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What is fixed annuity, variable annuity?
In simple terms, both fixed annuity and variable annuity are annual payments. More specifically, they are contracts offered by insurance companies that allow you to accumulate funds for retirement on a tax-advantaged basis and then, if you choose, receive a guaranteed income payable for life or for a specified period of time, such as five, ten or twenty. Annuities are usually paid monthly, but many companies offer quarterly, semi-annual or annual payments. Most of this discussion will focus on fixed annuities.
How do they work?
Both a fixed annuity and a variable annuity are vehicles for accumulating retirement savings. You pay premiums to the insurance company and they promise to pay you interest. Unlike other retirement savings vehicles, as long as you keep your money with the insurance company, you don’t have to pay income tax on your gains.
This is called ‘tax deferral’. Your profit is subject to income tax only when you decide to withdraw your funds. A fixed annuity also differs from other retirement savings plans in several important ways. When you decide to withdraw your funds, the insurance company will give you the option of receiving guaranteed income for as long as you live.
What are the benefits?
All fixed annuity variations have three primary benefits: tax deferral, avoidance of probate, and guaranteed income for life.
Who offers fixed annuity products?
Fixed annuities are only offered by insurance companies licensed to underwrite life insurance and annuities by the state in which you live. Many insurance companies are subject to financial requirements that require the company to maintain a minimum reserve on its policies.
Who sells them?
Only agents licensed by states to sell life insurance can sell you fixed annuities. This includes every licensed life insurance agent in your state, as well as most financial planners and stock brokers.
Why is guaranteed income for life a benefit?
Annuity is the only savings vehicle that provides guaranteed income throughout life. As with every other type of savings plan you can never be sure that your income will continue for as long as you live. The insurance company calculates the guaranteed income payment based on your age, life expectancy and interest rate. That payment is guaranteed for as long as you live.
Many insurance companies also offer guaranteed fixed income rates for a specific period of time, such as five to twenty years. Guaranteed lifetime income can be based on your life alone or on the life of you and a joint annuity, typically your spouse. In case of joint annuity, the monthly income from your fixed annuity will continue till the death of the last survivor.
What is Tax Deferral?
A tax-deferred fixed annuity enjoys special tax benefits. Under the existing tax laws, no interest or profit is taxable, unless you actually start earning income, i.e. the tax payable on the profit is deferred. So, since you don’t pay any tax while your money is compounding, you earn interest in three ways – interest on your principal, interest on your interest and, if not tax deferred, interest on the tax you paid. This results in increasing the earning potential of a deferred annuity over a bank CD or other fully taxable income.
Why is avoiding probate an advantage?
The other primary advantage common to all annuities over other investment vehicles is the ability to pay the proceeds directly to a beneficiary upon your death. Probate is a court process to establish the validity of a will. Assets in an estate generally cannot be passed on to heirs until the probate court has established the validity of the estate and authorized the executor to distribute them. Because probate is a judicial process, the process can take six to twelve months to complete, and legal costs can be significant.
On the other hand, proceeds from annuities and life insurance are not subject to probate and can go directly to your designated beneficiary without going through probate.
What does an insurance company need to fulfill its obligations?
In order to protect the funds of its contract holders or policy owners, an insurance company must meet strict financial requirements. Most importantly, these requirements include establishing a reserve fund which should always be equal to the withdrawal or surrender value of the total block of their variable and fixed annuity policies or contracts.
In other words, the insurer must set aside funds equal to the surrender value (principal plus interest less early withdrawal or surrender charges) of each annuity contract. In addition to these reserve requirements, state laws also require certain levels of capital and surplus to protect their contract holders or policy owners.
An immediate annuity provides for fixed annuity payments to begin immediately after the purchase date. Payments can be scheduled monthly, quarterly, semi-annually or annually as per prior agreement.
Often the proceeds from the sale of a life insurance policy or home are used to fund an immediate annuity. Immediate Annuity Depending on the choices made by the owner, such annuity payments provide immediate, regular income for a fixed period of time (5, 10, 15, 20 years) or for life.
A deferred annuity provides for payments to begin at a future date known as the extension date. A deferred annuity has an accumulation period and a payout or distribution period.
For example, a middle-aged wage earner can provide for an income supplement by purchasing a deferred fixed annuity during their retirement years. Lump sum or regularly scheduled payments will be contributed to the annuity account as they accumulate, then when the annuity matures at age 65, additional income will be available through scheduled annuity payments.
Single Premium Annuity
A fixed annuity can be purchased with a single premium that establishes a cash payment agreement.
The most common sources of such lump sums are life insurance death benefits, the sale of a home, or lottery winnings.
Flexible premium annuity
A fixed annuity can be funded over time with an initial premium and additional flexible premiums.
Both the premium amount and frequency can be flexible, thus accommodating funding schemes such as wage deductions over years of employment as well as changes in the employer’s financial circumstances.
What is Fixed Indexed Annuity?
A fixed indexed annuity (also known as an index annuity, indexed annuity or equity indexed annuity) is a fixed annuity that has an upside earning potential and a guarantee against downside loss of principal. Its earnings are linked to a stock or equity market index such as the Standard & Poor’s 500 Composite Stock Price Index or, simply, the S&P 500. Fixed Indexed Annuities (FIAs) have four guarantees:
1. The initial premium is guaranteed
2. Minimum rate of return
3. Take credit for market ups (downs), not corrections (downs).
4. Profits are locked in every year
How are they different from other fixed annuities?
The primary difference between a fixed indexed annuity and other fixed annuities is the annuity rate or earnings that are deposited into your account. A traditional fixed annuity credits interest with an annuity calculator that is set in the contract and may or may not be subject to market adjustments. A fixed indexed annuity makes an interest crediting formula based on changes in the equity market to which it is linked. This formula explains how interest is calculated, accrued, how much extra interest you get, and when you get it.
An insurance carrier issuing a fixed indexed annuity also promises to pay a guaranteed minimum interest rate. Even if indexed earnings are low, the minimum guarantee will apply and your account value will not fall below the guaranteed minimum. Both flexible premium and single premium deferred annuity contracts guarantee a minimum interest rate, often in the range of 1.5% to 3% based on 90% and 100% of premium paid. An insurance company’s annuity calculator will adjust account values at the end of each term.
What are the features or ‘moving parts’ of the contract?
The amount of additional interest that can accrue in a fixed indexed annuity is affected by the indexing method and the participation rate, which work together like form and function.
An indexing method is a design by which the rate of change in an index is measured. For example, annual point-to-point is a method that measures the difference between the initial index level and the level on the one-year anniversary. If this design “ratchets” up the account value (new principal) with each annual gain, the indexing method includes an annual reset feature. Currently, the industry’s best-selling equity indexed annuity is Allianz’s MasterDex annuity series, which incorporates a more progressive “monthly” point-to-point structure with annual resets. Functional differences between indexing methods will be explained in more detail below.
Like faucets, the participation rate determines how much of the increase in the index goes into the annuity account value. Let’s say the fixed annuity calculator shows a 12% increase in the index, but your participation rate limits you to 70% of the gain. Your annuity growth rate will be 70% of 12% or 8.4%. Participation rates are variable and may only be guaranteed for a specified period or may be guaranteed not to be adjusted below a given minimum or above a specified maximum. Keyport Index Multipoint from Sun Life Financial is one of the most popular fixed indexed annuities, which guarantees a 100% participation rate for the entire contract term.
Some fixed indexed annuities place a CAP or ceiling on the annuity rate, establishing an upper limit that the annuity can receive. In an annuity earning an index-linked interest rate of, say, 9%, the limit may be only 7%, which will be the accumulated growth amount.
Some annuities use an average to smooth out the highs and lows of a linked equity market index. Monthly averaging, for example, would use an annuity calculator that combines each month-to-month index closing value by dividing it by 12.
Some annuities reduce interest rates relative to an index by deducting a spread, margin or fee and crediting the balance. A positive change in the index of 11%, for example, with a 2.5% administrative charge, would result in a net increase of 8.5%. Among carriers selling annuity products with spreads, margins or fees, such amounts will be deducted only if the change in the remaining index is a positive rate of return.
Annual Restatement: The yield is determined every year by comparing the index value at the end of the contract year with the index value at the beginning of the contract year. The positive difference, if any, is your fixed indexed annuity earned income for the year. Any new positive (not negative) account value resets to become the new starting point for the upcoming year. Compare this formula with a variable annuity or direct equity investment in a bear market. With variables and stocks the owner may have a deep chasm to get out of before returning to zero.
High-water mark: Yield is determined by the increase in index value at the annual anniversary points of the contract during the term. The positive difference, if any, is determined by comparing the highest index value and the index value at the beginning of the term.
Point-to-point: The yield, if any, is determined by comparing the difference in the index value at the end of the term with the index value at the beginning of the term. A positive difference is added to the value of your annuity account at the end of the term.
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