What is a fixed annuity, a variable annuity?
Simply put, both a fixed annuity and a variable annuity are amounts payable annually. More specifically, they
are contracts offered by insurance companies which allow you to accumulate funds for retirement on a tax-
favored basis and then, if you choose, receive a guaranteed income payable for life or for a period certain
such as five, ten or twenty years. Usually the payments are made monthly, but many companies offer to make
the payments quarterly, semi-annually, or annually. Most of this discussion will focus on the fixed annuity.
How do they work?
Both a fixed annuity and a variable annuity are vehicles for accumulating retirement savings. You pay a
premium to an insurance company and they promise to pay you interest. Unlike other retirement savings
instruments, as long as you keep your money with the insurance company, you are not required to pay
income tax on your gains.
This is what is known as 'tax deferral.' Only when you decide to withdraw your funds are your gains subject to
income tax. A fixed annuity also differs from other retirement savings plans in another important way. When
you decide to withdraw your funds, the insurance company will give you the option to receive a guaranteed
income for as long as you live.
What are the advantages?
All fixed annuity variations have three primary advantages: Tax Deferral, Avoidance of Probate, and a
Guaranteed Income for Life.
Who offers fixed annuity products?
Fixed annuities are offered only by insurance companies licensed to underwrite life insurance and annuities
by the state in which you reside. Most insurance companies are subject to financial requirements specifying
the minimum reserves the company must maintain on its policies.
Who sells them?
Only agents licensed by the states to sell life insurance may sell you a fixed annuity. This includes every
licensed life insurance agent in your state as well as most financial planners and stock brokers.
Why is Guaranteed Income for Life an advantage?
Annuities are the only savings vehicle which offer a guaranteed income for life. With every other type of
accumulation plan you can never be sure your income will continue for as long as you live. The insurance
company calculates a guaranteed income payment based on your age, life expectancy and interest rates it
will credit. That payment is guaranteed for as long as you live.
Most insurance companies will also offer a guaranteed fixed rate of income for a specific period such as five
to twenty years. The guaranteed lifetime income may be based on your life only, or based upon the life of both
you and a joint annuitant, typically your spouse. In the event of a joint annuitant, the monthly income from your
fixed annuity will continue until the last survivor dies.
What does Tax Deferral mean?
A tax-deferred fixed annuity receives special tax advantages. Under existing tax laws, any interest or gain is
not taxable until you begin to actually receive the income, i.e. the tax payable on the gain is deferred.
Therefore, since you pay no taxes while your money is compounding, you earn interest in three ways -
interest on your principal, interest on your interest and interest on the taxes you would have paid if it had not
been tax deferred. This results in increased earnings capacity of a deferred annuity over a bank CD or other
fully taxable earnings.
Why is Probate Avoidance an advantage?
The other primary advantage over most other investment vehicles common to all annuities is the ability to
pass on the proceeds upon your death directly to a beneficiary. Probate is a judicial process to establish the
validity of a will. Assets in an estate typically cannot be passed on to heirs until the probate court has
established the validity of the will and authorized the executor to distribute them. Because probate is a judicial
process, the process can take anywhere between six and twelve months to conclude, and the legal
expenses can be significant.
Proceeds from annuities and life insurance, on the other hand, are not subject to probate and may be
passed to your designated beneficiary directly without going through probate. What is required of the
insurance company in order to meet its obligations?
To safeguard the funds of its contract holders or policyowners, an insurance company has to meet strict
financial requirements. Most importantly these requirements include the establishment of a reserve which at
all times must be equal to the withdrawal or surrender value of their total block of variable and fixed annuity
policies or contracts.
In other words, the insurance company must set aside funds equal to the surrender value (principal plus
interest less early withdrawal or surrender charges) of every annuity contract in force. In addition to these
reserve requirements, state laws also require certain levels of capital and surplus to further protect their
contract holders or policyowners.
Immediate Annuity
An immediate annuity provides for fixed annuity payments to begin immediately after the date of purchase.
Payments may be scheduled monthly, quarterly, semiannually or annually according to prior agreement.
Often the proceeds from a life insurance policy or the sale of a home are used to fund an immediate annuity.
Such annuity payments provide immediate, regular income for a period certain (5, 10, 15, 20 years) or for life,
depending on the choices made by the immediate annuity owner.
Deferred Annuity
A deferred annuity provides for payments to begin on a future date known as the maturity date. A deferred
annuity has an accumulation period and a payout or distribution period. For example, a middle-aged wage
earner could provide for an income supplement in their retirement years by purchasing a deferred fixed
annuity. Lump sum or regularly scheduled payments would be contributed to the annuity account as it
accumulates, then at age 65 when the annuity matures, additional income would be available through
scheduled annuity payments.
Single Premium Annuity
A fixed annuity may be purchased with a single premium in which one cash payment establishes the contract.
The most common sources of such lump sums are proceeds from a life insurance death benefit, the sale of
a home or winning the lottery.
Flexible Premium Annuity
A fixed annuity may be funded over time with an initial premium plus additional flexible premiums. Both
premium amounts and frequency may be flexible, thus accommodating convenient funding plans such as
payroll deduction over several years of employment as well as changes in the owner's financial situation.
What is a Fixed Indexed Annuity?
A fixed indexed annuity (also called an index annuity, an indexed annuity or an equity indexed annuity) is a
fixed annuity with an upside earning capacity and a guarantee against downside loss of principal. Its
earnings are linked to a stock or equity market index such as the Standard & Poor’s 500 Composite Stock
Price Index or, simply, the S&P 500. Fixed indexed annuities (FIAs) have four guarantees:
1. Initial premium is guaranteed
2. Minimum rate of return
3. Take credit for increases (ups) in market, not corrections (downs)
4. Gains are locked in every year
How do they differ from other fixed annuities?
The primary difference between a fixed indexed annuity and other fixed annuities is in the way the annuity rate
or earnings are credited to your account. A traditional fixed annuity credits interest with an annuity calculator
that is set in the contract and may or may not be subject to market adjustments. A fixed indexed annuity leads
to an interest crediting formula based on changes in the equity market to which it is linked. This formula
spells out how interest is calculated, credited, how much additional interest you get, and when you get it.
The insurance carrier issuing the fixed indexed annuity also promises to pay a guaranteed minimum rate of
interest. Even if the indexed earnings are lower, the minimum guarantee will apply and your account value
will not fall below the guaranteed minimum. Both flexible premium and single premium deferred annuity
contracts guarantee a minimum interest rate, often in the range of 1.5% to 3% based on between 90% and
100% of paid premium. The insurance company’s annuity calculator will adjust account values at the end of
each term.
What are the contract features or 'Moving Parts'?
The amount of additional interest that may be credited to a fixed indexed annuity is influenced most by the
Indexing Method and the Participation Rate working together like form and function.
The INDEXING METHOD is the design by which the amount of change in the index is measured. For
example, a method that measures the difference in the starting index level and the level on the one-year
anniversary is an annual point-to-point. If this design “ratchets” up the account value (new principal) with each
annual gain, the indexing method includes an Annual Reset feature. Currently, the industry’s best selling
equity indexed annuity is the MasterDex Annuity series from Allianz, which incorporates the more progressive
design of a “monthly” point-to-point together with an annual reset. Functional differences in indexing methods
will be explained in greater detail below.
Like a faucet, the PARTICIPATION RATE determines how much of the increase in the index will flow into the
annuity account value. Let’s say the fixed annuity calculator shows a 12% increase in the index, but your
participation rate limits you to 70% of the gain. Your annuity rate of increase would be 70% of 12%, or 8.4%.
Participation rates are variable and may be guaranteed only for a specific period or guaranteed not to be
adjusted below a given minimum or above a specified maximum. One of the most popular fixed indexed
annuities is the Keyport Index Multipoint from Sun Life Financial, which guarantees a 100% participation rate
for the full contract term.
Some fixed indexed annuities place a CAP or ceiling on the annuity rate, establishing the upper limit the
annuity may earn. An annuity earning an index-linked interest rate of, say, 9% may have a cap of only 7%,
which would be the amount of increase credited.
Some annuities use AVERAGING to smooth out the highs and lows of the linked equity market index. Monthly
averaging, for example, would use an annuity calculator which combines each month-to-month index closing
value divided by 12.
Some annuities reduce the index-linked interest rate by subtracting a SPREAD, a MARGIN, or a FEE and
crediting the balance. A positive change in the index of 11%, for example, with an administrative fee of 2.5%,
would yield a net increase of 8.5%. Of the carriers who sell annuity products with spreads, margins or fees,
such amounts will be subtracted only if the remaining index change is a positive earnings rate.
Indexing Methods
Annual Reset: Yield is determined each year by comparing the index value at the end of the contract year with
the index value when the contract year began. The positive difference, if any, is the yield your fixed indexed
annuity earns for the year. Any new positive (not negative) account value resets to become the new starting
point for the upcoming year. Contrast this formula to owning a variable annuity or a direct equity investment in
a bear market. With variables and stocks the owner may have a deep valley to climb out of before getting back
to zero.
High-Water Mark: Yield is determined by the rise in index value at the contract annual anniversary points
during the term. The positive difference, if any, is determined by comparing the highest index value and the
index value at the start of the term. Point-to-Point: Yield, if any, is determined by comparing the difference
between the index value at the end of the term with the index value at the beginning of the term. The positive
difference is added to your annuity account value at the end of the term.
