6.3 Deferred and Indexed Annuities

Deferred Annuities and Premium Funding

A deferred annuity postpones income until more than 12 months after purchase, allowing the contract value to grow tax-deferred. Deferred annuities are funded one of three ways:

• SPDA (Single-Premium Deferred Annuity) - one lump-sum deposit; income deferred to a future date.
• FPDA (Flexible-Premium Deferred Annuity) - the owner makes varying periodic deposits over time.
• Level/scheduled premium - fixed periodic deposits.

Note a contract can be single-premium but deferred (SPDA) or single-premium and immediate (SPIA). Periodic-premium contracts are always deferred - you cannot fund an immediate annuity over time.

Tax-Deferred Accumulation and the Nonforfeiture Floor

During accumulation, interest grows tax-deferred - no tax until withdrawal. A nonforfeiture provision guarantees that if the owner surrenders, they receive at least their premiums (less prior withdrawals and charges) plus a minimum guaranteed interest rate. This protects principal even after surrender charges.

The owner can usually surrender, take partial withdrawals (subject to charges and the 10% free amount), or annuitize. Death during accumulation pays the beneficiary the greater of accumulated value or total premiums paid, in most contracts.

Equity-Indexed (Fixed-Indexed) Annuities

An indexed annuity is a fixed annuity whose interest credit is linked to an external index such as the S&P 500. It is NOT a security - it is sold with a life license. It offers more upside than a plain fixed annuity while protecting principal with a guaranteed minimum floor (often 0% to 3%).

Three mechanisms limit the credited interest:

• Participation rate - the percentage of the index gain credited (e.g., 80% participation on a 10% index gain credits 8%).
• Cap rate - the maximum credited regardless of index (e.g., a 6% cap limits a 10% gain to 6%).
• Spread/margin/asset fee - a percentage subtracted from the index gain (e.g., a 2% spread on a 10% gain credits 8%).

Worked Example - Crediting Methods

The index rose 12% this term. How much is credited under each design?

The floor guarantees the owner is never credited a negative return even when the index drops. The insurer keeps the spread/cap upside in exchange for guaranteeing no loss. Indexed annuities use annual reset (ratchet), point-to-point, or high-water-mark methods to measure the index change.

Surrender Charges, Free-Withdrawal Corridors, and Bonus Annuities

A deferred annuity accumulates value for years before income begins and is the dominant retirement-savings annuity. Its defining cost is the surrender charge - a declining penalty on early withdrawals, typically starting near 7% in year one and stepping down to 0% over six to nine years. Most contracts allow a free-withdrawal corridor (commonly up to 10% of the account value each year) that escapes the surrender charge. A bonus (premium-enhancement) annuity adds an up-front credit such as 5% of premium but usually pairs it with a longer, steeper surrender schedule.

Indexed (Fixed-Indexed) Annuity Crediting

A fixed-indexed annuity credits interest linked to an index but guarantees a 0% floor, so principal is protected from market loss. Carriers limit upside with a cap, a participation rate, and sometimes a spread/margin. Example: with a 100% participation rate and a 9% cap, a 14% index gain credits 9%; a -5% index year credits 0%. Indexed annuities are insurance, not securities, so they need only a life license - contrast this sharply with variable annuities.

Indexing Methods and the Reset

Beyond the cap and participation rate, the indexing method determines how the index change is measured. Annual point-to-point compares the index on two anniversary dates - simple and common. Monthly averaging averages the index across the year, smoothing volatility. High-water mark credits based on the highest anniversary value reached. The annual reset (ratchet) locks in each year's gain so a later market drop cannot erase credited interest - the floor resets at the new, higher value.

Worked Numeric: Annual Reset Advantage

Suppose the index rises 8% in year one (credited and locked under a 10% cap) then falls 12% in year two. With annual reset and a 0% floor, year one credits 8%, year two credits 0%, and the year-one gain is permanently protected - the account never gives back the 8%. A point-to-point method measuring only the start and end of a two-year term might credit nothing. This loss protection, paid for by the cap on upside, is the central trade-off and a recurring exam question. Indexed annuities remain insurance products sold with only a life license, never securities.

Two-Tier Annuities and Liquidity Cautions

A few deferred annuities are two-tier: they credit a higher rate only if the owner annuitizes the contract, and a much lower rate if the owner simply surrenders for cash. This design locks the owner into the income phase to capture the advertised return and is heavily scrutinized for suitability, especially for seniors. Producers must disclose that the headline rate is available only through annuitization.

Worked Numeric: Surrender-Charge Erosion

Suppose a deferred annuity holds $50,000 with a year-three surrender charge of 5% and a 10% free-withdrawal corridor. If the owner withdraws $20,000 in year three, the first $5,000 (10% of value) is penalty-free; the remaining $15,000 is hit with the 5% charge = $750, so the owner nets $19,250 plus any market-value adjustment. This is why deferred annuities suit money the owner will not need for years. The IRS adds a 10% penalty on the taxable portion of withdrawals before age 59½, layered on top of the insurer's surrender charge, making early access doubly costly - a core suitability point for both national and California exams.