Insurance companies also provide annuities, which at its most basic, are interest-bearing contracts that ensure an income stream. A payment or series of payments are made to an insurance company, and in return, the insurer agrees to pay an income (the invested capital plus interest on the outstanding balance) for a specified time period. Annuities can take many forms but have a couple basic properties: an immediate or deferred payout, with fixed (guaranteed) or variable returns. Consequently, different annuity types can resemble Certificate of Deposits (CDs), pensions or even investment portfolios.
Challenges to Annuity Industry
Life insurance companies must minimize the risk of what is called disintermediation. This happens when annuity holders seeking higher-yielding alternatives withdraw funds prematurely (often during periods of increased interest rates), and force companies to pay these surrenders by liquidating investments in an unrealized loss position. Insurers can protect themselves by matching an interest-sensitive liability portfolio with the asset portfolio, and by selling a mix of low-risk and high-risk products.
Types of Annuities
- Immediate Annuities: Annuities designed to guarantee owners a determined income stream on a monthly, quarterly, annual or semiannual basis in exchange for a lump sum. Options are limited from the annuity holder’s perspective, so profits are less volatile, and because of the fixed nature of these products, immediate annuities are at the lower end of the annuity risk spectrum.
- Deferred Annuities: A type of long-term savings product that allows assets to grow tax deferred until payment. This product category includes:
- Fixed Annuities: These products guarantee a minimum rate of interest during the time that the account is growing, and typically guarantee a minimum benefit. For the issuer, fixed annuities are subject to significant asset/liability mismatch risks, as described above. Also, when interest rates fall, spread earnings, or the difference between the yield on investments and credited rates, can decrease and asset cash flows much be reinvested at lower rates.
- Fixed Indexed Annuities: These products are credited with a return that is based on changes in an equity index. The insurance company typically guarantees a minimum return. Payouts may be periodic or in a lump sum. The potential for gains is an attractive feature during favorable market conditions; however, gains may not be as favorable as those available from variable annuities or straight equity investments. Sales also likely will suffer if equity markets go through a prolonged downturn.
- Variable Annuities: The participant is given a range of different investment options, typically mutual funds, to choose from. The rate of return on the purchase payment, and the amount of the periodic payments, will vary depending on the performance of the selected investments. Like fixed indexed annuities, sales tend to slump during unfavorable market conditions. In addition, the only sources of revenue for these products are account-value based fees, which also decline when market conditions deteriorate. Relatively thin margins, increasing product complexity (e.g., guaranteed living benefits) and intense competition put variable annuities at the riskier end of the product continuum.
Because variable annuities contain a return linked to equity markets, they are regulated by the U.S. Securities and Exchange Commission (SEC). Fixed annuities are not securities, and as such, are not regulated by the SEC. Though it depends on the features, the typical equity-indexed annuity is not registered with the SEC.
Group annuities differ slightly from individual annuities in that the payout is dependent upon the life expectancy of all the members of the group rather than the individual. Many company retirement plans, such as 401(k) plans, are annuities that will pay a regular income to the retiree. Tax-deferred annuity plans – 403(b) and 457 plans – also are used widely by public-sector and non-profit workers.