Investment Configuration
MR. WATSON: I'm sure you remember when we were talking about both cash value life insurance and annuities we discussed the different investment configurations that the cash could be invested in.. With annuities the cash can be invested in the following types of investments.
- fixed
- indexed and
- variable
STUDENTS: Right.
MR. WATSON: Let's do a quick rundown.
Fixed Annuities
- investments and risk borne by the insurance company
- money held in the general account
- insurance company guarantees everything: interest rate, payout, principal
- may pay a higher interest rate than what is guaranteed but never lower
- inflation risk
Indexed Annuities
- considered a type of fixed annuity (doesn't require a securities license)
- guarantees a minimum interest rate (maybe zero, which this alone would guarantee the principal)
- invested in an "indexed" (average) fund like the S&P 500 (average of 500 stocks)
- meant for accumulation only
- will stay in this configuration for five to seven years
MR. WATSON: With the indexed annuity, the company will pay the greater of the S&P 500 or the minimum guaranteed interest rate, so some people say it's like having the best of both worlds. But, the insurance company will not pay the full amount earned by the indexed fund to which it is tied. They keep a little for expenses and profits. I'll tell you how they do this.
- Participation rate: the participation rate may be 90%. If the S&P 500 rose by 10%, the account would be credited with 90% of the 10% or, 9%. The participation rate is different with each company.
- Cap Rate: simply a cap on the amount the account is allowed to earn. If the cap rate was 7% and the index fund rose by 10% the company credits your account the 7% and keeps the extra 3%.
- Floor rate: mentioned earlier. A guaranteed minimum.
Variable Annuities
- investments and risk borne by the contract holder (policy holder chooses the investments)
- money held in the separate account
- earnings tied to market
- dually regulated (state and SEC)
- designed to offset inflation risk