Annuities are typically
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contracts
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sold by companies whereby the buyer agrees to make payments over a
specified period. For example, $100 paid each year for three years is a
three-year annuity. In a fixed annuity payments are for a fixed,
predetermined amount, in a variable annuity the amount of money paid out
each period varies. Normally, the amount fluctuates according to some
outside influence, such as the return on an investment. For example, a
three-year variable annuity may pay $70, $128, and $97 in years one, two,
and three, respectively.

The term "annuity" is most commonly used to describe a
contract between an insurance company and an individual or entity. Various
annuity products proliferated in the insurance industry during the 1980s
following increased competition for traditional life insurance dollars
from investment vehicles such as
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mutual funds
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and
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individual retirement accounts
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(IRAs). Typically, an investor in an annuity gives a sum of money to an
insurance company in return for that insurer's promise to supply a
series of payments for a fixed number of years during his or her lifetime.
The person can elect to have the payments begin immediately after the
initial payment of the premium (immediate annuity) or at some future date
(deferred annuity). Disbursements for deferred annuity contracts start at
least one year after the premium payment.

The most common type of annuities are deferred, because interest that
accrues on the investment is not taxed until the money is disbursed. The
advantage of such an arrangement is that the investor can time the payouts
to reduce total
**
tax
**
liabilities. For example, a young investor in a high-income tax bracket
could invest money in a deferred annuity with plans to withdraw the
investment in the form of annual payments after retirement, when he or she
would be in a lower-income tax bracket. Deferred annuities can be fixed or
variable.

Investors in variable annuities can usually move their money around into different mutual funds offered by the insurance company—usually five to ten different funds, including bond, stock, and money-market funds. A younger investor, for example, has the option of gradually adopting a more conservative underlying investment portfolio as time passes. The arrangement is similar to investing in an IRA. The key difference is that the maximum amount of money one can invest in an IRA is limited by federal law, and the initial IRA investment is tax-deductible. The amount that one can contribute to a deferred annuity, in contrast, is unlimited but not tax-deductible. Potential drawbacks of variable annuities include annual management fees, early-withdrawal penalties, and the risk of a negative return in a given year, unlike the minimum rate of return determined by fixed annuities.

Variable annuities are often combined with life insurance products to form variable life insurance. Variable life insurance offers the advantages provided by variable annuities that are described above as well as the benefits of life insurance. Typically, an individual (the insured) pays a single premium or a series of premiums. The insured can then select from a number of options to convert the policy into an income stream, which entails a stated death benefit. The basic options include: (1) taking the market value of the investment as a lump-sum payment; (2) receiving a variable periodic payment; and (3) receiving a fixed annuity. Variable life insurance gives the insured more control over his or her investment than do other types of life insurance, and the surviving beneficiary is not subject to income tax on the death benefit.

Actuaries at insurance companies determine benefits and payments related
to life annuities by consulting mortality tables. These tables of
historical data show the probability for life expectancy for specific
individuals based on demographic and behavioral attributes. Using that
information, the insurer effectively structures the variable annuity so
that the insured bears the investment risk of the underlying investment
portfolio. For example, assume that Jim retires at age 60 with $100,000 in
his variable annuity contract. Mortality tables suggest that Jim, a
motorcycle rider and heavy smoker, will likely die within five years.
Assuming that the insurance company can expect to get an average
investment return of 5 percent annually (the assumed investment return, or
AIR), the insurer can calculate Jim's annual benefit payment with
the following formula:

where
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B
*
equals the benefit payment in each year
*
t,
*
and
*
R,
*
is the actual return on Jim's portfolio in year
*
t.
*
The first payment is determined by simply calculating a constant payment
that, over five years, would equal $ 100,000 given a discount rate equal
to the AIR. In this case, the formula yields a first payment of $23,097
assuming a discount rate equal to the AIR of 5 percent. Thus, if
Jim's portfolio returned 6 percent in the second year after his
retirement, his annual payment would be $23,317, or $23,317 =
$23,097[1.06/1.05].

Thus, each year's benefit is calculated by multiplying the previous year's benefit by a factor that reflects the actual investment performance of the portfolio. The formula guarantees that Jim will continue to receive a relatively substantial annual benefit throughout his life, regardless of how long he actually lives. If Jim lives 15 years the insurance company will obviously lose money on his annuity contract. Theoretically, however, the mortality tables will ensure that the company profits from the average performance of its large pool of annuity contracts—some of those insured will die earlier than expected, and some will die later.

In the 1990s, variable annuities were continually threatened by efforts of Congressional Republicans to lower the capital gains tax. The Budget Reconciliation Act of 1997 finally succeeded, reducing the capital gains tax rate from 28 to 20 percent. As a result, tax-deferred variable annuities carry a relatively greater tax burden than previously, limiting their appeal to investors.

*
[
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Dave
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Mote
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]
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Holmes, Phil.
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Investment Appraisal.
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Boston, MA: International Thomson Business Press, 1998.

Kosnett, Jeffrey R. "Tracking Variable Life."
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Life Association News,
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May 1999, 69-79.

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