6.3 Deferred and Indexed Annuities

Deferred Annuities

A deferred annuity delays income for more than one year after purchase, giving the contract an accumulation phase in which earnings grow tax-deferred. It may be funded by a single premium (SPDA) or by flexible periodic premiums (FPDA). During accumulation the owner retains full access to the cash value, subject to surrender charges.

Deferred annuities are the savings vehicle of the annuity world; immediate annuities are the income vehicle. A buyer can later annuitize a deferred contract to convert the balance into income, or take withdrawals without annuitizing.

Surrender Charges and the Bailout Provision

Because the insurer prices the contract expecting funds to stay invested, early surrender triggers a surrender charge that declines over time. A typical schedule:

Many contracts allow a penalty-free withdrawal of up to 10% of value per year. A bailout provision lets the owner surrender without charge if the credited current rate drops below a stated trigger. These surrender charges are separate from the IRS 10% premature-distribution penalty discussed below.

Nonforfeiture and Death Benefit

Deferred annuities carry a nonforfeiture value: if the owner stops paying or surrenders, the law guarantees return of paid premiums (often minus a small percentage and surrender charges) plus minimum interest. If the annuitant dies during accumulation, the beneficiary receives the greater of the accumulated value or total premiums paid — this death benefit avoids the surrender charge.

Premature Distribution and the LIFO Trap

Withdrawals before age 59½ generally incur a 10% IRS penalty on the taxable portion, on top of ordinary income tax. Crucially, withdrawals from a non-qualified deferred annuity are taxed LIFO (last-in, first-out) — earnings (taxable) come out before basis (tax-free).

Worked example: an owner age 50 deposited $40,000 that grew to $55,000 and withdraws $10,000. Under LIFO the entire $10,000 is treated as taxable earnings (only $15,000 of gain exists). The owner owes ordinary income tax on $10,000 plus a $1,000 (10%) penalty. Contrast this with annuitized payments, which use the exclusion ratio and blend basis with earnings.

Equity-Indexed (Fixed-Indexed) Annuities

An equity-indexed annuity (EIA), now usually called a fixed-indexed annuity, is a fixed annuity whose interest is tied to a market index such as the S&P 500. It credits the greater of a guaranteed minimum or an index-linked return, so principal is protected on the downside while gains participate (partially) on the upside. Because principal is guaranteed and it is not a separate-account product, an EIA is generally treated as a fixed (non-security) annuity for licensing.

Key mechanics that limit how much index gain is credited:

• Participation rate — percentage of the index gain the contract counts (e.g., an 80% rate on a 10% index gain credits 8%).
• Cap rate — a ceiling on credited interest (e.g., a 6% cap limits a 10% index gain to 6%).
• Spread / margin / asset fee — a percentage subtracted from the index gain before crediting.
• Guaranteed floor — typically 0% to 1%; the contract never credits a negative return.

EIA Worked Example

Assume an index rises 10% in the crediting period. The contract has an 80% participation rate and a 7% cap.

Step 1 — apply participation: 10% × 80% = 8%. Step 2 — apply cap: 8% is above the 7% cap, so credited interest = 7%.

If the index instead fell 10%, the guaranteed floor (say 1%) applies and the contract still credits +1% — principal is never reduced by negative index performance. This downside protection is the central selling point and a common exam fact.

Deferred Annuity Death Benefit and Premium Designs

During the accumulation phase of a deferred annuity, if the owner/annuitant dies before annuitizing, the contract pays a death benefit equal to at least the greater of the accumulated value or total premiums paid (the principal guarantee) to the named beneficiary — surrender charges are typically waived at death. This is a distinguishing safety feature versus a SPIA, which usually has no residual value under a life-only option.

Premium structures:

• Single-premium deferred annuity (SPDA) — one lump sum, then years of tax-deferred growth.
• Flexible-premium deferred annuity (FPDA) — periodic, variable contributions; the only annuity allowing ongoing flexible deposits (immediate annuities require a single premium).

Equity-Indexed / Fixed-Indexed Annuity Crediting

A fixed-indexed annuity (FIA) credits interest linked to an index (often the S&P 500) with a guaranteed minimum floor (typically 0-1%), using the same cap, participation-rate, and spread/margin levers as indexed life. Crediting methods tested:

• Annual reset (ratchet) — locks in each year's gain; the floor protects against index declines, and gains are never given back. Most consumer-favorable.
• Point-to-point — compares the index only at the start and end of the term.
• High-water mark — uses the highest anniversary value during the term.

Worked FIA Example

An FIA with annual reset, an 8% cap, and a 1% floor: the index gains 11% in year one → credited the 8% cap; the index falls 6% in year two → credited the 1% floor (no loss). Because the FIA's values are insurer-guaranteed by formula and not held in a separate account, it is not a security and is sold with a life license only — the recurring "indexed = life license, variable = securities" distinction. FIAs are also subject to the strictest suitability and disclosure scrutiny in senior sales.