6.2 Fixed and Immediate Annuities

Fixed Annuities

A fixed annuity credits a guaranteed minimum interest rate and pays a fixed, level dollar income. Premiums go into the insurer's general account, which is invested conservatively in bonds and mortgages. Because the insurer bears the investment risk and guarantees principal, fixed annuities require only a life license - no securities registration.

Fixed annuities credit two rates:

• Guaranteed rate - a contractual floor (e.g., 1-3%) the insurer can never pay below.
• Current rate - a higher declared rate the insurer credits based on its actual portfolio earnings; it can change but never drops under the guaranteed floor.

The trade-off: the fixed annuity owner is protected from market loss but exposed to purchasing-power (inflation) risk - a level check buys less over a 25-year retirement. That risk is the standard exam answer for the main disadvantage of a fixed annuity.

Immediate Annuities (SPIA)

A single premium immediate annuity (SPIA) converts a lump sum into income that starts within one payment period - by definition no later than one year after purchase. There is essentially no accumulation phase; the contract is purchased to annuitize.

Contrast with a deferred annuity, where payments begin more than one year out (often decades). A retiree with a $250,000 401(k) rollover who wants checks starting next month buys a SPIA; a 40-year-old saving for retirement buys a deferred annuity.

Worked Example - Payout Math

Suppose a SPIA pays a 65-year-old male $5.80 per $1,000 of premium monthly under a straight life option. On a $200,000 premium:

• $200,000 / 1,000 = 200 units
• 200 x $5.80 = $1,160 per month for life

If instead he chose a 10-year period certain, the rate might drop to $4.90/$1,000 (the insurer guarantees at least 120 payments), yielding 200 x $4.90 = $980/month. The lower number reflects the cost of guaranteeing payments to a beneficiary if he dies early.

Payout (Settlement) Options

The income amount depends on the option chosen, ranked from highest income to lowest:

Straight life pays the most because the insurer reserves nothing for survivors. Under life with 10-year certain, if the annuitant dies in year 3, the beneficiary collects the remaining 7 years. Under a refund annuity, the beneficiary receives any premium not yet paid back. Joint and survivor (common for couples) pays the smallest check because two lives must be covered, often continuing at 100%, 66 2/3%, or 50% to the survivor.

Classifying Every Annuity

Name any annuity by combining how it is funded with when it pays. The two dimensions are independent, which produces the standard product set:

The lower-left cell is empty because you cannot pay flexibly into a contract that has already begun paying out - immediate annuities must be single-premium. A second classification layer is the underlying account: fixed (general account, guaranteed), indexed (general account, index-linked), or variable (separate account, owner bears risk).

Exam tip: When a question names "current vs. guaranteed rate," the answer is a fixed annuity. When it mentions "separate account" or "subaccounts," it is variable. When it mentions a "cap" or "participation rate," it is indexed.

Guaranteed Rate Periods and the Inflation Problem

Fixed annuities often quote a multi-year guaranteed rate (MYGA) - for example a 5% rate locked for five years, after which the insurer declares a new current rate (subject to the contractual floor). Buyers compare MYGAs the way they compare bank CDs, but unlike a CD an annuity adds tax deferral and an optional income guarantee.

The enduring weakness of any fixed payout remains purchasing-power risk. A level $1,160 monthly check that feels comfortable at 65 buys far less at 85 after two decades of inflation. The exam answers to this problem are:

• Choosing a cost-of-living-adjusted (COLA) payout option, which starts lower but rises each year.
• Laddering several annuities purchased over time at different rates.
• Using an indexed or variable annuity for some growth potential (covered in 6.3 and 6.4).

Understanding this trade-off - guaranteed safety versus eroding buying power - is exactly what suitability questions about fixed annuities are testing.

Annuitization vs. Systematic Withdrawals

A SPIA forces annuitization - the irrevocable conversion of the lump sum into income. But owners of a deferred fixed annuity have a choice at the end of accumulation:

• Annuitize: elect a settlement option (straight life, period certain, joint and survivor) and receive guaranteed payments, accepting that the decision cannot be reversed.
• Systematic withdrawals: keep ownership and draw money periodically, retaining control and the ability to leave a balance to heirs, but giving up the lifetime-income guarantee and the mortality credit.

Exam tip: Only annuitization invokes the exclusion ratio (covered in 6.4) that makes part of each payment a tax-free return of basis. Plain withdrawals from a non-qualified deferred annuity are taxed LIFO - all gain first - until the basis is reached.

Comparing the immediate options

A tax-free Section 1035 exchange can move a clunky old fixed annuity into a better SPIA without triggering tax, but watch for fresh surrender charges that could make the swap unsuitable.