6.2 Fixed and Immediate Annuities

Fixed Annuities: Guarantees and Risk Allocation

A fixed annuity guarantees both a minimum interest rate during accumulation and a fixed, level dollar amount during payout. The insurer assumes the investment risk - it credits a guaranteed rate and bears the burden if its own portfolio underperforms. Premiums go into the insurer's general account, alongside the company's other general assets, so the owner is a general creditor of the insurer.

Because the insurer bears investment risk and pays a guaranteed dollar amount, fixed annuities are considered insurance products, not securities. They require only a life insurance license to sell - no securities (FINRA) registration.

Guaranteed vs. Current Interest Rate

Fixed annuities credit two rates:

• Guaranteed (minimum) rate - the floor the insurer contractually promises (e.g., 1% or 3%). It can never be credited below this.
• Current (excess) rate - the rate actually credited today, typically higher than the guarantee, reflecting present portfolio yields. It is declared periodically and is not guaranteed long term.

The owner's purchasing power is exposed to inflation risk: a level fixed payment buys less over a long retirement. This is the central weakness of fixed annuities and a frequent exam point.

Immediate vs. Deferred Classification

Annuities are classified by when income begins:

An immediate annuity must be funded with a single premium - you cannot make periodic payments into an immediate annuity. The income usually starts one payment interval after purchase. A common buyer is a retiree who rolls over a 401(k) lump sum and wants income to begin next month. There is no accumulation phase to speak of - the contract moves straight to payout.

Worked Example - Inflation Erosion

A retiree buys a $200,000 SPIA producing a level $1,100/month for life. That is fixed forever. With 3% annual inflation, the purchasing power of that $1,100 falls to roughly $818 in real terms after 10 years and about $608 after 20 years. The nominal check never changes, but its real value erodes.

Contrast with the insurer's risk: if the company invested the $200,000 and earns less than projected, it must still pay $1,100 - the insurer, not the annuitant, absorbs the shortfall. This guaranteed-payment, insurer-bears-investment-risk structure defines the fixed annuity.

Market-Value Adjustment and the Single-Premium Distinction

Some fixed deferred annuities attach a market-value adjustment (MVA) to early surrenders: if interest rates have risen since purchase, the surrender value is reduced; if rates have fallen, it is increased. The MVA shifts interest-rate risk to the owner only on early exit and disappears at the end of the surrender period. A pure immediate annuity has no MVA because it has no accumulation value to adjust.

Why Immediate Annuities Solve Longevity Risk

The core purpose of a single-premium immediate annuity (SPIA) is to convert a lump sum into a guaranteed lifetime income the annuitant cannot outlive, directly addressing superannuation (living-too-long) risk. The insurer pools many annuitants; those who die early subsidize those who live long, which is the mortality credit that lets a SPIA pay more than a self-managed withdrawal could safely sustain.

Worked Numeric: Payout Composition

On the $200,000 SPIA paying $1,100/month, each early payment is part return of principal (tax-free) and part earnings (taxable), determined by the exclusion ratio. If the expected return is $264,000 over the annuitant's life expectancy, the exclusion ratio is $200,000 / $264,000 ≈ 76%, so about $836 of each $1,100 check is tax-free and $264 is taxable - until total principal is recovered, after which the entire payment is taxable.

Joint and Period-Certain Income Choices

A SPIA can be structured to match a household's needs. A straight life (pure life) option pays the most per dollar but stops at the annuitant's death, with nothing to heirs. A life with period certain option guarantees payments for at least, say, 10 or 20 years, so if the annuitant dies early the balance of the certain period goes to a beneficiary - in exchange for a slightly lower payment. A joint and survivor option (common for couples) continues income, often at 50% or 100%, to the survivor after the first death, reducing the payment further because two lives are covered.

Worked Numeric: Cost of Guarantees

On the same $200,000 SPIA, straight life might pay $1,100/month, life with 20-year certain about $1,000/month, and a 100% joint-and-survivor option about $920/month. Each added guarantee shifts more longevity risk to the insurer and therefore lowers the monthly check. The exam expects you to rank these from highest payment (straight life) to lowest (joint and survivor), and to recognize that adding a refund or certain feature reduces income but protects against forfeiting principal at an early death.

Quick Reference: Fixed Annuity Risk Allocation

This division is the single most-tested fixed-annuity idea: the insurer protects the owner against poor markets and long life, while the owner alone absorbs inflation and the cost of cashing out early. Memorize the grid and you can answer most fixed-annuity application questions on sight, because each distractor on the exam simply swaps one of these four parties.