The discussion in this section is not limited to immediate annuities in the technical sense but also includes the liquidation phase of deferred annuities. In other words, it is a description of the various arrangements under which a principal sum can be liquidated on the basis of life contingencies. The principles involved are equally applicable to the life-income options of life insurance contracts where the death benefit funds the lifelong payments.

As stated above, a pure annuity is one that provides periodic benefit payments of a stipulated amount as long as the annuitant lives, with the payments ceasing upon the death of the annuitant. The consideration paid for the annuity is regarded as fully earned by the insurance company by the time the benefit payments begin. The payments may be made monthly, quarterly, semiannually, or annually. The more frequent the periodic payments, the more costly the annuity is in terms of annual income. That is, 12 monthly payments of $100 each, the first due one month hence, are more costly than one annual payment of $1,200 due one year hence. This is due to the greater expense of drawing 12 checks, loss of interest by the insurance company, and the greater probability that the annuitant will live to receive the payments. If the annuitant should die 6 months and one day after purchasing the annuity, he or she would receive six monthly payments of $100 each in one case and nothing in the other. The principle would hold true regardless of the year in which the annuitant dies. Occasionally, annuities are made apportionable�that is, they provide for a pro rata fractional payment covering the period from the date of the last regular payment to the date of death. This feature necessitates an increase in the purchase price since premiums for the usual type of annuity are calculated on the assumption that there will be no such pro rata payment.

The pure annuity provides the maximum income per dollar of outlay and for that reason is perhaps most suitable for people with only a limited amount of capital. According to typical actuarial assumptions, $1,000 of capital will provide monthly income between $7 and $10 for males and between $6 and $9 for females under a straight life annuity to those aged 65 (see table 6-1 later in this chapter). If payments are guaranteed for 10 years, whether the annuitant lives or dies, the monthly income will be reduced approximately $.50 for each $1,000 increment. On an investment of $100,000, the difference in monthly income will be $50, which might be the difference between dependency and self-sufficiency for an elderly person. For a person aged 70 the difference in monthly income from $100,000 will be $100, and at 75 the difference will be $175�too large to ignore.

At younger ages, however, because of the high probability of survival, the difference in income between an annuity without a refund feature and one with a refund feature is extremely small. A person aged 35 can obtain an annuity with a 5-year guarantee for the same cost as a pure annuity and an annuity with a 10-year guarantee at the sacrifice of only a few cents of monthly income per $1,000 of outlay. Even someone aged 55 can obtain a 10-year guarantee at a reduction in monthly income of less than 50 cents. In general therefore males under 60 and females under 65 should not purchase a pure annuity unless the limited amount of capital makes it imperative. Below those ages, annuitants� chances of surviving the typical periods of guaranteed payments are so good that they gain little in monthly income by giving up the refund feature.

Most people have strong objections to placing a substantial sum of money into a contract that promises little or no return if they should die at an early age. Therefore to make annuities salable insurance companies have found it necessary to add a refund feature. The refund feature may take two general forms: a promise to provide a certain number of annuity payments whether the annuitant lives or dies or a promise to refund all or a portion of the purchase price in the event of the annuitant�s early death.

Life Annuity Certain. The first type of contract goes under various names, including life annuity certain, life annuity certain and continuous, life annuity with installments certain, life annuity with a period certain guarantee, and life annuity with minimum guaranteed return. The essence of the agreement is that a stipulated number of monthly payments will be made whether the annuitant lives or dies, and payments will continue for the whole of the annuitant�s life if he or she lives beyond the guaranteed period. Contracts may be written with payments guaranteed for 5, 10, 15, or 20 years, although not all insurers offer such a wide range of choices. A few companies will even guarantee payments for 25 years.

This type of refund annuity is composed of two elements: an annuity certain and a pure deferred life annuity. The annuity certain covers the period of guaranteed payments and, true to its characteristics, provides the payments whether the annuitant is alive or not. The deferred life annuity becomes effective at the end of the period of guaranteed payments and provides benefits only if the annuitant survives the term of the annuity certain. The benefits are deferred and are contingent upon the annuitant�s being alive to receive them. Therefore the second portion of the company�s promise can properly be described as a pure deferred life annuity. If the annuitant does not survive the period of guaranteed payments, no payments are made under the deferred life annuity, and no refund is forthcoming. If the annuitant does survive the term of the annuity certain, the deferred life annuity provides benefits for the remainder of the annuitant�s life.

An annuity with a period certain is always more expensive per dollar of income than a straight life annuity since it is not based solely on life contingencies. Some of the payments are a certainty; the only cost-reducing factor is the compound interest earned on the unliquidated portion of the purchase price. Therefore the longer the term of the period certain�or to put it more specifically, the longer the period of guaranteed payments�the more costly this type of refund annuity will be or the lower the yield on the purchase price. Since it is not based solely on life contingencies, the cost of an annuity certain does not depend on the age of the annuitant; it varies directly with the length of the term. At any particular age, however, the longer the period of guaranteed payments, the less expensive the deferred life annuity will be since the higher the age at which the deferred life annuity commences, the smaller the probability that the annuitant will survive to that age. This means that the larger the number of guaranteed payments, the smaller the portion of the purchase price going into the deferred life annuity.

Installment Refund Annuity. There are two important types of contracts that promise to return all or a portion of the purchase price. The first is called the installment refund annuity. This contract promises that if the annuitant dies before receiving monthly payments equal to the purchase price of the annuity, the payments will be continued to a contingent beneficiary or beneficiaries until the full cost has been recovered. According to the rates of a sample of insurers, $100,000 will provide a monthly life income between $650 and $950 on the installment refund basis to a male annuitant aged 65 at the time of purchase. If the annuitant dies after receiving 100 payments ($65,000 to $95,000), the payments will be continued to a contingent beneficiary until an additional $35,000 to $5,000 is paid out, making an aggregate of $100,000. If he dies after 13 years, there will be no further payments since the entire purchase price will already have been recovered. It is understood, of course, that payments to the annuitant continue as long as he lives even though the purchase price may long since have been recovered in full.

Cash Refund Annuity. The contract may promise, upon the death of the annuitant, to pay to the annuitant�s estate or a contingent beneficiary a lump sum that is the difference, if any, between the purchase price of the annuity and the sum of the monthly payments, in which case the contract is called a cash refund annuity. The only difference between the cash refund and installment refund annuities is that in the former, the unrecovered portion of the purchase price is refunded in a lump sum at the time of the annuitant�s death; in the latter, the monthly installments are continued until the purchase price has been completely recovered. The cash refund annuity is naturally somewhat more expensive because the insurance company loses the interest it would have earned while liquidating the remaining portion of the purchase price on an installment basis.

A frequently asked question is how a life insurance company can afford to promise to return the annuitant�s investment in full whether he or she lives or dies and yet continue monthly payments to annuitants who have already recovered their investment. It would seem that every dollar paid to an annuitant in excess of his or her investment would have to be offset by the forfeiture of a dollar by an annuitant who died before recovering the purchase price. The answer lies in compound interest. Note that the insurance company does not promise to pay out benefits equal to the purchase price plus interest. Under this type of refund annuity the interest earnings on the unliquidated portion of the premiums of all annuitants receiving benefits provide the funds for payments in excess of any particular annuitant�s purchase price (investment).

Fifty Percent Refund Annuity. An annuity contract that guarantees a minimum return of one-half of the purchase price is a compromise between the straight life annuity and the 100 percent refund annuity. Logically enough, such a contract is called a 50 percent refund annuity. Under its terms, if the annuitant dies before receiving benefits equal to half of the cost of the annuity, monthly installments are continued until the combined payments to both the annuitant and a contingent beneficiary equal half of the cost of the annuity. If the beneficiary so elects, it is customary to provide that he or she can receive the present value of the remaining payments in a lump sum. Since the guarantee under this contract is smaller than that under the 100 percent refund annuity, the cost is lower. Conversely, the income per dollar of purchase price is larger.

A form of annuity sometimes written provides that, regardless of the number of payments received prior to the annuitant�s death, 50 percent of the cost of the contract will be returned in the form of a death benefit. This contract is not a refund annuity in the strict sense. Instead, one-half of the premium is used by the company to provide a straight life annuity, and the other half is held on deposit. Earnings from the half held on deposit are used to supplement the annuity benefits provided by the other half of the premium. At the annuitant�s death the premium deposit is returned to the annuitant�s estate or to a designated beneficiary in the form of a death benefit.

Modified Cash Refund Annuity. Finally, another variation of the refund annuity is found among contributory pension plans. Called a modified cash refund annuity, it promises that if the employee dies before receiving retirement benefits equal to the accumulated value of his or her contributions with or without interest, the difference between the employee�s benefits and contributions will be refunded in a lump sum to the employee�s estate or a designated beneficiary. In other words, the refund feature is based on the employee�s contributions and not on the portion of the total cost of the annuity paid by the employer.

Comparisons. The range of monthly income amounts provided under various forms of annuities per $1,000 of premium accumulations are shown in table 6-1. The principal sum of $1,000 does not refer to a single premium of that amount paid at the various ages but to a sum accumulated through periodic premiums that contain an allowance for expenses or through the maturity by death of an insurance contract purchased with gross premiums. In other words, these benefits, which may be augmented by dividends, are based on premiums without policy fees and could not be purchased with a lump-sum payment on quite so favorable a cost basis, but they do illustrate the variations in yield among the various annuity forms.

Table 6-1 illustrates the inconsequential cost of a refund feature at younger ages and its high cost at advanced ages. It is interesting to note that at the higher ages, both the installment refund and the cash refund forms are less expensive�or, conversely, yield more�than a life annuity with a 10-year guarantee. At the advanced ages they cost less than even a 15-year guarantee. Remember, however, that the benefits under each of the forms are the actuarial equivalent of those under all the other forms, and the annuitant must choose the form that is most appropriate to his or her financial and family circumstances.

With the computing power available today it is possible for insurance companies to design annuity contracts with any length of period certain or with a refund guarantee for any specified portion from none to all of the purchase price. In practice, however, each insurer is likely to offer only a few options regarding period certain choices and refund potions. The costs of getting regulatory approval are probably the single most important impediment to offering a full spectrum of choices.

It is helpful in considering deferred annuities to distinguish between the accumulation period and the liquidation period. The preceding discussion of immediate annuities related entirely to the liquidation phase of annuities. It was assumed that the funds needed to provide the various income payments were on hand, and no consideration was given to the manner in which the funds had been accumulated.

With deferred annuities, however, there is always a period during which funds are accumulated with the insurance company to reach the amount necessary to provide the benefits promised at a specified future date. The sum may be accumulated through a lump-sum premium to which compound interest is added during the intervening years, or it may be accumulated through a series of periodic premiums. If the premiums are made periodically, they can range almost anywhere between a rigid schedule of level payments and (at the other extreme) flexible payments where the timing and amount of each payment is at the discretion of the purchaser.

Because it is impossible to predict the amount available to fund benefits, annuity contracts that allow flexibility in premium payments during the accumulation phase cannot specify in advance the level of benefit payments that will be paid during the liquidation phase. Instead, they specify the amount of benefit per each $1,000 of fund balance when the annuity switches over to the liquidation phase. The fund itself is merely an accumulation device similar to a defined-contribution pension plan prior to retirement.

Regardless of how the contributions are made to the fund, there is a question about the company�s obligation in the event the purchaser dies prior to the date the income is scheduled to commence. The agreement might provide that there is to be no refund of premiums if the annuitant dies before receiving any payments. If so, the annuity could be described as a "pure" annuity with respect to the period of accumulation. Such a contract has little popular appeal. Under private pension plans, however, employer contributions are almost invariably applied to the purchase of pure deferred annuities. If the employee terminates employment before retirement, the employer recovers the employer�s contributions, plus interest, but if the employee dies, employer contributions on his or her behalf remain with the insurance company to provide benefits to employees who remain with the employer to retirement. Such an annuity can be purchased at a much lower premium than one that promises to return contributions to the date of death, with the result that the employer can either finance the pension plan at the lowest possible outlay or can provide larger retirement benefits than he or she could otherwise afford.

Almost without exception deferred annuities sold to individuals promise to return all premiums with or without interest in the event of the annuitant�s death before "entering on" the annuity. The usual contract provides for a return of either gross premiums without interest or the cash value (whichever is larger). Such a contract therefore is a type of refund annuity with respect to the period of accumulation.

Everything about immediate annuities discussed earlier applies with equal force to the liquidation phase of deferred annuities. Once the necessary funds have been accumulated and the annuitant is ready to enter on the annuity, he or she usually has the option of taking the income under any of the benefit plans described. Thus annuitants might choose a straight life annuity, a life annuity with guaranteed installments, an installment refund annuity, or a cash refund annuity. As a matter of fact, they may be given the choice of taking cash in lieu of a life income. It is not inconsistent for annuitants to choose a pure or straight life annuity for the liquidation phase of an annuity that was a refund type of annuity during the accumulation phase. Conceivably some individuals might purchase an annuity that provides for no refund during the period of accumulation and elect to liquidate it on a refund basis. Most annuitants, however, prefer the refund basis during both the accumulation and the liquidation phases.

A deferred annuity that had fixed level premiums, known as a retirement annuity, is an annuity form that was widely available in the past. It was popular back when nearly all annuity contracts had heavy front-end expense loadings. A wide range of options permitted the annuitant to adjust the contract during the deferral period to changes of circumstances not anticipated when the contract was purchased. The retirement annuity was an early step in the development of increased annuity contract flexibility. The more flexible and lower-cost annuities available today have nearly eliminated the fixed-premium retirement annuity from the market.

The premiums for an annuity contract may be quoted in units of $100 annual premium or in terms of the annual premium needed to provide a monthly life income of $10 at a designated age. In the first case, the premium will be an even amount, and the income will vary with the age of issue and the age at which the income will commence. In the second case, the income will be a fixed even amount, and the premium will vary.

The structure of the deferred-annuity contract can best be understood by the following example. In accordance with the rate basis of several leading companies, for each $10 unit of monthly life income to be paid to a male annuitant at age 65 with payments guaranteed for 10 years, between $1,052 and $1,538 must be accumulated by age 65, regardless of the age at which the annuitant purchases the annuity^. Obviously, the younger the age at which the annuitant begins to contribute toward the accumulation objective, the smaller each annual contribution or deposit can be. To accumulate $15,380�the amount needed to provide $100 per month at age 65 with payments guaranteed for 120 months�a man aged 25 will have to contribute only $112 per year to age 65, while a man aged 45 will have to deposit $441 per year. A man aged 55 will have to deposit $1,195 per year for 10 years.

The level premiums or deposits, as they are usually called, are accumulated at a rate of compound interest equal to or greater than the specified long-term rate guaranteed in the contract�usually between 3 percent and 5 percent. Some deferred annuity contracts also include a short-term (such as one, 2, 3, or 5 years) interest rate guarantee that is competitive with current investment yields and higher than the guaranteed long-term rate. These short-term interest rate guarantees are often combined with a bail-out provision allowing the contract to be terminated without a surrender charge if the interest rate actually being credited falls below a stipulated rate (often 2 percentage points [200 basis points] below the short-term guaranteed rate). The bail-out provision may seem much more attractive than it really is for two reasons: (1) It is highly unlikely that competitors will be able to pay higher rates if and when the release is triggered, and (2) a cash-out will be subject to income taxes and possibly a 10 percent penalty tax (see chapter 11).

In the event of the annuitant�s death before age 65 (or whatever the maturity date) the company will return the accumulated gross premiums without interest or the cash value, whichever is larger. The cash value is equal to the gross premiums improved at a guaranteed rate of interest after deducting a charge for expenses. After about 10 years, the cash value exceeds the accumulated value of premiums paid (without interest) and thus becomes the effective death benefit. (It is of interest to note that, while this is an annuity contract, there is an insurance element during the accumulation period in that the death benefit exceeds the cash value.)

The annuitant may withdraw the full cash value at any time during the deferral period, whereupon the contract terminates and the company has no further obligation. Under some contracts the annuitant may borrow against the cash value, which would not bring about a termination of the contract.

At the maturity date the annuitant may elect to have the accumulated sum�$15,380 in the example�applied under any of the annuity forms offered by the company, even though the premium deposits were predicated on the assumption that the income would be provided under a life annuity with 120 guaranteed installments. Depending on the option elected, the actual monthly income might be more or less than the amount originally anticipated. Moreover, the annuitant is usually given the privilege of taking cash in lieu of an annuity. This is known as the cash option, and it exposes the company to serious adverse selection. Persons in poor health tend to withdraw their accumulations in cash, while those in excellent health usually choose an annuity. To offset this selection if the annuitant selects the cash option, some companies provide a retroactive reduction in the investment earnings rate applied to accumulations under a deferred annuity. The resultant penalty can be a substantial dollar amount, and it usually also applies to exchanges of annuity contracts.

Under most contracts the annuitant may choose to have the benefit payments commence at an earlier or a later date than the one originally specified in the contract with a subsequent adjustment in the amount of monthly benefits. It should be recognized that the privilege of having the income begin at an earlier age than the age specified in the contract is an option to convert the cash value to an immediate annuity. There is usually no age limit below which the benefit payments cannot begin, although the option is subject to the general requirement that the periodic income payments equal or exceed a stipulated minimum amount.

On the other hand, there is usually an upper age limit, sometimes as high as age 80 or as low as age 70, beyond which commencement of the income benefits cannot be postponed. The option to postpone the commencement of benefit payments may be particularly attractive if the annuitant is still in good health at the original maturity date and plans to work for a few more years. The life income payable at any particular age, whether the maturity date is moved ahead or set back, is the same amount that would have been provided had the substituted maturity date been the one originally selected and funded with the actual amount accumulated.