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									Understanding Annuities
Understanding Annuities

Various Types of Annuities
After completing this chapter, you will be able to:
1.   Describe the most common types of annuities and explain how they are
2.   Distinguish how annuities are categorized by:
        •   Investment options
        •   Timing of annuity payments
        •   Timing of premium payments
3.   Compare the advantages and disadvantages of fixed, variable, and equity-
     indexed annuities.
4.   Identify the most common usage associated with each particular type of
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Understanding Annuities | Various Types of Annuities

Types of Annuities
Annuities come in many different shapes and sizes.
The primary types of annuities can be classified by the
following three criteria:
       1.   The method of premium payment
                    (single or flexible)
       2.   How the annuity funds are invested
            (fixed, equity-indexed or variable)
       3.   When the annuity payments begin
                 (immediate or deferred)
To make matters even more complicated, a single
annuity can combine a number of these different
For example, one annuity can be a single premium -
fixed - immediate annuity. Another might be a flexible
premium - variable - deferred annuity. Let‟s start with
the types related to premium payment.
Understanding Annuities | Various Types of Annuities

Single Premium Annuity
A single premium annuity is what its name implies: an
annuity that is purchased with only one premium. This
lone premium is usually fairly large. From the
standpoint of investment options, a single premium
annuity might be a fixed annuity, an equity-indexed
annuity, or a variable annuity. From the standpoint of
payout timing, a single premium annuity might be
immediate or deferred.
Flexible Premium Annuities
The flexible premium annuity allows premium payments
to be made at varying intervals and in varying amounts.
This type of annuity is a useful tool for accumulating a
sum of money at intervals and in amounts that cannot
be predicted in advance. As with a single premium
annuity, a flexible premium annuity can be a fixed,
equity-indexed or variable annuity.
Understanding Annuities | Various Types of Annuities

Fixed Annuities
Let‟s move on and discuss these investment-related
In the realm of annuities, the term “fixed” refers to the
interest rate paid by the issuing insurance company on
the funds in the annuity. When an individual purchases
a fixed annuity, he or she knows what the current and
guaranteed interest rates are. Barring the insolvency of
the insurance company, he or she knows that these
rates of interest will be credited to the funds in his or
her annuity.
Fixed annuities offer security, because the rate of return
is certain. They also offer security since the annuity
holder is not responsible for making any decisions
about where or in what amount the funds in his or her
annuity are invested.
Understanding Annuities | Various Types of Annuities

Another aspect of the fixed annuity that is “fixed” is the
amount of the benefit that will be paid out when the
contract is annuitized. The downside of the “fixed”
aspect is that, over time, such an approach may fall
behind the cumulative effect of inflation.
Understanding Annuities | Various Types of Annuities

Equity-Indexed Annuities
An equity-indexed annuity credits earnings based on
the movement in an equity index -- yet guarantees a
certain minimum return. In other words, an equity-
indexed annuity allows the annuity holder to participate
in stock market gains without risking severe losses
when the market declines. In a financial environment
where interest rates on fixed annuities are relatively
low, this ability to share in stock market gains while
limiting potential loss clearly appeals to prospective
annuity buyers.
The U.S. Securities and Exchange Commission
recently voted to regulate certain indexed annuities as
securities for contracts sold after January 12, 2011.
This would mean that agents who sell indexed annuities
will be subject to federal securities laws concerning
reporting rules, suitability rules, and securities license
rules. Some insurers have filed suit to block the rule.
Understanding Annuities | Various Types of Annuities

One of the disadvantages of the equity-indexed annuity
is that because of its link to the equity index, it is
considerably more complex than the “plain vanilla” fixed
annuity. Also, different life insurance companies
calculate the rate payable on their equity-indexed
annuities in diverse ways.
Understanding Annuities | Various Types of Annuities

Variable Annuities
With a variable annuity, the annuity holder receives
varying rates of interest on the funds placed inside the
annuity. Depending upon the investment options
chosen at the time of annuitization, the holder might
receive benefit payments that vary in amount from
month to month or from year to year.
In addition, the holder of a variable annuity assumes
the risk associated with investment decisions that may
not turn out as well as the investor hopes.
Understanding Annuities | Various Types of Annuities

One major difference between the fixed and variable
annuities is that a variable annuity is considered a
“security” under federal law, and is therefore subject to
a greater degree of regulation. Anyone selling a
variable annuity must have the required securities
Any potential buyer of a variable annuity must be
provided a prospectus--which is a detailed document
providing information on the variable annuity and the
investment options available. With any sale of a
variable annuity, the person making the sale must
ascertain that the variable annuity is a suitable choice
for the individual purchaser.
The assumption of risk by the holder of the annuity is a
key element of the variable annuity; it is the product‟s
most distinguishing characteristic.
Understanding Annuities | Various Types of Annuities

Let‟s compare the assumption of risk with a typical fixed
annuity versus a variable one.
First, consider the risk assumed by Mr. Garcia, who has
just purchased a fixed annuity. The insurance company
has promised to credit the funds in Mr. Garcia‟s annuity
with a current interest rate of 6.5% for the next contract
year. After that, the funds will be credited with the new
current rate declared by the insurance company -
unless the current rate is less than the guaranteed rate
of 4.5%.
In any event, Mr. Garcia will receive at least the
guaranteed rate on his funds; regardless of how well or
how poorly the insurance company‟s investments
perform. It is the insurance company, which assumes
the risk that investment returns may be less than
Understanding Annuities | Various Types of Annuities

In contrast, with a variable annuity, it is the annuity
holder who assumes this risk. To illustrate, assume that
Mr. Mason is concerned that the return on his annuity
premium dollars not be outpaced by the inflation rate
over a period of time.
To combat this possibility, Mr. Mason decides to
purchase a variable annuity, which offers investment
choices of a guaranteed account, a stock fund
emphasizing growth potential, a stock fund
emphasizing income potential, a money market fund,
and a bond fund.
Understanding Annuities | Various Types of Annuities

With the inflation factor in mind, Mr. Mason allocated
75% of his premiums to the stock fund emphasizing
growth potential and the remaining 25% to the variable
annuity‟s guaranteed fund. On the funds in the
guaranteed account, which functions similarly to a fixed
annuity, Mr. Mason will receive the current interest rate
of 6.5%.
On the funds in the stock fund, however, Mr. Mason has
no guarantee from the insurance company or any other
party that he will receive a certain rate of return. In fact,
he has no guarantee that he will not lose part of the
premium dollars that he has allocated to the variable
investment account.
Understanding Annuities | Various Types of Annuities

Investment Options – The Variable Accounts
Typically, a variable annuity offers an annuity holder
subaccount options in which to invest all or a portion of
the annuity premiums. Typically, a variable annuity
offers between seven and ten variable such accounts.
These variable accounts are sometimes known as
flexible accounts or flexible subaccounts.
When an annuity holder purchases a variable annuity,
he or she determines which portion of his or her
premium payments, usually on a percentage basis, will
be allocated to the different variable accounts. Once
this percentage is determined, it remains in effect until
the annuity holder notifies the insurance company that
he or she wishes to alter his or her allocation
Understanding Annuities | Various Types of Annuities

In addition, most variable annuities allow an annuity
holder to transfer funds between accounts, subject to
certain dollar amount and timing limitations. Many
variable annuities offer an option called “dollar cost
averaging,” which provides a method for
systematically transferring sums inside the variable
annuity from one fund to another.
A typical variable annuity might offer the following
investment options:
     •   Money market fund
     •   Government securities fund
     •   Bond fund
     •   Total return (or balanced) fund
     •   Growth (or Common Stock) fund
     •   Growth with income (Stock) fund
     •   Guaranteed Account
Understanding Annuities | Various Types of Annuities

Investment Options – The Guaranteed Account
Remember that most variable annuity contracts offer as
an investment option a guaranteed account, or a fixed
account. This type of account receives a fixed or
guaranteed rate of interest.
For example, if Mr. Reese places $5,000 in the
guaranteed account of his variable annuity when the
current interest rate is 7%, Mr. Reese knows that he will
be paid 7% on the funds in this account for the current
interest rate period.
Understanding Annuities | Various Types of Annuities

Transfers Among Investment Accounts
As mentioned earlier, a variable annuity will allow the
annuity holder to transfer funds from one investment
account to another. This flexibility to reposition
investments offers the variable annuity holder the
opportunity to change his or her investment focus in
response to changes in the market generally.
It also allows an annuity holder to change the level of
risk that he or she is willing to accept as his or her
tolerance or desire for risk increases or decreases.
Understanding Annuities | Various Types of Annuities

Variable Annuity Death Benefit
Most nonqualified annuity contracts, including variable
annuities, provide that if the annuitant dies before the
contract has starting paying out benefits, the
beneficiary named in the annuity contract will be paid a
death benefit.
This offers the annuity holder a guarantee that he or
she will not lose all of the funds he or she has paid into
the annuity if he or she should die before he or she
begins to receive annuity benefit payments.
Understanding Annuities | Various Types of Annuities

Immediate Annuities
An immediate annuity is one, which begins paying
benefits very quickly, usually within one year of the time
it is purchased. By its nature, an immediate annuity is
almost always purchased with a single premium.
The immediate annuity can be useful for an individual
who has received a large sum of money or must count
on these funds to pay expenses over a period of time.
Examples might include someone who has received
substantial life insurance proceeds, or a
businessperson receiving a large payment from a long-
term project.
Understanding Annuities | Various Types of Annuities

Deferred Annuities
A deferred annuity is one under which the annuity
holder defers or delays the receipt of the benefit
payouts until a later date. Most deferred annuity
contracts provide considerable flexibility in the timing of
premium payments and benefit payouts.
The accumulation phase – the “putting in” phase when
premiums are being paid into the annuity – may last
only a few years or it may continue for many years.
Likewise, the annuitization phase – the “taking out”
phase when benefits are paid out – might last only a
few years, or could last for decades.
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