6.2 Fixed and Immediate Annuities

Fixed Annuities: Guarantees and Risk

In a fixed annuity, the insurer guarantees a minimum interest rate and assumes all investment risk. Premiums go into the insurer's general account, invested conservatively (investment-grade bonds, mortgages, some real estate). Because the insurer carries the risk, the owner makes no investment decisions and the principal is protected, subject only to the insurer's claims-paying ability.

Two interest rates appear in every fixed contract:

Because the insurer guarantees the rate, a fixed annuity acts as a tax-deferred CD substitute. The key exam trade-off: purchasing-power (inflation) risk. Level fixed income loses real value over a long retirement. A 3% inflation rate cuts a fixed $1,000 monthly payment's buying power to roughly $740 in ten years.

Multi-Year Guarantee Annuities (MYGAs)

A MYGA locks the current rate for a set term - 3, 5, 7, or 10 years - much like a bank CD but with tax deferral. At term end the owner can surrender, renew at the then-current rate, or annuitize. MYGAs usually pay a higher rate than traditional annual-reset fixed annuities.

Interest Crediting Methods

• Portfolio rate: all contracts earn the same blended current rate; simple but new deposits can dilute returns.
• New money rate: the rate is tied to when premium was received, so each deposit reflects its own rate environment.
• Tiered rate: different rates apply by balance band (e.g., first $100,000 at 4%, excess at 4.5%).

Bonus-Rate Trap

Some fixed annuities advertise a first-year bonus rate or premium bonus. These almost always come with a longer surrender period or higher ongoing charges. On the exam, evaluate the whole contract - a 1% bonus that adds three surrender years rarely pays off if the client may need liquidity.

Immediate Annuities (SPIA)

A Single Premium Immediate Annuity (SPIA) is bought with one lump sum, and income begins within one year of purchase (often within 30 days). There is no accumulation phase - the contract goes straight to payout. SPIAs are used to turn a 401(k) rollover, pension lump sum, lottery prize, or structured settlement into guaranteed lifetime income.

Worked Numeric: SPIA Exclusion Ratio

Non-qualified immediate annuity income is split into a tax-free return of cost basis and a taxable earnings portion using the exclusion ratio:

Exclusion ratio = Investment in the contract / Expected total return

Example: A client pays $100,000 for a SPIA paying $700/month for life. IRS life-expectancy tables show an expected return of $200,000 ($700 x 12 x ~23.8 years).

• Exclusion ratio = $100,000 / $200,000 = 50%
• Of each $700 payment, $350 is tax-free return of basis and $350 is taxable earnings.

Trap: Once the annuitant outlives the table and fully recovers basis, 100% of later payments become taxable. Conversely, if the annuitant dies early, the unrecovered basis is deductible on the final return.

Pure Versus Refund Immediate Income Options

A SPIA's payout option controls both income size and what beneficiaries get. The more guarantees you add, the smaller each payment.

The exam reasoning: each guarantee shifts risk back from the insurer to the contract, so the insurer pays less per period. A retiree wanting the maximum check and having no heirs to protect chooses life only.

Why a SPIA Solves Longevity Risk

A SPIA is the purest answer to outliving assets because the insurer - not the retiree - shoulders the chance the annuitant lives to 100. The cost is irreversible loss of liquidity: once issued, the lump sum is gone.

Fixed Annuity Suitability Snapshot

Fixed and immediate fixed annuities fit risk-averse clients near or in retirement who value guaranteed, predictable income over growth. They are a poor fit for young investors with decades to ride out market volatility, or for anyone who may need the principal back on short notice.

Guaranteed vs. Current Rate and the Immediate Annuity

Every fixed annuity quotes a guaranteed minimum interest rate (the floor the insurer must credit) and a higher current rate the insurer pays while experience allows; the current rate may drop but never below the guaranteed floor. An immediate annuity (SPIA) is bought with a single premium and begins income within one payment period (typically within a year), making it the tool to convert a lump sum -- a retirement rollover or an inheritance -- into an immediate guaranteed paycheck.

The General Account and Purchasing Power Risk

Fixed-annuity premiums sit in the insurer's general account, invested conservatively, so the insurer bears investment risk and the owner bears none on principal. The owner's real exposure is purchasing-power (inflation) risk: a level fixed payment loses real value as prices rise, which is why some buyers blend fixed annuities with indexed or variable products or add a cost-of-living feature.

Worked Immediate-Annuity Illustration

A retiree rolls $300,000 into a single-premium immediate annuity electing a straight life income. If the insurer's payout factor is, say, $5.50 per $1,000 per month for her age, her monthly income is 300 x $5.50 = $1,650 for life. Choosing a life-with-period-certain or joint option would lower that figure in exchange for a guarantee to a beneficiary, illustrating the trade-off between payment size and protection.

Market-Value-Adjusted Fixed Annuities

A market value adjusted (MVA) fixed annuity passes some interest-rate risk to the owner: early surrender is adjusted up or down based on rate movements since issue, rewarding the owner with a higher current rate for accepting that adjustment.

Additional Exam Traps

• The current rate can fall but never below the guaranteed minimum.
• A fixed annuity removes investment risk but leaves purchasing-power (inflation) risk.
• An immediate annuity begins income within one period and is funded by a single premium.