Fixed Index Annuity

Tim Barton       Click here to email us.
ChFC, CASL, CLU

Understanding Annuities:
A Lesson in Indexed Annuities Part 1
Did you know that an annuity can be used to systematically accumulate money for retirement purposes, as well as to guarantee a retirement income that you cannot outlive?

Table of Contents

Annuity Objectives
What Is an Annuity?
How Are Annuity Premiums Invested?
A Closer Look at Equity-Indexed or Indexed Annuities
Why Choose an Indexed Annuity?
Indexed Annuity Contract Features
Important Information
Annuity Ojectives
In planning for financial security in retirement, an annuity can help satisfy two basic objectives:
  1. To accumulate retirement assets on a tax-deferred basis. If you're already contributing the maximum to IRAs and any employersponsored retirement plans and need to save more for retirement, a deferred indexed annuity may be the answer to your retirement savings need.
  2. To convert retirement assets into an income that you cannot outlive. On the other hand, if you're near or at retirement, an immediate income annuity can be used to convert existing retirement assets into a lifetime income.
What is an Annuity?
An annuity is a long-term savings plan that can be used to accumulate assets on a tax-deferred basis for retirement and/or to convert retirement assets into a stream of income.

While both are insurance contracts, an annuity is the opposite of life insurance:
  • Life insurance provides financial protection against the risk of dying prematurely.
  • An annuity provides financial protection against the risk of living too long and being without income during retirement.
There are two basic types of annuities, depending on whether you need to accumulate assets for retirement or whether you're at or near retirement and interested in creating a lifetime retirement income:
Deferred Annuities
A deferred annuity has two distinct phases: the accumulation phase and the income phase.
  • During the accumulation phase, you contribute premiums to the annuity, where they accumulate on a taxdeferred basis until needed for income purposes.
  • During the income phase, the value of the annuity is converted into income payments.
Immediate Income Annuities
An immediate income annuity is purchased with a single premium and income payments begin immediately or shortly after the premium is paid.

How are Annuity Premiums Invested?
Depending on your investment objectives and risk tolerance, there are a variety of ways that you can choose to invest your annuity premiums:
  1. Fixed Interest Annuities
    A fixed interest annuity pays a fixed rate of interest on the premiums invested in the contract, less any applicable charges. The insurance company guarantees* that it will pay a minimum interest rate for the life of the annuity contract. A company may also pay an "excess" or bonus interest rate, which is guaranteed* for a shorter period, such as one year.
  2. Variable Annuities
    During the accumulation phase of a variable annuity, premiums less any applicable charges are placed in a separate account of the insurance company, where the annuity owner can invest them in one or more stock and bond subaccounts. During the income phase of a variable annuity, the amount of each income payment may be fixed and guaranteed*, or it may be variable, changing with the value of the investments in the separate account.
  3. Indexed Annuities
    An indexed annuity has characteristics of both a fixed interest annuity and a variable annuity. Similar to a variable annuity, the insurance company pays a rate of return on annuity premiums that is tied to a stock market index, such as the Standard & Poor's 500 Composite Stock Price Index. Similar to fixed interest annuities, indexed annuities also provide a minimum guaranteed* interest rate, meaning that they have less market risk than variable annuities. Since the minimum guaranteed interest rate is, however, combined with the interest rate linked to a market index, indexed annuities have the potential to earn returns better than fixed interest annuities when the stock market is rising.
* All guarantees are based on the claims-paying ability of the issuing insurance company.
A Closer Look at Equity-Indexed or Indexed Annuities
The indexed annuity is a hybrid of the fixed interest annuity and the variable annuity:
  • The insurance company pays a rate of return on your annuity premiums (less any applicable charges) that is tied to a stock market index, such as the Standard & Poor's 500 Composite Stock Price Index.
  • Similar to a fixed interest annuity, an indexed annuity also provides a minimum guaranteed* interest rate, meaning that it has less market risk than does a variable annuity.
An indexed annuity is an insurance contract and not an investment in the stock market. Indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. Any interest payable in excess of the minimum guaranteed* interest rate is determined by a formula contained in the annuity contract. This formula is determined by a variety of indexed annuity contract features, including:
  • Indexing Method: There are different methods used to determine the change in the relevant index over the period of the annuity. The indexing method used will impact the amount of interest credited to the contract.
  • Participation Rates: How much of the gain in the index will be credited to the indexed annuity? If, for example, an indexed annuity has an 80% participation rate, the annuity will be credited with only 80% of any gain experienced by the index.
  • Spread/Margin/Asset Fee: An indexed annuity may contain a spread/ margin/asset fee instead of, or in addition to, a participation rate. If, for example, an indexed annuity has a 3% spread/margin/asset fee and the index gains 9%, the interest credited to the annuity will be 6%.
  • Interest Rate Caps: Some indexed annuities contain a cap or upper limit on the amount of interest the annuity will earn. For example, if the cap rate is 10% and the index linked to the annuity gains 12%, only 10% will be credited to the annuity.
* All guarantees are based on the claims-paying ability of the issuing insurance company.
Why Choose an Indexed Annuity?
An indexed annuity provides the opportunity to benefit from potential gains in the equity markets, while paying a stated minimum interest rate during market downturns. An indexed annuity is a compromise between a fixed interest annuity and a variable annuity. The return on an indexed annuity varies more than a fixed interest annuity, but not as much as a variable annuity. As a result, an indexed annuity has more risk and more potential return than a fixed interest annuity, but less risk and less potential return than a variable annuity.

An indexed annuity may be right for you if you want to participate in the potential gains from the equity markets, while limiting your potential losses during market downturns. As a result, indexed annuities may be best suited for individuals who:
  • Are adverse to risk
  • Understand that a rate of return linked to stock market performance provides the potential for higher returns than fixed interest investments, together with the risk of losing money if the issuing company does not guarantee 100% of the principle and no index-linked interest is credited, or if the indexed annuity is surrendered while a surrender charge is in effect
  • Prefer to delegate investment decisions to others
  • Want less market risk than with a variable annuity
Indexed Annuity Contract Features
Before purchasing an indexed annuity, it is important to understand various contract features and their potential impact on annuity performance.

The Index
Indexed annuities credit interest based on the movement of the stock market index to which the annuity is linked. A market index tracks the performance of a group of stocks representing a specific market segment or the entire stock market. The S&P 500 is the index most commonly used for this purpose. Another index, however, may be used, such as the Dow Jones Industrial Average, NASDAQ 100 or Russell 2000. It is important to understand that when you buy an indexed annuity, you are purchasing an insurance contract and not shares of any stock or index.
Indexing Method
An indexed annuity earns a minimum rate of interest and then offers the potential for excess interest earnings based on the performance of the index to which the annuity is linked. The indexing method is the approach used to measure the amount of change in the index and, as a result, has a direct impact on the potential growth of an indexed annuity. Additional information is available on page 8.
Participation Rate
The participation rate determines how much of the increase in the index will be credited to the indexed annuity. The participation rate is usually less than 100%. For example, if the S&P 500 increases by 10% and the participation rate is 80%, the indexed annuity would be credited with 8%. The insurance company may have the right to change the participation rate from year to year or when the annuity is renewed for a new term.
Margin/Spread/Administrative Fee
Some indexed annuities subtract a specific percentage from the calculated change in the index before crediting interest to the contract. This "margin," "spread" or "administrative fee," which may be charged instead of, or in addition to, a participation rate, is subtracted only if the change in the index produces a positive interest rate.
Index Term
This is the period over which index-linked interest is calculated and/or the length of time during which withdrawals or surrenders are subject to a charge.
Cap Rate
Some indexed annuities put a cap or maximum on the indexlinked interest that will be credited to the annuity. For example, if the market index increases 20% and the annuity has a 15% cap rate, only 15% will be credited to the annuity. Not all annuities have a cap rate.
Floor
This is the minimum guaranteed interest that will be credited to the annuity. This guarantee is based on the claims-paying ability of the issuing insurance company.
Averaging
Some indexed annuities use an average of the changes in the index's value rather than the actual value of the index on a specified date.
Interest Compounding
Some indexed annuities pay simple interest during the index term, while others pay compound interest, meaning that index-linked interest that has already been credited to the contract during the term also earns interest in the future.
Exclusion of Dividends
In measuring index gains, most indexed annuities count only equity index gains from market price changes and exclude any gains from dividends.
Vesting
In some indexed annuities, none or only part of the index-linked interest is credited to the contract if the annuity is surrendered before the end of the term. The combination of these policy features found in any particular indexed annuity will make a difference in the amount of money your annuity investment will earn and in the amount of money you will receive if you surrender the annuity early. As a result, before you purchase an indexed annuity, it is important that you fully understand the various features in the contract you are considering.
Important Information
The information, general principles and conclusions presented in this report are subject to local, state and federal laws and regulations, court cases and any revisions of same. While every care has been taken in the preparation of this report, neither VSA, L.P. nor The National Underwriter Company is engaged in providing legal, accounting, financial or other professional services. This report should not be used as a substitute for the professional advice of an attorney, accountant, or other qualified professional.

Annuity contracts contain exclusions, limitations, reductions of benefits and terms for keeping them in force. All contract guarantees are based on the claims-paying ability of the issuing insurance company. Consult with your licensed financial representative on how specific annuity contracts may work for you in your particular situation. Your licensed financial representative will also provide you with costs and complete details about specific annuity contracts recommended to meet your specific needs and financial objectives.

NOTE: This annuity discussion is intended primarily to provide information on personal, non-qualified annuities that are not purchased to fund an IRA or qualified employer-sponsored retirement plan. An annuity purchased to fund an IRA or qualified employer-sponsored retirement plan does not provide any additional tax deferral, since tax deferral is provided by the IRA or qualified plan itself. If an annuity is purchased to fund an IRA or qualified employer-sponsored retirement plan, it should be done for the annuity features and benefits other than tax deferral. U.S. Treasury Circular 230 may require us to advise you that "any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor."

© VSA, LP All rights reserved (VSA 1a2-17 ed. 01-08)