6.2 Fixed and Immediate Annuities

Fixed annuities: guarantees and who bears the risk

In a fixed annuity the insurer guarantees two things: the principal (it cannot lose value) and a minimum guaranteed interest rate. Premiums are held in the insurer's general account, and the insurer bears the investment risk. Because the income is a fixed, level dollar amount, the annuitant bears the purchasing-power risk — inflation can erode the real value of a level payment over a long retirement.

Fixed annuities credit interest in two layers:

• Guaranteed (minimum) rate — the floor stated in the contract; the insurer can never credit less.
• Current (excess) rate — a higher rate the insurer declares based on its actual earnings. It may be reset periodically (often annually) but never below the guaranteed floor.

Because fixed annuities credit a fixed rate and do not involve securities, they are regulated as insurance products and require only an insurance license — not a securities (FINRA) registration.

Immediate annuities (SPIA)

A Single Premium Immediate Annuity (SPIA) is bought with one lump sum and begins paying income within one payment period — practically, within 12 months of purchase. There is no meaningful accumulation phase: the contract goes almost straight to payout. SPIAs are common when someone retires with a lump sum (a 401(k) rollover, an inheritance, a structured-settlement award) and wants guaranteed income immediately.

Contrast with a deferred annuity, which accumulates first and annuitizes later. The simple test: when does income start?

Payout (settlement) options — ranked by income

The payout option decides how long and to whom income is paid. The more the option guarantees, the smaller each payment.

Traps to watch

• Pure life is the right answer when the prompt says "maximum lifetime income" and the annuitant has no dependents. Its risk: death after one payment forfeits the rest.
• Fixed period and fixed amount are not life-contingent — they can run out or stop while the annuitant is still alive.

Taxation of payments: the exclusion ratio

During payout, each annuity payment is part return of the annuitant's cost basis (tax-free) and part earnings (taxable as ordinary income). The split is set by the exclusion ratio:

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

The resulting percentage of each payment is excluded from income (tax-free); the remainder is taxable.

Worked example

Marta paid $100,000 into a nonqualified annuity (her basis). She annuitizes at a guaranteed $1,000/month for life, and her life expectancy gives an expected return of $200,000.

• Exclusion ratio = $100,000 ÷ $200,000 = 50%.
• Of each $1,000 payment, $500 is tax-free return of basis and $500 is taxable earnings.

The basis-recovery rule

Once Marta has recovered her entire $100,000 basis (after 200 payments here), the exclusion ratio no longer applies — all later payments are 100% taxable. Conversely, if she dies before recovering her basis, the unrecovered amount is allowed as a deduction on her final return. The exclusion ratio thus stops the day basis is fully recovered, not at any fixed date.

Fixed vs. Immediate: Distinguishing the Axes

A frequent source of confusion is that fixed, variable, immediate, and deferred describe two different axes, not four mutually exclusive products. One axis is how the value grows: a fixed annuity credits a guaranteed minimum interest rate from the insurer's general account, shielding the owner from market loss, while a variable annuity invests in separate-account subaccounts where the owner bears the risk. The other axis is when income starts: an immediate annuity (a SPIA, always single-premium) begins payments within about a year of purchase, while a deferred annuity delays the payout for years.

A single contract therefore has a value on each axis, such as a single-premium immediate fixed annuity or a flexible-premium deferred variable annuity.

The immediate fixed annuity is the classic longevity-protection tool. Work a payout example: a 70-year-old deposits $200,000 in a SPIA and, based on her life expectancy and the insurer's payout rate, receives roughly $1,250 per month for life. The exclusion ratio splits each payment into a tax-free return of her $200,000 basis and a taxable interest portion until the basis is fully recovered, after which the entire payment becomes taxable. A younger annuitant buying the same $200,000 SPIA receives a smaller monthly check because the insurer expects to pay over more years.

Recognizing that fixed protects principal while immediate controls timing lets you parse compound product names that the exam uses as distractors.