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The Basics

Introduction | Regulation | Annuity Rates | Crediting Methods | History | Glossary

Introducton

You’re probably starting here, at The Basics because you’re looking for more information on annuities—you may not even be sure what an annuity is at all. Well, you have come to the right place. The Basics is an educational resource on AnnuitySpecs.com, which will teach you about the fundamentals of several types of annuities. When you’re done reading this, you should have the foundation for a solid understanding of annuities.

Let’s assume that you don’t know what an annuity is. Most everyone knows what life insurance is, so let’s start by making a comparison to life insurance.

Life insurance is an insurance product that protects individuals against the risk of death. If the insured person(s) die, the insurance company pays out a sum of money.

An annuity is sometimes referred to as the opposite of life insurance. This is because an annuity insures individuals against the risk of living too long. With an annuity, the annuity purchaser pays a premium to the insurance company, and receives in exchange, a regular stream of income payments from the insurer. The stream of income payments begin either immediately, or at some time in the future, and continue until the insured person(s) die.

Note that an annuity is one of many financial products that are available as a retirement income vehicle. You should work with a professional when determining which of these vehicles best-suits your needs and retirement goals.

Before making a decision about which product is most suitable for your retirement income goals, you should also consider a fundamental principal of risk:

Risk/Reward Tradeoff- a direct inverse relationship between possible risk and possible reward, which holds for a particular situation. To realize greater reward, one must generally accept a greater risk, and vice versa.

That being said, there are three questions that must be answered, when researching what type of annuity is right for you.

  1. What level of risk am I willing to assume with the annuity?
    1. If most concerned about high minimum guaranteed interest, regardless of the lower level of interest crediting/gains, consider a Fixed Annuity.

    2. If willing to accept a lower minimum guarantee than a fixed annuity, but looking for potentially greater interest crediting/gains, consider an Indexed Annuity.

    3. If willing to accept no minimum guaranteed interest, and the possibility of unlimited loss in exchange for the possibility of unlimited interest crediting/gains, consider a Variable Annuity.

  2. How soon will I need the regular stream of income payments from the annuity?
    1. If income will be taken within the first year, consider an immediate annuity (offered in Fixed, Indexed, and Variable types).

    2. If income will be taken at some time further in the future, consider a deferred annuity (offered in Fixed, Indexed, and Variable types).

  3. How many premium payments will I be making into the annuity?
    1. If only a single payment will be made into the annuity, consider a single premium immediate annuity or a single premium deferred annuity.

    2. If making more than one payment into the annuity, consider a flexible premium deferred annuity.

There are two different classifications of annuities: deferred and immediate.

What is a deferred annuity?
An insurance product whereby at least a year will elapse between when the lump sum or series of premium(s) are paid, and the annuity is transitioned into a stream of income through annuitization. Deferred annuities can be Fixed, Indexed, or Variable in nature.

What is an immediate annuity?
An insurance product whereby a lump sum premium is paid and the annuity is transitioned into a stream of income through annuitization within one year from the date of purchase. Immediate annuities can be Fixed, Indexed, or Variable in nature.

Deferred annuities typically are used as vehicles for accumulation, or building additional interest until the annuitant is ready to transition the annuity to a series of payments through annuitization. Alternatively, an immediate annuity is often used as a vehicle for individuals who are ready for their income stream to begin, well, immediately.

Both deferred and immediate annuities can have their interest credited in several different ways. The two basic types of deferred and immediate annuities are Fixed and Variable. Of the fixed variety, there are (traditional) Fixed, as well as Indexed.

Annuity Risk Spectrum

Risk Chart

  Guaranteed Interest Upside Potential Indexed Participation Client's Risk Tolerance
Fixed
(Traditional)
Typically 2% Very Limited: typically less than 5.50% None Low
Indexed Typically 87.5% of premium @ 3% Limited: typically capped at less than 9.00% Gains based on performance of external index Moderate
Variable Fixed account only Unlimited Gains based directly on fund performance High


(Note: any salesperson that suggests that Indexed Annuities provide unlimited gain potential either misunderstands or is misrepresenting the product. Indexed Annuities provide limited gain potential and are not intended to perform comparably to securities products. Indexed Annuities credit interest based on the performance of stock market indices; they do not allow you to invest directly in the stock market. They do, however, provide the opportunity to outpace fixed money instruments such as Fixed Annuities.)

What is a Fixed Annuity (FA)?
A contract issued by an insurance company that guarantees a minimum interest rate with a stated rate of excess interest credited, which is determined by the performance of the insurer’s general account. Multi-Year Guaranteed Annuities, a type of Fixed Annuity, guarantee a minimum interest rate for more than a one-year period; this rate is also determined by the performance of the insurer’s general account. A Fixed Annuity is considered a low risk/low return annuity product.

What is an Indexed Annuity (IA)?
A contract issued by an insurance company that guarantees a minimum interest rate of zero, where crediting of any excess interest is determined by the performance of an external index, such as the Standard and Poor’s 500® index. An Indexed Annuity is considered a moderate risk/moderate return annuity product.

What is a Variable Annuity (VA)?
A contract issued by an insurance company that has no minimum guaranteed interest rate, where crediting of any excess interest is determined by the performance of underlying investment choices that the annuity purchaser selects. A Variable Annuity is considered a high risk/high return annuity product.

In your evaluation of annuities, it helps to understand the overview of the annuity transaction. The sale of an annuity has to benefit three parties in the annuity transaction:

  1. The annuity purchaser- via fair interest rate crediting/gains

  2. The annuity salesperson- via fair compensation

  3. The annuity issuer (insurance company)- via a fair profit (i.e. a spread, which is different from the “asset fee” which is used to limit indexed interest on an indexed annuity; more about that later)

We refer to this as the “three-legged stool” of the annuity transaction. To fully understand, it also helps to consider how the insurance company makes money by selling annuities. Simplistically, the insurance company invests the annuity purchaser’s premium payment(s) in different investment vehicles, in order to make a return that is high enough to pay administrative costs (such as the salesperson’s compensation), credit interest to the annuity purchaser, and still retain a profit.

Let’s consider an example, using Fixed Annuities as a point-of-reference. With Fixed Annuities, the insurance company invests the annuity purchaser’s premium payment in bonds. This ensures that they will receive a guaranteed return on the monies, and be able to pay the annuity purchaser a guaranteed interest rate. Consider the following simplistic hypothetical: if 10-year bonds are paying a rate of 4.00% to the insurance company, the insurer will then credit [4.00% - X] to the annuity purchaser’s 10-year fixed annuity contract. The value of X is determined by knowing what amount the insurer needs to cover their expenses (i.e. salesperson’s compensation) and the amount of profit the insurance company intends to keep.

With Indexed Annuities, the example above is only modified slightly. The insurance company still invests the annuity purchaser’s premium payment in bonds, but not 100% of it. The difference of less than 5% of the payment is used to purchase options. These options are what give the insurance company the ability to credit interest to the annuity purchaser, based on the performance of a stock market index. The determinant in the rate that is credited to the annuity is: a) the cost of the option, and b) the stock market index’s performance.

So, we have established that there are several different types of annuities, the primary categories being Fixed and Variable. These products are very different, despite the fact that they both may be used for the same purpose. Now that we have seen some of the likenesses in these products above, let’s discuss some of the differences.

Who sells this product?

Licensed insurance agents have the ability to sell Fixed, Indexed, and Multi-Year Guaranteed Annuities, as long as they have an active life and annuity line of authority within the state that they are selling in.

A securities license is not required to sell Indexed Annuities, as they are fixed insurance products; the annuity purchaser is never directly invested in the stock index with an Indexed Annuity.

If a securities-licensed salesperson (i.e. someone who sells stocks, bonds, mutual funds, etc.) wants to sell Fixed, Indexed, or Multi-Year Guaranteed Annuities, they can do so by obtaining a life and annuity line of authority with their local state insurance commissioner’s office.

How is this product sold?

Fixed, Indexed, and Multi-Year Guaranteed Annuities, like other insurance products, are sold via an insurance contract. By contrast, securities products (such as Variable Annuities) are sold via a prospectus.

When an insurance agent sells any variety of fixed annuity, the sales materials and product brochures will be accompanied by the following (at a minimum):

  • Annuity application

  • Annuity disclosure document

  • Annuity suitability form

  • Annuity Buyer’s Guide

More forms may be required depending on the state that the purchaser lives in, whether they are replacing another annuity or investment with the current annuity purchase, and/or whether the monies that are being used to purchase the annuity are coming from a qualified plan (just to name a few variables).

Who carries the risk with this product?

Fixed Annuity

The insurance company must pay out a minimum guaranteed rate of interest, regardless of what they earn on their investments with a Fixed Annuity. An annuity purchaser may obtain a Fixed Annuity with a minimum guarantee of 3.00%, and a current credited rate of 4.50%. However, if the market “tanks,” and the insurance carrier can only earn 2.00% on the money they have invested (i.e. on the bonds purchased by the insurer at the time the annuity premium was paid), the annuity purchaser is still protected by the minimum guarantee of 3.00%. For this reason, the insurance company holds the risk with a Fixed Annuity. The insurer still has to make good on the minimum guarantees in the contract, regardless of the performance of their own investments.

Indexed Annuity

The insurance company must pay out a minimum guaranteed rate of no less than 0%, regardless of what they earn on their investments with an Indexed Annuity. The insurance company must also offer a secondary guarantee on Indexed Annuities, in the event the annuity purchaser dies or cash surrenders the annuity, or in the event the index does not perform. This guarantee is called the Minimum Guaranteed Surrender Value, or MGSV. An annuity purchaser may obtain an Indexed Annuity with a MGSV of 87.5% of premiums, credited at 3.00% interest. The maximum credited interest may not exceed a cap of 8.00% if the S&P 500 rises 8.00% or more over a one-year period. However, if the market “tanks,” and the insurance carrier can only earn 1.00% on the money they have invested (i.e. on bonds purchased by the insurer at the time the annuity premium was paid), the annuity purchaser is still protected by the Minimum Guaranteed Surrender Value of 87.5% of the premiums paid accumulated at 3.00% interest (which accumulates to the point where a return of premiums paid would occur in the fourth contract year). For this reason, the insurance company holds the risk with an Indexed Annuity. The insurer still has to make good on the minimum guarantees in the contract, regardless of the performance of their own investments.

Variable Annuity

The Variable Annuity purchaser chooses to directly invest in an array of available stocks, bonds, mutual funds, and underlying subaccounts on their annuity; any gain or loss is passed directly to the annuity purchaser in whole (less fees and charges). There is a potential for the annuity purchaser to experience a loss of principal and gains with a Variable Annuity, in the event of poor market performance. The variable sub-accounts have no minimum guaranteed interest, but the upside potential of a Variable Annuity is greater than that of Fixed and Indexed Annuities. An annuity purchaser may acquire a Variable Annuity with a minimum guarantee of 1.00% only on the fixed subaccount, and no minimum guarantee on the variable subaccounts. Assuming 100% of the premiums are allocated to variable sub-accounts, if the market “tanks,” the insurance company bears no risk, but passes it directly to the annuity purchaser through a loss in their annuity’s value. For this reason, the annuity purchaser holds the risk with a Variable Annuity. The insurer has no minimum guarantees to honor in the contract (they collect their fees and charges regardless of performance), and any negative performance on the underlying investments is fully-realized by the annuity purchaser.