Fixed Indexed Annuities:

Benefits, Risks & Options | MWB

A fixed index annuity (FIA) is a type of deferred annuity contract offered by insurance companies. It allows your retirement savings to grow tax-deferred while providing a measure of principal protection from market downturns.   Understand FIA growth methods, principal protection, caps, participation rates, liquidity limits, surrender charges, and lifetime-income options.

  How Fixed Indexed Annuities Work

Key Characteristics

Potential Drawbacks

Fixed index annuities are generally considered a middle ground between traditional fixed annuities (which offer lower, guaranteed returns) and variable annuities (which offer greater growth potential but also expose you to market risk). They can be a suitable option for individuals seeking a balance of growth potential and principal protection for their retirement savings. 

Annuity 101

What is an Annuity?

Annuities are insurance contracts sold by life insurance companies and life insurance licensed producers. Their purpose is to provide a stream of income over a certain period of time or for the rest of a person's lifetime; they are often used to protect individuals from outliving their income or assets. Premiums may be paid into an annuity in a lump sum or over a given period of time. Premiums in an annuity account accumulate at interest, and on a tax-deferred basis. This tax advantage sets annuities apart from other forms of investments that do not contain life insurance components.

In exchange for the premium paid by the contract owner, an insurance company issues an annuity policy and promises to pay a series of regularly spaced income payments in the future; the phase during which payments are made is known as annuitization. The date of annuitization, usually predetermined by the contract owner upon purchasing the annuity, is known as the annuity commencement date. Annuity payments can be made for a specified period of time, such as 10 or 20 years, or for the balance of an individual's lifetime. Some annuities also provide death benefits and other features.

An insurance producer's fiduciary duty... A fiduciary is a professional who is legally required to act in another’s best financial interest

Classification of Annuities by Premium Payment

Single Premium Annuity

A single premium annuity requires one upfront premium payment and begins paying out income either immediately or within a year of purchase. Once the contract is purchased, additional premium deposits cannot be made.

Flexible Premium Annuity

A flexible premium annuity requires the contract owner to deposit multiple premiums over time.

Immediate Annuity

An immediate annuity is purchased with a lump sum premium payment and begins paying benefits no later than 1 year from the date the premium was paid, usually within 30 days. The contract owner selects the payout option that best fits their needs; payout methods include monthly, quarterly, semi-annually, and annually. 

Deferred Annuity

A deferred annuity can be purchased with a single premium or multiple flexible premiums. Benefit payments do not begin until at least 1 year after the contract has been purchased.

Fixed Annuity

A fixed annuity is a life insurance product that invests its premiums in the general account, or operating account, of the life insurance company. Its contract value accumulates at a rate of interest stated by the insurance company at the time of purchase. Although the rate of interest fluctuates over time based on the rate of interest currently being paid by the insurer; however, the fixed annuity contract includes a provision that states a guaranteed minimum rate of interest must be paid by the insurer.

The total current value of the initial investment and accumulated interest in a fixed annuity is known as the annuity’s accumulation value.

Indexed Annuity

An indexed annuity is a type of fixed annuity. Its premiums are invested in the insurer's general account but the rate of interest paid is based on the performance of an external stock market index such as the Standard & Poor's 500 Composite Stock Price Index (S&P 500). Indexed annuities have some guarantees, but not as many as traditional fixed annuities. If an equity index performs well enough, an annuity it is linked to has the potential to earn a higher rate of interest than a traditional fixed annuity does. By contrast, if the equity index's performance is poor, the indexed annuity may not earn any interest at all in a given year.

Variable Annuity

A variable annuity is both an insurance product and an investment product. Premiums paid into a variable annuity are invested in the insurance company’s special account, which consists of multiple investment subaccounts. These subaccounts, which are similar to diversified mutual funds, are separate from the insurance company's general account. They can never be commingled with the insurance company’s other assets. Interest on the account value in these subaccounts is not guaranteed; instead, it is subject to the performance of the underlying subaccounts it is invested in.

Classification of Annuities by IRS Guidelines

Because they are life insurance products, annuities are different from other investment products and the income they provide is taxed differently. Because the account value in an annuity accumulates at interest on a tax-deferred basis, it offers many advantages to its owner. However, once funds are withdrawn or paid from an annuity, the IRS taxes those funds based on specific rules.

Tax-Qualified Annuities

• Premiums for tax-qualified annuities are funded with pre-tax dollars. Most tax-qualified (qualified) annuities are used for retirement purposes, such as to fund an individual retirement account (IRA). When withdrawals or payments are made from qualified annuities, the entire payment amount is taxable as ordinary income.

Non Tax-Qualified Annuities

• A non tax-qualified (nonqualified) annuity is funded with after-tax dollars; that is, the premiums are paid with money that has already been taxed. Nonqualified annuities are used for a variety of goals, including for retirement purposes. For example, a Roth IRA annuity is funded using Roth IRA contributions and allows for tax-free withdrawals in retirement. When withdrawals or payments are made from nonqualified annuities, taxation is based on IRS rules relating to the cost basis of the contract; in most cases only earnings are taxable as income.

Parties to the Annuity Contract

The annuity contract involves four main parties:

• Insurance company
• Owner
• Annuitant
• Beneficiary

Insurance Company

The potential lifetime guaranteed income stream from any fixed annuity is dependent upon the insurance company's ability to remain fiscally viable and honor its commitments. Both producers and consumers are encouraged to research an insurance company's financial strength ratings from independent agencies to determine its stability and claims-paying ability.

The most widely utilized rating agency in the insurance industry is the A.M. Best Company, which can be found online at www.ambest.com. Other agencies that rate insurer financial health include Moody's, Fitch, and Standard & Poor's, each of which has its own rating calculation formula.

Owner

The owner is the purchaser of an annuity. The annuity contract owner is responsible for paying the policy premiums. The owner has all inherent rights in the annuity contract. The owner may be a natural person (human being) or an entity, such as a nonprofit organization, trust, or corporation. In some cases, annuities may be owned by two or more individuals. The owner also has the right to name a second, or contingent, owner. An annuity’s contract owner will become the contract owner in the event the owner dies.

Annuitant

The annuitant of an annuity is the person designated to receive annuity payments; an annuitant is similar to the insured person in an insurance contract. The annuitant's age, life expectancy, and gender are used to calculate the policy's benefits. The annuitant must be a human being and cannot be any other type of entity.

Beneficiary

An annuity contract's beneficiary receives the policy's death benefit when the contract owner dies. The payment may be made as a lump-sum payment, in a series of remaining payments, or as the commuted present value of the future stream of payments the annuitant would have received if they had not died. Because not all types of annuities pay out death benefits, not all annuities have a beneficiary.

Two Phases of an Annuity

The main purpose of an annuity is to provide a stream of income at some future point in time. The life cycle of an annuity contract includes two discrete phases: the first is the process of accumulating cash for use in the second phase, when the accrued cash is paid out to the annuitant.

Accumulation Phase

During the accumulation phase, the annuity serves as a receptacle for cash. Premium dollars are deposited into the annuity and accumulate at interest. In an immediate annuity, the accumulation phase lasts from the time the premium is paid until the date the first payment is made. Immediate annuity accumulation phases legally may not last longer than a year and, in most cases, last 30 days. 

The accumulation phase of a deferred annuity can last for many years, especially if the purchaser is young and intends the contract to provide income in retirement.

Distribution Phase

During the distribution phase, the funds that have accumulated in the contract are distributed to the annuitant as income payments. The process of transitioning from the accumulation phase to the distribution phase is called annuitization. During this process, the total amount in the annuity is converted into a series of regular and periodic payments that will be made for a stated length of time, such as 10 years, or for the lifetime of the annuitant. The IRS requires the distribution period to be more than one full year.

Common uses of annuities include:

• Providing a lifetime stream of income
• Accumulating tax-deferred wealth
• Depositing funds in a safe investment
• Obtaining market-based investment returns
• Generating supplemental income in the future, usually during retirement
• Funding long-term care
• Providing income to a surviving spouse and/or heirs

Annuities and State Guaranty Funds

Unlike many other financial products, annuities are not backed by the Federal Deposit Insurance Corporation (FDIC), the organization which provides deposit insurance to banks in the United States. If an insurance company becomes insolvent and can no longer meet its financial obligations, the state insurance department and its state guaranty association step in to provide special regulatory oversight.

Insurance guaranty associations protect insurance policyholders and beneficiaries when insurers become impaired and are unable to meet their contractual and financial obligations. Separate associations exist for life/health products and property/casualty products. Every state, the District of Columbia, and Puerto Rico have established insurance guaranty associations.

Insurance companies are required by state law to become members of the state's guaranty association as a requirement of obtaining and maintaining licensure in each state.

Underwriting Annuity Contracts

Although an annuity is a form of life insurance, annuity contracts are underwritten differently from regular life insurance because of their unique function. Life insurance is designed to provide financial benefits when the insured person dies, so the insured risk is the insured person’s death. An annuity, by contrast, provides financial benefits while the insured person is alive, offering protection an annuitant cannot outlive. Therefore, risk assessment is more complex and varies by annuity type.

Provisions Common to All Annuities

Free Look Period

For a certain period of time after each annuity contract is issued, the owner has the contractual right to return and cancel it for any reason. The mandatory free look provision is found in all life insurance products, including annuities. It refers to the time period during which contract owners have the right to review and accept the contract after it has been issued by the insurance company. If the owner is not satisfied with the contract during the term of the free look period for any reason, they may return it to the insurance company for a full refund of all premiums paid.

Depending upon applicable state law, the free look period usually ranges from 10 to 30 days after contract delivery, with 30 days being the most common requirement.

Surrender Charges and Penalties

Annuities are designed to be long-term financial tools and, once purchased, are intended to remain in force for the remainder of the annuitant’s lifetime. If substantial amounts are withdrawn from annuities before they are annuitized, or if the contracts are surrendered for their cash value after only a few years, the method used to calculate benefits is altered. For this reason, annuities contain a provision that imposes surrender charges, or penalties for premature withdrawals and contract terminations.

A surrender charge is a penalty assessed against the amount withdrawn from the contract. The penalty is similar to an interest penalty for the early withdrawal from a time deposit, such as a certificate of deposit (CD) purchased from a bank. Surrender charges tend to discourage annuity owners from making partial withdrawals and full policy surrenders. A surrender charge is also a way for the insurance company to recover some of the upfront costs incurred to market and sell policies. These costs include agent commissions, operating expenses involved in underwriting and issuing the contracts, and all other expenses associated with placing the annuity premium in an underlying investment designed to achieve the promised benefits.

Surrender Charge Window

Because the contract owner of a deferred annuity may not make a cash withdrawal during the first 7 to 10 years of the contract without incurring a penalty, many annuities include a window provision to provide the contract owner with some liquidity. During this window, the contract allows the owner to withdraw a limited amount, commonly 10%, from the annuity’s accumulation value each year without triggering surrender charges or penalties. For example, a 10% surrender charge window waives surrender charges, so long as no more than a total of 10% of the cash values are withdrawn in any given policy year. The percentage is usually applied to the accumulation value at the time of the withdrawal; however, some contracts apply the percentage to the accumulation value as of the policy's last anniversary. 

Bonus Annuities

Because annuities are insurance products, they often do not provide investment returns as high as those of other financial products. To be more competitive with other types of investments, some insurance companies offer bonus annuities, which include premium bonuses in connection with deferred annuities.

Annuity bonuses are calculated based on all premiums received in the first contract year and are added to the annuity’s value. Premium bonus annuities pay higher interest rates than standard annuity contracts. These bonus credits are advantageous to the contract owner in that they increase the account value. 

The disadvantage of bonus credits is that the cost of the bonus is passed along to the contract owner in the form of higher surrender charges that apply for a longer period of time. It is not uncommon for the surrender charge period in a premium bonus annuity to be 10 to 15 years; some contracts impose a 20-year surrender charge period.

Settlement Options

In most cases, the annuitant chooses how the income payments will be made during the annuitization phase. These options include single life (life only), joint and survivor, period certain, and cash refund.

Regardless of whether the funds in an annuity are earmarked as principal or interest, balances accumulate and grow on a tax-deferred basis. This allows for the growth of the annuity via tax-deferral, meaning that any taxes due on any portion of an annuity’s account value are not due and payable until the taxable funds are distributed from the contract. Tax-deferral can be seen as an advantage of annuities as it delays or defers the payment of income tax on investment earnings.

Of course, tax-deferred does not mean tax-free; taxes will be due on money withdrawn from a tax-qualified account or a non-qualified annuity. The taxation of distributions is dependent on whether the premiums paid were pre-tax or after-tax dollars and whether the distribution is a one-time payment or part of a series of payments.

• Tax-qualified (qualified) annuities are funded with PRE-tax dollars.
• Non tax-qualified (nonqualified) annuities are funded with After-tax dollars.
  

Internal Revenue Code § 1035 Exchange

Under certain circumstances, the Internal Revenue Code allows the account values of certain existing insurance contracts, including eligible annuities, to be exchanged without taxation or penalty. These exchanges are regulated by IRS Code 1035, which specifies that the exchanges may occur between annuity contracts, life insurance policies, long-term care products, or endowments and must occur between two products of like kind. In order to qualify for a 1035 Exchange, an individual must submit documentation of their eligibility to their insurance company.

Estate Taxation and Required Minimum Distributions (RMDs)

In most cases, if an individual owns an annuity and later dies, that person's estate will include the annuity value as an asset—even when benefits are paid to a beneficiary. Internal Revenue Code §20.2039-1 contains requirements for the estate taxation of annuities.

When the owner of a tax-qualified annuity, an individual retirement account (IRA), or another qualified retirement plan such as a non-Roth 401(k), reaches age 73, annual required minimum distributions (RMDs) must begin. RMD payments to the retiree are a percentage of the plan's account value as of December 31 of the previous year, with the initial payment starting no later than April 1 of the year after the account owner’s 73rd birthday. All subsequent annual RMDs must be taken no later than December 31.

Definitions

• FINRA: Financial Industry Regulatory Authority or a succeeding agency. FINRA is authorized by Congress to protect investors by ensuring that the broker-dealer industry operates fairly and honestly.
  
• Producer: A person or entity required to be licensed under state law to sell, solicit, or negotiate insurance—including annuities.
  
• Recommendation: Advice provided by a producer to an individual consumer that results in, or was intended to result in, the purchase, exchange, or replacement of an annuity in accordance with the producer's advice. A recommendation does not include general communication to the public, generalized customer service assistance or administrative support, general educational information or tools, prospectuses, or other product and sales material.

Suitability Becomes a Best Interest Standard

Purchasing or exchanging an annuity product can have serious financial repercussions if the sale does not align with the customer’s needs. During producer training, it is important that producers learn to recommend appropriate products based on each individual consumer’s answers to the profile information:

• Age
• Annual Income
• Financial situation and needs (includes debts and other obligations)
• Risk tolerance, including willingness to accept non-guaranteed elements of the annuity
• Financial experience
• Insurance needs
• Financial objectives
• Intended use of the annuity
• Financial time horizon
• Existing assets and financial products
• Liquidity needs
• Liquid net worth
• Financial resources to fund annuity
• Tax status
  

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