6.3 Deferred and Indexed Annuities
Key Takeaways
- Deferred annuities (SPDA/FPDA) grow tax-deferred and guarantee a cash surrender value plus an accumulation-phase death benefit.
- On death during accumulation, the beneficiary receives the death benefit - value is not forfeited to the insurer.
- Fixed-indexed annuities are FIXED annuities tied to an index with a guaranteed floor; they need no securities license.
- Index credits are shaped by participation rate, cap rate, and spread; the cap overrides participation, and the floor prevents negative crediting.
Deferred Annuities
A deferred annuity postpones the payout phase, allowing the contract value to grow tax-deferred during an accumulation period that may last decades. Deferred annuities are funded by a single premium (SPDA) or by flexible periodic premiums (FPDA). They are the dominant retirement-savings annuity.
Every deferred annuity guarantees a cash surrender value and a death benefit during accumulation:
| Feature | What it guarantees |
|---|---|
| Cash value / surrender value | Accumulated premiums plus interest, minus any surrender charge |
| Death benefit (during deferral) | Generally the greater of total premiums paid or current account value, paid to the beneficiary if the owner/annuitant dies before annuitization |
| Bailout provision | Lets the owner surrender without charge if the credited rate falls below a stated trigger |
Exam point: if the annuitant dies during the accumulation phase, the beneficiary receives the death benefit - the contract does not simply forfeit to the insurer the way a life-only payout does.
Nonforfeiture and Withdrawals
State nonforfeiture law guarantees that a deferred-annuity owner can never lose the value of premiums paid (less surrender charges and prior withdrawals). The owner may:
- Surrender the contract for its cash value;
- Take a partial withdrawal (often up to the 10% free amount annually); or
- Annuitize and convert to income.
Remember the tax order on a nonqualified deferred annuity: withdrawals are LIFO - interest (taxable) comes out before basis, and amounts taken before age 59 1/2 incur the 10% penalty on the taxable portion.
Surrender Charges and the Free-Look on Deferred Annuities
Deferred annuities recover acquisition costs through a declining surrender-charge schedule, often running 7-10 years. A typical schedule might charge 7% in year one, declining one point per year to 0%. Most contracts permit a 10% free withdrawal each year without charge.
Worked example: an owner surrenders a $50,000 SPDA in year three when the charge is 5%, after using no free withdrawals. Surrender charge = $50,000 x 5% = $2,500; the owner nets $47,500 (before the LIFO tax and any pre-59 1/2 penalty on the interest portion).
Comparing the Two Index Methods Tested Most
| Method | How it measures the index | Effect |
|---|---|---|
| Annual reset (ratchet) | Year-over-year change, locked each year | Past gains protected from later drops |
| Point-to-point | Start vs. end of the full term | Simpler but exposed to end-date timing |
| High-water mark | Highest anniversary value during the term | Can credit more, often lower cap |
Trap: an FIA is a fixed annuity for licensing - principal is protected and only an insurance license is required - yet its return is not fixed; it varies with the index subject to the cap, participation rate, and spread. Candidates miss questions that pair "guaranteed principal" with "guaranteed return"; only the principal/floor is guaranteed.
Market Value Adjustment and the Free-Look Window
Many deferred annuities carry a Market Value Adjustment (MVA): surrendering early adjusts the cash value up or down based on interest-rate changes since issue. If rates have risen, the MVA reduces the surrender value; if rates have fallen, it can increase it. The MVA applies in addition to the surrender charge during the surrender period.
State law also grants annuity buyers a free-look period (commonly 10-30 days, longer for seniors) to return the contract for a refund.
Worked trap: an MVA shifts interest-rate risk to the owner only when they surrender early; it does not affect a contract held to the end of the surrender period or annuitized. Examiners pair "rates rose after purchase" with "surrender now" to test that the MVA reduces the payout.
| Surrender-period charge | Effect |
|---|---|
| Surrender charge | Fixed declining schedule |
| Market value adjustment | Varies with interest-rate moves |
| Free withdrawal (10%) | No charge up to the allowed amount |
If the owner of a deferred annuity dies during the accumulation phase, what happens to the contract value?
Equity-Indexed / Fixed-Indexed Annuities (FIA)
A fixed-indexed annuity (FIA), historically called an equity-indexed annuity, is a fixed annuity that credits interest tied to the performance of an external index such as the S&P 500 - but it is NOT a security and does not invest in the market. The owner gets some upside participation with downside protection.
Core moving parts:
| Term | Definition |
|---|---|
| Guaranteed minimum rate | A floor (e.g., 1-2%) credited even when the index falls; principal is protected |
| Participation rate | Percentage of the index gain credited (e.g., 80%) |
| Cap rate | Maximum interest creditable in a period (e.g., 6%) |
| Spread/margin/asset fee | A percentage subtracted from the index gain before crediting |
| Indexing method | How the index change is measured: annual reset (ratchet), point-to-point, or high-water mark |
How the Index Credit Is Calculated
Worked example (participation + cap): the S&P 500 rises 10% in a year. The FIA has an 80% participation rate and a 6% cap.
- Apply participation: 10% x 80% = 8%.
- Apply cap: 8% exceeds the 6% cap, so credited interest = 6%.
Worked example (spread): the index rises 9% and the contract has a 3% spread. Credited = 9% - 3% = 6%.
Downside example: the index falls 15%. Because of the guaranteed floor, the credited rate cannot go negative; the owner is credited the guaranteed minimum (e.g., 0-1%) and principal is protected.
Annual reset (ratchet) locks in each year's gain and resets the starting index level, so a market drop in a later year cannot claw back a previously credited gain. Because FIAs are fixed annuities, they require only an insurance license - no securities registration.
An index rises 12%. A fixed-indexed annuity has a 70% participation rate and a 7% cap. How much interest is credited?