ANNUITIES 101

What is AN ANNUITY?

Simply put, both a fixed annuity and a variable annuity are amounts payable annually. More specifically, they are contracts offered by insurance companies which allow you to accumulate funds for retirement on a tax-favored basis and then, if you choose, receive a guaranteed income payable for life or for a period certain such as five, ten or twenty years. Usually the payments are made monthly, but many companies offer to make the payments quarterly, semi-annually, or annually. Most of this discussion will focus on the fixed annuity.

Tax deferral

A tax-deferred fixed annuity receives special tax advantages. Under existing tax laws, any interest or gain is not taxable until you begin to actually receive the income, i.e. the tax payable on the gain is deferred. Therefore, since you pay no taxes while your money is compounding, you earn interest in three ways - interest on your principal, interest on your interest and interest on the taxes you would have paid if it had not been tax deferred. This results in increased earnings capacity of a deferred annuity over a bank CD or other fully taxable earnings.

Why is Guaranteed Income for Life an advantage?

Annuities are the only savings vehicle which offer a guaranteed income for life. With every other type of accumulation plan you can never be sure your income will continue for as long as you live. The insurance company calculates a guaranteed income payment based on your age, life expectancy and interest rates it will credit. That payment is guaranteed for as long as you live.

Most insurance companies will also offer a guaranteed fixed rate of income for a specific period such as five to twenty years. The guaranteed lifetime income may be based on your life only, or based upon the life of both you and a joint annuitant, typically your spouse. In the event of a joint annuitant, the monthly income from your fixed annuity will continue until the last survivor dies.

Why is Probate Avoidance an advantage?

The other primary advantage over most other investment vehicles common to all annuities is the ability to pass on the proceeds upon your death directly to a beneficiary. Probate is a judicial process to establish the validity of a will. Assets in an estate typically cannot be passed on to heirs until the probate court has established the validity of the will and authorized the executor to distribute them. Because probate is a judicial process, the process can take anywhere between six and twelve months to conclude, and the legal expenses can be significant.

Proceeds from annuities and life insurance, on the other hand, are not subject to probate and may be passed to your designated beneficiary directly without going through probate.

What is required of the insurance company in order to meet its obligations?

To safeguard the funds of its contract holders or policyowners, an insurance company has to meet strict financial requirements. Most importantly these requirements include the establishment of a reserve which at all times must be equal to the withdrawal or surrender value of their total block of variable and fixed annuity policies or contracts.

In other words, the insurance company must set aside funds equal to the surrender value (principal plus interest less early withdrawal or surrender charges) of every annuity contract in force. In addition to these reserve requirements, state laws also require certain levels of capital and surplus to further protect their contract holders or policyowners.

What is a Fixed Indexed Annuity?

A fixed indexed annuity (also called an index annuity, an indexed annuity or an equity indexed annuity) is a fixed annuity with an upside earning capacity and a guarantee against downside loss of principal. Its earnings are linked to a stock or equity market index such as the Standard & Poor’s 500 Composite Stock Price Index or, simply, the S&P 500. Fixed indexed annuities (FIAs) have four guarantees:

1. Initial premium is guaranteed
2. Minimum rate of return
3. Take credit for increases (ups) in market, not corrections (downs)
4. Gains are locked in every year

How do they differ from other fixed annuities?

The primary difference between a fixed indexed annuity and other fixed annuities is in the way the annuity rate or earnings are credited to your account. A traditional fixed annuity credits interest with an annuity calculator that is set in the contract and may or may not be subject to market adjustments. A fixed indexed annuity leads to an interest crediting formula based on changes in the equity market to which it is linked. This formula spells out how interest is calculated, credited, how much additional interest you get, and when you get it.

The insurance carrier issuing the fixed indexed annuity also promises to pay a guaranteed minimum rate of interest. Even if the indexed earnings are lower, the minimum guarantee will apply and your account value will not fall below the guaranteed minimum. Both flexible premium and single premium deferred annuity contracts guarantee a minimum interest rate, often in the range of 1.5% to 3% based on between 90% and 100% of paid premium. The insurance company will adjust account values at the end of each term.

What are the contract features or 'Moving Parts'?

The amount of additional interest that may be credited to a fixed indexed annuity is influenced most by the Indexing Method and the Participation Rate working together like form and function.

THE INDEXING METHOD is the design by which the amount of change in the index is measured. For example, a method that measures the difference in the starting index level and the level on the one-year anniversary is an annual point-to-point. If this design “ratchets” up the account value (new principal) with each annual gain, the indexing method includes an Annual Reset feature. Currently, the industry’s best selling equity indexed annuity is the MasterDex Annuity series from Allianz, which incorporates the more progressive design of a “monthly” point-to-point together with an annual reset. Functional differences in indexing methods will be explained in greater detail below.

THE PARTICIPATION RATE, alike to the faucet, determines how much of the increase in the index will flow into the annuity account value. Let’s say the fixed annuity calculator shows a 12% increase in the index, but your participation rate limits you to 70% of the gain. Your annuity rate of increase would be 70% of 12%, or 8.4%. Participation rates are variable and may be guaranteed only for a specific period or guaranteed not to be adjusted below a given minimum or above a specified maximum. One of the most popular fixed indexed annuities is the Keyport Index Multipoint from Sun Life Financial, which guarantees a 100% participation rate for the full contract term.

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Some fixed indexed annuities place a CAP or ceiling on the annuity rate, establishing the upper limit the annuity may earn. An annuity earning an index-linked interest rate of, say, 9% may have a cap of only 7%, which would be the amount of increase credited.

Some annuities use AVERAGING to smooth out the highs and lows of the linked equity market index. Monthly averaging, for example, would use an annuity calculator which combines each month-to-month index closing value divided by 12.

Some annuities reduce the index-linked interest rate by subtracting a SPREAD, a MARGIN, or a FEE and crediting the balance. A positive change in the index of 11%, for example, with an administrative fee of 2.5%, would yield a net increase of 8.5%. Of the carriers who sell annuity products with spreads, margins or fees, such amounts will be subtracted only if the remaining index change is a positive earnings rate.

Indexing Methods

ANNUAL RESET

Yield is determined each year by comparing the index value at the end of the contract year with the index value when the contract year began. The positive difference, if any, is the yield your fixed indexed annuity earns for the year. Any new positive (not negative) account value resets to become the new starting point for the upcoming year. Contrast this formula to owning a variable annuity or a direct equity investment in a bear market. With variables and stocks the owner may have a deep valley to climb out of before getting back to zero.

HIGH-WATER MARK

Yield is determined by the rise in index value at the contract annual anniversary points during the term. The positive difference, if any, is determined by comparing the highest index value and the index value at the start of the term.

POINT-TO-POINT

Yield, if any, is determined by comparing the difference between the index value at the end of the term with the index value at the beginning of the term. The positive difference is added to your annuity account value at the end of the term.