Annuity Consideration: What It is, How It Works

What Is Annuity Consideration?

An annuity consideration or premium is the money an individual pays to an insurance company to fund an annuity or receive a stream of annuity payments. An annuity consideration may be made as a lump sum or as a series of payments, often referred to as contributions.

How Annuity Considerations Work

Account owners who receive annuity income payments can choose different frequencies of distribution, such as monthly, quarterly, semiannually, or annually. Payments are based on several factors, including the following:

• The amount of the annuity consideration or accumulated value of an existing deferred annuity
• The age at which the annuitant begins receiving payments
• The annuitant's life expectancy or the length of the term
• The annuity's anticipated investment returns
• Whether the annuity is fixed or variable and guaranteed for a specified amount of time or the lifetime of the annuitant

Payments guaranteed for a shorter-term are often higher.

Annuities can be structured according to a wide array of details and factors. Immediate annuities generate a stream of payments upon being issued. Deferred annuities are retirement products in which payments are deferred until initiated by the account owner. Account-holders may remit contributions into their accounts to earn interest; depending on the tax structure (e.g., qualified or non-qualified), considerations or contributions may be limited. Annuitizing the deferred annuity prompts the payout feature, in which a stream of payments is made.

Types of Annuities

Annuities can be structured generally as either fixed or variable. Fixed annuities earn fixed rates of interest and often have a minimum guaranteed rate. Variable annuities allow account owners to invest in funds tied to the market. Most variable deferred annuities have a fixed account, which provides a hedge of protection against market fluctuations. Some immediate annuities contain a variable account, allowing the owner to invest different funds. For this reason, payments from these annuities often vary.

Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse (if survivorship benefit is elected) is alive. Examples of life guaranteed annuities include the life only annuity (payments are guaranteed for the annuitant's life only) and the life with a guaranteed period annuity (payments are guaranteed for the annuitant's life, but if they decrease within the guaranteed period, the remaining guaranteed payments are paid to their beneficiary. Alternatively, annuities can be structured to pay out funds for a specific period, such as 20 years.

Annuities in 401(k)s

Americans may find more annuity offerings in their 401k plans due to the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. The new law makes it easier for employers to offer annuity products within an employee's 401(k) account. Before the passage of the bill, employers were responsible for products offered to their employees in a retirement portfolio. However, under the new law, the responsibility will lie with the insurance companies offering the annuity options to the employees. Experts believe employers will feel more comfortable offering annuity products under the new law.

For those who have retirement savings in a 401(k), they can transfer a portion of those funds and purchase a qualified longevity annuity contract (QLAC). A QLAC is a deferred annuity, which is funded from an individual retirement account (IRA) or a qualified retirement plan.

A QLAC annuity provides guaranteed monthly payments until the recipient's death and is exempt from the required minimum distribution (RMD) rules associated with IRAs. An annual RMD is usually required by the age of 73, while payouts with a QLAC can begin after a preset starting date. The IRS has established a limit on how much money can be transferred from an IRA to a QLAC. In 2020 and 2021, an individual can spend 25% or $135,000 (whichever is less) of their savings in an IRA or retirement plan to purchase a QLAC. As part of the SECURE 2.0 Act, Congress eliminated the 25% limit and increased the allowable QLAC amount to $200,000.

Special Considerations

These instruments are not for everyone, especially those who may need access to their money. Deferred annuities often have surrender schedules, in which all or a portion of withdrawn money is subject to a penalty. Fees during the surrender period can be high, more so in the early years of ownership.

These surrender periods can last anywhere from two to more than ten years, depending on the particular product. Surrender fees can start at 10% or more, though the penalty typically declines annually over the surrender period. For some immediate annuities, surrenders are not possible after payments begin.

Some advisors argue that investors looking for a stream of payments can structure their annuity-like instrument with a combination of dividend-paying stocks, bond ladders, and money markets. Among the advantages of this approach are low fees and ready access to your cash.

The Bottom Line

Many investors prefer guaranteed or predictable cash flow in the future; for this reason, many investors turn to annuities. To fund an annuity, an investor often has to make a one-time lump sum payment or pay into a monthly amount. In either case, this funding is referred to as an annuity consideration. Once the annuity is funded, it provides the investor an opportunity to receive that money back in the future as a fixed, predictable amount.