Fixed-rate annuities are similar to universal life policies in that amounts credited to cash values are based on the insurer’s current declared rate, subject to a minimum guarantee of 3 to 4.5 percent (varying by annuity contract and insurance company). Insurers may guarantee rates paid on new money (current contributions) for one to five years (or occasionally as long as ten years).
The currently declared rate depends on the performance of the insurer’s general investment portfolio or general account, which is largely invested in fixed income investments such as bonds and mortgages. Although interest credits to the annuity depend on market rates on these types of fixed income investments, the cash value itself is not market valued. Similar to a savings account, once the insurer credits interest, the cash value will not decline if the market value of the underlying assets in the insurer’s general account declines. (However, some insurers levy a market adjustment to the annuity contract value based upon interest rate changes in the event of early surrender). The insurer bears the market risk.
Variable annuities are similar to variable insurance policies. The annuity owner may choose to invest contributions and cash values in a broad spectrum of investment options or separate accounts, which are similar to mutual funds (although the investor is limited to the selection of investment choices that are offered within the annuity contract).
The investment options usually include diversified stock, bond, and money market funds and frequently include specialized stock funds, foreign stock and bond funds, real estate equity and mortgage funds, and even asset allocation funds (a type of balanced fund where the insurer’s investment manager allocates investments among the other funds). In contrast with fixed-rate annuities, cash values depend on the market value of the underlying assets in the selected separate accounts.
Variable annuity owners bear the market risk of investment and forego minimum interest rate guarantees (although some limited guarantees may be available, subject to additional costs and substantial restrictions). However, they have the flexibility to choose their investment portfolio and the potential to earn far greater total returns than they would earn on fixed-rate annuities.
Equity-Index Annuities (EIAs) are a hybrid of fixed and variable annuities. The returns on EIAs are linked to an equity index, such as the S&P 500 index. However, the annuity is not actually invested in the stocks making up the index. Rather, like with fixed annuities, the insurer pays the returns to EIAs from its general account.
However, the insurer bases the amount allocated to the EIA on some percentage, for example, 85 percent, of the appreciation in the reference index (often subject to annual caps and/or interest spreads). If the index declines in value, the insurer credits the EIA with a minimum guaranteed amount (which may be 0 percent, but is generally never negative). In this way, EIAs attempt to provide investors with some of the upside potential of the equity markets with the downside protection of more conservative general-account investments.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM