin or spread
A margin or spread percentage is used in indexed annuities to determine the amount of interest credited to your account based on the index’s performance. It reduces the index’s growth, but the annual interest credited to your account will never be less than zero.
Multi-year guarantee annuity
Multi-year guarantee annuities (MYGAs) are a type of fixed annuity that offers a guaranteed interest rate over a specific period of time, typically five to 10 years. If you withdraw your funds before the end of the period, you may face early withdrawal penalties, similar to a CD.
Nonqualified annuity
A nonqualified annuity is funded with post-tax dollars and not part of a qualified retirement plan. Most annuities are nonqualified, which simply describes the annuity’s tax treatment. A nonqualified annuity can be fixed, variable, immediate or deferred. You only pay taxes on the earnings and won’t have a required minimum distribution.
Participation rates
Participation rates are commonplace in many indexed annuity contracts, and they determine the percentage of the index’s growth that will be credited to your account. For example, if the participation rate is 70 percent, and the index increases by 10 percent, your annuity will earn 7 percent. This means that you’ll benefit from some of the market’s gains, but you won’t capture the full performance of the index.
Period certain
A fixed-period annuity option that provides regular payments for a predetermined length of time. The payment amount is calculated based on the annuity’s value and the chosen period. If the annuitant passes away before the guaranteed period is over, a named beneficiary may choose to continue receiving payments or receive a lump sum.
Premium
The payment(s) you make to the life insurance company to fund your annuity contract. You can purchase an annuity with a single, large premium (immediate annuity) or a series of premiums over time (deferred annuity).
Qualified annuity
A qualified annuity is funded with pre-tax dollars, typically from a retirement account, such as a 401(k) or IRA. Qualified annuity withdrawals are fully taxable. You won’t get a double tax break by purchasing a qualified annuity through a retirement account. A required minimum distribution also applies.
Rider
An annuity rider is an optional feature that can be added to an annuity contract to enhance its benefits or provide additional protections. Common annuity riders include death benefits, guaranteed minimum income benefits and living benefits, which provide greater immediate access to your annuity funds under certain conditions, such as a terminal illness or nursing home care.
Single-premium immediate annuity
A type of annuity offering a guaranteed income stream, typically for life or a specified period, with payments starting within a year. This is a popular option for individuals who have a large sum of money to invest.
Surrender charge
This fee is deducted if you choose to surrender (cash in) your annuity contract. These fees vary among insurance companies and can change over time and may change over the life of the annuity contract.
Variable annuity
A variable annuity offers a rate of return based on the performance of underlying investments, such as stocks or bonds. This means that the income payments can fluctuate depending on market conditions. Variable annuities are generally considered more risky (and more expensive) than fixed annuities.
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