Definition (plain)
– Annuitant: the individual who receives the scheduled payouts from an annuity contract or a pension. Payouts can be paid for the annuitant’s lifetime or for a fixed term.
Other key terms (defined on first use)
– Annuity: a financial contract (often sold by an insurance company) that converts a sum of money into a stream of payments, either immediately or at some future date.
– Owner: the person or entity that owns the annuity contract and can usually name beneficiaries or change contract features.
– Beneficiary: the person who receives any death benefit from the annuity after the annuitant dies.
– Basis: the amount of after‑tax money the owner invested in the annuity.
– Ordinary income: income taxed at standard income‑tax rates (not capital‑gains rates).
Core ideas, in plain language
– Who receives the payments: The annuitant is the person entitled to the periodic or lump‑sum payments under the contract. The annuitant may be the same person who owns the contract, but the contract can also name someone else (for example, a surviving spouse) as the annuitant.
– Payments depend on life expectancy: Insurers set payment amounts using the annuitant’s age and expected lifespan. If the contract names a younger surviving spouse to receive payments after the annuitant’s death, the insurer will reduce initial payments because the expected payout period is longer.
– Contract types that affect death benefits:
– Single‑life payout: payments stop when the annuitant dies; typically no death benefit.
– Joint‑life payout: payments continue (often at reduced amounts) for the surviving annuitant/beneficiary’s lifetime.
– Life‑plus: payments continue for the annuitant’s life and then for a specified period to another person.
– Who can be annuitant: the annuitant must be a natural person; companies, charities, or trusts cannot be the annuitant.
– Annuitant vs beneficiary: They are different roles. The annuitant receives the scheduled payments during life. The beneficiary is the person entitled to death benefits after the annuitant dies; under most contracts the annuitant cannot simultaneously be the beneficiary.
– Tax treatment: Most annuity payments are taxed as ordinary income. For non‑qualified annuities bought with after‑tax dollars, the portion of each payment that represents a return of basis (the owner’s invested principal) is tax‑free; the gain portion is taxed as ordinary income. Employer pension payments are generally fully taxable as ordinary income.
Short checklist: what to confirm before you buy or accept annuity payments
– Who is named as owner, annuitant, and beneficiary? Are they the people you intend?
– Type of payout: single life, joint life, guaranteed period, or life‑plus?
– Are payments fixed, variable, or indexed? How will they change (if at all)?
– How were the payment amounts calculated (age, joint life, interest assumptions)?
– Death benefits and survivor
– Death benefits and survivor provisions: what happens to unpaid principal or remaining guaranteed payments when the annuitant dies? Is there a cash refund, period‑certain guarantee (e.g., 10 years), or a spouse survivor option (single life vs joint life)? What are the survivor payout percentages (100%, 50%, etc.) and how do they affect initial payments?
– Fees and charges: identify surrender charges and their duration, mortality and expense (M&E) fees, administrative fees, rider costs (e.g., guaranteed lifetime withdrawal benefits), underlying fund expense ratios for variable annuities, and commissions. Ask for a dollar and percentage breakdown of all recurring and one‑time fees.
– Liquidity and contract flexibility: are there penalty‑free withdrawal amounts or rider features that allow access for nursing care or terminal illness? What are the surrender penalties and how do they decline over time?
– Inflation protection: is there a cost‑of‑living adjustment (COLA) rider or an indexed feature? If so, what is the cap, participation rate, or spread that limits upside?
– Pricing and payout assumptions: confirm the interest rate, mortality table or life expectancy assumptions, and whether payments are calculated using guaranteed (conservative) or current (potentially variable) assumptions.
– Insurer creditworthiness and state guaranty limits: check ratings from rating agencies and the protections (and limits) provided by your state’s insurance guaranty association if the insurer becomes insolvent.
Quick checklist of documents and questions to get from the insurer/agent
1. A complete copy of the annuity contract and any riders.
2. An “illustration” showing guaranteed and non‑guaranteed payment scenarios.
3. A current fee schedule with explicit dollar examples.
4. Surrender schedule (years and percentage).
5. Insurer financial strength ratings (A.M. Best, S&P, Moody’s) and date of the rating.
6. Death benefit and beneficiary forms.
7. Tax reporting examples (how payments will be reported on Form 1099‑R).
8. A written explanation of how payments were calculated (age, joint life, interest rate assumption).
Worked numeric examples
Example A — Single premium immediate annuity (SPIA), single life
– Premium (one‑time): $100,000
– Buyer: age 65, single life
– Payout rate quoted: 5.5% annual (fixed)
Calculation:
– Annual payment = 100,000 × 5.5% = $5,500 per year, paid monthly = $458.33 per month.
Notes:
– If the buyer instead elects a 10‑year period certain (payments continue to beneficiary for remaining period), the payout rate would be lower; joint life with spouse would also reduce the initial payout.
Example B — Taxation of non‑qualified annuity payments (exclusion ratio)
Definitions: Exclusion ratio = investment in contract / expected return. The exclusion amount (return of basis) each year = payment × exclusion ratio. The rest is taxed as ordinary income.
– Purchase: non‑qualified annuity bought with after‑tax money = $100,000 principal (investment in contract).
– Payout: $6,000 per year for expected 20 years (life expectancy used for expected return) → expected return = 6,000 × 20 = $120,000.
– Exclusion ratio = 100,000 / 120,000 = 0.8333 (83.33%).
– Excluded amount per year = 6,000 × 0.8333 = $5,000 (return of principal, tax‑free).
– Taxable portion per year = 6,000 − 5,000 = $1,000 (ordinary income).
Notes:
– For life annuities where the number of payments is uncertain, the IRS uses actuarial tables or the expected return period to compute exclusions. For qualified annuities (e.g., IRA distributions), the entire payment is generally taxable as ordinary income because the principal was pre‑tax.
Practical step‑by‑step when evaluating an annuity offer
1. Get the full contract and illustration in writing.
2. Verify the payout formula: ask for the exact factor used (payout per $1,000) or the actuarial assumptions.
3. Compare quotes from at least two insurers for the same options (single vs joint, period certain, riders).
4. Compute after‑fee net payout and run a break‑even comparison versus alternative uses of the money (e.g., laddered bonds, dividend portfolio).
5. Check liquidity needs and whether surrender charges match your planning horizon.
6. Confirm tax treatment with a tax professional; get examples of Form 1099‑R reporting.
7. Review insurer ratings and state guaranty limits.
8. If considering income riders, calculate the rider’s cost and how it affects net yield.
Risks and tradeoffs (brief)
– Longevity risk: annuities shift the risk of outliving assets to the insurer.
– Inflation risk: fixed payments lose purchasing power unless indexed.
– Counterparty (insurer) risk: guarantees depend on the insurer’s ability to pay.
– Opportunity cost: funds in an annuity cannot be reallocated easily; compare expected returns net of fees against other investments.
– Complexity and fees: riders and variable products can obscure costs; always ask for a clear fee breakdown.
Sources for further reading
– Investopedia — Annuitant: https://www.investopedia.com/terms/a/annuitant.asp
– IRS — Publication 575, Pension and Annuity Income: https://www.irs.gov/publications/p575
– U.S. Securities and Exchange Commission (SEC) — Annuities
Practical checklist before buying an annuity
– Confirm the product type: fixed, variable, or indexed. Each has different return mechanics and risks.
– Check payout timing and form: immediate (payments start now) vs deferred (payments start later); life-only, period-certain, joint, or inflation‑indexed.
– Request the written illustration showing guaranteed vs non‑guaranteed elements and assumptions (interest, mortality, fees).
– Get a clear fee breakdown: sales loads, administrative fees, mortality & expense (M&E) charges, subaccount fees (variable annuities), and rider costs.
– Ask about surrender charges and their schedule (how long and how steep).
– Verify insurer financial strength ratings from at least one rating agency (A.M. Best, Moody’s, S&P).
– Confirm death benefit rules and beneficiary procedures.
– Compare the annuity’s implied payout rate (payments ÷ premium) to alternative yield opportunities, adjusting for guarantees and liquidity differences.
– Understand the tax status: qualified vs non‑qualified purchase, and how taxable income is determined (see IRS Pub. 575).
How to compare two annuity quotes — step by step
1. Standardize inputs: same premium amount, same start date, same payout frequency (annual/monthly).
2. Note the payout amount and form (life vs term) for each quote.
3. Add explicit annual costs: rider cost + fees expressed as % of premium or $/year.
4. Compute simple payout rate = annual payment / premium. This is a rough comparator (does not adjust for mortality or inflation).
5. If both are fixed‑period annuities, compute the internal rate of return (IRR) using the PMT formula (see below) to compare.
6. Consider non‑financial factors: insurer rating, liquidity needs, and beneficiary provisions.
Worked numeric examples (assumptions stated)
A. Fixed‑period annuity (deterministic math)
Assumption: single premium PV = $100,000, annual effective interest r = 3%, period n = 20 years, level annual payment PMT.
Formula: PMT = PV * r / (1 – (1 + r)^(-n))
Computation:
– (1 + r)^(-n) = (1.03)^(-20) ≈ 0.55368
– Denominator = 1 – 0.55368 = 0.44632
– PMT = 100,000 * 0.03 / 0.446
= Computation continued (Example A: fixed‑period annuity)
– Numerator = 100,000 × 0.03 = 3,000.
– Denominator = 0.44632 (from previous line).
– PMT = 3,000 / 0.44632 ≈ 6,722.28.
Result: a 20‑year fixed annuity bought for $100,000 at a 3% effective annual discount rate pays about $6,722.28 per year.
Quick comparisons (same example)
– Simple payout rate (annual payment / premium) = 6,722.28 / 100,000 = 6
.72228% (about 6.72%)
– Yield (internal rate of return on the contract, by construction) = 3.00% effective annual. This is the discount rate used to price the annuity, not the same as the simple payout rate.
– Total nominal payments over 20 years = PMT × n = 6,722.28 × 20 = 134,445.60.
– Total excess of payments over premium (nominal “interest” received) = 134,445.60 − 100,000 = 34,445.60.
– Payback period (time to recover premium in nominal dollars) = Premium / PMT = 100,000 / 6,722.28 ≈ 14.87 years.
– Perpetuity comparison: a perpetual (infinite) payment at a 3% yield would pay PV × r = 100,000 × 0.03 = 3,000 per year. The 20‑year annuity pays more annually because it returns principal gradually as well as interest.
– First two rows of an amortization-style breakdown (payments at year end, ordinary annuity):
– Year 1: interest portion = 100,000 × 0.03 = 3,000. Principal repaid = 6,722.28 − 3,000 = 3,722.28. Remaining principal = 96,277.72.
– Year 2: interest portion = 96,277.72 × 0.03 ≈ 2,888.33. Principal repaid ≈ 6,722.28 − 2,888.33 = 3,833.95. Remaining principal ≈ 92,443.77.
(These numbers illustrate how interest falls and principal repayment rises over time.)
Checklist — what to check when comparing annuity offers:
– Confirm whether payments are immediate (starting now) or deferred, and whether they are ordinary (end of period) or annuity‑due (beginning).
– Confirm guaranteed period, survivor options, and beneficiary rules.
– Check fees, surrender charges, and embedded riders that affect cash flows.
– Consider inflation protection (COLA rider) or investment‑linked structures for buying power risk.
– Understand tax treatment: annuity earnings may be taxed differently than return of principal.
– Compare simple payout rate, contractual yield, and alternative investments using the same discounting assumptions.
Assumptions made in these calculations: payments are annual, level, and paid at period end (ordinary annuity); the discount rate is constant at 3% effective annual; there are no fees or taxes included.
Sources
– Investopedia — “Annuitant” (background on annuities and annuitants): https://www.investopedia.com/terms/a/annuitant.asp
– FINRA — “Annuity Basics” (investor guidance and considerations): https://www.finra.org/investors/annuity-basics
– U.S. Securities and Exchange Commission (Investor.gov) — “Annuities” (how annuities work and risks): https://www.investor.gov/introduction-investing/investing-basics/investment-products/annuities
Educational disclaimer: This explanation is for educational purposes only and is not individualized investment advice. Consider consulting a licensed financial professional and reading contract documents before buying an annuity.