Let’s assume that you don’t know what an annuity is, states Chris Sumner, Founder of RS Financial Group. No worries. Most everyone knows what life insurance is, so let’s just start by making a comparison to life insurance.
Life insurance protects against the risk of death, or dying too soon; if the insured person(s) die, the insurance company pays out a sum of money to one or more designated beneficiaries; An annuity is sometimes referred to as “the opposite of life insurance.” Annuities insure against the risk of life, or living too long; the insured person receives a stream of income they cannot outlive from the insurance company.
A contract issued by an insurance company that guarantees a minimum interest rate with a stated rate of excess interest credited, which is determined by the performance of the insurer’s general account. Multi-Year Guaranteed Annuities (MYGAs), a type of Fixed Annuity, guarantee a minimum interest rate for more than a one-year period; this rate is also determined by the performance of the insurer’s general account. A Fixed Annuity is considered a low risk/low return annuity product.
A contract issued by an insurance company that guarantees a minimum interest rate of zero, where crediting of any excess interest is determined by the performance of an external index, such as the Standard and Poor’s 500® index. In addition, Indexed Annuities have a secondary guarantee that is payable in the event of death, surrender, or if the external index does not perform. This secondary guarantee is referred to as a Minimum Guaranteed Surrender Value (MGSV); it credits a rate of interest between 1% and 3% on a percentage of the premiums paid in to the annuity.
A contract issued by an insurance company that has no minimum guaranteed interest rate, where crediting of any excess interest is determined by the performance of underlying investment choices that the annuity purchaser selects. A Variable Annuity is considered a high risk/high return annuity product.
In your evaluation of annuities, it helps to understand
the “300 foot view” of the annuity transaction. The sale
of an annuity has to benefit the three parties to the annuity
1. The annuity purchaser- via fair interest rate crediting/gains
2. The annuity salesperson- via fair compensation
3. The annuity issuer (insurance company)- via a fair profit, i.e. a spread
We refer to this as the “three-legged stool” of the annuity transaction. To fully understand, it also helps to consider how the insurance company makes money by selling annuities. Simplistically, the insurance company invests the annuity purchaser’s premium payment(s) in different investment vehicles, in order to make a return that is high enough to pay administrative costs (such as the salesperson’s compensation), credit interest to the annuity purchaser, and still retain a profit. So, let’s consider an example, using Fixed Annuities as a point-of-reference.
• The Fixed Annuity purchaser submits a payment of $100,000 to the insurance company for her 10- year annuity;
• The insurance company invests the annuity purchaser’s premium payment in bonds (This ensures that they will receive a guaranteed return on the monies, and be able to pay the annuity purchaser a guaranteed interest rate);
• Assume that 10-year bonds are paying a rate of 4.00% to the insurance company;
• The insurance company then credits [4.00% - X] to the annuity purchaser’s 10-year fixed annuity contract [the value of X is determined by knowing what amount the insurer needs to cover their expenses (i.e. salesperson’s compensation) and the amount of profit the insurance company intends to keep].
Now, with Fixed Indexed Annuities, the example above is only modified slightly.