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Why Annuities – Terms & Types
Why Annuities Terms & Types
Secure Your Financial Future with Annuities
It’s Never Too Early to Plan for Retirement
It’s easy to let retirement planning slip by while focusing on your career or raising a family. However, retirement savings are crucial for long-term financial security. In fact, 57% of working Americans admit they’re behind on retirement savings, according to a 2024 Bankrate survey. That’s why it’s essential to understand your options and their benefits as you plan for a financially secure future.
Why Consider Annuities?
Annuities are a powerful tool for retirement planning, offering benefits tailored to individuals seeking stability and peace of mind.
- Guaranteed Income: Annuities provide dependable, regular payments during retirement—and in some cases, even before.
- Protection from Market Losses: Unlike traditional market investments, certain annuities safeguard your principal, ensuring stability even in volatile markets.
- Tax Deferral: Contributions to annuities grow tax-deferred, allowing your savings to compound more effectively over time.
Guaranteed Rates of Return:
Annuities provide dependable, regular payments during retirement—and in some cases, even before.
Survivor
Benefits:
Many annuities include options for legacy planning, ensuring financial support for your loved ones.
The Primary Reason for Buying an Annuity
As retirement approaches, it’s natural to worry about whether your savings will last. With the right annuity, you can eliminate the fear of outliving your money. An annuity ensures a steady income for as long as you live, offering the financial security and peace of mind you deserve in retirement.
Are Annuities a Good Investment for You?
When planning for retirement, it’s essential to consider your risk tolerance, time horizon, and long-term financial goals—just as you would when investing in stocks or bonds. While annuities are sold by insurance companies, they play an important role in building a reliable income for retirement.
To determine if an annuity is the right choice for you, start by asking yourself:
- What are my short- and long-term financial goals?
- How might an annuity fit into my overall financial plan?
- Is an annuity the best option to achieve my goals?
- Do I have the cash to purchase an annuity after making other retirement contributions?
- Have I recently received a financial windfall, such as an inheritance or lottery winnings?
- Retirement Plan transfer from employer
When an Annuity May Be a Good Investment
An annuity can be a valuable addition to your retirement strategy if:
- You’re concerned about outliving your savings.
- You want a guaranteed income stream to cover your lifetime or support beneficiaries.
- You’re comfortable with the potential drawbacks, such as higher fees and inflexible contracts.
- You’ve received a financial windfall or need to plan for long-term care expenses.
Why Consult with Me? Annuities are complex products, and they aren’t suitable for everyone. A financial advisor can provide personalized guidance based on your unique circumstances, such as your:
An experienced advisor can help you weigh the pros and cons of annuities to determine whether they align with your financial goals.
Annuity Terms & Strategies
When investing fixed index annuity premium, the Insurance Company takes into consideration the contractual guarantees, expenses and profits, and the goals of the annuity.
The 2 components of fixed index annuity investing consist of:
- Fixed Income Investments (Bonds, Treasuries etc.)
- Equities (Call options, Futures etc.)
The mechanics of fixed index annuity investing occur in the following order:
- First, fixed income investments are used to support the underlying minimum guarantee.
- Second, the company covers normal expenses and profit margins. (The cost of doing business.)
- Next, options are purchased to support the growth in the index.
Guarantees
All fixed annuities offer a minimum contract value. To provide this minimum guaranteed return, the insurance company invests in bonds or other conservative instruments. A fixed index annuity contains guarantees that protect retirement dollars. The customer is GUARANTEED the greater of the following values:
Surrender
Value:
The Surrender Value is the amount that is available at the time of surrender. The Surrender Value is equal to the Accumulation Value, subject to the Interest Adjustment, less applicable surrender charges, Premium Bonus Recapture if applicable and state premium taxes. The Surrender Value will never be less than the minimum requirements set forth by state laws, at the time of issue, in the state where the contract is delivered.
Standard Non–Forfeiture Value:
The Standard Non–Forfeiture Value equals 87.5% of the premiums (excluding premium bonus), less any withdrawals (before any Interest Adjustment, surrender charges or Premium Bonus Recapture, if applicable), accumulated at the SNF interest rate. This SNF rate is based upon the issue date of the contract and is guaranteed for the entire term of the contract.
Minimum Guaranteed Contract Value (MGCV):
Some of our products offer an MGCV. This value equals 100% of premiums paid (excluding any premium bonus), less any withdrawals (before any surrender charges, Premium Bonus Recapture, if applicable, or Interest Adjustment) accumulated at a predetermined MGCV rate, less surrender charges. The MGCV Interest Rate is set at issue and is guaranteed for the entire contract term.
Basic Designs of Fixed Index Annuities
There are a wide variety of fixed index annuity designs! The most familiar design is the Annual Reset/Ratchet method. The main components are illustrated below.
Annual Reset Method
- Gains are calculated and interest credited each year.
- Interest is “locked–in”. This means once interest has been earned, it cannot be subtracted in the future due to a market downturn.
- Because interest is “locked–in” each year, the contract holder benefits from compounding.
- This design is usually coupled with an Index Cap Rate, Participation Rate or Margin that is reset each year.
Potential Customers for Annual Reset
- Customers who want the potential to earn greater than fixed rates over the term of the contract
- Customers who want to see a return credited annually
- Customers who feel market is choppy or unstable
- Customers who want “locked–in” growth
The number of crediting methods/Index Account options and combinations is virtually boundless. This makes it extremely difficult for a producer to compare “apples to apples”. However, the more knowledge obtained about the different crediting methods/Index Account options, guarantee provisions, and features of fixed index annuities (Index Cap Rates, Index Margins, Participation Rates, etc.) the more effective producers will be in determining which products to offer customers. The modules that follow will help to increase fixed index annuity knowledge.
What if Option Costs Change?
It is important to remember that the change in the price of the options will affect the Index Cap Rate, Participation Rate and/or Index Margin/Spread that the company can offer. The following is an example assuming $.04 per dollar invested is available for the insurer to purchase options.
If one “full” option costs $.04 = 100% Participation Rate
If one “full” option costs $.08, then we can only buy 1/2 option = 50% Participation Rate
Setting Participation Rates and Index Margins
As illustrated in the examples above, the Participation Rate and/or Index Margin depends on the amount of options that can be purchased after covering the minimum guaranteed return and expenses. If the Insurance Company only has enough money left over to buy 80% of a “full” option, then the annuity participates in 80% of any growth or has a Index Margin greater than zero. The Insurance Company doesn’t get “the other 20%” of the option because there was no money to buy the other 20% – the seller of the option keeps it.
In summary, both bond rates and option costs have an effect on Index Cap Rates, Participation Rates and Index Margins.
On newly issued contracts, as bond rates go up, the company has more money remaining to buy more options and therefore can set higher Participation Rates on an annual basis. If option prices go up, the money does not go as far, and the company must set lower Participation Rates. If option prices fall, the company can afford more options, thus crediting a higher Participation Rate.
Variations in Product Design Elements
Although there are a multitude of product designs and variations within them, the most popular variations are the use of Averaging or Point–to–Point crediting methods/Index Account options, having a Cap Rate, Participation Rate or an Index Margin/Spread and offering different indexes from which to choose.
Averaging vs. Point–to–Point:
Each fixed index annuity contract will have either a Point–to–Point or an Averaging element, and some will incorporate both. Averaging usually takes the form of either a Daily Average or a Monthly Average. In either instance, it will smooth out the highs and lows of the index movement. Point–to–Point products measure the index movement from a starting date to a final date.
Multiple Index Options:
As discussed in module one, there are numerous indices to base the measure of growth for the contract. Contracts that offer multiple indices may or may not have transfer options available.
Index Cap Rate vs. Participation Rate vs. Spread/Margin:
Most products will have an Index Cap Rate, Participation Rate or an Index Margin/Spread. The Index Cap Rate is the upside percent cap on the earnings. The Participation Rate is the percentage of index movement credited to the annuity. The Index Margin/Spread is the percentage deducted from index movement prior to crediting the index interest to the annuity.
Six Annual Reset Fixed Index Annuity Designs as well as a Biennial Reset Design:
- Daily Averaging
- Annual Point–to–Point
- Monthly Point–to–Point
- Monthly Averaging
- Biennial Point–to–Point
- 3–Year Monthly Averaging
- Inverse Performance Trigger
Types of Annuities
There are many types of annuities, including fixed, variable, indexed, immediate, and deferred. The type of annuity you choose depends on your goals, risk tolerance, and when you want to start receiving payments.
Fixed annuities
- Fixed period annuities: Pay a fixed amount at regular intervals for a set period of time
- Single life annuities: Pay a fixed amount at regular intervals for the life of the annuitant, ending when they die
- Fixed annuities: Guaranteed to earn a minimum interest rate, but have lower returns
Variable annuities
- Payments vary in amount for a set period of time or for life
- The amount paid may be based on factors like the profits of the annuity fund or cost-of-living indexes
- Higher risk because there's no guaranteed return
Indexed Annuities*
- Also called equity-indexed or fixed-index annuities
- Earn a higher interest rate than fixed annuities, but there’s no guaranteed minimum interest rate
- Low-to-moderate risk and provide moderate returns
Immediate annuities
- Have a short or no accumulation period, so payments start soon
Deferred annuities
- Can last over 10 years, so payments start later
Joint and survivor annuities
- Pay a fixed amount to the first annuitant for their life, then to a second annuitant for their life
Equity-indexed annuities (EIAs)
- EIAs are insurance products regulated by state insurance departments.
- EIAs typically have a guaranteed minimum interest rate plus an interest rate linked to a market index.
How Indexed Annuities Work*
An indexed annuity pays a rate of interest based on a particular market index, such as the S&P 500. Indexed annuities give buyers an opportunity to benefit when the financial markets perform well, unlike fixed annuities, which pay a set interest rate regardless of how the markets are performing.
An indexed annuity is a type of fixed annuity, but its returns are based upon the performance of a market index, such as the Standard & Poor’s 500 Composite Stock Price Index (the S&P 500), the Dow Jones Industrial Average (DJIA), or the National Association of Securities Dealers Automated Quotations (NASDAQ), Others: Russell 2000, Gold, Barclays Trail Blazer, GS Global Factor Index, Balanced Asset 5 Index, iShares Index Fund, and more. Remember Upside Gains Without the Downside Risk.
Indexed annuities offer their owners, or annuitants, the opportunity to earn higher yields than fixed annuities when the financial markets perform well. Typically, they also provide some protection against market declines. The rate on an indexed annuity is calculated based on the year-over-year gain in the index or its average monthly gain over a 12-month period.
In years when the stock index declines, the insurance company credits the account with a minimum rate of return. A typical minimum rate guarantee is about 2%. Some can be as low as 0% or as high as 3%. There are no losses when the market isn’t performing well, only gains when it is. However, these gains may be limited via provisions in the contract, such as participation rates and rate caps.
Cap Rates
Let’s say you have a cap rate of 5%. The market goes up 10%. You would receive 5% interest growth because you are “capped” at 5%.
Spreads
Let’s say you have a spread of 5%. The market goes up 10%. You would receive 5% interest growth because you keep everything above 5% or above the “spread.”
Participation Rates
Let’s say you have a 50% Par Rate. The market goes up 10%. You would receive 5% interest growth because you are “participating” in 50% of the growth.
Participation Rates
While indexed annuities are linked to the performance of a specific index, the annuitant won’t necessarily reap the full benefit of any rise in that index. One reason is that indexed annuities often set limits on the potential gain at a certain percentage, commonly referred to as the participation rate. The participation rate can be as high as 100%, meaning the account is credited with all of the gain, or as low as 25%. Most indexed annuities offer a participation rate between 80% and 90%, at least in the early years of the contract.
If the stock index gained 15%, for example, an 80% participation rate translates to a credited yield of 12% (80% x 15%). Many indexed annuities offer a high participation rate for the first year or two, after which the rate adjusts downward.
Yield or Rate Caps
Most indexed annuity contracts also include a yield or rate cap that can further limit the amount that’s credited to the accumulation account. A 4% rate cap, for example, limits the credited yield to 4%, no matter how much the stock index has gained. Rate caps typically range from a high of 15% to a low of 2%. They are subject to change.
In the example above, the 15% gain reduced by an 80% participation rate to 12% would be further reduced to 4% if the annuity contract specifies a 4% rate cap.
Adjusted Values
At specific intervals, the insurer will adjust the value of the account to include any gain that occurred in that time frame. The principal, which the insurer guarantees, never declines in value unless the account owner makes a withdrawal. Insurers use several different methods to adjust the account’s value, such as a year-over-year reset or a point-to-point reset, which incorporates two or more years’ worth of returns.
How Does an Annuity Work?
An annuity is an insurance contract that you buy to provide a steady stream of income during retirement. First, there’s an accumulation phase. After that, you can begin receiving regular income by annuitizing the contract and directing the insurer to start the payout phase.
This income provides security because you can’t outlive it. It varies based on the type of annuity you choose: indexed, variable, or fixed.1
An indexed annuity tracks a stock market index, such as the S&P 500. (It doesn’t participate in the market itself.) Though your returns are based on market performance, they may be limited by a participation rate and a rate cap. A variable annuity allows you to choose between various investment options, typically mutual funds. Your payout depends on these investments. A fixed annuity is the most conservative of the three, with a steady interest rate and a payout that is consistent over time, with periodic payments.
You might also have the opportunity to purchase a rider so that the contract has death benefits, as well, so your beneficiaries, such as your spouse, would receive benefits after you die.
Which Is Better, a Fixed Annuity or an Indexed Annuity?
This depends on what you want out of this retirement product. A fixed annuity offers a guarantee that an index annuity doesn’t: a set amount of income in the payout phase. However, the potential for growth is smaller than what you might get with an indexed annuity. In fact, the interest rate on a fixed annuity might be so low that it won’t match inflation. That said, there is a bit more risk with an indexed annuity, since it follows (but doesn’t participate in) the stock market.