Mechanics of an Annuity

A more in-depth look at how FIA’s Cash/Income Value accounts function during the Accumulation and Income phases.

In this article, we take a closer look at how Fixed Index Annuity (FIA) accounts operate. Most products have two account types: Cash Value (CV) and Income Value (IV). The CV is the account balance available to the user at any point in time. The IV is an internal accounting system used for determining benefits such as the starting income, death benefit, etc. The CV and IV accounts track a market index during the Accumulation Phase, and pay out an income during the Income Phase. The investment grows tax-deferred during the Accumulation Phase.

The CV earns credit from the index strategy. The index credit is the rate after applying a cap, spread or a participation rate on the underlying index, multiplied by the CV. The fees are taken out of the CV balance. The rider fee for providing lifetime income (typically 0-1%) is calculated off of the IV balance. The surrender charge is typically 8% in the first year and reduces by one point each year thereafter. However, free withdrawals up to 10% of CV per annum are usually permitted with no fees.

The IV (sometimes referred to as the Benefit Base) earns the same index credits as CV, plus other enhancements, which keeps its balance generally well above the CV balance. These enhancements could include a premium bonus, index credit bonus, roll-ups and step-ups. Premium bonus is a one-time bonus of 3-20% of the premium paid. Index credit bonus is index credit enhanced by 50% or 75%. Roll-up is a fixed percentage, typically 5-10% simple or compound interest, applied to IV. In rare occasions, the CV balance could exceed the IV balance. Steps up are credits given to IV to level the balance with CV. These enhancements typically apply during the first 8-10 years of the policy life, though some competitive products do keep them active even during the income phase. Below is an example that shows how various credits are calculated for CV/IV accounts.

Annuitization is the act of starting income. The started income is the payout rate multiplied by IV balance. Subsequent income is not affected by CV/IV balances.  The income stream can never decrease in value, but competitive products will adjust the income upward with a positive market return, acting as a good inflation-hedge. Once income is started, CV cannot be taken out as a lumpsum. Income taken reduces CV/IV balance, which is still essential for providing living or death benefits.

The payout rate (typically 4-5% at age 65) increases with age as does the length of deferral period for some products. For Joint Life policies, the payout rate is ≈0.5% smaller compared to that of the Single Life, and is also based on the age of the younger spouse. A deferred FIA that offers premium and index credit bonus to IV is illustrated in our blog “How An Annuity Works.”

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