What Is an Annuity?
How do annuities work? Let’s look at the annuity definition first. An annuity is a name given to the periodic disbursements that an insurance company pays a person who has made a series of payments or a lump sum amount of money in the past. Generally, the goal of annuities is to create security for the future or after retirement. It is an investment a person makes for stability. So, an annuity works by transferring the risk to the insurance company, which bears this risk in return for the premiums or the lump sum amount paid by the investor.
There are different types of annuities. Fixed annuities, variable annuities, and indexed annuities are the three major types of annuities. There are also immediate and deferred annuities.
A Brief Introduction About the Annuity Contract
What is an annuity contract? The annuity agreement is a set of terms and conditions, outlining the contractual obligations of the parties concerning annuities. The contract binds the insurance company to make guaranteed payments to the investor during retirement. It lays down the type of annuity and the period on paper.
An annuity agreement is a widespread occurrence across the globe. People often purchase an annuity to secure their future and not worry about income during retirement or old age. You might need to sign an annuity contract too in your lifetime, which is why it is important to do it right.
Who Takes the Annuity Contract?
Any person willing to invest in an annuity offered by an insurance company can take the contract. There can be as many as four parties to the contract. The owner, the issuer or the insurance company, the beneficiary, and the annuitant are the four parties to the contract.
The owner is the person who pays for the annuity in question; the annuitant is the person on whose health and life expectancy the contract is based, and the beneficiary is the person who will receive the money when the annuity owner dies. In some cases, the annuitant and the owner are the same people. There can also be a joint annuitant who can continue the contract in case one annuitant passes away.
Purpose of the Annuity Contract
The main purpose of the contract is to provide a guarantee to the investor. The annuity agreement creates a consistent income source from wealth for the investor by purchasing an annuity from an insurance company. The contract ensures that the insurance company delivers on its promise, and the investor is protected from any default.
An annuity contract is a tool opted by many investors to grow their money at a decided rate of interest, in a safe, legally enforceable manner. The contract has specific aims like lifetime income protection, payment options, surrender benefits, etc. The contract lays down all the terms on paper which helps the investor become fully aware of what he or she is agreeing to. The contract is proof of what was agreed upon by all the parties, also serving the purpose of record-keeping.
Contents of the Annuity Contract
These are broadly classified contents of an annuity agreement:
- Details: The first part is where the personal details of all the parties, term of the contract, date from which it becomes effective, age of the insured at the time of purchasing the annuity, premium amount, riders, policy number, etc. are written.
- Interest rate: Regarded as the most crucial section of the contract. This includes any bonus rate, minimum guaranteed rate, etc.
- Surrender fees: Percentage of the surrender fees that will be charged year wise.
- Definitions of all the terms in the contract.
- Details about the annuity fund, like maximum premium limit, interest calculation, the value of the annuity fund, etc.
- The benefit provisions like payment options, annuity benefits, surrender benefits, death benefits, market value adjustment, etc.
- The rights and obligations of the owner, annuitant, insurance company, and beneficiary.
- What constitutes as a breach of contract and the process for termination of the contract?
How to Draft the Annuity Contract
Keeping these points in mind while drafting the agreement can prove helpful:
- Determine the type of annuity contract.
- Ensure the language is readable, especially when it comes to disclosures. Avoid ambiguity.
- The most important part of the contract is the interest rate. The ‘lifetime interest rate’ must be mentioned as insurance companies tend to offer a high-interest rate in the start as a teaser.
- A clause about the surrender period (the time in which the annuity owner can withdraw the annuity money that was paid, without any penalties) must be included.
- Draft a clause about the percentage of withdrawal (usually 10%) that can be made before the payments begin, in case of emergency.
- Check that the contract is not multi-tiered (different interest rates for complete withdrawal and partial payments by the insurance company).
- Check the penalties clause and if the amount of the penalties decided it agreeable to both parties.
- A joint annuitant can be added to the contract, to continue the contract in case one annuitant passes away.
- State the governing laws.
- Insert a clause to govern dispute resolution procedures.
- Insert the general legal clauses like the statute of limitations, entire agreement, severability, indemnity, etc.
Rounds of negotiation may prove helpful to arrive upon a good rate of interest and in creating a contract that has no loopholes. Creating a win-win in case of annuity contracts is a must, and that can be made possible through good negotiation strategies. Aspects such as payment options, withdrawal percentage, penalties, etc. can be negotiated between the parties.
Are Annuities a Good Investment?
The best pitch that you will hear from an insurance company is that an annuity will guarantee income for the rest of your life. Depending upon your financial needs, annuities may or may not be good for you. They are considered to be one of the most expensive investment options.
Should you decide to buy an annuity, be well-informed about the type, you need. For example, a deferred annuity offers tax benefits. Is that what you want? Research well and then agree to sign an annuity agreement. Also, buy annuities gradually instead of buying in a lump sum, that will allow you to average good interest rates that are ever-changing. Annuities do not necessarily grow with the stock market, check the minimum guaranteed rate of interest that is offered by an insurance company before investing.
Benefits & Drawbacks of Annuity Contract
Here are the pros and cons of entering into an annuity agreement:
- Annuity agreements offer guaranteed, regular payments that are helpful during retirement.
- Some types of annuity agreements offer tax benefits.
- Some annuities offer a death benefit.
- They create a safety net for the owner and the annuitant, should the insurance company breached the contract.
- The contract is proof and legally enforceable.
- The annuity agreement brings in safety and stability.
- As the agreements are hard to draft and very complex, drafting involves legal fees, which makes the process expensive.
- Generally, a lot of high fees are attached to annuities, making them a costly investment option.
- Surrendering an annuity after the surrender period has passed may result in loss, if not impossible.
- The income from the annuity will be taxed like regular income in most countries.
- Annuities are not flexible.
- An annuity contract is often difficult to understand for a layman and might lead to misunderstandings in the future, eventually leading to an expensive and long legal battle.
What Happens in Case of Violation?
When the annuity contract is breached because of the violation of any of the terms of the contract, the non-breaching, injured party can sue for damages or request for enforcement of the terms of the contract that was earlier breached. The basic remedies of breach of contract are available to the aggrieved party. Depending upon whether the breach is minor, fundamental, or material, the damages can be claimed. The injured party can also request for specific performance, restitution and the other remedies available under the contract law(1).
An annuity agreement may not be for everyone. If you think that this is the best investment option for you, get your contract examined by a legal professional and minutely study every clause to understand how it will affect you in the future. A well-drafted annuity agreement can go a long way in ensuring timely future payments during your retirement. Also, at the same time, a bad agreement can make you lose much hard-earned money.
Understanding an annuity contract is never simple. The contract is one of the most complicated ones you will come across, which is why it is advised to hire a legal professional to draft your agreement or refer to a sample available online.