Introduction | Regulation
| Annuity Rates | Crediting Methods
| History | Glossary
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
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.
- What level of risk am I willing to assume with the annuity?
- If most concerned about high minimum guaranteed interest, regardless of the lower
level of interest crediting/gains, consider a Fixed Annuity.
- If willing to accept a lower minimum guarantee than a fixed annuity, but looking
for potentially greater interest crediting/gains, consider an Indexed Annuity.
- 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.
- How soon will I need the regular stream of income payments from the annuity?
- If income will be taken within the first year, consider an immediate annuity (offered
in Fixed, Indexed, and Variable types).
- If income will be taken at some time further in the future, consider a deferred
annuity (offered in Fixed, Indexed, and Variable types).
- How many premium payments will I be making into the annuity?
- If only a single payment will be made into the annuity, consider a single premium
immediate annuity or a single premium deferred annuity.
- If making more than one payment into the annuity, consider a flexible premium deferred
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
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
Client's Risk Tolerance
Very Limited: typically less than 5.50%
Typically 87.5% of premium @ 3%
Limited: typically capped at less than 9.00%
Gains based on performance of external index
Fixed account only
Gains based directly on fund performance
(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
- The annuity purchaser- via fair interest rate crediting/gains
- The annuity salesperson- via fair compensation
- 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?
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.
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.
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.