Prior to the late ‘70s annuities were primarily used as a retirement income vehicle. If you look at some of the magazines for this and previous decades you’ll find ads - usually with a picture of a silver hair gentleman in a fishing boat, telling you how he retired on $200 or $300 a month by contributing so many dollars a month to an annuity plan. Alternatively, instead of paying in a few dollars each month you could pay the cost of the retirement annuity with one check. The 1978 edition of “Personal Finance” stated that “individuals such as entertainers, prize fighters, and others receiving large lump-sum income frequently are the purchasers of single-premium annuities”.

A quarter century ago the emphasis changed and annuities began to be marketed as retirement accumulation vehicles rather than retirement income vehicles. Single premium (without the hyphen) deferred annuities were sold as long term savings instruments. These annuities offered guarantees of principal, guarantees of interest and tax-deferral. Sure, you could also annuitize the accumulated value down the road and turn these into a traditional annuity, but the emphasis was on building assets.

Although single premium fixed annuities began to be used for building long term savings, variable annuities initially stayed in the background. Variable annuities have been around for over thirty years, but they spent the first half of their life as a niche vehicle in the tax sheltered annuity arena. These annuities were also sold as retirement income vehicles with the difference being that the annuity owner would bear the investment risk of income based on stock prices rather than a guaranteed sum. A decade and a half ago, variable annuities came into their own as an investment vehicle with tax deferral.

The current generation of index annuities were introduced early in 1995. Since the financial tools to create index annuities had been around for several years why were they introduced then? One big reason is that the psychology of the times was right. 1994 had been a rocky year - bond fund returns were poor, the S&P 500 ended the year on a down note, and many stock funds and variable annuities had marginal or negative returns. In addition, the 8% and 9% rates consumers had realized on traditional fixed annuities in the previous decade appeared to be over. Interest rates were on a long downward slope, from a historic point of view, and insurers were looking for an annuity that could continue to deliver respectable returns.

Immediate (Income) Annuities       Top   
Immediate annuities are designed to produce a stream of income usually beginning almost as soon as they are purchased. Although all deferred annuities may become immediate annuities, no immediate annuity may become a deferred annuity. Immediate annuity payments are usually fixed and unchanging, but payments may be variable or have both fixed and variable elements. Variable immediate annuities have a fixed number of income units with the value of those units fluctuating because it is based on the value of the underlying investments. The income you receive from a variable immediate annuity will go up and down. An index immediate annuity would have a guaranteed payment with additional amounts dependent upon the performance of an external index.

Deferred Annuities        Top   

Fixed annuities provide a minimum guaranteed return. If the insurance company believes they can earn excess interest in their general account beyond this minimum guarantee, after paying expenses, the annuity owner receives a declared rate of interest. An index annuity is a fixed annuity. The major difference between a traditional fixed annuity and a fixed index annuity is in the crediting of excess interest above the minimum guarantee.

Index annuities are underwritten by insurance companies. They are a fixed annuity that provide a minimum guaranteed return with excess interest crediting based on the movement of an external index. Index annuities share the same features as other fixed annuities:

Tax Deferral        Top   
The interest earned inside an index annuity grows on a tax-deferred basis. However, tax-deferred doesn’t mean tax-free. Interest withdrawn from the annuity is subject to income taxes in the year it is received and upon death of the annuity owner all interest earnings are taxable. In addition, interest withdrawn from an annuity before age 59 1/2 is subject to an additional IRS penalty, unless the distribution meets certain exceptions. Taxes or penalties do not apply on the original principal.

Surrender Penalties        Top   
All index annuities charge a surrender penalty if the policy is cashed in prior to the end of the surrender period. Depending on the policy selected, the surrender period varies in length from one to sixteen years; the penalty does not usually apply if the policy is cashed in due to death of the owner. 

Index-Linked Interest        Top   
Index annuities enable an individual to participate in the upside potential of an equity index linked return, yet the principal and credited interest earnings can never decrease due to market declines. If the index grows a portion of this growth is credited to the annuity. The percentage of index growth credited depends upon the actual movements of the index and the crediting formula used by the insurance company.

Minimum Guarantees        Top       
The original principal and credited interest are not subject to market risk. Even if the index declines the individual would receive no less than their original principal back if they decided to cash in the policy at the end of the surrender period. Unlike a security, index annuities guarantee the original principal and your principal is backed by, and is as safe as, the insurance company that issued it.  

Specs        Top       
Most index annuities require a minimum premium of $5,000 for nonqualified and $2,000 for qualified funds. Some annuities are flexible and will accept initial and additional premiums as low as $50. The maximum age at which you can purchase an index annuity ranges from 75 to 90, depending on the policy. 

Indexes        Top       
Most index annuities base the crediting of excess interest on movements of the S&P 500. The S&P 500 Index includes a representative sample of 500 common stocks from companies trading on the New York Stock Exchange, American Stock Exchange and NASDAQ National Market System. The objective of the index is to be a benchmark for U.S. stock market performance and represents over 70% of the domestic equity market capitalization. Index annuities also base crediting on movements of the Dow Jones Industrial Average, NASDAQ 100, Russell 2000, S&P 400 MidCap, and bond and international indices.

Unlike an equity index mutual fund neither dividends nor capital gains are included in the index annuity calculation. No index-linked product is sponsored, endorsed, sold or promoted by the index itself. Only insurance companies may underwrite index annuities.

Every index annuity guarantees that at the end of the surrender period the original premium will still be there, even if the index steadily declines. Most index annuities credit a minimum interest rate of 1 to 3% a year, however this is usually credited on less than the full premium so the actual minimum interest earned is less. If the minimum rate is calculated on less than the full premium this allows the insurance company to channel more of premium dollar to providing the potential for more excess interest.

The same licensing required for the agent to sell traditional fixed annuities is used with indexed annuities. Index annuities are currently regulated as insurance products and not as securities.

Summary        Top       
Annuities began as retirement income vehicles, but the emphasis changed to using annuities as retirement accumulation instruments due to their tax-deferral benefit and other features. Index annuities are a type of fixed annuity offering the same minimum guarantees and protection against market loss of principal associated with traditional fixed annuities, but with the potential for higher excess interest linked to the performance of an external index. 

All information is for illustrative and educational purposes only,  does not provide investment or tax advice, and is not an inducement to buy or sell anything.  Information is from sources believed accurate but is not warranted. Advantage Compendium neither markets nor endorses any financial product.