What Is a Commercial Annuity and How Does It Work?

A commercial annuity is a contract established between an individual and a licensed insurance company. This financial product serves as a strategy for retirement savings and income generation, providing a structured way to receive future payments. Individuals typically contribute funds, either as a single lump sum or through a series of payments, in exchange for the insurer’s promise of regular disbursements. The primary goal of an annuity is to offer a dependable income stream, particularly during retirement, helping to mitigate concerns about outliving savings.

Defining a Commercial Annuity

Several key parties are involved in an annuity contract. The “owner” is the person who purchases the annuity and controls the contract, making decisions regarding its terms and beneficiaries. The “annuitant” is the individual whose life expectancy is used to determine the timing and amount of the annuity payments. While the owner and annuitant are frequently the same person, this is not always a requirement. Lastly, the “beneficiary” is the person or entity designated to receive any remaining benefits or death benefits from the annuity upon the annuitant’s death.

How Commercial Annuities Function

A commercial annuity operates through two distinct phases: the accumulation phase and the annuitization phase. The accumulation phase is the period during which funds are paid into the annuity, either through a single premium or multiple contributions, and allowed to grow. During this time, the money invested within the annuity grows on a tax-deferred basis, meaning that earnings are not taxed until they are withdrawn or payments begin. This tax deferral can allow for greater compounding of returns over time.

Funds in the accumulation phase can be invested in various ways, depending on the type of annuity, such as in fixed accounts or market-linked subaccounts. The annuitization phase begins when the accumulated value is converted into a stream of regular income payments. This conversion can result in payments that last for a predetermined period or for the remainder of the annuitant’s life.

Exploring Different Commercial Annuity Structures

Commercial annuities come in various structures, each offering distinct characteristics regarding growth potential, risk, and payment timing.

Fixed Annuities

Fixed annuities offer a guaranteed interest rate for a specified period, providing predictable growth and payments. The principal investment is protected from market fluctuations, and the income stream is stable and guaranteed. These annuities are considered lower risk, as the insurance company bears the investment risk.

Variable Annuities

Variable annuities allow the owner to allocate funds into various investment subaccounts, similar to mutual funds. The value of a variable annuity fluctuates based on the performance of these underlying investments, offering the potential for higher returns but also carrying investment risk. Payments during the annuitization phase can vary depending on the investment performance.

Indexed Annuities

Indexed annuities, also known as fixed indexed annuities, link their growth to a market index, such as the S&P 500, but with mechanisms to limit both gains and losses. They offer a guaranteed minimum return and participate in market gains up to a certain cap, while protecting against market downturns with a floor. This structure provides a balance between growth potential and principal protection.

Immediate and Deferred Annuities

Immediate annuities are purchased with a single lump sum, and income payments begin almost immediately. These are suitable for individuals who need an immediate income stream. Deferred annuities delay income payments until a future date chosen by the owner, allowing for a longer accumulation period and tax-deferred growth.

Income Distribution Options

When an annuity transitions into the annuitization phase, several income distribution options become available, determining how payments will be received.

Life Only

A “Life Only” or “Straight Life” option provides guaranteed income payments for the entire lifetime of the annuitant. While this option offers the highest monthly payout, payments cease entirely upon the annuitant’s death, with no remaining value for beneficiaries. This option maximizes personal lifetime income.

Period Certain

A “Period Certain” annuity guarantees payments for a specific, predetermined number of years, such as 10, 15, or 20 years. If the annuitant dies before the period certain expires, the remaining payments are made to a designated beneficiary. However, payments stop once the specified period ends, even if the annuitant is still living.

Life with Period Certain

The “Life with Period Certain” option combines aspects of both, providing income for the annuitant’s lifetime but also guaranteeing payments for a minimum number of years. If the annuitant passes away before the guaranteed period ends, beneficiaries receive payments for the remainder of that period. If the annuitant lives beyond the period certain, payments continue for their entire life.

Joint and Survivor

A “Joint and Survivor” annuity ensures that payments continue for the lifetimes of two individuals, typically spouses. If one annuitant dies, the payments continue to the surviving annuitant, often at a reduced amount. This option provides financial security for both partners.

Lump Sum

A “Lump Sum” option allows the owner to take the entire accumulated value of the annuity as a single payment, if available and not yet annuitized. However, taking a lump sum can have significant tax implications and may not be available for all annuity types.

Associated Costs and Tax Implications

Annuities, like other financial products, come with various associated costs that can impact their overall returns.

Associated Costs

One common charge is the surrender charge, which is a penalty for withdrawing funds from a deferred annuity or canceling the contract before a specified period, often ranging from six to ten years. These charges typically start high, around 6% to 10% in the first year, and gradually decrease over the surrender period. Many contracts allow for penalty-free withdrawals of a small percentage, often up to 10% of the account value, each year during this period.

For variable annuities, additional fees include mortality and expense (M&E) fees, which compensate the insurance company for guarantees such as death benefits and lifetime income. These fees typically range from 0.20% to 1.80% annually and are deducted from the subaccount value. Administrative fees, covering record-keeping and customer service, are also common, often around 0.3% of the annuity’s value or a flat annual fee. Optional riders, which add enhanced benefits like guaranteed income or death benefits, also incur additional annual costs, typically ranging from 0.25% to 1.00% of the annuity’s value.

Tax Implications

The growth within an annuity is tax-deferred. When payments are received, the portion representing investment gains is taxed as ordinary income. If withdrawals are made before age 59½, they may be subject to a 10% IRS penalty in addition to ordinary income tax.