How Does an Annuity Contract Work?
Annuity contracts are designed to provide you with an income stream that either begins immediately after you purchase the contract or at a future date. Insurance companies sell annuity contracts, and aside from providing income, the contracts usually have the option to include some life insurance coverage, which means your beneficiaries receive some of the contract proceeds if you die during the contract term.
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Deferred vs. Immediate
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Annuities fall into two categories: deferred annuities and immediate annuities. If you buy a deferred annuity, your insurer agrees to provide you with an income stream that usually begin at least five or 10 years in the future. If you buy an immediate annuity, you start to receive income payments the following month and, depending on the terms of the contract, these payments last for five, 10 or 20 years, or for the duration of your life.
Annuity Premium
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When you purchase an immediate annuity contract you pay a lump-sum single premium, which the insurance company immediately converts into an income stream. The insurer multiplies your initial investment by a fixed rate of interest and then divides the resultant amount into roughly equal payments that are paid to you over the course of the contract term. When you purchase a deferred annuity you either make a single premium payment or a series of premium payments. Your payments are invested in mutual funds or fixed-interest accounts that are intended to grow your money until you eventually begin making withdrawals.
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Death Benefit
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Variable annuities contracts are a type of deferred annuity that includes a standard death benefit. Your funds are invested in mutual funds, but if you die during the accumulation phase while the funds are growing, then your beneficiaries receive the amount you originally invested as a death benefit payout. Some contracts include enhanced death benefit provisions, in which case your beneficiaries receive the higher of your original premium or the current account value.
Immediate income annuities often include a death benefit, which involves your beneficiaries continuing to receive your monthly payments for a set number of years, or a lump sum refund of equal to your original premium minus withdrawals.
Fees
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Insurance companies make money on annuity contracts by charging fees. If you buy a variable annuity contract, annual fees equal to 3 or 4 percent of the contract value are deducted from the account. If you withdraw funds from a deferred annuity during the accumulation phase you must pay a penalty of up to 10 percent. Fixed annuities are deferred annuities that pay a fixed rate of interest and on a fixed annuity you can normally receive your premium back without penalty at any time but you do forfeit interest if you access funds during the accumulation phase.
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