5.4 Types of Annuities
Fixed (Guaranteed) Annuity
During the accumulation period, the insurer guarantees a minimum fixed interest rate on the annuity. When the contract is annuitized, benefits are paid as a fixed periodic amount.
Because the payment amount is fixed, the purchasing power may decline over time as the cost of living increases. The actual interest rate credited at any given time is based on the performance of the insurer's general account, and the insurance company assumes the investment risk.
In most states, only a life insurance license is required to sell fixed annuities.
Some fixed annuities offer a base interest rate plus a bonus interest rate, which together form the current credited rate applied to the annuity. This current rate is established by the insurer when the contract is issued and is typically guaranteed for a specified period of time.
Indexed (Equity Indexed) Annuity: An indexed annuity is a type of annuity in which the credited interest rate is linked to the positive performance of a market index, such as the Standard & Poor's 500 Index (S&P 500).
With this type of annuity, the contract owner benefits from principal protection and a guaranteed minimum return. The principal and any previously credited interest are protected by the insurer's general account. The minimum guaranteed interest rate may be as low as 0%, meaning that the contract value will not decrease due to negative market index performance.
Indexed annuities typically include a fixed account, from which funds may be allocated to the selected index strategy. These contracts often feature higher surrender charges and longer surrender charge periods compared to other annuity products.
Market-Value Adjustment (Adjusted) Annuity
A Market-Value Adjustment annuity is a product that combines fixed interest rate guarantees with a market-value adjustment feature that may increase or decrease the contract's surrender value depending on prevailing interest rate conditions. When funds are withdrawn or the contract is surrendered, the MVA may either add to or subtract from the annuity value or withdrawal amount.
If the interest rates used to calculate the MVA are higher than they were when the annuity was purchased, the adjustment will generally be negative, which means an additional amount may be deducted from the contract value or withdrawal.
If those interest rates are lower than they were at the time of purchase, the adjustment will generally be positive, meaning an additional amount may be added to the annuity value or withdrawal amount.
Variable Annuity
Variable annuities are regulated by the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and state insurance departments. The value of the annuity and the amount of income payments fluctuate based on the investment performance of the separate accounts selected by the contract owner. Payments are calculated in units rather than fixed dollar amounts. Although returns are not guaranteed, variable annuities may help address inflation risk because income payments can increase if investment performance improves.
In a variable annuity, the contract owner assumes the investment risk. The return received depends on the performance of the assets invested in the separate accounts, after deducting applicable insurer and investment management fees. No minimum investment return is guaranteed. During the accumulation period, premium payments are invested in separate accounts that operate similarly to mutual funds.
Investment performance is measured against the Assumed Interest Rate (AIR). If the actual investment return is below the AIR, the annuity payment decreases. If the return equals the AIR, the payment remains unchanged. If the return exceeds the AIR, the payment increases compared to the previous period.
Because variable annuities are considered securities, individuals who sell them must hold both a life insurance license and the appropriate securities license. These products must comply with federal securities regulations as well as state insurance laws. Prospective purchasers must receive a prospectus, which provides detailed information about the available separate accounts, including investment objectives, risks, and historical performance. The prospectus must be provided at or before the time of sale.
During the accumulation period, premium payments may be flexible in both amount and frequency, subject to the terms of the contract. These payments purchase accumulation units within the separate account, similar to shares of a mutual fund. When the contract is annuitized, accumulation units are converted into annuity units. While the number of annuity units remains constant, the value of each unit fluctuates according to the investment performance of the selected separate account.
Qualified vs. Nonqualified Annuities
A qualified annuity is funded with pre-tax dollars, meaning the contributions may be tax-deductible and can reduce the contributor's taxable income in the year they are made. Because the funds have not previously been taxed, all distributions from a qualified annuity—including both contributions and earnings—are taxed as ordinary income when withdrawn.
A nonqualified annuity is funded with after-tax dollars, meaning the money used to purchase the annuity has already been taxed. As a result, when distributions are received, only the earnings portion is taxable as ordinary income, while the return of the original contributions is not subject to additional taxation.
Quiz
1. Which type of annuity guarantees a minimum interest rate during the accumulation period and pays a fixed periodic amount once annuitized?
A. Variable annuity
B. Indexed annuity
C. Fixed annuity
D. Market-value adjustment annuity
Correct Answer: C
Rationale: A fixed annuity guarantees a minimum interest rate during the accumulation period and provides fixed, predictable income payments during the payout phase. The insurer bears the investment risk because the payments do not fluctuate with market performance.
2. What is a key feature of an indexed (equity-indexed) annuity?
A. The contract value decreases when the stock market declines
B. Interest credited is linked to the performance of a market index
C. Payments are calculated in investment units
D. It requires both an insurance and securities license to sell
Correct Answer: B
Rationale: Indexed annuities credit interest based on the positive performance of a market index, such as the S&P 500. However, the contract typically includes principal protection and a minimum guaranteed return, meaning the account will not decline due to negative index performance.
3. Which annuity type places the investment risk on the contract owner and requires both an insurance license and a securities license to sell?
A. Fixed annuity
B. Indexed annuity
C. Market-value adjustment annuity
D. Variable annuity
Correct Answer: D
Rationale: Variable annuities are considered securities and are regulated by the SEC and FINRA in addition to state insurance departments. The contract owner assumes the investment risk because the value of the annuity depends on the performance of investments in separate accounts.
4. How does a Market-Value Adjustment (MVA) annuity affect withdrawals?
A. Withdrawals are always increased by interest
B. Withdrawals are guaranteed to remain unchanged
C. The surrender value may increase or decrease depending on interest rate changes
D. Withdrawals are only allowed after age 59½
Correct Answer: C
Rationale: An MVA annuity adjusts the contract's surrender value based on prevailing interest rates. If interest rates rise after purchase, the adjustment is usually negative; if rates fall, the adjustment may be positive.
5. What is the primary tax difference between qualified and nonqualified annuities?
A. Qualified annuities are taxed only on earnings
B. Nonqualified annuities are funded with pre-tax dollars
C. Qualified annuity distributions are fully taxable, while only earnings are taxable in nonqualified annuities
D. Nonqualified annuities are not taxed at all
Correct Answer: C
Rationale: Qualified annuities are funded with pre-tax dollars, so both contributions and earnings are taxed as ordinary income when withdrawn. Nonqualified annuities are funded with after-tax dollars, meaning only the earnings portion of distributions is taxable.