The Basics
Introduction |
Regulation |
NTM 05-50 |
IA Rates |
Crediting Methods |
History |
Glossary
Introducton
You’re probably starting here, at The Basics because you’re
looking for more information on what an Indexed Annuity is—you may not even
be sure what an annuity is at all. Well, you came to the right place.
The Basics is an educational resource on our site which will teach you
about the fundamentals of Indexed Annuities. When you’re done reading this,
you should have the foundation for a solid understanding of Indexed Annuities.
Let’s assume that you don’t know what an annuity is.
Most everyone knows what life insurance is, so let’s make 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 it insures individuals against the risk of living
too long. With an annuity, the insurance company pays a series of payments until
the insured person(s) die. 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 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 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, well,
immediately.
Both deferred and immediate annuities can have their interest credited based on
several external factors. 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
| |
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% 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 |
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. 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 has a minimum guarantee 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 where crediting of any interest is determined
by the performance of underlying investment choices that the annuity owner selects.
A Variable Annuity is considered a high risk/high return annuity product.
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 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. A client may purchase 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
their money, the consumer is still protected by the minimum guarantee of 3.00%.
For this reason, the insurance carrier holds the risk with a Fixed Annuity.
Indexed Annuity
The insurance company must pay out a minimum guaranteed surrender value, regardless
of what they earn on their investments. The minimum guarantees on Indexed products
are lower than those of a Fixed nature, but their potential interest crediting is
greater. A client may purchase an Indexed Annuity with a minimum guarantee of 87.5%
of premiums, credited at 3.00% interest. The maximum credited interest may not exceed
a cap of 8.00%. However, if the market “tanks,” and the insurance carrier
can only earn 1.00% on their money, the consumer is still protected by the minimum
guaranteed surrender value of 87.5% @ 3.00%. For this reason, the insurance carrier
holds the risk with an Indexed Annuity.
Variable Annuity
The client invests directly in the underlying funds, and any gain or loss is passed
directly to them in whole (less fees and charges). There is a potential for loss
of principal with a Variable Annuity, due to poor market performance. The variable
sub-accounts have no minimum guaranteed interest, but the upside potential is greater
than that of Fixed and Indexed products. A client may purchase 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 carrier bears no
risk, but passes it directly to the client. For this reason, the client holds the
risk with a Variable Annuity.