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Fixed Annuity Basics by The Annuity Reporter

In this report we’ll explore the inner-workings of index annuities in simple terms. Generally speaking, advisors who consider index annuities complicated have just been too lazy to do research and develop a fact-based understanding of the product. I know because that used to be me. Fixed index annuities are not complicated, especially when compared to many of the futures, derivatives and options contracts available to investors. It should be easy for you to gain a firm knowledge of index annuities and apply that to individual products when you decide to buy one. Let’s get started… How Do Index Annuities Work? Fixed index annuities are nothing more than fixed annuities with a different method of crediting interest. With a fixed annuity, the contract owner receives a stated rate of interest each year. With an index annuity, the stated rate is calculated based on growth in an outside market index. If the index goes up, the contract makes money but if the index goes down, the principle is protected and the contract does not lose value. Index annuities give consumers partial participation in the equity markets in exchange for principle guarantees. Annuity owners will not lose money no matter how bad the market performs. It is a place for safe money. Now that’s all well and good in theoretical terms but how can insurance companies make that work? It’s easy and we’ll start with the structure of a fixed annuity. When you purchase a fixed annuity, the insurance company essentially invests in bonds. Whatever return the bond portfolio generates, less company operating expenses equals the interest credit rate available for the annuity contract. The insurance company has all this calculated ahead of time and makes the fixed interest rate offer accordingly. As an example,

let’s assume an insurance company can make 6% return on investment and that annual operating expenses are 2%. This is fairly accurate and representative of today’s market. In this case, a fixed annuity will be credited with 4% interest. It works the same way with an index annuity and you have two basic options. The insurance company invests the principal in the same type of bonds, but uses the interest earned from the bonds differently, and gives you options. You can elect to take the base interest rate (which is roughly equivalent to what a fixed annuity would pay) or you can opt for the possibility of more growth. If you want greater potential interest the company will instead use the interest earned from the bond portfolio to purchase an option in a market index. An option is simply the right but not the obligation to purchase securities at a future date for a contractually stated price. If the market goes up, the company will exercise the option and credit interest to the annuity contract based on the gain. If the market moves sideways or down, the option expires worthless and no interest is available for crediting. The money the underlying bond portfolio earned was spent on the option, and thus the account earns nothing, but still, your principal is safe and nothing is lost. Most people will notice that index annuity contracts don’t offer the entire market return or dividends for crediting and feel that the insurance company is taking too much of the profit from the deal. That sentiment is inaccurate but needs to be explored nonetheless. In part, limited upside is the price you pay for downside protection. Of course there are other reasons that we’ll cover next. For all intents and purposes, the fixed interest credit available(earned by the invested underlying bond portfolio) is not enough to cover the full cost of

the market option. So if the insurance company doesn’t have enough money to purchase 100% of the option then 100% of the gain is not available when the account is credited. Nobody gets the money, not you and not the insurance company. Let’s go back to our example of 6% investment income for the insurance company and the 2% operating expenses that results in a 4% interest credit. With an annuity premium of $100,000 that would make $4000 available to purchase the market option. If $4000 isn’t enough to purchase 100% of the market option, then 100% of option’s value is not available for crediting to the account. There are three different ‘pricing controls’ an insurance company can place on a contract that are specifically meant to apply an interest credit that’s in line with the net gain from the option. The three pricing controls are the participation rate, cap rate and spread. Participation Rate- One way of limiting the account credit is to specify the percentage of index growth available for credit to the account. Cap Rate- Another option is to have a stated maximum level of interest available for account crediting. Spread- This is a fee imposed on the index credit that represents overall operating expenses for the insurance company. Every annuity will apply one or more of these pricing controls and are subject to change according to contractually stated terms. The company needs to be flexible to take into account changes in interest rates and market volatility, which affects options pricing. Crediting Methods Every index annuity comes with one or more crediting methods which is

nothing more than a means to calculate the amount of interest to be applied to the account value. Total interest credit is subject to any one or more of the pricing controls previously mentioned, as defined by the contract. There are several crediting methods available, depending on the contract but I’ll focus on the most common three. Annual Point to Point- The beginning and ending index value are used to calculate the total gain or loss. For example, if the S&P 500 starts the year at 1000 and ends at 1100, the interest credit would be 10%, subject to the participation rate, cap rate or spread. If the annual return is 0% or less, no interest will be credited. While the option contract that gives you participation in the market expired ‘out of the money’ the underlying principal value, guaranteed by contract, cannot lose value. Monthly Average- Each monthly anniversary, the level of the index is recorded. Those levels are added up at year’s end and the total is divided by twelve and compared to the index level at the beginning of the year. The difference represents the gain or loss for the year, subject to the participation rate, cap rate or spread. If the annual return is 0% or less, no interest will be credited. Again, while the option contract that gives you participation in the market expired ‘out of the money’ the underlying principal value, guaranteed by contract, cannot lose value.

Monthly Sum- The gain or loss in the index every month is recorded. Each value is totaled to calculate the annual gain or loss, subject to the participation rate, cap rate or spread. If the annual return is 0% or less, no interest will be credited. Again, while the option contract that gives

you participation in the market expired ‘out of the money’ the underlying principal value, guaranteed by contract, cannot lose value. Extensive studies have been done in an attempt to determine which crediting method is most profitable. No single method has shown total superiority as each works well in different market conditions. Choice of crediting method will depend on your view of where the market is going and since no one really knows, the prudent strategy is to divide the investment between various methods. Income Riders Some index annuities, like their variable annuity counterparts come with the option for a guaranteed lifetime income rider. This optional feature, commonly called a guaranteed lifetime withdrawal benefit or GLWB, gives the added benefit of a future lifetime income guarantee regardless of account performance. Because of the rising popularity and relevance of guaranteed income riders, Annuity Straight Talk offers The GLWB Report that describes how this contract option works in greater detail for both index and variable annuities. Since the subject at hand is index annuities, I’ll cover the basics here and point you to the GLWB Report for a deeper analysis. A comparison of variable and index annuities with income guarantees is also available on the site. First of all, you need to understand the difference between the income benefit value and account value. The income benefit value is the basis for calculating lifetime income payments and is guaranteed to increase each year. The account value is simply the initial investment as it grows according to the contract provisions previously discussed.

At the end of the surrender term, you can take either income or a lump sum payment and walk away. The income payment will be based on the greater of the income benefit value or the account value. The account value, however, is the amount of money you would receive if you chose to cancel the contract and take a lump sum of cash. How about a little example? Let’s assume a 50 year old guy named Darwon purchases an index annuity with a guaranteed income rider for $100,000 and plans to either take income or surrender the contract at age 60. The contract states that the income rider will grant annual 7% increases to the income benefit value and the account value will grow according to market performance and subject to the participation rate, cap rate and/or spread. After ten years, the income benefit value is guaranteed to be roughly $200,000. The account value, on the other hand, rolled along with the ups and downs of the market and managed to return a shade over 4% to accumulate a total sum of $150,000. Now Darwon has a choice to make. He can either take lifetime income payments from the income benefit value ($200,000) or surrender the contract and take the account value in one lump sum ($150,000). To keep it simple, we’ll assume a 5% payout rate. So to break it down further, Darwon will receive annual lifetime income of $10,000 or one single lump sum of $150,000. That’s how a lifetime income rider works with an index annuity. It’s exactly the same as a variable annuity. That means you have another choice to make between index and variable. I am not going to get into that here since it is covered extensively in the GLWB Report which I consider essential reading for anyone choosing whether to include an income rider on any annuity purchase.

Final Thoughts Index annuities shouldn’t scare anyone, regardless of what the financial press wants you to believe. Throughout the site I will continually attempt to document the negative press directed toward index products and any research available that will combat the bias from an analytical angle. Recently the Wharton School released a white paper that studied actual returns of index annuities since they hit the market in 1995. This report gives a fair comparison between index annuities and various market indexes. The results show that although the annuities were never meant to compete with actual market returns they have performed favorably in most years. The real benefit that makes index annuities competitive is the ability for the account value to flat-line when the market experiences a downturn. The reduced volatility makes them more competitive in the long run. In fact, there is a strong argument for index annuities being positioned as the perfect safe money investment vehicle during a highly volatile economic climate. The report is excellent because it’s useful to cast aside polarizing opinions and get down to the concrete facts. If you are looking for more information please browse and contact me with any questions. The Wharton report can be found here and is also a great factual resource for independent market analysis from someone who does not sell or endorse any annuity contract or company.

Fixed Annuity Basics