The flexible-premium deferred annuity (FPDA), one of the most popular individual annuity contracts, permits the contract owner to pay premiums at whatever time and in whatever amount he or she wishes, subject to insurer minimums. It provides for the cash value to be applied at some future time designated by the contract owner to supply an income, if elected, for the annuitant. Within the United States, Canada, and many other countries, interest credited on the cash values of personally owned annuities is not taxable to the contract owner as long as it remains on deposit with the insurance company. On liquidation, annuity payments are taxable as ordinary income to the extent that each payment represents previously untaxed income. Obviously, the tax-deferred nature of cash accumulations under such annuities represents a significant privilege that is justified as an instrument for encouraging individuals to provide for their retirement needs. Tax laws impose certain restrictions on annuity withdrawals prior to retirement to ensure that this privilege is not abused.
FPDA contracts permit flexible contributions to be made as and when the owner desires, either monthly, yearly, or, with most companies, as often or as infrequently as the owner desires. There is no set contribution amount or required payment frequency. Although a premium payment is not generally required each year for FPDA contracts, companies usually establish a minimum acceptable payment level (e.g., $25 to $50) if a payment is to be made, and also encourage owners to establish target payment plans. Within the United States, FPDA contracts have effectively supplanted an earlier product known as the retirement annuity contract, which provides for a set schedule of fixed periodic premiums. The product usually is not unbundled, so that its internal functioning is not transparent.
Cash Surrender Values Keen competition for consumer savings among life insurers and between life insurers and other financial institutions continues to result in better value FPDA contracts. The trend is toward FPDA contracts with little or no front-end loads. Rather, most insurers use a back-end load or surrender charge on policy termination, as with some of the cash-value life insurance products discussed earlier. Most contracts permit a free withdrawal corridor, meaning that no surrender charge will be assessed on partial surrenders, such as those of less than 10 percent of the cash value. The surrender charge is usually stated as a percentage of the total accumulation value and commonly decreases with duration. Thus, an insurer may assess a surrender charge of 7 percent on all withdrawals in excess of 10 percent of the fund balance during the first contract year, with this rate decreasing 1 percent per year, thereby grading to zero in the eighth contract year. No surrender charge would be applied thereafter. Surrender charge percentages and durations vary considerably; some first-year charges are as high as 20 percent, but most are within the 5 to 10 percent range. A few policies do not have identifiable back-end or front-end loads.
Interest Rates FPDA contracts typically guarantee a minimum interest rate, which is often within the 3.0 to 4.5 percent range, depending on economic conditions at the time of issuance. Although this rate may seem low, it must be recognized that the guarantee could easily span three, four, or more decades and, therefore, could prove to be exceedingly valuable. For its part, the insurer would be foolish to guarantee high rates of such long durations. In any event, this type of long-term guarantee is only rarely found in other comparable savings media such as those offered by banks, savings associations, or money management accounts.
The actual rate of interest credited to the FPDA cash value will be a function of the earnings rate of the insurer and its desired competitive position within the financial services marketplace. Some insurers utilize a bonus rate approach wherein first-year considerations receive an extra 1 percent or so over the expected renewal interest rate. All rates are subject to revision by the insurer, although most companies guarantee the current rate for at least the first contract year. A few insurers are developing equity-indexed FPDAs whose interest rate varies with some underlying securities index. Also, note should be taken that the majority of variable annuities are technically FPDAs.