For the right client, a single premium deferred indexed annuity (SPDIA) can provide a valuable retirement income product that allows the client to both protect his or her principal investment and participate in market upturns. However, as with many other financial products, choosing the right SPDIA cannot be accomplished by using a one-size-fits-all approach (see State Crackdown on Annuities Sharpens Suitability Issues for Advisors).
Differences in the available interest crediting methods and limitations, premature withdrawal rules and associated guarantees can make all the difference in ensuring that the client ends up with the product best suited for accomplishing his or her goals—and it is the responsibility of the advisor to explain the ins and outs of these often complicated choices and potential repercussions, based on the client’s individual circumstances.
SPDIAs and Interest Crediting
Like other indexed annuity products, a SPDIA is an annuity where investment performance is tied to a major stock or bond index (or indexes)—however, the entire investment in the contract is paid up front, rather than in installments over time. Unlike directly investing in the equity markets, the SPDIA itself offers principal protection in exchange for limitations on the potential for investment gains.
When purchasing a SPDIA, the client is able to choose his or her interest crediting method, which essentially determines the way interest is credited to the SPDIA account value. Many products use the traditional annual point-to-point interest crediting method, which is popular because of its simplicity” the beginning index value is compared to the ending index value on the SPDIA contract’s (annual) anniversary date, and the percentage of change is calculated. If the ending value is higher, the client generally receives interest, and if it is lower, no interest will be credited.
Most SPDIAs that use annual point-to-point crediting also include a cap or a spread to limit investment gains. A cap will “cap” the client’s credited interest at the cap amount (i.e., if the index gained 10% and the cap is 6%. Then 6% will be credited, but if the gain was 1%, the client would receive the 1% credit because it is less than the cap amount).
A spread is subtracted from the value of the gain—so if the index gained 10% and the spread was 5%, the account would be credited with 5% interest. If the index gained only 1%, no interest would be credited because the spread is greater than the gain.
While annual point-to-point is a traditional interest crediting method, many products have evolved to modify this method.
For example, some newer SPDIAs offer seven-year point-to-point crediting, where interest is only credited to the account after the entire seven-year period has elapsed. While this may seem riskier to clients, products using the seven-year method often do not contain spreads and caps that can limit the client’s participation in market gains—potentially allowing a client with a greater risk tolerance to participate more fully in market gains.
Depending upon the product, the client may be permitted to change interest crediting methods from year to year. Some products even allow the client to change the index or indexes to which the product is tied—while the S&P 500 is fairly standard, other products tie investment performance to indexes such as the Hang Seng, Euro Stoxx 50 or J.P. Morgan U.S. Sector Rotator 5 Index (among others).
Because the client is generally investing a larger lump sum in a SPDIA, whether he or she can access the funds through withdrawals after the initial investment is made (and before annuitization) can be an important consideration. Some modern SPDIAs allow penalty-free withdrawals of a certain portion of the contract as soon as the second contract year (for example, some SPDIAs allow up to 10% of the account value to be withdrawn without penalty each year, but any unused portion of the annual 10% value can be rolled over up to a maximum of 50% of the account value).
Other SPDIAs allow penalty-free withdrawals only upon occurrence of a specific event, such as being diagnosed with a terminal disease or being admitted to a nursing home.
Other Features and Guarantees
Many SPDIAs offer some form of performance guarantee that is either built into the standard product itself, or can be attached to the product as a rider. For example, a SPDIA that credits interest only after seven years may guarantee that the annuity value will reach a minimum level (such as 107 % of the original investment) by the end of the seven-year term.
Other products add a bonus amount to the single premium amount invested at the time of investment (such as 4% of the amount invested).
Some products will calculate the minimum amount that can be withdrawn once the accumulation phase of the product has ended (and allow that amount to either be withdrawn, or rolled over and added to the amount that may be withdrawn in the following year).
Once a client has determined that he or she is interested in SPDIAs, it is important that the various product features be clearly explained to ensure the client purchases the product that is best designed to accomplish that client’s financial goals—whether withdrawal options or the type of index itself are most important, it is likely that a product designed to suit the client can be found.
See these addtional blog posts by Professors Bloink and Byrnes:
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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