9.2 Fixed, Indexed, and Variable Annuities
Key Takeaways
- Fixed annuities guarantee principal and a minimum interest rate; the insurer bears investment risk and funds them in its general account.
- Variable annuities place premium in separate-account subaccounts; the owner bears investment risk, values fluctuate, and a securities license plus a prospectus are required.
- Indexed (fixed indexed) annuities credit interest tied to an index like the S&P 500, limited by caps, participation rates, and spreads, with a guaranteed floor (often 0%).
- Only variable annuities are securities; fixed and most fixed-indexed annuities are insurance products regulated by the state department of insurance.
- Caps, participation rates, and spreads reduce indexed crediting, so the credited rate is almost always less than the raw index gain.
Three Investment Designs
The biggest classification on the exam is where the premium is invested and who bears the investment risk. Three designs cover the field.
| Type | Where premium sits | Who bears investment risk | Return | Licensing |
|---|---|---|---|---|
| Fixed | Insurer's general account | Insurer | Guaranteed minimum + declared rate | Insurance license only |
| Variable | Separate account (subaccounts) | Owner | Varies with market | Insurance + securities (FINRA) |
| Fixed indexed | Insurer's general account | Insurer (with a floor) | Tied to an index, capped | Insurance license (state) |
Fixed Annuities
A fixed annuity guarantees the principal and credits at least a guaranteed minimum interest rate, often with a higher current (declared) rate the insurer sets. Premium goes into the insurer's general account, so the insurer the not the owner bears investment risk. Because returns are guaranteed and do not float with markets, a fixed annuity is not a security; an ordinary life insurance license is sufficient.
The trade-off is inflation exposure: a level fixed payout loses purchasing power over a long retirement. Fixed annuities suit conservative buyers who prize principal protection over growth.
Variable Annuities
A variable annuity places premium in a separate account divided into subaccounts that resemble mutual funds (equity, bond, money market). The owner bears the investment risk values rise and fall with the markets and there is generally no guarantee of principal during accumulation.
Because the owner is exposed to market risk, a variable annuity is a security. The producer must hold both a life insurance license and a FINRA (Financial Industry Regulatory Authority) securities registration, and the buyer must receive a prospectus. The Securities and Exchange Commission (SEC) regulates the security feature while the state insurance department regulates the insurance feature dual regulation.
Variable annuities carry layered fees: mortality and expense (M&E) charges, administrative fees, subaccount management fees, and rider charges. The exam expects you to know these fees can materially reduce net return.
Fixed Indexed Annuities
A fixed indexed annuity (FIA) credits interest based on the performance of an external index such as the Standard & Poor's 500 (S&P 500), but the owner is not actually invested in the index. Premium stays in the general account, so principal is protected and a guaranteed floor (commonly 0%) prevents loss from a negative index year.
Three levers limit upside:
- Cap rate: the maximum credited rate (e.g., 8%) regardless of how high the index climbs.
- Participation rate: the percentage of the index gain credited (e.g., 70% of a 10% gain = 7%).
- Spread/margin/asset fee: an amount subtracted from the index gain (e.g., 10% gain minus a 2% spread = 8%).
Worked Crediting Examples
Assume the index rises 10% in the crediting period.
| Mechanism | Setting | Credited interest |
|---|---|---|
| Cap | 6% cap | 6% (gain exceeds cap) |
| Participation | 70% participation | 7% (70% of 10%) |
| Spread | 2% spread | 8% (10% minus 2%) |
| Negative index year | floor 0% | 0% (no loss credited) |
Because of caps, participation rates, and spreads, the credited rate is almost always less than the raw index gain. Most FIAs are insurance products, not securities, so a securities license is usually not required (a small number of registered indexed products are exceptions).
A fixed indexed annuity is linked to an index that gained 12% this period. The contract has an 80% participation rate and a 7% cap. What interest is credited?
Which annuity requires the producer to hold a securities registration and to deliver a prospectus to the buyer?
Guarantees, Crediting Methods, and Suitability
Fixed and indexed annuities carry a contractual guaranteed minimum interest rate (often 1% to 3%) and a guaranteed minimum surrender value; a variable annuity has no accumulation-phase guarantee, which is precisely why it is a security.
FIAs differ by crediting method, a frequent exam point:
- Annual point-to-point compares the index at the start and end of each year.
- Monthly averaging averages the index across the year to smooth volatility.
- High-water mark credits based on the highest index value reached during the term.
Worked Comparison: Same 12% Index Gain
| Annuity | Mechanism | Credited |
|---|---|---|
| Fixed | 3% declared rate | 3% (index irrelevant) |
| FIA, 7% cap | point-to-point | 7% (capped) |
| FIA, 80% participation | point-to-point | 9.6% (80% of 12%) |
| Variable | full market exposure | ~12% minus M&E and fund fees |
Suitability: match design to risk tolerance. Conservative clients needing principal protection take fixed or FIA; clients seeking growth and accepting loss take variable. Selling a variable annuity to a risk-averse retiree, or an illiquid FIA to someone needing cash soon, is an unsuitable recommendation.
An indexed annuity has an 80% participation rate and a 7% cap. The linked index rises 12% in the period. What interest is credited?