6.3 Deferred and Indexed Annuities
Key Takeaways
- Deferred annuities grow tax-deferred and delay income beyond 12 months; SPDAs take a lump sum, FPDAs take periodic premiums.
- Surrender charges decline over a schedule (e.g., 7% to 0% over years); a 10% IRS penalty applies to gains withdrawn before age 59 1/2.
- Fixed indexed annuities link interest to an index but guarantee principal, so they are not securities and need only a life license.
- Participation rate, cap, and spread all reduce the credited return; the floor (usually 0%) is the only feature that prevents loss in a down year.
- Credit indexed interest by applying participation first, then the cap; NAIC suitability rules require a documented fact-find before recommending an annuity.
A deferred annuity delays the payout phase beyond 12 months, allowing the contract value to grow tax-deferred during accumulation. Earnings are not taxed until withdrawn, which lets interest compound on money that would otherwise have gone to taxes.
Single vs. Flexible Premium Deferred
| Type | Funding | Typical buyer |
|---|---|---|
| SPDA (single premium deferred) | One lump sum | Has money now, income later |
| FPDA (flexible premium deferred) | Periodic deposits | Saving gradually for retirement |
Surrender Charges
Deferred annuities impose a declining surrender charge to recover acquisition costs and discourage early lapse. A typical schedule:
| Contract year | Surrender charge |
|---|---|
| 1 | 7% |
| 2 | 6% |
| 3 | 5% |
| ... | declines 1%/yr |
| 8+ | 0% |
Most contracts allow a free withdrawal (often 10% of value per year) without charge. A 10% IRS penalty also applies to gains withdrawn before age 59 1/2.
Equity-Indexed Annuities (EIA / FIA)
A fixed indexed annuity is a fixed annuity whose interest is linked to a market index (commonly the S&P 500), but it is not a security — principal is guaranteed and the producer needs only a life license.
Three Levers That Limit Crediting
| Feature | What it does |
|---|---|
| Participation rate | The % of the index gain credited (e.g., 80%) |
| Cap rate | The maximum interest credited in a period (e.g., 9%) |
| Spread/margin | A % subtracted from the index gain before crediting |
| Floor | The minimum credited — usually 0% (no loss in a down year) |
The guaranteed floor (typically 0%) means a down market credits nothing but never reduces principal — the key selling point.
Worked Example: Indexed Crediting
The S&P 500 rises 12% in the crediting period. The contract has an 80% participation rate and an 8% cap.
- Apply participation: 12% x 0.80 = 9.6%
- Apply the cap: 9.6% is above the 8% cap, so credited interest = 8%
If instead the index fell 12%, the 0% floor applies — the account is credited 0% and loses nothing.
Crediting-Method Trap
Annual reset (ratchet) locks in each year's gain and resets the starting point, so a later downturn cannot erase locked gains. Point-to-point measures only start vs. end of a multi-year term. High-water mark uses the highest anniversary value. Know that the cap, participation rate, and spread all reduce the credited return — only the floor protects it.
Suitability
NAIC suitability rules require the producer to have reasonable grounds that an annuity recommendation fits the consumer's financial situation, needs, and objectives — based on a documented fact-find (age, income, liquidity needs, risk tolerance, time horizon, existing holdings). Replacing one annuity with another that restarts surrender charges without clear benefit can be an unsuitable recommendation and a market-conduct violation.
An indexed annuity has an 80% participation rate and a 7% cap. The linked index gains 10% during the crediting period. The interest credited is:
What protects a fixed indexed annuity owner from loss when the linked index declines in a crediting period?
Indexing Terms and Time Frames
Indexed annuities credit interest over a defined index term (the multi-year measuring window) and a shorter crediting period (often annual). The most tested distinction is how the index change is measured:
| Crediting method | How the index change is measured |
|---|---|
| Annual reset (ratchet) | Each year's gain locked; starting point resets up |
| Point-to-point | Start vs. end of the full term only |
| High-water mark | Highest anniversary value vs. start |
Worked Example: Annual Reset Protects Gains
Year 1 the index rises 10% (credited, subject to cap); year 2 it falls 8%. With annual reset, the year-1 gain is locked and year 2 simply credits the 0% floor — the locked gain is safe. A point-to-point contract measuring only start vs. end would have captured a smaller net change. This is why annual reset is marketed as the most consumer-friendly method even though caps are usually lower to pay for it.
Liquidity and Penalty Recap
- Free withdrawal: typically 10% of value per year without surrender charge
- Surrender charge: declining schedule (e.g., 7% down to 0% over 7-8 years)
- IRS penalty: 10% on gains withdrawn before 59 1/2
- Nursing-home / terminal-illness waiver: many contracts waive surrender charges if the owner is confined or terminally ill
Trap: an indexed annuity is not a security and credits a minimum of 0% — it can never lose principal to market declines, unlike a variable annuity.
Two-Tier and Bonus Annuities (Watch Closely)
Two product designs draw extra scrutiny. A bonus (premium-enhanced) annuity credits an upfront bonus (e.g., 5% of premium) but usually offsets it with lower caps or longer surrender schedules. A two-tier annuity pays a higher accumulation value only if the owner annuitizes for a long period, and a much lower value on surrender — a design many states restrict because consumers do not understand the catch.
Trap: a "bonus" is rarely free. The exam wants you to recognize that the insurer recovers it through reduced participation rates, lower caps, or extended surrender charges.
Suitability Documentation for Indexed Sales
NAIC and most states require an annuity suitability form documenting the consumer's age, income, liquidity needs, time horizon, risk tolerance, and existing holdings before recommending an indexed annuity. A recommendation that replaces an existing annuity, restarting surrender charges, must show a clear net benefit. Producers selling indexed annuities also need product-specific training and the standard state CE; failing to document suitability is a market-conduct violation even if the client is satisfied.