Annuities in Practice

An annuity is a contract that turns a sum of money into a stream of income, and the contract’s dollar values are set by a few moving parts: who holds the rights, what interest the money earns, what it costs to leave early, and how the payout is figured. Each of those parts is worked below with numbers, with Michigan’s rules for individual deferred annuities (MCL 500.4072 and 500.4073) applied where they change the result, and the uses an annuity is put to come last. Names and figures in the examples are invented. They are not statutory figures, and not any insurer’s actual rates.

Owner, Annuitant and Beneficiary

Three people can be named in an annuity, and each one triggers something different. The owner holds the contract rights: paying premiums, naming the beneficiary, taking withdrawals, surrendering the contract and choosing the payout option. The annuitant is the person whose life measures the payout. The annuitant’s age and life expectancy set how large a lifetime payment can be. The beneficiary receives the death benefit if the contract pays one. One person may fill all three roles, but they do not have to.

The roles matter at death. Take Tomas Nowak, who buys a deferred annuity and names his mother Irena as annuitant and his sister Katya as beneficiary.

• If Irena dies before payments begin, the contract’s death benefit is payable to Katya. In most contracts the annuitant’s death, not the owner’s, triggers it.
• If Tomas dies first, the contract does not simply continue. The federal Code treats a contract as an annuity only if it requires distribution when a holder dies. When a holder dies before the annuity starting date, the entire interest must be distributed within 5 years of the death (26 U.S.C. 72(s)(1)(B)). A designated beneficiary may instead take the interest over the beneficiary’s own life or life expectancy if distributions begin within a year of the death (72(s)(2)). If the designated beneficiary is the holder’s surviving spouse, the spouse is treated as the holder and may continue the contract (72(s)(3)).
• If the owner is not an individual, such as a trust or company, the primary annuitant is treated as the holder for the distribution rule and for the early-distribution penalty exception for death (72(s)(6), 72(q)(2)(B)).

Katya’s choices on Tomas’s death therefore differ from what they would be on Irena’s death. The producer who sets up the contract should say so at the application, because the roles decide who must act at a death, and a beneficiary’s options are narrower than many owners expect.

The Insurance Features of an Annuity

An annuity is an insurance product because the insurer takes on risks the owner cannot manage alone. Before annuitization, most contracts pay a death benefit. Michigan sets a floor for deferred annuities that provide a cash surrender benefit: the death benefit must be at least equal to the cash surrender benefit (MCL 500.4072(9)). At annuitization, the insurer takes on the longevity risk. A life income option promises payments for as long as the annuitant lives, however long that proves to be, and a stated payment guarantee protects against falling interest rates. Michigan requires an individual deferred annuity contract to state the mortality table and interest rates behind any guaranteed minimum benefits (MCL 500.4072(3)(c)).

Immediate and Deferred Annuities

A single premium immediate annuity, called an SPIA, takes one lump sum and begins payments within a short period, usually within a year. It has no accumulation stage, so most contracts have no surrender charge schedule, no death benefit before payments start, and no cash value to withdraw. Michigan’s standard nonforfeiture law for deferred annuities does not apply to it (MCL 500.4072(2)). A deferred annuity accumulates first and pays later, and it can be funded in three ways: a single premium, a flexible premium that the owner varies, or a scheduled premium paid at set intervals. Its owner-facing features are the ones the next sections work: crediting, surrender charges, the nonforfeiture floor and the payout calculation.

Fixed Annuities: Minimum Versus Current Rates

A fixed annuity is backed by the insurer’s general account. The insurer, not the owner, carries the investment risk. Two rates appear in the contract. The current rate is declared by the insurer for a period, often a year, and it is not guaranteed past that period. The minimum guaranteed rate is the least the contract can ever credit. The contract states the minimum in advance, and the insurer cannot go below it.

Ruth Szabo puts $100,000 into a fixed deferred annuity. The first-year rate is 4.00% and the contract guarantees a minimum of 2.00%. The insurer declares these renewal rates in later years: 3.50%, 3.00%, 3.00% and 2.75%.

End of year	Rate credited	Account value
1	4.00%	$104,000.00
2	3.50%	$107,640.00
3	3.00%	$110,869.20
4	3.00%	$114,195.28
5	2.75%	$117,335.65

If the insurer had credited only the 2.00% minimum for all five years, the account would be $100,000 times 1.02 to the fifth power, or $110,408.08. The difference of $6,927.57 is what the current rates added. It is not promised, and a producer who quotes the first-year rate as the rate the account will earn is misleading the client. The first-year rate is the highest in this example, and no later rate matches it. A producer should also ask whether the first-year rate includes a bonus, which can make the first-year figure look far better than the rates that follow.

Fixed annuity payouts are level. Once annuitized on a fixed basis, each payment is the same amount, so the owner trades purchasing power against certainty.

Surrender Charges, Free Withdrawals and the Michigan Floor

A surrender charge is a fee for withdrawing more than the contract allows, or giving up the contract, in its early years. Most deferred annuities set it as a percentage of the amount withdrawn that declines yearly. A free withdrawal provision lets an owner take a stated percentage of the account value each year without a charge, often 10%.

Suppose Ruth’s contract charges 7%, 6%, 5%, 4%, 3%, 2% and 1% in contract years 1 to 7, and nothing after, and allows a free withdrawal of 10% of the account value each year.

• A full surrender at the end of year 3 pays the account value of $110,869.20 less the 5% year-3 charge of $5,543.46, which is $105,325.74.
• A withdrawal of $8,000 in that year is within the free amount of $11,086.92 (10% of $110,869.20). Ruth receives $8,000.
• A withdrawal of $20,000 exceeds the free amount by $8,913.08. The charge is 5% of that excess, or $445.65, and Ruth receives $19,554.35.

In a contract written this way the charge applies to the excess only, so an owner who has been told “you will lose 5%” may be put off from using the free amount.

The Nonforfeiture Floor

Michigan does not let surrender charges and low credited rates push cash values below a statutory minimum. For individual deferred annuities, the minimum nonforfeiture amount is built from 87.5% of the gross considerations paid, accumulated at a statutory interest rate. It is reduced by prior withdrawals, a $50.00 annual contract charge, any premium tax the company paid, and any contract loan (MCL 500.4072(5)(b), (c)). The rate is the lesser of 3% a year and the 5-year constant maturity Treasury rate, rounded to the nearest 1/20 of 1% and then reduced by 125 basis points, and it may not be less than 0.15% (MCL 500.4072(6)). The cash surrender benefit may never be less than that minimum amount (MCL 500.4072(9)).

The example sets the Treasury rate at 3.80%. The statutory rate is then 3.80% minus 1.25%, or 2.55%. The floor on Ruth’s $100,000 single premium is $87,500 accumulated at 2.55%. To keep the arithmetic readable, the table leaves out the $50.00 annual charge and any premium tax, and it assumes only the 2.00% minimum is credited each year, which is the worst case.

End of year	Account value at 2.00%	Surrender charge	Net cash surrender value	Statutory floor at 2.55%
1	$102,000.00	7%	$94,860.00	$89,731.25
3	$106,120.80	5%	$100,814.76	$94,365.89
5	$110,408.08	3%	$107,095.84	$99,239.91
7	$114,868.57	1%	$113,719.88	$104,365.68

In every year the contract’s net value clears the floor with room to spare. The floor is a backstop: it would matter only for a contract with a high charge or a very low credited rate. It also explains why Michigan annuity contracts must include a statement of the mortality table and interest rate used to calculate the minimum benefits, and a statement that the benefits are not less than the law requires (MCL 500.4072(3)(c), (d)).

Three other Michigan rules attach to the same section.

• If the owner stops paying premiums, the contract must grant a paid-up annuity on request, in a value the section specifies (MCL 500.4072(3)(a)).
• If consideration has not been received for 2 full years and the paid-up benefit at maturity from the earlier premiums would be under $20.00 a month, the company may at its option end the contract by paying the present value in cash (MCL 500.4072(4)).
• A company may reserve the right to delay a cash surrender for up to 6 months, but only if it asks the Director in writing, shows the delay is necessary and fair to all policyholders, and the Director approves in writing (MCL 500.4072(3)(b)). An insurer cannot defer a surrender simply because its contract says it may.

Equity-Indexed Annuities: How the Credit Is Figured

An equity-indexed annuity is a fixed annuity whose interest is tied to an index. The owner does not own index shares. The insurer uses the index’s movement over a crediting period to compute a rate and applies it to the account. A floor of 0% means a falling index does not reduce the account. Three terms set how much of a gain reaches the owner. A participation rate is the percentage of the index gain that is credited. A cap is the highest rate the contract will credit for the period. A spread, also called a margin or asset fee, is a percentage subtracted from the index gain. A contract may use one of these or several, and the NAIC annuity disclosure model calls for its disclosure document to explain the participation rates, caps or spread and how they operate (Model 245, section 5B(3)(a)).

This example uses annual point-to-point crediting, which compares the index at the end of each contract year to the index at the start. Ruth puts $100,000 into two indexed annuities. The index changes by +12.0%, -6.0%, +4.0%, +9.0% and +1.5% over five years.

Contract A has a 70% participation rate, a 6.00% cap and a 0% floor. Contract B has a 2.00% spread, full participation, no cap and a 0% floor. In Contract B, the spread is subtracted from the gain and the result cannot be below zero.

Year	Index change	Contract A credit	Contract A value	Contract B credit	Contract B value
1	+12.0%	6.00% (70% of 12.0% is 8.4%, capped)	$106,000.00	10.00% (12.0% less 2.0%)	$110,000.00
2	-6.0%	0.00% (floor)	$106,000.00	0.00% (floor)	$110,000.00
3	+4.0%	2.80% (70% of 4.0%)	$108,968.00	2.00% (4.0% less 2.0%)	$112,200.00
4	+9.0%	6.00% (70% of 9.0% is 6.3%, capped)	$115,506.08	7.00% (9.0% less 2.0%)	$120,054.00
5	+1.5%	1.05% (70% of 1.5%)	$116,718.89	0.00% (1.5% less 2.0% is below zero)	$120,054.00

Compare three benchmarks. A fixed annuity at 3.00% a year would reach $115,927.41. An investment that rose and fell with the index, with no floor, would reach $121,135.59. Contract B ends near the index result and above the fixed annuity. Contract A ends just above the fixed annuity. Neither contract passed through the 6% loss in year 2. The tradeoff is plain: the floor and the limits come together.

Two points follow for the producer. First, a contract’s cap, participation rate and spread are usually not guaranteed for the life of the contract. The insurer may reset them each period within contractual limits, so an illustration of past index performance does not show what a new period will credit. Second, many indexes are price indexes that leave out dividends. An owner whose comparison is a stock fund with reinvested dividends will see a larger gap than the table shows. Michigan allows an insurer to reduce the nonforfeiture interest rate by up to 100 additional basis points while a contract provides substantive participation in an equity-indexed benefit (MCL 500.4072(7)). That reduction is limited to the market value of the benefit, and the Director may require the insurer to show it.

Market Value Adjusted Annuities

A market value adjusted annuity, or MVA annuity, guarantees a fixed interest rate for a stated period, such as 7 years. If the owner surrenders or withdraws before the period ends, a market value adjustment is applied. The NAIC annuity disclosure model defines the adjustment as a positive or negative change applied to account or cash value on withdrawal, surrender, annuitization or death benefit payment, based on an index or on the company’s current guaranteed rate for new premiums, when the event falls at a time other than a specified guaranteed benefit date (Model 245, section 4I). The reason for it is that the insurer bought long-term investments to support the guaranteed rate. If rates have risen, those investments are worth less and the insurer would take a loss on an early exit.

A contract states its own formula. One common form compares the rate guaranteed at issue with the rate the insurer is currently offering for the time remaining:

adjustment factor = (1 + rate at issue) divided by (1 + current rate for the remaining term), raised to the number of years remaining.

Hana Ortiz owns a 7-year MVA annuity at 4.00%. After 3 years the account value is $100,000 times 1.04 cubed, or $112,486.40. She surrenders with 4 years left.

Current rate for 4 years	Factor	Value after adjustment	After 5% year-3 surrender charge
5.50% (rates have risen)	0.9443	$106,224.22	$100,913.01
3.00% (rates have fallen)	1.0394	$116,918.83	$111,072.89
No adjustment	1.0000	$112,486.40	$106,862.08

When rates rose, Hana receives about $5,949 less than with no adjustment. When rates fell, she receives about $4,211 more. The adjustment cuts both ways, which is why the NAIC definition says it is positive or negative and why the model’s illustration rules call for showing both the upside and the downside (Model 245, section 6I). This example takes the surrender charge after the adjustment. A contract may say otherwise. The statutory floor still applies: for a contract that provides cash surrender benefits, the cash benefit may not be less than the minimum nonforfeiture amount, which on these figures at the 2.55% statutory rate would be $94,365.89 at the end of year 3 (MCL 500.4072(9)). In both rows Hana’s value is above it.

Payouts: Calculating Each Option

When an owner annuitizes, the insurer converts the account value into payments. Four things set the first payment: the account value, the annuitant’s age and life expectancy, the interest rate the insurer assumes, and the payout option chosen. The insurer expresses the result as a payout rate per $1,000 of value. The payout rates below are invented to show how the options compare. They are not a table.

Options Certain and Life Contingency Options

A fixed period option pays for a set number of years regardless of whether the annuitant survives. Its payment is a loan payment worked backward. For a value of $200,000 at 3.6% interest compounded monthly, which is 0.3% a month, the monthly payment is:

payment = $200,000 times 0.003 divided by (1 minus 1.003 to the power of negative n), where n is the number of months.

Fixed period	Months	Monthly payment
10 years	120	$1,987.10
20 years	240	$1,170.22
30 years	360	$909.29

A life contingency option pays only while the annuitant lives. Because payments end at death, money that would have paid a short-lived annuitant remains available to pay a long-lived one. That pooling is the reason a lifetime payment can be larger than a period payment of similar length. With the invented payout rate of $5.60 per $1,000 for a straight life option at the annuitant’s age, the payment on $200,000 is 200 times $5.60, or $1,120.00. That is more than the 30-year period payment of $909.29, and the annuitant is paid for life.

The other options trade some of that payment for protection.

Option	Invented rate per $1,000	Monthly payment on $200,000	What it protects
Straight life (life only)	$5.60	$1,120.00	Nothing after death
Life with 10 years certain	$5.45	$1,090.00	At least 120 payments
Life with 20 years certain	$5.00	$1,000.00	At least 240 payments
Installment refund	$4.95	$990.00	Value returned in full
Joint and survivor, 100% to survivor	$4.70	$940.00	Full payment to the second person
Joint and survivor, 50% to survivor	$5.05	$1,010.00	Half payment to the second person

Three cases show how the options behave.

• Life only. The annuitant dies after 24 payments. The insurer has paid $26,880 and owes nothing more. The remaining value stays in the pool that supports the other annuitants.
• Life with 10 years certain. The annuitant dies after 24 payments. The beneficiary receives the 96 payments left in the guaranteed period, 96 times $1,090.00, or $104,640.00. The price of that protection was $30.00 a month, the difference from the straight life payment.
• Installment refund. The annuitant dies after 24 payments of $990.00, which total $23,760.00. The contract’s value at annuitization was $200,000, so the beneficiary receives the unpaid $176,240.00, in installments or in a lump sum depending on the form.

A joint and survivor option covers two lives, usually spouses. At 100% to the survivor, the payment is $940.00 for as long as either lives. At 50% it starts higher at $1,010.00 and falls to $505.00 after the first death. A couple who will need most of the income after one death takes the lower start for a larger survivor payment.

Variable Payouts

A variable annuity pays in annuity units. The number of units is fixed at annuitization and the value of a unit changes with the separate account’s investment results against the assumed interest rate. If the first payment is $1,000.00 and the unit value is $20.00, the annuitant holds 50 annuity units. If the unit value rises to $21.00, the payment becomes 50 times $21.00, or $1,050.00. A unit value rises only when the account’s net return exceeds the assumed interest rate and falls when it does not. A variable annuity is also a security under federal law, so its sale carries licensing and disclosure rules beyond those for a fixed contract.

How a Life Income Payment Is Taxed

Each payment from a non-qualified annuity is part return of the owner’s investment and part taxable income. The excluded share is the ratio of the investment in the contract to the expected return, applied to each payment (26 U.S.C. 72(b)(1)). Suppose Ruth’s investment is $200,000 and the straight life payment is $1,120.00, or $13,440.00 a year. If the tables give an expected payout of 20.0 years, the expected return is $13,440 times 20.0, or $268,800. The ratio is $200,000 divided by $268,800, or 74.40%. Of each $1,120.00 payment, $833.33 is excluded and $286.67 is taxable. The exclusion cannot go beyond the unrecovered investment (72(b)(2)).

The Right to Cancel

Michigan requires every annuity contract to carry a notice on the front page. For not less than 10 days after the policyholder receives it, the policyholder may cancel and receive a prompt refund of any premium paid, including a policy fee or other charge. The contract is then void from the beginning (MCL 500.4073(1)). The rule does not reach a contract issued to an employee to fund a qualified plan when participation in the plan is a condition of employment (MCL 500.4073(3)).

For a variable annuity, the refund is different, because the owner bears the investment result. It equals the difference between the premiums paid, including fees and charges, and the amounts allocated to the separate accounts, plus the value of the separate account allocations on the date the insurer or producer receives the returned contract (MCL 500.4073(2)).

Take a $50,000 premium that includes a $100 contract fee. $49,900 goes to the separate account. The account has fallen to $47,000 by the day the owner returns the contract. The refund is $50,000 minus $49,900, which is $100, plus $47,000, or $47,100. The owner bears the market loss but recovers the fee.

The NAIC annuity disclosure model, which each state adopts in its own form, would add a free look of at least 15 days where the buyer’s guide and disclosure document are not provided at or before the application, running together with any other free look (Model 245, section 5A).

Individual and Group Annuities

An individual annuity is a contract between one owner and the insurer. A group annuity covers many people under one master contract, usually issued to an employer or plan. Each participant holds a certificate, and the NAIC model’s term “contract owner” includes a certificate holder of a group contract (Model 245, section 4C). Several of Michigan’s individual rules do not follow the group contract.

• The standard nonforfeiture law for individual deferred annuities does not apply to a group annuity purchased under an employer’s retirement or deferred compensation plan. It does apply to individual retirement accounts and annuities under section 408 of the Internal Revenue Code (MCL 500.4072(2)). An IRA annuity bought by an individual is covered.
• The 10-day cancellation notice does not apply to a contract issued to an employee to fund a pension, annuity or profit-sharing plan qualified under the Code sections it names when participation is a condition of employment (MCL 500.4073(3)).
• The federal required-distribution rule at the holder’s death also does not apply to contracts under qualified plans and individual retirement annuities (26 U.S.C. 72(s)(5)).

In practice, the participant in a group annuity rarely chooses the investment’s terms and may be unable to surrender except by leaving the plan, while an individual owner holds all of the contract rights.

Uses of Annuities

Lump-Sum Settlements

An annuity can convert a lump sum into income. Dee Okafor receives a $240,000 lump sum, either as a life insurance death benefit or from another settlement. She can keep the cash, take it from the insurer under a settlement option, or buy an SPIA. The SPIA’s payment is set by her age and the option she chooses, as in the tables above. The advantage is a payment that cannot be outlived. The costs are that the money is no longer available for emergencies, that inflation erodes a level payment, and that a life-only option leaves nothing to heirs. Whether the principal is taxable depends on its source and on how the annuity is bought, and the exclusion ratio above applies to income from an annuity bought with after-tax money.

Retirement Income and Tax-Deferred Growth

Accumulation inside a deferred annuity is not taxed until it is withdrawn. A withdrawal before the annuity starting date is taxed to the extent the cash value exceeds the investment in the contract, so earnings come out first (26 U.S.C. 72(e)(2)(B), (e)(3)(A)). A taxable withdrawal before age 59 1/2 also carries a 10% additional tax on the includible amount, unless an exception applies, such as death, disability or a series of substantially equal payments for life (72(q)(1), (2)).

Education Funds

A parent could use a deferred annuity to save for a child’s education, and the numbers show where it is weak. Suppose a parent aged 35 puts $10,000 into a deferred annuity at 4% for 18 years. The value is $10,000 times 1.04 to the 18th power, or $20,258.17. The child needs $15,000 for tuition. Because earnings come out first, the first $10,258.17 of any withdrawal is taxable income, and the remaining $4,741.83 is a return of premium. The parent is under 59 1/2, and paying tuition is not among the exceptions listed in 72(q)(2), so 10% of $10,258.17, or $1,025.82, is added. Other education savings vehicles exist, and a producer who proposes an annuity for this purpose should be able to say why this one fits.

Lesson summary

• The owner holds the contract rights, the annuitant’s life measures the payout, and the beneficiary takes any death benefit. A holder’s death before annuitization triggers the federal distribution rule: 5 years, or the beneficiary’s life if distributions begin within a year, with a special rule for a surviving spouse.
• A fixed annuity credits a current rate that can change and never less than its guaranteed minimum. The first-year rate is not a prediction of later years.
• A surrender charge applies to the amount withdrawn above the free withdrawal amount. Michigan’s nonforfeiture law sets a floor for cash surrender benefits built from 87.5% of premium accumulated at a statutory rate, and the cash surrender benefit may not fall below it.
• An equity-indexed credit is the index change after the participation rate, cap and spread, never below the 0% floor. A market value adjustment can raise or lower the surrender value depending on whether rates have fallen or risen.
• Payout options trade payment size for protection: life only pays the most, period certain and refund options pay less, and joint and survivor options pay less again to cover a second life.
• Michigan requires a front-page right to cancel of at least 10 days, with a variable annuity refund equal to the fee and charges plus the account’s current value.
• Group annuities under employer plans fall outside some individual rules, while individual retirement annuities fall inside Michigan’s nonforfeiture law.