6.2 Fixed and Immediate Annuities

Fixed Annuities: Guarantees and Risk

A fixed annuity credits a guaranteed minimum rate of interest and pays a fixed, predictable income. Premiums go into the insurer's general account, where they back the guarantees, so the insurer bears the investment risk. Because there is no securities exposure, a fixed annuity is an insurance product requiring only a state life insurance license, not a securities registration.

Fixed annuities credit two rates:

The trade-off the exam emphasizes: fixed annuities give safety and predictability but expose the owner to purchasing-power (inflation) risk, because a level payment buys less over time.

The Naming Grid: Timing x Funding

Annuity product names combine when payout begins with how premium is paid.

Exam trap: an immediate annuity can only be a single-premium product. You cannot pay flexible premiums into a contract that has already started paying you. There is no such thing as a "flexible premium immediate annuity."

Immediate vs. Deferred and the General-Account Guarantee

The pay-in/payout timing defines two categories. A Single Premium Immediate Annuity (SPIA) is funded with one lump sum and begins income payments within about one payment period (typically within 12 months). A deferred annuity delays income, allowing tax-deferred accumulation first.

Fixed annuities are backed by the insurer's general account, which is why the insurer - not the owner - bears the investment risk and can guarantee both a minimum interest rate and the income amount.

Worked Immediate-Annuity Use Case

A 70-year-old with a $250,000 rollover wants guaranteed lifetime income now. A SPIA converts the lump sum into a fixed monthly check the owner cannot outlive. Trap: SPIA payments are irrevocable once annuitized - there is no cash value to surrender, so liquidity is gone. This is why suitability rules stress that an annuitant retain enough liquid assets outside the annuity for emergencies before committing to immediate annuitization.

Immediate Annuities and Payout (Settlement) Options

A SPIA annuitizes immediately. The chosen payout option controls how long payments last and whether anything passes to a beneficiary. There is an inverse relationship: the stronger the guarantee to survivors, the smaller each payment.

Worked comparison: for a 65-year-old male with $200,000, life only might pay roughly $1,250/month while joint-and-survivor with his spouse might pay roughly $1,050/month - the difference is the cost of insuring two lives.

Taxation of Annuities

Growth inside any annuity is tax-deferred; no tax is due until money comes out. Payments are taxed under the exclusion ratio, which separates the tax-free return of your own cost basis from the taxable interest.

Exclusion ratio = Investment in the contract / Expected total return

Worked example: an owner pays $100,000 for a SPIA expected to return $200,000 over life expectancy. Exclusion ratio = 100,000 / 200,000 = 50%. Of each $1,000 payment, $500 is tax-free return of basis and $500 is taxable interest. Once the entire $100,000 basis has been recovered, all subsequent payments become fully taxable.

Key tax traps:

• Nonqualified annuity gains come out first (LIFO) on withdrawals, so the first dollars withdrawn are fully taxable interest.
• A 10% IRS penalty applies to taxable amounts withdrawn before age 59 1/2 (with exceptions).
• A Section 1035 exchange lets an owner swap one annuity for another (or life-to-annuity) tax-free; you cannot 1035 an annuity into a life insurance policy.