Fixed annuity basics


Published on

all about fixed annuity basics

Published in: Economy & Finance, Business
  • Be the first to comment

  • Be the first to like this

No Downloads
Total Views
On Slideshare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Fixed annuity basics

  1. 1. Fixed Annuity Basics by The Annuity Reporter
  2. 2. In this report we’ll explore the inner-workings of index annuities in simpleterms. Generally speaking, advisors who consider index annuitiescomplicated have just been too lazy to do research and develop a fact-basedunderstanding of the product. I know because that used to be me.Fixed index annuities are not complicated, especially when compared tomany of the futures, derivatives and options contracts available to investors.It should be easy for you to gain a firm knowledge of index annuities andapply that to individual products when you decide to buy one. Let’s getstarted…How Do Index Annuities Work?Fixed index annuities are nothing more than fixed annuities with a differentmethod of crediting interest. With a fixed annuity, the contract ownerreceives a stated rate of interest each year. With an index annuity, thestated rate is calculated based on growth in an outside market index. If theindex goes up, the contract makes money but if the index goes down, theprinciple is protected and the contract does not lose value.Index annuities give consumers partial participation in the equity markets inexchange for principle guarantees. Annuity owners will not lose money nomatter how bad the market performs. It is a place for safe money.Now that’s all well and good in theoretical terms but how can insurancecompanies make that work? It’s easy and we’ll start with the structure of afixed annuity. When you purchase a fixed annuity, the insurance companyessentially invests in bonds. Whatever return the bond portfolio generates,less company operating expenses equals the interest credit rate available forthe annuity contract. The insurance company has all this calculated aheadof time and makes the fixed interest rate offer accordingly. As an example,
  3. 3. let’s assume an insurance company can make 6% return on investment andthat annual operating expenses are 2%. This is fairly accurate andrepresentative of today’s market. In this case, a fixed annuity will becredited with 4% interest.It works the same way with an index annuity and you have two basicoptions. The insurance company invests the principal in the same type ofbonds, but uses the interest earned from the bonds differently, and givesyou options. You can elect to take the base interest rate (which is roughlyequivalent to what a fixed annuity would pay) or you can opt for thepossibility of more growth. If you want greater potential interest thecompany will instead use the interest earned from the bond portfolio topurchase an option in a market index. An option is simply the right but notthe obligation to purchase securities at a future date for a contractuallystated price. If the market goes up, the company will exercise the optionand credit interest to the annuity contract based on the gain. If the marketmoves sideways or down, the option expires worthless and no interest isavailable for crediting. The money the underlying bond portfolio earnedwas spent on the option, and thus the account earns nothing, but still, yourprincipal is safe and nothing is lost.Most people will notice that index annuity contracts don’t offer the entiremarket return or dividends for crediting and feel that the insurance companyis taking too much of the profit from the deal. That sentiment is inaccuratebut needs to be explored nonetheless. In part, limited upside is the priceyou pay for downside protection. Of course there are other reasons thatwe’ll cover next.For all intents and purposes, the fixed interest credit available(earned by theinvested underlying bond portfolio) is not enough to cover the full cost of
  4. 4. the market option. So if the insurance company doesn’t have enoughmoney to purchase 100% of the option then 100% of the gain is notavailable when the account is credited. Nobody gets the money, not youand not the insurance company. Let’s go back to our example of 6%investment income for the insurance company and the 2% operatingexpenses that results in a 4% interest credit. With an annuity premium of$100,000 that would make $4000 available to purchase the market option.If $4000 isn’t enough to purchase 100% of the market option, then 100% ofoption’s value is not available for crediting to the account.There are three different ‘pricing controls’ an insurance company can placeon a contract that are specifically meant to apply an interest credit that’s inline with the net gain from the option. The three pricing controls are theparticipation rate, cap rate and spread. Participation Rate- One way of limiting the account credit is to specify the percentage of index growth available for credit to the account. Cap Rate- Another option is to have a stated maximum level of interestavailable for account crediting. Spread- This is a fee imposed on the index credit that represents overall operating expenses for the insurance company.Every annuity will apply one or more of these pricing controls and aresubject to change according to contractually stated terms. The companyneeds to be flexible to take into account changes in interest rates andmarket volatility, which affects options pricing.Crediting MethodsEvery index annuity comes with one or more crediting methods which is
  5. 5. nothing more than a means to calculate the amount of interest to be appliedto the account value. Total interest credit is subject to any one or more ofthe pricing controls previously mentioned, as defined by the contract. Thereare several crediting methods available, depending on the contract but I’llfocus on the most common three. Annual Point to Point- The beginning and ending index value are used to calculate the total gain or loss. For example, if the S&P 500 starts the year at 1000 and ends at 1100, the interest credit would be 10%, subject to the participation rate, cap rate or spread. If the annual return is 0% or less, no interest will be credited. While the option contract that gives you participation in the market expired ‘out of the money’ the underlying principal value, guaranteed by contract, cannot lose value. Monthly Average- Each monthly anniversary, the level of the index is recorded. Those levels are added up at year’s end and the total is divided by twelve and compared to the index level at the beginning of the year. The difference represents the gain or loss for the year, subject to the participation rate, cap rate or spread. If the annual return is 0% or less, no interest will be credited. Again, while the option contract that gives you participation in the market expired ‘out of the money’ the underlying principal value, guaranteed by contract, cannot lose value. Monthly Sum- The gain or loss in the index every month is recorded. Each value is totaled to calculate the annual gain or loss, subject to the participation rate, cap rate or spread. If the annual return is 0% or less, no interest will be credited. Again, while the option contract that gives
  6. 6. you participation in the market expired ‘out of the money’ the underlying principal value, guaranteed by contract, cannot lose value.Extensive studies have been done in an attempt to determine whichcrediting method is most profitable. No single method has shown totalsuperiority as each works well in different market conditions. Choice ofcrediting method will depend on your view of where the market is going andsince no one really knows, the prudent strategy is to divide the investmentbetween various methods.Income RidersSome index annuities, like their variable annuity counterparts come with theoption for a guaranteed lifetime income rider. This optional feature,commonly called a guaranteed lifetime withdrawal benefit or GLWB, givesthe added benefit of a future lifetime income guarantee regardless ofaccount performance. Because of the rising popularity and relevance ofguaranteed income riders, Annuity Straight Talk offers The GLWB Report thatdescribes how this contract option works in greater detail for both index andvariable annuities.Since the subject at hand is index annuities, I’ll cover the basics here andpoint you to the GLWB Report for a deeper analysis. A comparison ofvariable and index annuities with income guarantees is also available on thesite. First of all, you need to understand the difference between the incomebenefit value and account value. The income benefit value is the basis forcalculating lifetime income payments and is guaranteed to increase eachyear. The account value is simply the initial investment as it grows accordingto the contract provisions previously discussed.
  7. 7. At the end of the surrender term, you can take either income or a lump sumpayment and walk away. The income payment will be based on the greaterof the income benefit value or the account value. The account value,however, is the amount of money you would receive if you chose to cancelthe contract and take a lump sum of cash.How about a little example? Let’s assume a 50 year old guy named Darwonpurchases an index annuity with a guaranteed income rider for $100,000and plans to either take income or surrender the contract at age 60. Thecontract states that the income rider will grant annual 7% increases to theincome benefit value and the account value will grow according to marketperformance and subject to the participation rate, cap rate and/or spread.After ten years, the income benefit value is guaranteed to be roughly$200,000. The account value, on the other hand, rolled along with the upsand downs of the market and managed to return a shade over 4% toaccumulate a total sum of $150,000.Now Darwon has a choice to make. He can either take lifetime incomepayments from the income benefit value ($200,000) or surrender thecontract and take the account value in one lump sum ($150,000). To keep itsimple, we’ll assume a 5% payout rate. So to break it down further, Darwonwill receive annual lifetime income of $10,000 or one single lump sum of$150,000.That’s how a lifetime income rider works with an index annuity. It’s exactlythe same as a variable annuity. That means you have another choice tomake between index and variable. I am not going to get into that here sinceit is covered extensively in the GLWB Report which I consider essentialreading for anyone choosing whether to include an income rider on anyannuity purchase.
  8. 8. Final ThoughtsIndex annuities shouldn’t scare anyone, regardless of what the financialpress wants you to believe. Throughout the site I will continually attempt todocument the negative press directed toward index products and anyresearch available that will combat the bias from an analytical angle.Recently the Wharton School released a white paper that studied actualreturns of index annuities since they hit the market in 1995. This reportgives a fair comparison between index annuities and various market indexes.The results show that although the annuities were never meant to competewith actual market returns they have performed favorably in most years.The real benefit that makes index annuities competitive is the ability for theaccount value to flat-line when the market experiences a downturn. Thereduced volatility makes them more competitive in the long run. In fact,there is a strong argument for index annuities being positioned as theperfect safe money investment vehicle during a highly volatile economicclimate.The report is excellent because it’s useful to cast aside polarizing opinionsand get down to the concrete facts. If you are looking for more informationplease browse and contact me with any questions.The Wharton report can be found here is also a great factual resource for independentmarket analysis from someone who does not sell or endorse any annuitycontract or company.
  9. 9.