9.2 Fixed, Indexed, and Variable Annuities
Key Takeaways
- Fixed annuities guarantee principal and a minimum interest rate; the insurer bears investment risk and holds funds in the general account.
- Variable annuities place premiums in separate-account subaccounts; the owner bears investment risk and the value can rise or fall.
- Variable annuities are securities requiring a FINRA registration (Series 6/7) and a state insurance license plus prospectus delivery.
- Indexed annuities credit interest tied to an index (e.g., S&P 500) subject to caps, participation rates, and spreads, with a guaranteed floor (often 0%).
- Match the product to risk tolerance: fixed for safety, variable for growth potential, indexed as a middle ground.
Classifying Annuities by Investment Risk
Annuities are categorized by where the premium is invested and who bears the investment risk. The three product types are fixed, variable, and indexed (also called fixed indexed or equity indexed).
| Type | Where invested | Who bears investment risk | Return |
|---|---|---|---|
| Fixed | Insurer's general account | Insurer | Guaranteed minimum interest |
| Variable | Separate-account subaccounts | Owner | Varies with subaccount performance |
| Indexed | General account (with index link) | Shared | Index-linked with a guaranteed floor |
Exam Tip: "Who bears the risk?" is the fastest way to identify the product. Insurer = fixed; owner = variable; shared with a floor = indexed.
Fixed Annuities
A fixed annuity guarantees both the principal and a minimum rate of interest. Premiums go into the insurer's general account, where the insurer invests conservatively (bonds, mortgages) and bears all investment risk.
Key fixed-annuity guarantees:
- Guaranteed minimum interest rate - a contractual floor (for example, 1% to 3%).
- Current (declared) rate - the higher rate the insurer credits today, which can change but never falls below the guaranteed minimum.
- Guaranteed payout - a fixed dollar amount per period during annuitization.
Inflation Caution
Because payments are fixed, a fixed annuity exposes the annuitant to purchasing-power (inflation) risk: $1,000 per month buys less in 20 years. This is the chief trade-off for safety.
Exam Tip: Fixed annuity = guaranteed principal + guaranteed minimum rate + insurer bears risk + inflation risk to the annuitant.
Variable Annuities
A variable annuity invests premiums in separate-account subaccounts that resemble mutual funds (stock, bond, money-market). The contract value and future income rise or fall with subaccount performance, so the owner bears the investment risk and there is no guarantee of principal (absent an optional living-benefit rider).
Dual Regulation and Licensing
Because the owner bears market risk, a variable annuity is both an insurance product and a security. To sell one, a producer must hold:
- A state insurance license (life), AND
- A FINRA registration (Series 6 or Series 7) with a registered broker-dealer.
The applicant must also receive a prospectus. Variable separate accounts are not part of the insurer's general account and are insulated from the insurer's creditors.
Measurement Units
- Accumulation units measure value during the pay-in phase; their number and value fluctuate.
- Annuity units are fixed in number at annuitization, but the dollar value per unit varies, so income payments fluctuate.
Exam Tip: Variable annuity = securities license + prospectus + separate account + owner bears risk.
How Variable Annuity Units Work
Variable annuities are valued in units, not dollars, and the exam tests the difference between the two unit types.
| Unit type | When used | What fluctuates |
|---|---|---|
| Accumulation unit | Pay-in / accumulation phase | Both the NUMBER of units and their value |
| Annuity unit | Payout / annuitization phase | The NUMBER is fixed; only the dollar VALUE varies |
During accumulation, each premium buys more accumulation units, and the unit value rises and falls with the subaccounts. At annuitization, the insurer converts the accumulated value into a fixed number of annuity units based on the annuitant's age and an Assumed Interest Rate (AIR).
Thereafter the number of annuity units stays constant, but each payment equals that fixed number times the current annuity-unit value. If actual subaccount performance beats the AIR, the next payment rises; if it lags, the payment falls.
Exam Tip: Accumulation units = number changes; annuity units = number is FIXED, value changes. Payments rise only when performance exceeds the AIR.
Indexed (Fixed Indexed) Annuities
A fixed indexed annuity (FIA) credits interest linked to an external index such as the Standard & Poor's 500 (S&P 500), but limits both upside and downside. The principal sits in the general account, so the insurer guarantees a floor (commonly 0%), meaning the owner cannot lose principal to market declines, while sharing some of the upside.
Three levers limit the credited interest:
- Participation rate - the percentage of the index gain credited. An 80% participation rate on a 10% index gain credits 8%.
- Cap rate - a maximum credited rate. With a 6% cap, a 10% index gain credits only 6%.
- Spread / margin / asset fee - a percentage subtracted from the index gain. A 2% spread on a 10% gain credits 8%.
Worked Numeric Example
Index rises 12% this term. Contract terms: 70% participation rate, then a 6% cap.
- Apply participation: 12% x 70% = 8.4%.
- Apply cap: 8.4% exceeds the 6% cap, so 6% is credited.
If the index instead fell 12%, the floor applies and 0% is credited - no loss of principal.
Exam Tip: Caps, participation rates, and spreads all REDUCE the credited interest below the raw index return. The guaranteed floor protects principal.
A producer wants to sell a variable annuity. Which credentials are required?
An indexed annuity has an 80% participation rate and a 5% cap. The linked index returns 9% for the term. How much interest is credited?