6.3 Deferred and Indexed Annuities
Key Takeaways
- Deferred annuities grow tax-deferred and begin income after one year; SPDA and FPDA differ only in how premium is paid.
- Surrender charges decline over a 6-8 year period; most contracts allow a 10% free withdrawal each year.
- Withdrawals before age 59 1/2 incur a 10% IRS penalty on the taxable portion plus ordinary income tax.
- Fixed indexed annuities credit interest tied to an index but guarantee principal with a floor (usually 0%) - so they are not securities.
- Participation rate, cap, and spread reduce the credited gain: apply participation first, then test against the cap.
Deferred Annuities
A deferred annuity has a true accumulation phase: income begins more than one year after purchase, and the contract value grows tax-deferred until withdrawal. Deferred annuities come in two premium structures:
- SPDA (Single Premium Deferred Annuity) - one lump-sum deposit that grows until a future payout date.
- FPDA (Flexible Premium Deferred Annuity) - the owner contributes varying amounts over time, like a savings plan.
The only difference between SPDA and FPDA is how premium is paid; both defer income and both grow tax-deferred.
Surrender Charges and Free Withdrawals
Because the insurer expects to hold the money, deferred annuities impose surrender charges on early withdrawals. A typical schedule declines each year - for example 7% in year 1, 6% in year 2, down to 0% after 7 years. Most contracts allow a free withdrawal each year (commonly 10% of the value) without surrender charge. Withdrawals before age 59 1/2 also trigger a 10% IRS penalty on the taxable portion, on top of ordinary income tax.
| Provision | Typical Term |
|---|---|
| Surrender period | 6-8 years, declining percentage |
| Free withdrawal | 10% of value per year |
| IRS early-withdrawal penalty | 10% before age 59 1/2 |
| Bailout provision | Lets owner withdraw penalty-free if the current rate drops below a stated bailout rate |
Worked Example - Surrender Charge
An owner holds a $100,000 SPDA in year 2 (6% surrender charge, 10% free-withdrawal allowance) and withdraws $30,000. The first $10,000 is free; the remaining $20,000 is subject to the 6% charge: $20,000 x 0.06 = $1,200 surrender charge. If the owner is under 59 1/2, the taxable earnings inside that $30,000 also face the 10% IRS penalty.
Indexed (Fixed Indexed) Annuities
A fixed indexed annuity (FIA), also called an equity-indexed annuity, credits interest based on the performance of a market index such as the S&P 500, while guaranteeing the principal. It blends features of fixed and variable annuities: upside is tied to the index, but the owner cannot lose principal to market losses. Because the insurer guarantees principal, an FIA is not a security in most states and is sold under a life license.
The Three Limiting Factors
The index's gain is rarely credited in full. Three mechanisms limit the credited interest:
| Term | What It Does |
|---|---|
| Participation rate | Percentage of the index gain credited (e.g., 70% of the gain) |
| Cap rate | Maximum interest credited regardless of index gain (e.g., 10% ceiling) |
| Floor | Minimum credited (usually 0%) - protects against market loss |
| Spread/margin | A percentage subtracted from the index gain before crediting |
Worked Example - Crediting
An FIA has a 70% participation rate and a 10% cap. The S&P 500 gains 12% this term:
- Apply participation: 12% x 70% = 8.4%.
- Compare to the cap: 8.4% is below the 10% cap, so the cap does not bind.
- Credited interest = 8.4%.
Now suppose the index instead falls 15%. The 0% floor applies, so the credited interest is 0% - the owner loses nothing but gains nothing. A common crediting method is annual point-to-point, which compares the index at the start and end of each year and locks in (resets) the gain annually.
Crediting Methods and the Indexed-Annuity Trade-off
The insurer chooses how it measures the index gain, and the method materially affects the credited interest. The exam expects familiarity with the common approaches.
| Crediting Method | How It Works |
|---|---|
| Annual point-to-point | Compares the index value one year apart; gain locked in each year |
| Monthly point-to-point | Sums monthly changes (a single bad month can wipe out the year) |
| High-water mark | Uses the highest index value reached during the term |
| Annual reset (ratchet) | Locks in each year's gain so it cannot be lost later |
Why the Index Itself Is Not Owned
An indexed annuity owner does not buy stocks and does not receive dividends from the index. The index is only a measuring tool for crediting interest; the insurer's general account still backs the guarantee. This is why an FIA, unlike a variable annuity, is generally not a security and needs no securities registration to sell.
Deferred Annuity Death Benefit
If the owner dies during a deferred annuity's accumulation phase, the beneficiary typically receives the greater of premiums paid or the current account value, bypassing surrender charges. This guaranteed death benefit during accumulation is a feature shared with variable annuities.
Worked Example - Free Withdrawal Plus Surrender
Return to a deferred annuity in year 3 with a 5% surrender charge and a 10% free-withdrawal allowance on a $200,000 value. An owner withdrawing $50,000 takes the first $20,000 free, and the remaining $30,000 incurs 5%: $30,000 x 0.05 = $1,500 surrender charge. Under age 59 1/2, the earnings portion also faces the 10% IRS penalty - layering two costs the exam wants you to compute separately.
Deferred Annuity Surrender and Free Withdrawals
A deferred annuity accumulates tax-deferred until the owner annuitizes or withdraws. Early access triggers surrender charges on a declining schedule, and withdrawals before age 59½ add a 10% IRS penalty on the taxable gain. Most contracts permit a penalty-free 10% annual withdrawal and waive surrender charges on death, terminal illness, or nursing-home confinement.
Equity-Indexed (Fixed Indexed) Annuities
An indexed annuity is a fixed annuity whose interest is tied to a market index (commonly the S&P 500) but with a guaranteed minimum floor, so the owner cannot lose principal to market drops. Crediting is limited by several moving parts:
| Mechanism | What It Does | Effect on Credited Interest |
|---|---|---|
| Participation rate | % of index gain credited (e.g., 80%) | Lower rate = less credited |
| Cap rate | Maximum credited (e.g., 9%) | Caps the upside |
| Spread/margin/asset fee | Subtracted from index gain | Reduces credited interest |
| Floor | Minimum (often 0%) | Prevents loss in down years |
Worked Example: With an 80% participation rate, a 9% cap, and a 12% index gain, the indexed interest is the lesser of 80% × 12% = 9.6% or the 9% cap — so 9% is credited. In a year the index falls, the 0% floor protects principal.
Exam Distinction: Because principal is guaranteed, indexed annuities are insurance products sold under a life license, not securities — unlike variable annuities.
A fixed indexed annuity has a 70% participation rate and a 10% cap. The linked index gains 12% for the term. How much interest is credited?
The market index linked to a fixed indexed annuity declines 15% during the crediting period and the contract has a 0% floor. What interest is credited?