6.3 Deferred and Indexed Annuities

The Deferred Annuity

A deferred annuity postpones income to a future date, allowing the contract value to grow during an accumulation period. Deferred annuities accept either a single premium (SPDA) or flexible periodic premiums (FPDA), making them a popular tax-deferred savings vehicle. Earnings accumulate tax-deferred — no annual tax on interest — and are taxed only when withdrawn or annuitized.

A deferred annuity owner has two distinct exit doors. They may annuitize (convert to a guaranteed income stream) or simply surrender / withdraw cash. Most deferred contracts let the owner take a free withdrawal (often up to 10% of value per year) but impose a surrender charge on amounts above that during the early contract years. A typical surrender schedule declines annually — for example 7% in year 1, 6% in year 2, and so on to 0% after seven years.

Nonforfeiture, Death Benefit, and Bailout

Deferred annuities include a nonforfeiture value: even if the owner stops paying, the contract retains a guaranteed cash value (generally at least the premiums paid plus minimum interest, less surrender charges and withdrawals). If the annuitant dies during the accumulation period, the contract pays a death benefit — usually the greater of the account value or total premiums paid — to the beneficiary, bypassing surrender charges.

Some contracts add a bailout provision: if the insurer's declared current rate drops below a stated bailout rate (e.g., more than 1% under the rate at issue), the owner may surrender without any surrender charge. This protects buyers who were attracted by a high teaser rate that the company later cuts.

The Equity-Indexed (Fixed-Indexed) Annuity

An equity-indexed annuity (EIA / FIA) is a fixed annuity (general account, life license — generally no securities registration) whose interest is linked to a market index such as the S&P 500. It offers more upside than a plain fixed annuity while keeping a guaranteed floor, so the annuitant takes on some market exposure but never loses principal to a market drop. Key crediting mechanics tested on the exam:

• Participation rate: the percentage of the index gain credited. An 80% participation rate on a 10% index gain credits 8%.
• Cap rate: a ceiling on credited interest. A 6% cap limits credit to 6% even if the index rose 12%.
• Spread/margin/asset fee: a percentage subtracted from the index gain before crediting.
• Floor / guaranteed minimum: typically 0%, so a falling index credits zero rather than a loss; many states require a minimum value based on ~87.5% of premium at 1-3% interest.

Worked Crediting Example and Indexing Methods

Suppose the index rises 10% in a contract year. With an 80% participation rate and a 7% cap: 10% x 0.80 = 8%, but the cap reduces it to 7%. If a 2% spread applied instead of a cap: 10% - 2% = 8% credited. If the index fell 10%, the 0% floor means 0% credited — principal is preserved.

Indexing (crediting) methods determine how the index change is measured:

Trap: an indexed annuity is still a fixed annuity for licensing — the floor protects principal — so it does not require a variable/securities license in most jurisdictions, unlike a variable annuity.

Single vs. Flexible Premium Deferred Annuities in Practice

A SPDA is funded once and is common for rolling over a lump sum (a maturing CD, a pension cash-out) into tax-deferred growth. A FPDA accepts varying deposits and suits a worker saving for retirement over time; the insurer sets a small minimum deposit but no maximum on a non-qualified contract.

Both share the same tax treatment: interest compounds untaxed during accumulation, and the owner controls the annuitization date (subject to a contractual maximum maturity age). A useful comparison for the exam: a deferred annuity resembles a non-deductible IRA in its tax-deferred growth and 59 1/2 penalty rule, but it has no annual contribution cap and no required minimum distributions until annuitization (for non-qualified contracts), giving it more flexibility than a qualified plan.

Why Indexed Annuities Are Not Variable Annuities

New producers frequently confuse indexed and variable annuities, and the exam exploits this. The decisive difference is where principal risk lands:

Because an indexed annuity guarantees the principal and credits a non-negative return, it remains a fixed insurance product. A variable annuity places funds in market subaccounts with no floor, making it a security.