How do Annuities work? What are the stages of Annuities?

Learn how Annuities can supply you with a lifetime income stream you can never outlive in Washington D.C.

Stages of Annuities

Learn what type of Annuity works best for your unique situation

Stages of Annuities and what is important about them.

Accumulation Phase – Fixed Indexed Annuities 

The majority of annuities purchased in the United States are Fixed Indexed Annuities, which begin in the accumulation phase upon deposit of funds, or savings period. During this time, a Fixed Indexed Annuity owner makes one deposit or multiple deposits (to maximize annuity bonuses) to increase the value of their assets for use in creating an income stream for uses in retirement.

If you make withdrawals during this time that exceed contract guidelines, usually more than 10% per year, you may be charged high surrender fees, income tax and a 10% federal penalty tax if you are under age 59½. There are also other contract options like nursing home waiver, or disability waivers that allow more than the stated contract withdrawal amount features.

It’s also worth noting that fixed indexed annuity owners seldom follow through with the whole contract term.  Instead, they seem to treat their contracts like a normal savings account but with an insurance company and take withdrawals as needed or to withdrawal as a lump sum for use elsewhere.

Annuitization Phase – Immediate Annuities

During the annuitization phase, the contract value is transferred to the insurance company in exchange for a stream of payments. These payments last either for life or a set number of years with certain contract choices such as life, period certain, life with cash refund, life with installment refund.

There are three paths to annuitization: the first is by buying an immediate annuity, which begins in the annuitization phase and begins payments usually a month after the contract is accepted. The second is by converting your fixed indexed annuity into an immediate annuity to begin collecting regular payments under the contract guidelines. The third is to trigger an income rider that will start income payments based on your age, account value, distribution choices and in what contract year the option was triggered. There are different income rider options so please make sure you understand the benefits and costs.

How do I start an Annuity?

Meet with a Broker and ask every single question you can think of. You can call him Jack.

In each state, there are suitability rules that you the annuitant have to comply with. Most annuity purchasers already know about annuities or they are exchanging their contracts utilizing a 1035 exchange provision set forth by the IRS. The most important thing to think about before starting an annuity is the ratings of the insurance company you are looking into. An annuity offered by a B+ company might have a little more attractiveness than an A++ so look at all of your options.

First you need to determine if the contract is going to be qualified or non-qualified. Qualified means that the deposit to start the contract comes from pre-tax contributions or for example a rollover of a IRA or 401(k). The IRS governs which plans are qualified. Non-qualified means the initial deposit is with after tax cash that could be in the bank, a CD, or inside your mattress.

Most companies require a minimum deposit for Qualified at 2k and Non-qualified of 10k. Again there are suitability requirements that have to be met to even be eligible to open a contract.

Choosing an Annuity

Take your time. Read, read and then read some more. Ask a ton of questions and make sure your understand the differences from different carriers and each of their products. That is where we can help to highlight which is optimum for your situation.

If you are over 40, most companies offer income riders that offer lifetime income provisions so look at the cost or charges for these riders.

Once suitability has been met, you can apply for a contract. The company will issue the contract, then you have a free look period to examine the fine detail of the actual annuity contract to match up benefits and features disclosed in the brochure.

Make the best choice for you, not your broker.

Fixed or CD Types of Annuities

Fixed Annuities or CD Type Annuities are like the name implies. Interest is fixed and determined by the length of the contract. These types of annuities are also used in laddering strategies similar to that of short term CD’s. Contract terms can be as little as 1 yr. up to 10 years so its ok to be safe and break the deposit up and start a laddering strategy.

Fixed Indexed Types of Annuities

Fixed Indexed Annuities are also as the name implies. There are two accounts or baskets inside the same account. This is commonly referred to as the basket methodology. Once your funds are deposited with an insurance company they can be allocated by you to either a Fixed Account or Index Account. Most companies will automatically place extra deposits during the contract year into the fixed account until your contract anniversary where you have a choice to change asset allocation. The Index Account has exposure to the upside of any and all indexes you allocate with your initial contract selection.

Some index accounts are based  either on floor and cap rates, or participation rates. The insurance company will offer a guaranteed minimum interest rates on index accounts and also offer a cap rate. If an index has performance of 7% and your cap rate is 6%, then you will receive 6%. If the index has 0% gain then some contracts will guarantee 1% or even 2% as a floor rate.

Some carriers have an option for those of you who like to short or have so much doubt that you think the index will have a 0% gain or negative downturn. If so there is an option called the Inverse Performance Trigger. What is states is that if an index does zero gain or negative, then the contract will guarantee 2,3, or even 4% gains for the funds allocated in that part of the index account.

Most if not all Fixed Indexed Annuities have optional riders called Income riders or GWLB riders and other names they came up with. These riders create another basket, an income basket that is credited with the performance of both your index and fixed account and a rider percentage. These rider baskets have no real value except for future income. Some contracst will take the value of the greater or the two accounts and base your income from that. Most likely your rider account could and always will be higher than your actual fixed-index accounts. Income rider options are set at contract and guarantee a rollup or crediting of interest each year in amounts of 5%, 6.25, or even 6.5% each year. Each have costs associated with them so make sure you ask Jack about that.

Immediate Annuities

Immediate Annuities are also as the name implies. Immediate means now or really soon in my book. Immediate Annuities are used mainly to create an income stream after a lump sum deposit with an insurance company. In exchange for the lump sum, the insurance company will guarantee income for life or for a fixed period, of your the rest of your life and the rest of your spouses life.

Once the funds are deposited the income stream usually starts within 30 days of contract acceptance. Pay close attention to the meanings of the payout options in the contract because life only will only pay for one life, then the insurance company will keep the rest. We do not advise that option unless you are really mean and do not want anything left over to go to your heirs.

Qualified Annuities

The term Qualified denotes the definition by the IRS as in qualified plans. These qualified plans are plans like an IRA, SEP IRA, ROTH IRA, or 401(k). These plans are funded by pre-tax dollars so distributions are taxed as regular income. The most common form of annuity purchase in an IRA Rollover to an IRA Annuity or a 401(k) Rollover to a 401(k) Annuity. Rollovers are a simple process but you first need to understand the annuity product and its crediting methods, and income rider options if any.

Most carriers set funding limits to qualified plans as in contributions to an IRA, or 401(k). You would only need 2k to start an IRA Annuity, or a 401(k) Annuity qualified account. Some carriers set higher limits but the average is stated above.

Non Qualified Annuities

Non-qualified annuities are annuity contracts started with cash and do not comply with the IRS definition of qualified. These accounts are started with after tax dollars and contributions are limitless up to 1 million set by most carriers. These accounts need a average of 10k to start an account and issue ages are on average 0-80 years old. When is the last time you heard that “Grandpa bought me an non qualified college saving plan annuity”?

Well I had to put in a little humor but these accounts are used for that and many other things. The important thing to remember that when you take distributions from these non qualified annuities, it is done on a LIFO basis. LIFO is last in first out. That means that the last money that was put in is the first distribution out. You could have a period of tax free income until you deplete the initial deposit and start working that down until you receive the interest earned.

Surrender Charges

Surrender charges for annuities are my favorite subject. Well almost. When you open an account with an insurance company, they will take that deposit and purchase bonds that pay interest. The interest from the bonds is what is invested in the indexes and you will be credited a rate between the floor rate and cap rate. The initial investment is never at risk. Insurance companies that offer annuities have surrender charges that are incurred by you if you cancel the contract or withdrawal more than the 10% per year after the first year.

Surrender charge terms are in a way like penalties incurred when you cancel a CD at a bank, or cash in a savings bond before its maturity.They vary depending on the contract term and I personally think this is the main source of negative feedback about annuities. Some people make quick decisions about everything they do in life, while some people think things through. Some people no matter what will always blame the other person when things don’t go the way they imagined or what they thought. Some people will always want something for nothing and think in their own minds they can cancel anything in life without penalties. When penalties are accessed, they take it personally and seek legal recourse. Annuities are not for everyone and every situation which is the exact reason that suitability training and suitability requirements must be met before contract issue.

Take the time to examine the brochure, contract and ask about surrender charges so you are informed about your actions or inaction to keep what you signed up for.

Crediting Methods of Annuities

Crediting Methods Volatility

Introduction to the Different Types of Annuity Crediting Methods

  1. Fixed Account / Annual Reset
  2. Annual Point-to-Point with a Cap
  3. Point-to-Point
  4. Monthly Sum
  5. Monthly Average with a Spread
  6. High Water Mark.

Fixed Account / Annual Reset

The Annual Reset (also called Ratcheting) method compares the index at the beginning and ending of the contract year, adding interest to the annuity value each year. This method has the advantage of “locking in” an early gain. The annual “reset” prevents losses if the index declines in a future year.

Annual Point-to-Point with a Cap

Each year, the Annual Point-to-Point with a Cap method calculates the value of the annuity by comparing the beginning value with the ending value at the end of the contract term. The cap limits the payout to a pre-determined amount. This method offers moderate volatility with moderate rewards.


The Point-to-Point method determines the value of the index by measuring the value at the beginning and the ending of the contract term. Interest is added at the end of the contract. This method tends to smooth out volatility.

Monthly Sum

The Monthly Sum method identifies the percentage growth for each month, then adds those totals together to reach the annual total. If the index is high-growth, then this method offers better opportunities for higher interest returns.

Monthly Average with a Spread

The Monthly Average with a Spread method calculates the change in the index value at the end of the month; then, it adds all of the months together and divides by twelve. After that, the beginning index value is subtracted from the average index value; the difference is divided by the beginning index value, then the spread is subtracted. This method is better when there is dramatic volatility and sharp declines because it averages the index value for the month.

High Water Mark

With the High Water Mark method, the interest is calculated by comparing the difference between the beginning and highest value at pre-set reference points during the year; the interest is added at the end of the contract term. This method has advantages when the zenith is reached in the early-to-middle portion of the term contract and declines later.

Participation Rates, Spreads, Caps and Floors Defined

Insurance companies are experts in risk management; thus, they may include limiting features to control how much interest will be paid.

The following are important limitations on annuity crediting methods:

  • Participation Rate: Percentage allocation of profits between annuity holder and insurance company (100% means annuity holder makes all the profits)
  • Spread: Management fee
  • Caps: Upper limit on profits

How do “Participation Rates” and “Caps” Impact Crediting?

The “Participation Rate” is a percentage that allocates profits between the annuity holder and insurance company. The “Cap” is also a percentage that sets the maximum limit for interest accrued on an annuity; it is usually used for crediting methods that have higher returns. Investors should consider how much money they are making when the annuity increases in value compared to how much money the insurance company is making.

Guaranteed Minimum Contract Value

The minimum guaranteed surrender value regardless of the performance of the market
index. Companies will typically guarantee a percentage of the initial premium (for
example, 87.5% of the initial premium) at between 1.5% – 3% annual interest rate with
no surrender charge. The Guaranteed Minimum Surrender Value is the greater of that
value or the account value minus surrender charges. This is what makes a Fixed Indexed
Annuity an insurance contract and not an investment security.

Can I ever lose money?

No. Contract values are locked-in at annual reset and protected by both the interest crediting strategy and the Minimum Guaranteed Value. Guarantees are dependent on the claims-paying abilities of the issuing insurance company. Insurance company ratings are really important factor in choosing an annuity. The only “RISK” if any, to a clients principal and accumulated interest is withdrawal charges you would incur if you cancelled the contract.

When canceling an annuity contract you will incur surrender charges, that go down over time. You will most likely have a market value adjustment and or tax penalties if you withdraw more than the allowed 10% per year. If it is a qualified annuity, you would also incur income tax on the amount withdrawn, the same for IRA’s and other qualified accounts.

These are all stated in the Annuity brochures and policies when issued. Surrender Charges, Market Value Adjustments, and tax penalties are the only way to lose money with annuities. If this happens you are the cause and not the insurance company.

Stages of Annuities