The minimum guaranteed value in a fixed annuity: what the floor protects

Every fixed annuity contract contains a number that almost nobody looks at: the minimum value the insurer must pay you if you leave, no matter how little interest it has chosen to credit. State nonforfeiture laws require that number to exist, and the contract spells out how it is calculated. It is a floor under your money, set low on purpose, and in ordinary circumstances it is far below what your statement shows. Understanding what it is, and what it is not, helps you read the guarantees in a contract without mistaking a legal minimum for an expected outcome.

This post explains the mechanism. It uses invented numbers, because the point is how the parts fit together. The actual percentages and formulas in a contract come from the contract itself and from the state where it was issued.

What a nonforfeiture law does

A deferred annuity takes your money now and promises value later, and there are costs in the early years: commissions, expenses and the setup of the contract. Without a rule, an insurer could take the premium, charge steep fees on early exit and leave a policyholder who surrendered in year two with almost nothing. Nonforfeiture laws prevent that. They require that a contract owner who stops paying or who surrenders is left with at least some minimum value, that is, a value that cannot be "forfeited."

The same word appears in life insurance, where nonforfeiture options: reduced paid-up and extended term such as reduced paid-up insurance and extended term insurance are what a policyholder can choose when a permanent policy lapses. For annuities, the principle is the same and the mechanics differ: the law sets a floor on the amount you can take.

Insurance is regulated by the states. The National Association of Insurance Commissioners writes a model law for individual deferred annuities, which has no force by itself, and each state enacts its own version on its own schedule. For that reason the details can vary, and the contract is the final word. The model's central idea is a minimum nonforfeiture amount, described below.

Three numbers in every contract

A fixed annuity has three values that people sometimes confuse.

1. The accumulated (account) value. Your premium, plus the interest the insurer has credited, less any withdrawals and charges. This is the number most statements lead with.
2. The surrender value. What you would receive if you closed the contract today: the accumulated value less any surrender charge, and adjusted up or down by a market value adjustment if the contract has one. See annuity surrender charges and free withdrawals for how the schedule works. The related life insurance term is cash surrender value.
3. The minimum guaranteed value. The floor required by the nonforfeiture law, as it is written into the contract.

On surrender, the contract pays the greater of the surrender value and the minimum guaranteed value. In ordinary years the first number is higher, and the second never comes into play. The floor matters only if the first falls below it, which can happen when the insurer has credited very little and surrender charges are steep.

How the minimum is calculated

The calculation in the NAIC model has two ingredients.

• A percentage of what you paid. The model law and many contracts use 87.5 percent of the premiums paid (some contracts use a higher percentage). This is the "gross considerations" the law refers to. The idea is that the insurer may keep up to 12.5 percent to cover its up-front costs, but no more.
• A minimum interest rate. That 87.5 percent is credited with interest at a statutory minimum rate each year. The rate is set by a formula tied to government bond yields, with a floor and a cap, and the contract states the rate that applies to it. Because the formula follows yields, contracts issued at different times can carry different minimum rates. The model has been revised over time, and the rate in an older contract may differ from that in a newer one.

Withdrawals taken reduce the amount, and some contracts deduct an annual contract fee. The result is a guarantee that grows slowly and never falls.

Here is a hypothetical with an invented minimum rate of 1 percent. A buyer pays $100,000.

• Starting base: 87.5% × $100,000 = $87,500.
• After 1 year at 1%: $87,500 × 1.01 = $88,375.
• After 3 years: $87,500 × 1.01^3 ≈ $90,151.
• After 5 years: $87,500 × 1.01^5 ≈ $91,963.
• After 7 years: $87,500 × 1.01^7 ≈ $93,812.
• After 10 years: $87,500 × 1.01^10 ≈ $96,654.

The floor starts below the premium and takes a little over thirteen years at 1 percent to catch up to $100,000. That is the intended design. It is a guarantee of last resort and is not meant to be competitive.

Why the floor rarely matches what you are being credited

Compare that floor with a contract that credits a real rate. Say the insurer credits 4 percent a year, as in a seven-year fixed contract. The accumulated value after seven years is $100,000 × 1.04^7 ≈ $131,593. The floor at that date is $93,812, which is about $37,800 less. The two numbers are not close, and they are not meant to be. The credited rate is what the insurer earns on its investments minus costs and profit, as described in how annuity rates are set and why they move. The floor is the worst-case value written into the contract.

Several kinds of rates appear in a fixed annuity contract, and keeping them apart avoids a lot of confusion.

• The initial guaranteed rate. The rate credited for a stated period, such as three, five or seven years in a multi-year guaranteed annuity. The insurer cannot lower it during the period.
• The renewal or declared rate. The rate the insurer chooses after the initial period, or each year in a flexible contract. It is a non-guaranteed element, which means it can change at the insurer's discretion, within the contract's limits.
• The guaranteed minimum interest rate. The lowest rate the insurer may declare. In many contracts this is the rate that determines how low renewal credits can go.
• The nonforfeiture rate. The rate used for the floor calculation above. It can be the same as the guaranteed minimum or a different figure, depending on the contract.

A statement usually reports the first two. The others live in the contract and in a table of guaranteed values.

Where the floor can actually bind

It can look as if the floor never matters, and in many contracts it does not. It can bind in a few cases.

An early exit with a steep charge and little credit. Suppose an indexed annuity earned no index credit for several years, which can happen when the index is flat or falls and the contract protects principal. The accumulated value stays at $100,000. Suppose also that the surrender charge starts at 12 percent and falls by one point a year. The table compares the surrender value with the floor from the earlier example, which uses the invented 1 percent rate.

In the first four years the floor is higher than the charged value, so the contract pays the floor, by amounts that range from $375 down to $53. From year five the charge schedule has fallen far enough that the surrender value takes over. This is how a floor is designed to work: a modest rescue in the worst combination of events, which fades as the contract ages. A schedule that began at 9 percent would never touch the floor in this example.

A renewal at the minimum. Say a flexible-premium contract credits 4 percent for three years, then the insurer declares the minimum of 1 percent for the next four years. The accumulated value after seven years is $100,000 × 1.04^3 × 1.01^4 ≈ $117,054. That is far above the floor of $93,812, because the floor is based on 87.5 percent of the premium and grows at the minimum rate from the start, while the actual account grew faster for three years. The floor does not bind. The real cost of a renewal at the minimum is not a loss of principal but a lost chance for better credit elsewhere, which relates to the question in rates rise after you buy: what happens to the fixed annuity you hold.

The floor's role in ordinary life is therefore modest. It is mainly a legal minimum that keeps contracts from being priced so that early exit takes nearly everything.

The indexed annuity floor is a different thing

In a fixed indexed annuity, people often use the word "floor" for a different feature: the index credit cannot be negative. If the index falls, the credit is zero instead of a loss, so the account value does not fall because of the index. See fixed indexed annuities: caps, participation rates and trade-offs for the way caps, participation rates and floors fit together. That feature is a floor on each period's index credit, usually 0 percent. It is not the same thing as the nonforfeiture floor on the total surrender value.

The two floors work together. The 0 percent index floor stops the account value from declining due to market moves. The nonforfeiture floor gives a minimum on the cash value at exit, usually about 87.5 percent of premium plus small interest. In between, the surrender charge can reduce what you receive within the schedule. An indexed contract that credits zero for several years can leave an owner with a surrender value below the premium, as in the example above, for reasons that have nothing to do with the stock market falling. Understanding the difference helps with "principal protection" claims. The protection holds if you stay through the surrender period; it does not mean you can take your premium back on day one. For a worked calculation of credits, see work out an indexed annuity credit by hand with your own contract terms.

Three common misunderstandings

"The contract only guarantees me 87.5 percent of my money." The 87.5 percent is the starting point for the floor, not a forecast. A buyer who holds a fixed annuity through its term and receives the declared credits ends with the accumulated value. The floor is relevant only to a person who leaves early, and even then the surrender value is usually higher.

"Principal protection means I can get my premium back whenever I want." Principal protection normally means the account value does not fall because of market movements. It does not cancel the surrender charge, and the table above shows that an early exit can return less than the premium even when the account lost nothing. This is one reason the surrender period is worth reading before the rate.

"A higher floor makes a better contract." A floor with a higher percentage or rate is a stronger guarantee, but contracts are priced as a whole. An insurer that offers a richer floor may offer a lower declared rate, or the other way round. Compare the floor, the credited rate, the surrender schedule and the insurer's strength together, and see reading a surrender charge schedule before you need the money for the schedule.

What the floor does not protect

• It does not protect against the insurer's failure. The floor is a promise by the company. If the company is placed in liquidation, the state guaranty association applies its own limits, which are separate from the contract's floor. See state life and health guaranty associations.
• It does not cover taxes or penalties. A withdrawal can still be taxable and, before age 59½, can carry an additional 10 percent federal tax. See how annuities are taxed.
• It does not set the value of an income rider. A rider's benefit base is a calculation for income and is usually a different figure from the contract's surrender value.
• It does not guarantee a competitive return. A contract whose only guarantee is the floor is guaranteeing very little.
• It generally does not apply to market-linked variable accounts. A variable annuity's subaccount values rise and fall with the markets, and the nonforfeiture floor concept applies mainly to the fixed side.

Reading it in your own paperwork

You can find the guaranteed values in three places. The contract has a table of guaranteed values or a nonforfeiture section that lists the minimum cash values by year, or describes the formula. The annual statement may show the guaranteed minimum interest rate and sometimes the minimum guaranteed value. Many insurers also provide an illustration or specimen contract that shows both the "guaranteed" and the "current" columns. The guide on reading statements, reading your annual annuity statement line by line, explains the layout, and declared rates and non-guaranteed elements in annuity contracts covers the declared rates that sit above the floor.

Questions to ask

1. What percentage of premium and what minimum rate set the nonforfeiture floor in this contract?
2. What is the guaranteed minimum value at years 1, 3, 5, 7 and 10?
3. What is the lowest credited rate the insurer can declare, and when can it declare it?
4. How does the surrender charge compare with the floor in the early years?
5. For an indexed contract, is the index floor 0 percent, and does the contract also include a nonforfeiture floor?
6. Can I see the guaranteed and the current values side by side?

A state insurance department can confirm what the law requires in your state, and the insurer's service department can supply the table in writing.

Key takeaways

• The minimum guaranteed value is a legal floor under surrender value, commonly built from 87.5 percent of premium credited at a low statutory rate, and the contract states the exact terms.
• On surrender, a fixed annuity pays the greater of the surrender value and that floor, which in ordinary years means the floor never applies.
• In the illustration, a floor of about $93,812 after seven years sits roughly $37,800 below the $131,593 that a 4 percent credit produces.
• The floor can bind only when little interest was credited and surrender charges are heavy, and even then it adds a modest amount.
• An indexed annuity's zero index floor and its nonforfeiture floor are separate protections, and neither covers insurer failure or tax.