Despite the difference in function, annuities are simply another type of insurance, and both life insurance policies and annuities are based on the same fundamental principles. Pooling underlies both, and premiums in each case are computed on the basis of probabilities of death and survival as reflected by mortality tables.
Classification of Annuities
Annuities may be classified in numerous ways.
• Number of lives covered
• method of premium payment
• time when income begins
• method of disposing of proceeds
• denomination in which benefits are expressed
Number of Lives Covered This classification involves the question of whether annuity payments are made with reference to one life or multiple lives. Perhaps most annuities sold worldwide, including in North America, are issued on a single life. That is, payments are made with reference to one life only. Annuities covering two or more lives are becoming more popular, especially in husband/wife situations. Thus, the joint and last-survivor annuity provides income payments for as long as either of two or more persons lives. This option is common in employer sponsored pension plans. As this annuity provides for payment until the last death, it will pay to a later date, on the average, than a single-life annuity and, therefore, is more expensive than single-life annuity forms. Stated differently, a given principal sum provides less income under a joint and last-survivor form than under a single-life annuity form at either of the two ages.
The joint and last-survivor annuity continues the same income until the death of the last survivor. A modified form provides (assuming two covered lives) that the income will be reduced following the death of the first annuitant to two-thirds or one-half of the original income. This contract is known as a joint and two-thirds (or joint and one-half) annuity. Naturally, for a given principal, the modified form provides more income initially because of the later reduction.
Another type of multilife annuity, known as a joint-life annuity, provides a specified income for two or more named persons, with the income ceasing upon the first death among the covered lives. Such contracts, although relatively inexpensive, have limited markets.
Method of Premium Payment Annuities may be purchased with single or periodic premiums. Thus, some single-life annuities are purchased with a single payment by beneficiaries under life insurance policies who receive the policy face amount on the death of the insured. Other single-premium payments are accumulated through savings, inheritance, or other means. Most individuals choose to spread the premium payment over a specified period by paying periodic premiums.
Time When Income Payments Commence Annuities may also be classified as to whether income payments are deferred or immediate. An immediate annuity is an annuity purchased with a single premium and the first annuity payment is due (almost) immediately. It would make no sense for the applicant to pay the insurer a large sum of money, just to have the insurer instantly return a portion of it, so the first annuity payment under immediate annuities actually is made one payment interval (e.g., a month or a year) from the date of purchase.
A deferred annuity, on the other hand, is an annuity purchased with either a single premium or periodic premiums. The first annuity benefit payment is made after the passage of more than one payment interval. The longer the deferral period, the more flexibility permitted in premium payments. Normally, many years elapse before benefit payments commence.
Disposition of Proceeds Insurers offer a variety of options as to how annuity proceeds are distributed. The annuitant elects the option that he or she believes is most beneficial to him or herself; thus, there is some element of adverse selection. Most insurers also include a provision in their contracts to the effect that they will provide any other annuity option that is mutually agreed upon by the insurer and the contract owner. This provision provides flexibility and helps ensure that the contract does not become obsolete or uncompetitive with the passage of time.
When a deferred annuity is issued, a maturity date typically is chosen, such as the annuitant’s sixty-fifth birthday. Most insurers contact the contract owner as the maturity date approaches, offering a range of payout options. If the annuitant fails to provide instructions to the insurer, many insurers automatically begin payments under the life- annuity-with-period-certain option. Some insurers allow the cash value to continue to build with no payouts. Some annuities provide for a so-called “refund” if the annuitant dies before a certain period has elapsed. This subject is discussed in the following section, which deals with the nature of the insurer’s obligation before and after income payments commence.
Denomination of Benefits Historically, annuity benefits have been expressed in fixed currency units, such as dollars. More recently, great interest has been shown in variable annuities in which annuity benefits are expressed in units of ownership in an investment fund. Of course, we also find annuity benefits expressed in various currencies, such as the Swiss franc.