Annuity Phases
Annuities have two distinct phases: the accumulation phase (when money is being put in) and the annuitization or payout phase (when money is being paid out). Understanding these phases is critical for the licensing exam.
Overview of Annuity Phases
| Phase | Also Called | What Happens |
|---|---|---|
| Accumulation phase | Pay-in phase, deferral period | Premiums paid, value grows tax-deferred |
| Annuitization phase | Payout phase, liquidation period | Periodic income payments received |
The Accumulation Phase
The accumulation phase is the period when the annuity owner is building value in the contract.
Characteristics of the Accumulation Phase
| Feature | Description |
|---|---|
| Premium payments | Owner pays into the contract |
| Tax-deferred growth | Earnings not taxed until withdrawn |
| Accumulation units | Variable annuities track value with accumulation units |
| Interest crediting | Fixed annuities credit declared interest rates |
| Surrender charges | Early withdrawals may face charges |
| Death benefit | Typically equals account value or premiums paid |
How Value Grows
| Annuity Type | Growth Mechanism |
|---|---|
| Fixed annuity | Interest credited at declared rate (minimum guaranteed) |
| Variable annuity | Value of accumulation units fluctuates with subaccount performance |
| Indexed annuity | Growth linked to market index with caps and floors |
Accumulation Units (Variable Annuities)
During accumulation in a variable annuity:
- Owner purchases accumulation units with each premium payment
- Number of units depends on unit value at purchase
- Unit value fluctuates based on subaccount performance
- Account value = Number of units × Current unit value
Example: Accumulation Unit Purchase
| Premium | Unit Value | Units Purchased |
|---|---|---|
| $1,000 | $10.00 | 100 units |
| $1,000 | $12.50 | 80 units |
| $1,000 | $8.00 | 125 units |
| Total | — | 305 units |
The Annuitization Phase
The annuitization phase (or payout phase) begins when the owner elects to convert the accumulated value into a stream of income payments.
Characteristics of the Annuitization Phase
| Feature | Description |
|---|---|
| Income payments begin | Regular payments to annuitant |
| Annuity units | Variable annuities convert to annuity units |
| Irrevocable election | Once annuitized, cannot be reversed |
| Payment amount | Based on account value, age, gender (if applicable), and payout option |
| Taxation | Portion of each payment is taxable |
Annuity Units (Variable Annuities)
At annuitization in a variable annuity:
- Accumulation units convert to a fixed number of annuity units
- Number of annuity units stays constant
- Value of each annuity unit varies with investment performance
- Payment = Number of annuity units × Current annuity unit value
Example: Annuity Unit Payments
| Month | Unit Value | Payment |
|---|---|---|
| January | $12.00 | 100 units × $12.00 = $1,200 |
| February | $11.50 | 100 units × $11.50 = $1,150 |
| March | $13.00 | 100 units × $13.00 = $1,300 |
Exam Tip: In a variable annuity, during the payout phase, the number of annuity units is FIXED, but the VALUE of each unit (and therefore the payment) VARIES.
Surrender Charges and Free Withdrawal
Surrender Charges
Surrender charges are fees imposed when the owner withdraws more than the free withdrawal amount or surrenders the contract during the surrender period.
| Feature | Description |
|---|---|
| Surrender period | Typically 5-10 years |
| Charge structure | Usually declines over time |
| Purpose | Allows insurer to recover sales costs |
| Applies to | Withdrawals exceeding free withdrawal amount |
Example: Declining Surrender Charge Schedule
| Year | Surrender Charge |
|---|---|
| 1 | 7% |
| 2 | 6% |
| 3 | 5% |
| 4 | 4% |
| 5 | 3% |
| 6 | 2% |
| 7 | 1% |
| 8+ | 0% |
Free Withdrawal Amount
Most annuities allow free withdrawals without surrender charges:
| Common Free Withdrawal Provisions |
|---|
| 10% of account value per year |
| Interest earnings only |
| Systematic withdrawal programs |
| Death or disability (often waived) |
| Nursing home confinement (often waived) |
Transitioning Between Phases
When to Annuitize
| Consider Annuitizing When | May Not Be Right If |
|---|---|
| Ready for guaranteed lifetime income | May need large lump sums |
| Comfortable with irrevocable decision | Uncertain about future needs |
| Want to maximize monthly income | Want to leave assets to heirs |
| Have other liquid assets available | Only asset is the annuity |
Alternatives to Annuitization
Many owners choose not to annuitize and instead take:
| Alternative | Description |
|---|---|
| Systematic withdrawals | Regular withdrawals while maintaining ownership |
| Partial withdrawals | Occasional withdrawals as needed |
| Required Minimum Distributions | For qualified annuities after age 73 |
| Lump sum surrender | Take entire value (after surrender period) |
Key Decision Factors
| Factor | Impact on Decision |
|---|---|
| Age | Older = higher payments |
| Health | Poor health may favor alternatives to life annuity |
| Need for income | Immediate need favors annuitization |
| Desire for flexibility | Systematic withdrawals offer more control |
| Legacy goals | Annuitization may reduce inheritance |
Key Takeaways
- The accumulation phase is when value builds tax-deferred
- Accumulation units track value in variable annuities during accumulation
- The annuitization phase converts value to guaranteed income payments
- Annuity units are fixed in number; their value fluctuates during payout
- Surrender charges apply during the surrender period (typically 5-10 years)
- Most contracts allow 10% annual free withdrawals
- Annuitization is irrevocable—once elected, it cannot be undone
- Many owners use systematic withdrawals instead of formal annuitization
During the accumulation phase of a variable annuity, the owner purchases:
During the payout phase of a variable annuity:
Surrender charges on an annuity typically:
The free withdrawal provision in most annuities typically allows withdrawals of:
15.1 Classification by Premium Payment
Chapter 15: Types of Annuities