Fixed vs. Variable Annuities

Understanding the differences between fixed, variable, and indexed annuities is essential for CFP candidates. Each type offers distinct risk-return characteristics, regulatory implications, and suitability considerations. This section provides a comprehensive comparison of these annuity types along with important features like surrender charges and living benefit riders.

The Three Main Types of Annuities

Annuities are broadly categorized by how returns are determined: guaranteed by the insurer (fixed), tied to investment performance (variable), or linked to a market index (indexed).

Fixed Annuities

A fixed annuity guarantees a minimum interest rate on the accumulated value. The insurance company invests the premiums in its general account (primarily bonds and mortgages) and assumes all investment risk.

Key characteristics:

• Guaranteed minimum rate: Typically 1%-3%, set at contract inception
• Current rate: May be higher than the minimum, declared periodically by the insurer
• Principal protection: Account value cannot decline due to market losses
• Insurer bears investment risk: The insurance company guarantees both principal and interest
• Not a security: Regulated by state insurance commissioners, not the SEC
• No registration required: Agents need only a state insurance license to sell

How fixed annuity rates work:

The insurance company declares a current crediting rate (e.g., 4.5%) that applies for a specified period (often one year). This rate may be adjusted periodically but cannot fall below the guaranteed minimum rate stated in the contract.

Best for clients who:

• Prioritize safety of principal over growth potential
• Are risk-averse and uncomfortable with market fluctuations
• Want predictable, guaranteed returns
• Are approaching or in retirement

Variable Annuities

A variable annuity allows the owner to invest premiums in subaccounts, which are similar to mutual funds. The account value fluctuates based on the performance of the underlying investments.

Key characteristics:

• Subaccounts: Investment options including stock funds, bond funds, and money market funds
• Market risk: Owner bears all investment risk; account value can increase or decrease
• No guaranteed return: Returns depend entirely on subaccount performance
• Separate account: Assets held separately from insurer's general account, protecting them from insurer insolvency
• Securities product: Regulated by the SEC under federal securities laws
• Registration required: Agents must hold FINRA Series 6 or Series 7 license, plus state insurance license
• Prospectus required: Must be provided to purchaser before or at sale

Subaccount options typically include:

• Domestic equity funds (large-cap, mid-cap, small-cap)
• International equity funds
• Fixed income (bond) funds
• Balanced/asset allocation funds
• Money market funds

Higher fees: Variable annuities typically have higher fees than fixed annuities:

• Mortality and expense (M&E) charges: 1.00%-1.50% annually
• Administrative fees: 0.10%-0.30% annually
• Subaccount management fees: 0.50%-1.50% annually (varies by fund)
• Total typical cost: 2.00%-3.00% annually before any riders

Best for clients who:

• Have a longer time horizon and can tolerate market volatility
• Want growth potential to keep pace with or exceed inflation
• Have already maximized tax-advantaged retirement accounts
• Understand and accept investment risk

Fixed Indexed Annuities (Equity-Indexed Annuities)

A fixed indexed annuity (FIA) is a hybrid product that ties interest credits to the performance of a market index (such as the S&P 500) while protecting principal from market losses.

Key characteristics:

• Index-linked returns: Interest credited based on performance of an external index
• Floor protection: Minimum guaranteed rate (often 0%-1%) protects against losses
• Not directly invested in the market: Index is used only to calculate interest credits
• Cap and participation rates: Limit upside potential in exchange for downside protection
• Insurance product: Regulated by state insurance commissioners, not the SEC
• Complex crediting methods: Multiple indexing strategies with varying terms

How Fixed Indexed Annuities Calculate Returns

Fixed indexed annuities use several mechanisms to determine how much of the index gain is credited to the account. Understanding these is critical for the CFP exam.

Participation Rate

The participation rate is the percentage of the index gain that is credited to the annuity. For example, with an 80% participation rate:

• If the index gains 10%, the annuity is credited with 8% (80% x 10%)
• If the index gains 5%, the annuity is credited with 4% (80% x 5%)

Participation rates typically range from 25% to 100%, with most contracts offering 70%-90%. Rates can change annually based on market conditions.

Cap Rate

The cap rate is the maximum interest that can be credited in any period, regardless of how well the index performs. For example, with a 7% cap:

• If the index gains 15%, the annuity is credited with only 7%
• If the index gains 5%, the annuity receives the full 5% (below the cap)

Caps can be combined with participation rates. If the participation rate is 80%, the cap is 10%, and the index gains 15%: the participation calculation yields 12% (80% x 15%), but the cap limits the credit to 10%.

Floor

The floor is the minimum interest rate guaranteed regardless of index performance. Most indexed annuities have a 0% floor, meaning the account cannot lose value due to negative index returns. Some contracts offer floors of 1%-3%.

Example with 0% floor:

• If the S&P 500 declines 20%, the annuity is credited 0% (not -20%)
• The account value remains unchanged during down markets

Spread (Margin)

Some indexed annuities use a spread (also called margin or asset fee) instead of or in addition to a cap. The spread is subtracted from the index gain before crediting.

Example with 3% spread:

• If the index gains 10%, the annuity is credited with 7% (10% - 3%)
• If the index gains 2%, the annuity is credited with 0% (2% - 3% = -1%, but floor protects)

Comparison Table: Fixed vs. Variable vs. Indexed Annuities

Exam Tip: Regulatory Classification

The CFP exam frequently tests the regulatory distinction between annuity types. Remember:

• Variable annuities = Securities (SEC-regulated, prospectus required, Series 6/7 license)
• Fixed and Fixed Indexed annuities = Insurance products (state-regulated, no prospectus, insurance license only)

Registered Index-Linked Annuities (RILAs)

Registered Index-Linked Annuities (RILAs), also called buffer annuities or structured annuities, are a newer hybrid product combining features of fixed indexed and variable annuities.

Key RILA characteristics:

• Limited downside exposure: A "buffer" absorbs initial losses (e.g., first 10% of market decline)
• Principal can decline: Unlike fixed indexed annuities, account value can decrease
• Higher upside potential: Typically higher caps than fixed indexed annuities
• SEC-regulated security: Requires prospectus and Series 6/7 license (like variable annuities)
• No floor guarantee: After the buffer is exhausted, the owner bears remaining losses

Example: With a 10% buffer and 15% cap, if the index declines 25%, the RILA absorbs the first 10% of loss, and the owner loses 15%. If the index gains 20%, the owner receives 15% (capped).

Emerging trend: RILAs have grown rapidly since 2018, appealing to investors seeking more upside than fixed indexed annuities while accepting some downside risk in exchange for higher caps.

Surrender Charges

Surrender charges are penalties imposed by insurance companies when annuity owners withdraw more than the free withdrawal allowance or surrender the contract during the surrender period.

How Surrender Charges Work

• Surrender period: Typically 5-10 years from contract inception
• Declining charge: Usually starts at 7%-10% and decreases by 1% annually
• Applies to excess withdrawals: Beyond the free withdrawal amount (usually 10% of account value annually)
• Protects insurer: Allows insurer to recover sales costs and maintain investment strategy

Typical Surrender Charge Schedule

Ways to Avoid or Minimize Surrender Charges

1. Free withdrawal provision: Most annuities allow 10% of account value to be withdrawn annually without surrender charges
2. Free look period: 10-30 days after purchase to cancel without penalty
3. Death benefit: Surrender charges often waived upon owner's death
4. Nursing home/disability waivers: Some contracts waive charges if owner enters nursing home or becomes disabled
5. Terminal illness: Many contracts waive charges upon terminal illness diagnosis
6. Systematic withdrawals: Using the free withdrawal provision each year

Rolling Surrender Periods

Many annuities have rolling surrender periods—each new premium payment starts its own surrender period. For example, if premiums are added in years 1, 3, and 5, each has its own 7-year surrender schedule.

Exam Tip: Surrender Charges vs. 10% Penalty

Surrender charges (imposed by the insurance company) and the 10% early withdrawal penalty (imposed by the IRS) are separate. A withdrawal before age 59 1/2 may trigger both charges. The 10% IRS penalty applies to the taxable portion of the withdrawal; the surrender charge applies to the withdrawal amount exceeding the free withdrawal allowance.

Living Benefit Riders

Living benefit riders provide additional guarantees during the owner's lifetime. These riders are most common with variable annuities but are also available with indexed annuities. They typically add 0.75%-1.50% annually to the contract cost.

Guaranteed Lifetime Withdrawal Benefit (GLWB)

A GLWB rider guarantees the owner can withdraw a specified percentage of a "benefit base" for life, regardless of actual account performance.

Key features:

• Benefit base: A phantom value used to calculate withdrawals (not the actual account value)
• Roll-up rate: Benefit base may grow by a guaranteed rate (e.g., 5%-7% annually) if no withdrawals are taken
• Step-up provision: Benefit base may step up to actual account value if investments perform well
• Withdrawal percentage: Typically 4%-6% of benefit base annually, based on age at first withdrawal
• Withdrawals reduce account value: Actual account is depleted first; guarantee kicks in if account reaches zero

Example: A variable annuity with a GLWB has a $100,000 investment. The benefit base grows at 6% annually. After 10 years without withdrawals, the benefit base is $179,085. At age 65, the owner can withdraw 5% annually ($8,954) for life, even if the actual account value declines to zero.

Guaranteed Minimum Income Benefit (GMIB)

A GMIB rider guarantees a minimum future income amount when the contract is annuitized.

Key features:

• Requires annuitization: Owner must convert account to income stream to trigger benefit
• Waiting period: Typically 7-10 years before GMIB can be exercised
• Benefit base growth: Usually grows at a guaranteed rate (e.g., 5%-6% annually)
• Annuitization rates: Guaranteed rates used to convert benefit base to income
• May be less flexible: Once annuitized, cannot access remaining funds as lump sum

GLWB vs. GMIB Comparison

Guaranteed Minimum Accumulation Benefit (GMAB)

A GMAB rider guarantees the account value will be at least equal to the original investment (or a percentage of it) after a specified period, regardless of market performance.

Example: After 10 years, the GMAB guarantees the account will be worth at least 100% of the original $100,000 investment, even if the subaccounts have declined in value.

Guaranteed Minimum Death Benefit (GMDB)

A GMDB rider guarantees a minimum death benefit to beneficiaries, typically at least equal to premiums paid, even if account value has declined.

Common GMDB provisions:

• Return of premium: Beneficiary receives at least total premiums paid
• Highest anniversary value: Beneficiary receives highest account value on any contract anniversary
• Roll-up: Death benefit grows at guaranteed rate (e.g., 5% annually)

Cost Considerations for Annuity Riders

Exam Tip: Rider Suitability

When evaluating annuity rider suitability, consider:

• Client age: Older clients may benefit less from long waiting periods
• Income need timing: GLWB for flexibility; GMIB for maximum guaranteed income
• Legacy goals: GMDB riders for clients wanting to leave assets to heirs
• Cost-benefit analysis: Rider costs compound over time; evaluate if guarantees are worth the expense

Suitability Considerations

FINRA Rule 2330 (formerly 2821) requires registered representatives to have a reasonable basis for believing a deferred variable annuity is suitable for a customer before recommending the purchase or exchange.

Key Suitability Factors

1. Age: Older clients may not benefit from long surrender periods or deferred guarantees
2. Liquidity needs: Annuities are illiquid; clients should have adequate emergency funds
3. Tax status: Tax-deferred growth is less valuable if client is in low tax bracket
4. Investment objectives: Match annuity type to risk tolerance and goals
5. Existing annuity holdings: Evaluate if exchange (1035) is in client's interest
6. Retirement plan contributions: Ensure client has maximized 401(k)/IRA contributions first

Key Concepts Summary