By Sheryl Moore
This article is part one in a series of articles, explaining the basic product features of several types of annuities. This first piece in the series focuses on traditional fixed deferred annuities.
Recently, I had the opportunity to speak with a “life insurance guy.” He sold tons of life insurance, but had only sold a couple of annuities in his career. He didn’t feel confident presenting annuities to his prospects. When I asked about the reason behind his lack of annuity sales, his response surprised me: “I don’t understand them, and therefore don’t feel confident presenting them.”
When I began to explain the basics about why his prospects might want annuities, he interrupted me. “No, I get why someone would want an annuity, and I understand how to make the sale, I just don’t understand the basic annuity features.” That being the case, Life Insurance Guy -- this one’s for you.
Traditional fixed annuities are the simplest type of deferred annuity that is available for sale today. A deferred annuity, unlike an immediate annuity, allows the purchaser to defer taking lifetime income from the contract. Whenever the fixed annuity purchaser decides that they are ready to start taking income from the annuity, annuitization options provide a guaranteed income that the purchaser can never outlive. If the annuity purchaser doesn’t voluntarily turn this income on, there is a maturity date on the contract that dictates that the purchaser MUST take income from the contract at a certain point; typically age 115. Until policy maturity, the annuity is in a deferral period; where the contract is earning interest with the goal of accumulating more retirement income for the purchaser.
For those who are familiar with how a bank certificate of deposit (CD) works, fixed annuities are not much of a stretch. Fixed annuities credit a fixed interest rate, which is declared by the underwriting insurer, on an annual basis. The interest that is credited to the annuity each year is nearly always compounded, as opposed to receiving simple interest. Many fixed annuities are banded, and pay a relatively greater interest rate, should the annuity purchaser deposit a minimum amount of funds (i.e. the annuity may credit 3 percent interest for premiums of $99,999 or less, or 3.5 percent interest for premiums of $100,000 or more). It is important to understand that the interest rate that is credited to the annuity may change. Sure, it could go up, but it is more likely to stay the same or decline. However, the credited interest rate on an annuity is always subject to the minimum guaranteed interest rate on the contract (a.k.a. floor).
The minimum guaranteed interest rate has become one of the more complicated features of these relatively simple products. Just a decade ago, all annuities offered a guaranteed minimum floor of 3 to 5 percent. This floor is the lowest rate that the insurer can credit to the contract each year. Today, historical low interest rates have affected annuity guarantees. The trend in fixed annuity minimum guarantees today has drifted toward offering a minimum floor of 0 percent. The annuities with these lower guarantees also offer a secondary guarantee, called a Minimum Guaranteed Surrender Value (MGSV). This secondary guarantee credits a rate of 1 to 3 percent interest on no less than 87.5 percent of the premiums paid on the annuity. (For a glimpse at how this secondary guarantee accumulates on the annuity contract, see the charts at http://www.annuityspecs.com/Basics/Rates.aspx)
The surrender charges on deferred annuities provide a deterrent to the owner/annuitant cashing-out the annuity early. This penalty allows the insurance company to invest the monies that are backing the fixed annuity properly because when an annuity purchaser makes a premium payment into a fixed annuity, the insurance company turns around and uses that premium to purchase bonds. Generally, the bonds are high quality and mature at the same time the surrender charges expire on the purchaser’s annuity (i.e. I buy a 10-year surrender charge annuity and the insurance company then purchases 10-year Grade “A” bonds to cover my annuity’s guarantees). This provides a relatively safe investment vehicle for the insurance company to make enough interest off of, in order to earn their profit in the transaction.
So, just for simplicity’s sake, let’s make the assumption that these bonds are currently paying 4 percent interest and the insurance company is crediting 3 percent interest on their fixed annuities. This means that the difference of 1 percent is what the insurance company is using to cover their expenses and anything that is left is their profit. Makes sense, right? Well, if I cash surrender my annuity before the end of that 10-year period, the insurance company is going to incur penalties on cashing-out that bond early too. Hence, the need for surrender charges on deferred annuities.
There are sources of liquidity on deferred annuities, however. Nearly all annuities allow the purchaser to withdraw at least 10 percent of the annuity’s value, without penalties, after the first year of the contract. That means that after a 10-year period, the annuity purchaser has had the ability to access 100 percent of the premiums paid into the contract, without having to incur any surrender charges. Most fixed annuities also offer benefits that waive either all of the surrender charges, or a portion of the surrender charges on the contract, should the purchaser face certain circumstances. If the annuitant is confined to a nursing home, is diagnosed with a terminal illness, becomes disabled or even becomes unemployed -- most fixed annuities will waive any surrender penalties for one or more of these occurrences. Most importantly, fixed annuities typically pay the full account value of the contract to contract beneficiaries, without applying surrender charges, upon the death of the annuitant.
Most fixed annuities are flexible premium contracts, accepting more than one premium payment. This feature is important to purchasers that are using qualified, or untaxed, money to fund the contract. Because the vast majority of annuity sales are qualified, those using an annuity as the medium for their IRA, TSA, or other tax-qualified vehicle, have many choices for which fixed annuity product they’d like to purchase. However, there certainly are products that accept only one premium payment (single premium deferred annuities, or SPDAs). The majority of SPDAs have a bonus on the contract. An interest bonus on a fixed annuity is a feature where the credited interest rate on the contract is increased for a limited period of time, typically one year.
Feeling more confident about the features on fixed annuities? Let’s build on that moment and discuss fixed indexed annuities .. .stay tuned for next month!
Sheryl Moore is president and CEO of Moore Market Intelligence, an indexed product resources in Des Moines, Iowa. She has over a decade of experience working with indexed products and provides competitive intelligence, market research, product development, consulting services and insight to select financial services companies. She may be reached at firstname.lastname@example.org.