Annuity Primer

How does the annuity company invest the funds in the contract? 


Annuities can also be defined according to their investment configuration, which affects the income benefits they pay.  Two major classifications are fixed annuities, which provide a fixed, guaranteed accumulation or payout, and variable annuities, which attempt to offset inflation by providing a benefit linked to a variable underlying investment account.  A third option, equity-indexed annuities, is fairly new but has become quite popular.  Equity-indexed annuities combine features of fixed and variable annuities.



Fixed Annuities


Fixed annuities provide a guaranteed minimum rate of return. The contractholder’s contributions into the contract are placed in the general assets of the annuity company – which invests these payments in conservative, long-term securities (typically bonds). This allows the company to credit a steady interest rate to the annuity contract. The interest payable for any given year is declared in advance by the insurer and is guaranteed to be no less than a minimum specified in the contract. So a fixed annuity has two interest rates: a minimum guaranteed rate and a current rate.



Current Interest Rate


Each annuity company credits the fixed contract with the current rate on a regular schedule, typically each year, but that rate cannot be less than the minimum guaranteed rate.  Some contracts guarantee a rate of interest (higher than the minimum rate) for the first years of the contract, after which the current declared rate applies.   There are four basic methods annuity companies use to apply the current interest rate to the contract:


Portfolio Method.  This is the most straightforward method -- all contracts are credited with the same declared rate regardless of when the contractholder paid the premium into the contract.  (New contracts that have a guaranteed rate will, of course, credit interest at the guaranteed rate during the guarantee period.)


New Money Method. This method, sometimes called the "pocket of money" method, takes into account the timing of the premium payments.  The company will declare an interest rate for the year and all contributions made during that year will be credited with that rate in the future.  So a contract may be credited various interest rates depending on when the contractholder made contributions.  For example, premiums contributed during calendar year 2007 will earn 3.65%, 2008 contributions earn 3.78%, 2009 contributions earn 3.57%, etc.


Sliding Scale Method.  This method credits interest based on the size of the cash value in the annuity larger balances earn higher rates of interest.  For example, the company may declare a current rate of 4.25% for the first $50,000 of cash value, 4.50% for the next $50,000 and 4.60% for cash value in excess of $100,000.  Given the fixed costs of administering annuity contracts, smaller contracts are less profitable for the company, and this method takes that into account.


Tiered Interest Rate Method.  This method credits different rates of interest depending on whether the contractholder eventually annuitizes the account or surrenders the contract.  In these contracts, two different values are disclosed to contractholders annually the annuity value and the cash (or contract) value.  A higher rate of interest is created in the calculation of the annuity value; a lower declared rate is applies to the cash value.  If the contract is eventually annuitized, the annuity payments are based on the higher annuity value.  If the contract is surrendered, the contractholder receives the lower cash value.  The annuity company will continue to profit from a contract that has been annuitized; that profit opportunity evaporates if the contractholder surrenders the contract -- hence the company's incentive to encourage annuitization. 


Companies will declare a current rate of interest  each year (or another period as set forth in the contract).   To a certain extent, the term "current rate" is misleading.  The rate is not necessarily tied to current market conditions, nor does the company pledge to do so.  "Renewal rate" is perhaps a better label.  Each "renewal" rate is entirely at the discretion of the company (subject to the minimum guaranteed rate).  Some companies declare very competitive renewal rates; others do not.  While there is no accurate predictor of how competitive a company’s future rates will be, advisors should review each company's history of interest rate renewals.  Some companies in the past have offered special, introductory rates of interest -- but as soon as the guarantee period ends, the contractholder find the contract pays little more than the contract's guaranteed minimum rate.  There are independent sources advisors can use to ferret out the "bait-and-switch" companies, including A.M. Best (   It is important to note that, in practice, companies rarely credit rates higher than their initial rate.  The initial rates that companies offer (which are a key aspect in marketing annuities) will change as market conditions change but once the contract is established, most companies do not base renewal rates on market conditions.  


Some fixed deferred annuities offer a "bail-out" rate.  If the renewal rate drops below the bail-out rate, the company will waive any surrender charges -- this allows the contractholder to bail out of his annuity position and find other higher-yielding investments without paying a contract penalty.   (Surrender charges and other contract costs are discussed below)  Another variation is the so-called "CD Annuity".  The type of contract guarantees its initial rate of interest during the surrender charge period (typically the first six years of the contract, or less).  Designed as an alternative to bank certificates of deposit, a CD Annuity has a fixed rate of return for a number of years that is tax-deferred and no surrender charges, if held to "maturity".     (For deferred annuity holders under age 59˝, there may be a tax penalty for bailing out of the annuity, or if the holder of a CD Annuity is under age 59˝ at "maturity".)     


One popular policy feature available in some deferred annuities is the "bonus" interest rate.  This is a rate credited over and above the current renewal rate for deposits made in the first year or first few years of the contract.  The bonus interest is immediately vested with the contractholder, that is, there are no strings attached to the extra interest.   Companies use the bonus to encourage additional premium contributions to the contract.  While bonus interest sounds good, this incentive comes at a cost.  Surrender charges on bonus contracts may be higher, interest rate guarantees may be lower or a less advantageous interest crediting method might used as always, there are no free lunches.    Some companies use the same principle to encourage annuitization (vs. surrender or withdrawals), extra interest is credited to the contract if it is annuitized.


When the contract is annuitized, a fixed annuity provides guaranteed income payments of a fixed amount based on the payout method selected by the contractholder.  The contract will usually display possible payout in terms of dollars per $1,000 of accumulated value. For example, an annuity promises a 65-year annuitant lifetime monthly payments of $5.60 per $1,000 of value.  At age 65 the contractowner chooses to annuitize the account when the annuity had accumulated to $100,000. The annuitant will receive $560 per month for the rest of his life.  This fixed amount is based on an interest rate that is fixed and guaranteed at the point of annuitization.  As mentioned above, the contract will initially show minimum payout rates for the various payout options.  In the case of deferred annuities, the company may be able to offer higher payout rates at the time of annuitization based on a higher interest rate environment at that time.  


The tables on the preceding page show other possible monthly payments for this 65-year old contractholder with a $100,000 annuity balance:


Text Box:  © 2008 Wall Street Instructors, Inc. No part of this material may be reproduced without the written permission of the publisher.

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straight life


($5.60 x 100 thousands)

straight life with installment refund


($5.22 x 100 thousands)

straight life with 5 year period certain


($5.56 x 100 thousands)

straight life with 10 year period certain


($5.44 x 100 thousands)

straight life with 20 year period certain


($4.99 x 100 thousands)

joint and full survivor (with his 60 year old wife)


($4.34 x 100 thousands)

joint and one-half survivor (with 60-year old wife)


($5.32 x 100 thousands)

monthly payments lasting 5 years


($18.12 x 100 thousands)

monthly payments lasting 10 years


($9.83 x 100 thousands)

monthly payments lasting 15 years


($7.10 x 100 thousands)