What did you mean when you said “annuity”? A personal viewArticle added by John Olsen on April 30, 2014
John L. Olsen, CLU, ChFC, AEP

John Olsen


Joined: September 04, 2002

Consider the following statements:
    1. “Annuities have two phases: accumulation and payout”

    2. “Annuities impose annual fees”

    3. “Annuities pay annual interest which is not taxed until distributed”

    4. “When the annuitant dies, the annuity pays the death benefit to the beneficiary”
What can we say about those statements? Are they true? If “true” means “accurate in every case,” then no, they aren’t. But are they false? Well, no, because they’re often true. So, what’s the problem? Why are those statements useless to a reader who wants to understand how annuities work?

The problem is specificity — or, rather, the absence of it. General statements about annuities (or automobiles or farm animals, for that matter) must be true of all members of the group (all automobiles, every farm animal, and every single annuity arrangement) or they’re overgeneralizations — statements that are true of some, perhaps many, members of the group, but untrue when applied to other members.

Overgeneralizations are a mortal enemy of understanding, and if we seek to promote understanding (to ensure that our prospects and clients grasp how the product we’re recommending actually works), we need to avoid making them.

Let’s look at those four statements again.

The first says, ““Annuities have two phases: accumulation and payout.” Well, all deferred annuity contracts do, but immediate annuities have only one phase — the payout phase. The second says, ““Annuities impose annual fees.” That’s true of variable annuities, either immediate or deferred, but not of fixed annuities, except to the extent of extra-cost riders in fixed deferred contracts.

The third statement, “Annuities pay annual interest which is not taxed until distributed,” is a bit trickier. It’s certainly true of fixed contracts, both immediate and deferred, and of variable immediate annuities (due to the effect of the assumed interest rate (AIR) in those contracts). But it’s not how variable deferred annuities work. The value of those contracts varies with the performance of the sub-accounts chosen. An increase in that value doesn’t occur by crediting of interest, but by an increase in the value of the accumulation units. That increase could be reduced or wiped out the next day by a decrease in those unit values.

What about the fourth statement: “When the annuitant dies, the annuity pays the death benefit to the beneficiary”? It’s true only of deferred annuities that are “annuitant-driven” (where the death of the annuitant triggers payment of a death benefit) and of immediate annuities where a refund feature has been chosen and when that feature still has a value. In “life only — no refund” immediate annuities and “non-annuitant driven” deferred ones, there’s no death benefit when the annuitant dies.

Why do people make these overgeneralizations? In my purely personal opinion, it’s not from a conscious desire to deceive or mislead, but from an unconscious expectation that the reader knows which sort of annuity contract is being discussed. I’ve seen many articles by insurance professionals extolling the virtues of one particular type of annuity contract (e.g., the “declared rate” fixed deferred annuity) in which it was described only as an annuity. I suspect that each author felt that this was sufficient, because he had a clear picture in his head of the type of annuity he was talking about and was describing that picture accurately.
The problem, of course, is that the reader cannot see that picture. When we say or write things about annuities without specifying the types, we practically ensure misunderstanding.

What does “annuity” mean?

One problem faced by those of us who deal regularly with annuities is the slipperiness of that term. Strictly speaking, “annuity” means “a series of payments over time in which principal and interest are amortized over the payout period.” But that’s not what most people think of when they hear or use that term; for most people, “annuity” means “annuity contract” — a contract for income, either immediate or deferred, between a purchaser and an insurance company; literally, a contract to provide an annuity. That is why I use the term “annuity contract” in the classes I teach, so as to distinguish between the contract and the income stream itself. This is especially important when one deals with annuity taxation. For example, in the Internal Revenue Code and Regulations, there are only two kinds of distributions from any annuity contract:
    1. “amounts received as an annuity” — regular income payments made under an annuity payout option; and

    2. “amounts not received as an annuity” — every other kind of distribution, whether actual or imputed. Clearly, the term “annuity” here refers to the income stream and not to a contract to provide it.
But, as I said before, most people (including most insurance agents) use that word to describe contracts; and that’s not so bad, provided that we specify the kind of contract we mean. At the very least, we should make clear whether we’re talking about immediate or deferred annuities, because those two types work and are taxed very differently and were designed to do very different jobs. We should certainly distinguish between fixed and variable contracts. And, in my opinion, we should specify, when we’re discussing the fixed variety, whether we are talking about fixed index annuities or the declared rate variety.

Of course, the reader might be thinking at this point, “Is this guy really suggesting that instead of talking about annuities, which everybody understands, I should be using terms like 'fixed deferred annuity?' Yes, he is — when that degree of precision is necessary to avoid confusion.

Why? Because everybody does not understand what you mean by “annuity.”
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