There are two types of fixed annuities: traditional fixed and indexed annuities.
Fixed annuities are regulated by state insurance departments and sold through insurance agents, banks, or registered representatives.Fixed annuities pursuant to state insurance law must provide a minimum rate of interest as provided in the annuity policy. How the actual rate of interest is credited on the policy differentiates traditional fixed annuities from indexed annuities. Traditional fixed annuities pay interest on the premium contributed at a rate declared by the insurer in advance. This rate can never be less than the minimum guaranteed rate stated in the policy. Fixed annuities are a very conservative safe money place for retirement dollars.
Indexed annuities are a type of fixed annuity which are regulated and distributed in the same manner as fixed annuities. Indexed annuities are a moderately conservative safe money place for retirement dollars.
Indexed annuities usually provide a purchaser with various options for interest crediting. A buyer may choose a declared account option which functions the same as a traditional fixed annuity. However, the annuity also provides other options which consider the performance of an outside stock index (such as the Standard and Poor's 500, a.k.a. S&P 500) to determine interest. These options pay interest at a rate determined by a formula which considers any increase in the outside index subject to a “participation rate” and “cap.” Indexed annuities have a floor of zero, so a consumer may receive no interest in a particular year but can not lose any previously credited interest or premiums due to downturns in the market. A “participation rate” is the percentage multiplied by any percentage increase in the outside index. The resulting percentage from this formula is reduced by the “cap.” Both the participation rate and cap are set by the insurance company annually in advance. For example, if the S&P 500 increases by 10% and the participation rate is 70% and the cap is 6%, the rate of interest paid will be 6% (10% times 70% equals 7% subject to a cap of 6%)
Purchasers of fixed indexed annuities also must pick the method of determining any increase in the index they choose for his/her policy. The two most common methods are the point to point and averaging method. The point to point method determines the value of the index on a certain day and compares it to the value of that index on a date in the future (generally one year later). The average method looks at the value of the index every day and takes the average value for that year and compares it to the average value from the preceding year.
There is also a monthly sum interest crediting method tracked each month (subject to a cap each month) and the results from each month are totaled to get the annual interest rate credited.
The one year period is measured from the day the premium is invested and not on a calendar year basis. Interest is credited to the policy only once a year on indexed interest crediting methods. Once interest is credited it can not be taken away in a subsequent year when the measuring index is a negative value. This is called a “0” floor. As required by state insurance law, indexed annuities do provide for a minimum amount of interest. This interest rate is stated in the policy (usually 1% to 3%), but does not apply to 100% of the premiums paid. Usually the rate applies to 87.5% of the premiums paid. This guaranteed rate is considered only against premiums paid and does not consider any interest previously credited. When considering a policy’s value, the customer receives the higher of the value considering the guaranteed formula or the indexed account value.
To put this guarantee into perspective, if the guarantee was 87.5% of the premiums paid accumulated at 1% compounded annually, it would take 13 years for a policyholder's guaranteed minimum value to equal 100% of a single sum premium paid.
Like traditional annuities, indexed annuities have surrender charges. These charges can be as high as 20% and apply for a couple of years to in excess of 15 years (surrender charge period). Some policies measure the surrender charge period from the date the policy is issued, others apply the surrender charge period to each premium paid to the policy.
Some annuities also have an additional feature called a Market Value Adjustment or MVA. MVAs apply when a withdrawal is made from the annuity in excess of the penalty free amount. Generally, if interest rates are lower at time of the withdrawal than at the time the policy was purchased, the value of the annuity would increase. If interest rates are higher, the reverse is true.
Indexed annuities are retirement savings vehicles and are not meant for short term savings. Most indexed annuities do provide some penalty free amount that may be withdrawn each year(for example, the right to withdraw 10% of the annuity’s value per year). These products may also waive surrender charges if the policy is annuitized (paying the owner the value of the policy in equal payment amounts over the life of the annuitant). Some annuities provide additional riders to have surrender charges waived (which may have a cost) in the event the annuitant is confined to a nursing home or contracts a catastrophic illness.
As with all traditional fixed annuities, money can be withdrawn from an indexed annuity at any time (but such withdrawal may be subject to a surrender charge if the policy is still within the surrender charge period). Owners may also choose to receive a payment based on the value of the policy for their lifetime (called annuitization).
In the event of the owner’s (and the annuitant’s in some policies) death, the beneficiary of the contract usually receives any remaining value in the policy. If a policy is annuitized and payments were for the life of the annuitant without a term certain period, no death benefit will be paid to the beneficiary.