9.2 Fixed, Indexed, and Variable Annuities

Classifying Annuities by Investment Risk

Annuities differ chiefly in who bears investment risk and how interest is credited. The three core types — fixed, fixed indexed, and variable — sit on a spectrum from full insurer guarantee to full owner risk. Knowing which party bears risk also tells you which regulator and license apply.

Fixed Annuities

A fixed annuity credits a guaranteed minimum interest rate and pays a level dollar amount in the payout phase. Premiums go into the insurer's general account, where the insurer bears all investment risk and guarantees principal. Because the income is level, fixed annuities are exposed to inflation/purchasing-power risk — a $1,000 monthly check buys less in 20 years.

Insurers often credit a higher current rate above the guaranteed floor. For example, a contract may guarantee 1% but credit a current 4%. If markets fall, the owner still receives at least the 1% floor. Fixed annuities require only an insurance license to sell because they are not securities.

Variable Annuities

A variable annuity places premium in a separate account invested in subaccounts (mutual-fund-like portfolios) selected by the owner. The owner bears all investment risk: values and payouts rise and fall with market performance, with no guaranteed minimum return on the underlying funds. Because the contract is a security, the producer needs both a life insurance license and a FINRA securities registration (Series 6 or 7), and the buyer must receive a prospectus.

Variable annuities carry layered fees: mortality and expense (M&E) charges, administrative fees, subaccount management fees, and rider charges. Their advantage is inflation protection through equity growth; their drawback is volatility and cost. Accumulation units measure value in the pay-in phase; annuity units (variable in value) measure payments after annuitization.

Fixed Indexed Annuities

A fixed indexed annuity (FIA) is a fixed annuity whose interest is linked to an external index such as the S&P 500. The owner gets upside participation with downside protection: gains are credited when the index rises, but a 0% floor (guaranteed minimum) prevents loss in down years. The insurer limits credited interest through three common mechanisms:

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

Worked example: Index rises 12%. With a 70% participation rate, that is 8.4%; if a 7% cap also applies, the credited rate is the lower 7%. In a year the index falls 5%, the floor credits 0% — the owner loses no principal. FIAs need only an insurance license because they are not securities, though regulators scrutinize their suitability closely.

Indexing Methods and the Order of Operations

FIAs also vary by indexing method — how the index change is measured over the crediting term:

• Annual point-to-point compares the index value at the start and end of each year.
• Monthly averaging averages monthly index values, smoothing volatility.
• High-water mark uses the highest anniversary value reached during the term.

The insurer may reset participation rates, caps, and spreads at each term, so a contract attractive in year one can be less generous later. On exams, apply the limiting factors in the order participation → spread → cap, then compare against the 0% floor; the credited rate is whatever the contract's combination produces, never less than zero and never more than the cap. Because the owner gives up dividends and full upside in exchange for downside protection, FIAs are positioned as a middle ground between fixed and variable contracts.

Matching Type to Client Risk Tolerance

Use the risk spectrum to match a product to a client. A conservative retiree who cannot tolerate any principal loss fits a fixed annuity. A moderate client who wants some market upside but no losses fits a fixed indexed annuity. An aggressive, market-comfortable client seeking inflation-beating growth and willing to accept volatility — and who already holds the required securities suitability profile — fits a variable annuity.

A trap on exams: do not put an inflation-worried client into a level-pay fixed annuity without addressing purchasing-power risk, and do not put a loss-averse client into a variable annuity simply because returns look higher. The license you hold also constrains what you may sell — without a securities registration, you cannot recommend or sell variable annuities at all.