6.2 Fixed and Immediate Annuities

The Fixed Annuity

A fixed annuity credits a guaranteed rate of interest and pays a guaranteed, level dollar income. The insurer holds these funds in its general account and bears all investment risk — if its investments underperform the assumed rate, the company must still credit the guarantee. Because the insurer carries the risk, a fixed annuity is an insurance product, and the producer needs only a life insurance license to sell it (no securities registration).

Fixed annuities carry two interest rates. The guaranteed (minimum) rate is the floor stated in the contract — the company can never credit less. The current (excess) rate is what the insurer actually declares, usually higher than the floor, reflecting present portfolio yields. Marketing illustrations often emphasize the current rate, but the only enforceable promise is the guaranteed minimum.

The Level-Benefit Trade-off and Purchasing Power

Because a fixed annuity pays the same dollar amount each period, the annuitant enjoys predictability but bears inflation (purchasing-power) risk. A $1,000 monthly check buys progressively less over a 25-year retirement. This is the classic disadvantage tested on exams: fixed annuities guarantee the number of dollars, not their buying power.

Worked example of purchasing power: at 3% annual inflation, the rule of 72 (72 / 3) tells us prices double in roughly 24 years. So a fixed $1,000 monthly benefit would purchase only about $500 worth of goods (in today's terms) after roughly 24 years. Products that address this — variable annuities or indexed annuities — shift some or all of the investment risk to the annuitant in exchange for inflation-fighting upside.

The Immediate Annuity (SPIA)

A Single-Premium Immediate Annuity (SPIA) is funded by one lump sum and begins income within one payment interval — at the latest within 12 months. There is no accumulation period; the contract goes straight into the payout phase. SPIAs are popular for retirees who want to convert a 401(k) rollover or inheritance into a guaranteed paycheck immediately.

Contrast the two timing types:

Trap: an immediate annuity must be single-premium — you cannot make ongoing deposits to a contract that is already paying you.

Taxation of the Income Stream — the Exclusion Ratio

When a non-qualified annuity is annuitized, each payment is part return of the owner's after-tax cost basis (tax-free) and part interest earnings (taxable as ordinary income). The split is governed by the exclusion ratio:

Exclusion ratio = Investment in the contract (cost basis) / Expected total return

Worked example: An owner pays $100,000 for a SPIA that will pay $700/month for a 20-year-period-certain payout. Expected return = $700 x 12 x 20 = $168,000. Exclusion ratio = 100,000 / 168,000 = 59.5%. Each $700 payment is therefore about $416.65 tax-free (return of principal) and $283.35 taxable (earnings). Once total tax-free amounts equal the cost basis, the exclusion ends and further payments are fully taxable; if the annuitant dies first, the unrecovered basis is deductible on the final return.

Early Distributions and Accumulation-Phase Taxation

Gains inside a non-qualified annuity grow tax-deferred, but distributions are taxed on a LIFO (last-in, first-out) basis — earnings come out first and are fully taxable before any tax-free return of basis. Worse, amounts withdrawn before age 59 1/2 generally incur a 10% federal penalty on the taxable portion, mirroring the qualified-plan early-distribution rule.

Worked example: an owner deposited $50,000 that has grown to $80,000 and withdraws $20,000 at age 55. Because LIFO treats the withdrawal as earnings first, the full $20,000 is taxable as ordinary income (gain remaining is $30,000, more than $20,000), and a 10% penalty of $2,000 applies because the owner is under 59 1/2. Only after all $30,000 of gain is distributed would withdrawals tap tax-free basis.

Annuity Suitability and the Market-Value-Adjusted (MVA) Annuity

State suitability rules require that the producer have reasonable grounds to believe a fixed-annuity recommendation fits the consumer's age, income, liquidity needs, and financial objectives — capturing the surrender period, fees, and tax consequences. NAIC suitability training (often 4 hours plus product-specific training) is commonly required before a producer may solicit annuities.

A market-value-adjusted (MVA) annuity is a fixed deferred annuity whose surrender value is adjusted up or down by an interest-rate formula if the owner surrenders early. If market rates have risen since issue, the MVA reduces the surrender value; if rates have fallen, it increases it. The annuitant shares some interest-rate risk in exchange for a higher guaranteed rate during the term.

Immediate vs. Deferred and the Income-Now Decision

The timing of the first payment defines two categories:

• A Single Premium Immediate Annuity (SPIA) is bought with one lump sum and begins paying within one payment interval (e.g., one month or one year). It is the classic tool to convert a lump sum — a retirement account, an inheritance, or a structured-settlement award — into guaranteed lifetime income starting now.
• A deferred annuity delays the income start, allowing tax-deferred accumulation first.

Guaranteed Floor on Fixed Annuities

A fixed annuity credits a guaranteed minimum interest rate during accumulation (often 1%–3%) and may credit a higher current rate. The insurer bears the investment risk and guarantees both the principal and a minimum return; payments in the income phase are a fixed, level dollar amount. Because purchasing power erodes with inflation, the exam pairs fixed annuities with inflation/purchasing-power risk — the trade-off for their guarantees. Contrast this with variable annuities, where the owner bears investment risk in exchange for inflation-hedging growth potential.