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Annuities 101
| What is an Annuity?
What questions should I ask my Agent or the Company? Immediate or Deferred Fixed or Variable Interest Rates for Fixed Deferred Annuity Equity-Indexed Annuities You Should be Prepared to Answer these Questions from Clients Current Interest Rate Individual Fixed Deferred Annuities,Single Premium or Multiple Premium What are some Fixed Deferred Annuity Contract Benefits? How do I know if a Fixed Deferred Annuity is right? Premium Tax Recognition of Earnings Lock-in of earnings Free Withdrawal Vesting |
How are Equity-indexed Annuities different from other Fixed Annuiti
Tax Treatment of Annuities Definitions Annual Reset Cap Participation Rate Starting Point Minimum Guaranteed Rate Multiple Interest Rates Surrender or Withdrawal Charges Transaction Fee Contract Fee Index Period or Term Automatic Rollover Death Benefit |
An annuity is a contract in which an insurance company makes a series of income payments at regular intervals in return for a premium or premiums paid. Annuities are most often bought for future retirement income. Only an annuity can pay an income that can be guaranteed to last as long as you live.
Your value in an annuity contract is the premiums paid, less any applicable charges, plus interest credited. The insurance company uses the value to calculate the amount of most of the benefits received from an annuity contract.
Individual Fixed Deferred Annuities Single Premium or Multiple Premium
Only one payment for a single premium annuity. A series of payments for a multiple premium annuity. There are two kinds of multiple premium annuities: flexible premium contract, scheduled premium annuity.
With an immediate annuity, income payments start no later than one year after the premium is paid. You usually pay for an immediate annuity with one payment
The income payments from a deferred annuity often start many years later. Deferred annuities have an accumulation period, which is the time between when you start paying premiums and when income payments start.
Fixed
During the accumulation period of a fixed deferred annuity, your money (less any applicable charges) earns interest at rates set by the insurance company or in a way spelled out in the annuity contract. The company guarantees that it will pay no less than a minimum rate of interest. During the payout period, the amount of each income payment to you is generally set when the payments start and will not change
Variable
During the accumulation period of a variable annuity the insurance company puts your premiums (less any applicable charges) into a separate account. You decide how the company will invest those premiums, depending on how much risk you want to take. You may put your premium into a stock, bonus or other account, with no guarantees, or into a fixed account, with a minimum guaranteed interest. During the payout period of a variable annuity, the amount of each income payment to you may be fixed (set at the beginning) or variable (changing with the value of the investments in the separate account).
Interest Rates for Fixed Deferred Annuity
During the accumulation periods, your money (less any applicable changes) earns interest at rates that change from time to time. Usually, what these rates will be is entirely up to the insurance company.
The current rate is the rate the company decides to credit to your contract at a particular time. The company will guarantee it will not change for some time period.
The initial rate is an interest rate the insurance company may credit for a set period of time after you first buy your annuity. The initial rate in some contracts may be higher than it will be later. This is often called a bonus rate.
The renewal rate is the rate credited by the company after the end of the set time period. The contract tells how the company will set the renewal rate, which may be tied to an external reference or index.
The minimum guaranteed interest rate is the lowest rate your annuity will earn. This rate is stated in the contract.
Some annuity contracts apply different interest rates to each premium you pay or to premiums you pay during different time periods.
Other annuity contracts may have two or more accumulated values that fund different benefits options. These accumulated values may use different interest rates.
You get only one of the accumulated values depending on which benefit you choose.
Charges may be subtracted from a Fixed Deferred Annuity
Most annuities have charges related to the cost of selling or servicing it. These charges may be subtracted directly from the contract value.
Surrender or Withdrawal Charges
You may be able to take all or part of the value of your annuity at any time during the accumulation period. If you take out part of the value, you may pay a withdrawal charge. If you take out all of the value and surrender, or terminate, the annuity, you may pay a withdrawal charge. In either case, the company may figure the charges as a percentage of the value of the contract, of the premiums you've paid or of the amount you're withdrawing. The company may reduce or even eliminate the surrender charge after you've had the contract for a stated number of years. A company may waive the surrender charge when it pays a death benefit.
Some annuities have stated terms. When the term is up, the contract may automatically expire or renew. You're usually given a short period of time, called a window, to decide if you want to renew or surrender the annuity. If you surrender during the window, you won't have to pay surrender charges. If you renew, the surrender or withdrawal charges may start over.
In some annuities, there is no charge if you surrender your contract when the company's current interest rate falls below a certain level. This may be called a bailout option.
In a multiple-premium annuity, the surrender charge may apply to each premium paid for a certain period of time. This may be called a rolling surrender or withdrawal charge.
Some annuity contracts have a market value adjustment feature. If interest rates are different when you surrender your annuity than when you bough it, a market value adjustment may make the case surrender value higher or lower. An annuity with a MVA feature may credit a higher rate than an annuity without that feature.
Your annuity may have limited free withdrawal feature. That lets you make one or more withdrawals without a charge. The size of the free withdrawal is often limited to a set percentage of your contract value. If you make a larger withdrawal, you may pay withdrawal charges. You may lose any interest above the minimum guaranteed rate on the amount withdrawn. Some annuities waive withdrawal charges in certain situations, such as death, confinement in a nursing home or terminal illness.
A contract fee is a flat dollar amount charged either once or annually.
A transaction fee is a charge per premium payment of other transaction.
Percentage of Premium Charge
A percentage of premium charge is a charge deducted from each premium paid. The percentage may be lower after the contract has been in force for a certain number of years or after total premiums paid have reached a certain amount.
Some states charge a tax on annuities. The insurance company pays this tax to the state. The company may subtract the amount of the tax when you pay your premium, when you withdraw your contract value, when you start to receive income payments or when it pays a death benefit to your beneficiary.
What are some Fixed Deferred Annuity Contract Benefits?
Annuity Income Payments
One of the most important benefits of deferred annuities is your ability to use the value built up during the accumulation period to give you a lump sum payment or to make income payments during the payout period.
Life Only
Pays income for your lifetime. It doesn't make any payments to anyone after you die.
Life Annuity with Period Certain
Pays income for as long as you live and guarantees to make payments for a set number of years even if you die. This period certain is usually 10 or 20 years. During the period certain, the beneficiary gets regular payments for the rest of that period.
Joint and Survivor
The company pays income as long as either you or your beneficiary lives. You may choose to decrease the amount of the payments after the first death. You may also be able to choose to have payments continue for a set length of time.
In some annuity contracts, the company may pay a death benefit to your beneficiary if you die before the income payments start. The most common death benefit is the contract value or the premiums paid, whichever is more.
"Free Look Provision"
Many states have laws which give you a set number of days to look at the annuity contract after you buy it. You can return the contract and get all your money back. This is often referred to as a free look or right to return period.
Below is a general discussion about taxes and annuities. You should consult a professional tax advisor to discuss your individual tax situation.
Under current federal law, annuities receive special tax treatment; Income tax on annuities is deferred, which means you aren't taxed on the interest your money earns while it stays in the annuity. Most states tax laws on annuities follow the federal law.
Part of the payments you receive from an annuity will be considered as a return of the premium you've paid. You won't have to pay taxes on that part. Another part of the payments is considered interest you've earned. You must pay taxes on the part that is considered interest when you withdraw the money. You may also have to pay a 10% tax penalty if you withdraw the accumulation before age 59 1/2. The internal Revenue Code also has rules about distributions after the death of a contract holder.
Annuities used to fund certain employee pension benefit plans (those under Internal Revenue Code Sections 401(a), 401(k), 403(b), 457 or 414) defer taxes on plan contributions as well as on interest or investment income. Within the limits set by the law, you can use pretax dollars to make payments to the annuity. When you take money out, it will be taxed.
You can also use annuities to fund traditional and Rth IRAs under Internal Revenue Code Section 408. If you buy an annuity to fund and IRA, you'll receive a disclosure statement describing the tax treatment.
How do I know if a Fixed Deferred Annuity is right?
The questions listed below may help your clients decide which type of annuity, if any, meets their retirement planning and financial needs. They should think about what their goals are for the money they may put into the annuity.
- How much retirement income will I need in addition to what I will get from Social Security and my pension?
- Will I need that additional income only for myself or for myself and someone else?
- How long can I leave my money in the annuity?
When will I need income payments?
- Does the annuity let me get money when I need it?
- Do I want a fixed annuity with a guaranteed interest rate and little or no risk of losing the principal?
- Do I want a variable annuity with the potential for higher earning that aren't guaranteed and the possibility that I may risk losing principal?
- Or, am I somewhere in between and willing to take some risks with an equity-indexed annuity?
What questions should I ask my Agent or the Company?
- Is this a single premium or multiple premium contract?
- Is this an equity-indexed annuity?
- What is the initial interest rate and;how long is it guaranteed?
- Does the initial rate include a bonus rate and how much is the bonus?
- What is the guaranteed minimum interest rate?
- What renewal rate is the company crediting on annuity contracts of the same type that were issued last year?
- Are there withdrawal or surrender charges or penalties if I want to end my contract early and take out all of my money? How much are they?
- Can I get a partial withdrawal without paying surrender or other charges or losing interest?
- Does my annuity waive withdrawal charges for reasons such as death, confinement in a nursing home or terminal illness?
- Is there a market value adjustment (MVA) provisions in my annuity?
- What other charges, if any, may be deducted from my premium or contract value?
- If I pick a shorter or longer payout period or surrender the annuity, will the accumulated value or the way interest is credited change?
- Is there a death benefit? How is it set? Can it change?
- What income payment options can I choose? Once I choose a payment option, can I change it?
[This appendix is not suitable for use in Massachusetts.] An equity-indexed annuity is a fixed annuity, either immediate of deferred, that earns interest or provides benefits that are linked to an external equity reference or an equity index. The value of the index might be tied to a stock or other equity index. One of the most commonly used indices is Standard & Poor's 500 Composite Stock Price Index (the S&P 500), which is an equity index. The value of any index varies from day to day and is not predictable.
When you buy an equity-indexed annuity you own an insurance contract. You are not buying shares of any stock or index.
The difference in EIAs is in the details of how the index calculation is made, how they count gains as well as the related feature and benefits. There are substantial variations between company designs; and no two products in existence are a like. Many are substantially different.
- How do you understand them?
- How do you choose what is best for you and your prospect?
To begin, you should understand the basic designs and features.
As we begin describing basic design types, here are a few practical working definitions that will be used.
- Cap: A Cap is a maximum percentage limitation on the earning as defined by the EIA index formula. There are several products, all with reset features, that have "cap" rates between 12% and 15% annually. All "capped" EIAs we have seen so far have the annual reset feature and the "combine all the years' gains" feature (versus one anniversary mark or one point to determine the gain for the entire index term).
- Participation Rate: A percentage amount, which may be guaranteed either by the year of the policy index term, which is multiplied times the percentage gain of the index formula. For example, an index formula might yield an annual gain figure of 10%, which is then multiplied by a participation rate of either 80% or, in another EIA, 110%, to yield 8% and 11% respectively, in terms of the calculation for that year.
- Starting Point: Or "index starting point" is the index level on the starting date or issue date of the EIA policy. It is the base-line number from which gains or losses are measured the first year, where there is an annual reset feature, or for the term of the index if there is no annual reset feature (e.g. Annual Point - to - Point or High Water Anniversary Mark, Look-Back designs).
- Annual Reset (of starting point): The Annual Reset of starting point feature is a re-establishment of the starting point for gain calculations, annually. This is largely of importance if the market goes down and closes on a year below the initial start point. This annual reset feature allows gains below the initial starting point to be recognized and locked in for the customer, which does not happen without a new lower start point. For example, a policy is issued at an index level of 500, but the year closes at an index level of 400. The following year the index moves back to 490. With an annual reset, the new annual start point was 400 (instead of 500) so gains from the second year's move from 400 to 490 were recognized. Without a reset, no gain occurs unless and until the index passes the 500 mark, potentially at some time in later years. For example, if there were no reset feature, and the index moved from 490 at the end of the year two to 550 at the end of year three, then the gain from 500 to 550 would be recognized. However the gain from 490 to 500 during the same year would not be recognized since it occurred below the line of the initial starting point (at issue) of 500.
- Index Period or Term: This is the length of time during which the owner has earning linked to the index, and it is the time frame for the final index gain calculation for the term of that annuity contract. At the end of the term, various options are offered, which differ by company.
- Recognition of Earnings: By the terms of the policy, a gain calculation is completed and noted or recognized.
- Lock-in of earnings: By the terms of most contract designs, the gains are not only "recognized", but they are guaranteed at the level, that is, they are "locked in". Locked-in earnings cannot be lost by subsequent declines in the market index.
- Automatic Rollover: This is an end of term provision in some, but not all EIAs. When this feature is present, the EIA owner is limited to a relatively short period of time (similar to a Certificate of Deposit) to decide whether or not to recommit to the next term. Typically, this window of time is 30 to 60 days. If no notification is received by the Home Office, the default option is to enter another equity index term, with newly declared participation rates, caps (if applicable), etc. and new surrender provisions. Normally, the new term is the same as the first term. One of the major areas of confusion among agents is the calculation of various values within the EIA design. Specifically, it is important that you understand that various contractually defined value such as:
- Full index value
- Surrender value during the term or at maturity
- Minimum guaranteed account value
- As well as values at death, annuitization, nursing home or terminal illness values, etc.
All these items may be, and usually are, calculated independently of each other. For example, Minimum Guaranteed Account Values are often calculated based on 90% of premium, plus 3% interest. Simultaneously, full index values are based on 100% of premium plus potential defined gains from the index formula. Both exist simultaneously, but do not directly relate to each other in this example. Your ability to specifically understand EIA values depends on understanding this point.
How are Equity-Indexed Annuities different from other Fixed Annuities?
An equity-indexed annuity is different from other fixed annuities because of the way it credits interest to your annuity's value. Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked.
Your equity-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum.
Floor on Equity Index-Linked Interest
The floor is the minimum index-linked interest rate you will earn. The most common floor is 0%.
Averaging
In some annuities, the average of an index's value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity.
Interest Compounding
Some annuities pay simple interest during an index term. That means index-linked interest is added to your original premium amount but does not compound during the term. Others pay compound interest during a term, which means that index-linked interest that has already been credited also earns interest in the future. In either case, however, the interest earned in one term is usually compounded in the next.
Margin/Spread/Administrative Fee
In some annuities, the index-linked interest rate is computed by subtracting a specific percentage from any calculated change in the index. This percentage, sometime referred to as the "margin", "spread" or "administrative fee"; might be instead of, or in addition to, a participation rate.
Some annuities credit none of the index-linked interest or only part of it, if you take out all your money before the end of the term. The percentage that is vested, or credited, generally increases as the term comes closer to its end and is always 100% at the end of the term.
You Should be Prepared to Answer these Questions from Clients
- How long is the term?
- What is the guaranteed minimum interest rate?
- What is the participation rate? For how long is the participation rate guaranteed?
- Is there a minimum participation rate?
- Does my contract have an interest rate cap? What is it?
- Does my contract have an interest rate floor? What is it?
- Is interest rate averaging used? How does it work?
- Is interest compounded during a term?
- Is there a margin, spread, or administrative fee? Is that in addition to or instead of a
- participation rate?
- What indexing method is used in my contract?
- What are the surrender charges or penalties if I want to end my contract early and
- take out all of my money?
- Can I get a partial withdrawal without paying charges or losing interest? Does my contract have vesting? If so, what is the rate of vesting?