Premium bonus annuities: how the bonus gets paid for

A premium bonus annuity adds a percentage of your deposit to your account on day one. Deposit $100,000, receive an 8 percent bonus, and the first statement shows $108,000. The offer is real, but so is the question it raises: an insurance company does not give away money, so where does it come from? The honest answer is that you pay for the bonus through other terms of the contract, sometimes in ways that are easy to miss. This post tests seven common claims about bonuses, one at a time, and then works through an invented example in which a bonus nets out to little.

None of this says a bonus annuity is a bad choice. For some buyers, with money that will stay put for the whole period, a bonus contract can come out ahead. The point is to know what you are comparing. For the glossary definition, see bonus annuity.

How a bonus works, briefly

A premium bonus is a percentage of the money you put in, credited to the contract's account value at the start. It is not extra cash you can spend. It is a number in the account, and the contract's terms decide how much of it you can keep and under what conditions. Three mechanisms usually decide:

• Vesting. The bonus becomes yours gradually. A common design vests a share each year, so an early exit forfeits the part that has not vested.
• Recapture. The contract may take back some or all of the bonus if you surrender or annuitize early, or on certain withdrawals.
• Surrender charges. A longer or steeper surrender schedule is the usual companion of a bonus, and applies on top of any forfeiture.

Some contracts also pay an interest-rate bonus, a higher rate for the first year only. The same questions apply to it.

Claim 1: "The bonus is free money"

Test. Money has to come from somewhere. The insurer expects to invest your deposit for years and earn a spread over what it credits you. A bonus is an advance on that spread, and the company protects itself with terms that make sure it earns the advance back. Those terms are the cost. A bonus contract commonly pays for the bonus through some combination of a lower crediting rate or cap, a longer surrender period, vesting or recapture, and higher fees.

Verdict. False as a general statement. A bonus is a trade, and the price is spread across years. Whether the trade is good depends on your holding period, not on the headline percentage.

Claim 2: "I start ahead, so I'm ahead"

Test. Starting with $108,000 instead of $100,000 is an advantage only if the contract grows at a comparable rate afterward and you stay long enough. If the bonus contract credits less each year, the gap closes. The crossover point is the question: how many years until a no-bonus contract with better ongoing terms catches up?

Verdict. Partly true. You are ahead at the beginning, and you remain ahead only if the ongoing terms do not give it back. The worked example below shows a crossover.

Claim 3: "The bonus is mine even if I leave early"

Test. Read the vesting clause. If the bonus vests over, say, ten years at 10 percent a year, then leaving at the end of year three means 70 percent of it, $3,500 of a $5,000 bonus, is forfeited. Contracts differ: some vest faster, some vest only at the end, and some forfeit nothing on death or on certain waived events. The surrender charge may apply as well.

Verdict. Usually false for early exits. The bonus is conditional, and the condition is time.

Claim 4: "A bigger bonus is always better"

Test. Compare bonus with the terms that pay for it. A 10 percent bonus tied to a 14-year schedule and a low cap is a different deal from a 5 percent bonus with a seven-year schedule. The bigger bonus is also a larger advance the company must recover. The guide on fixed indexed annuities: caps, participation rates and trade-offs explains how caps, participation rates and spreads work in indexed contracts, and these are among the first terms to be trimmed to pay for a bonus. In an indexed contract, the lower cap rate is hard to see in advance, because the credit depends on how the index performs.

Verdict. False. The right comparison is the total outcome over your holding period, not the size of the bonus.

Claim 5: "The bonus is tax-free"

Test. A bonus credited inside a non-qualified annuity is not premium. Your cost basis, the after-tax money you put in, stays $100,000. The bonus raises the account value, so it is part of the gain, and gain is taxed as ordinary income when withdrawn, with a 10 percent additional tax on gain taken before 59½ in most cases. In an IRA, the whole withdrawal is generally taxable anyway. See how annuities are taxed.

Verdict. False. The bonus is gain, with all the usual tax consequences.

Claim 6: "A bonus makes it worth replacing my old annuity"

Test. A replacement brings its own costs: the surrender charge on the old contract, a new surrender period and the lost features of the old one. A bonus on the new contract is often smaller than those costs, and part of it may be recaptured if you leave early. Bonus offers are a common feature of sales that move money from one annuity to another, because the headline number makes the swap look attractive. The post on before you replace an annuity: what to check about what you lose lists what to compare, and the guide on annuity sales abuses targeting seniors describes the sales pattern.

Verdict. Usually false. The bonus should be weighed against the full cost of leaving, and it rarely covers it.

Claim 7: "The income-rider bonus works like a cash bonus"

Test. Some annuities advertise a bonus on the income rider instead of on the account. That bonus is added to the benefit base, the formula number used to set lifetime income, not to the account value you can withdraw or leave to heirs. Say a rider adds a 10 percent bonus to a $100,000 base, making the base $110,000. At an illustrative 5 percent payout, the yearly income is $5,500 instead of $5,000, an extra $500 a year ($110,000 times 0.05 minus $100,000 times 0.05). The account value is still $100,000. If you surrender the contract, or die before taking income, the bonus on the base is worth nothing in cash. The rider may also carry a fee on the larger base. The guide on guaranteed lifetime withdrawal benefit riders explains why the base and the account value are different numbers.

Verdict. False. A rider bonus is a promise about future income, conditional on how and when you start it, not money in your account.

A worked example where the bonus nets out to little

The numbers below are invented to show a method. They are not products, and the rates are illustrations, not quotes. They ignore taxes and fees.

Say two fixed contracts each take a $100,000 deposit.

• Contract A (bonus). A 5 percent bonus, so it starts at $105,000. It credits 3 percent a year. It has a 10-year surrender schedule, charging 10 percent in year one and falling one point a year. The bonus vests 10 percent a year.
• Contract B (no bonus). It starts at $100,000, credits 4 percent a year, and has a seven-year surrender schedule, charging 7 percent in year one and falling one point a year.

Value over time, before any charges

Each figure is the starting value times the yearly factor: $105,000 times 1.03 for A, and $100,000 times 1.04 for B, raised to the power of the number of years. The lead the bonus gives A shrinks every year because B's rate is one point higher, and at the end of year five it is $58.49. After that B is ahead, and the gap widens.

So in this example the bonus is worth having only if the money stays long enough and the other terms are equal. Here, over ten years, the contract without the bonus ends $6,913.21 ahead, before taxes.

If you leave early. Say you need the money at the end of year three.

• Contract A: the value is $114,736.34. Only 30 percent of the $5,000 bonus has vested, so $3,500 is forfeited: $114,736.34 minus $3,500 is $111,236.34. The year-three surrender charge is 8 percent: $111,236.34 times 0.08 is $8,898.91. You receive $102,337.43. (To keep the arithmetic simple, this ignores the interest that the forfeited bonus would have earned.)
• Contract B: the value is $112,486.40. The year-three charge is 5 percent, or $5,624.32. You receive $106,862.08.

The bonus contract leaves you $4,524.65 behind ($106,862.08 minus $102,337.43) and only $2,337.43 above your original deposit. That is the result in the case where a bonus nets out to little.

A fairer case for the bonus. To avoid leaving the impression that a bonus never wins, change two inputs. Say the bonus is 8 percent, so Contract A starts at $108,000, and the rates are closer: A credits 3.00 percent and B credits 3.50 percent. After ten years A is worth $145,142.97 ($108,000 times 1.03 to the tenth power) and B is worth $141,059.88 ($100,000 times 1.035 to the tenth power), so A leads by $4,083.09. A stays ahead through year 15, when the lead is $725.60, and falls behind in year 16 by $90.31. For a buyer who is sure the money will stay put for ten years or more, that is a bonus doing real work. The same buyer should note that the lead still shrinks every year, and that the surrender charges and vesting apply if plans change.

What the example does not prove. If you are certain the money will not be touched for more than ten years, the bonus contract may be the better one. If the bonus is paid by a lower index cap rather than a fixed rate, the outcome depends on the index and cannot be shown with a single line. The method is the lesson: put both contracts on the same page, over the same years, with the exit costs shown.

Who a bonus might suit, and who it might not

Each side has a fair case.

The case for. A bonus can suit a buyer who has money they will not need for the whole surrender period, who understands the vesting, and who has compared the total outcome. The bonus can offset the effect of a higher entry cost, and a vesting schedule that rewards patience is not unreasonable for money meant to stay put.

The case against. A bonus can mislead a buyer who focuses on the first-day number. It often sits with the longest surrender periods, and long surrender periods weigh most on older buyers and on anyone who might need cash. A bonus can also attach to a replacement sale that pays a commission.

The guide on annuity surrender charges and free withdrawals shows how schedules work, and the post on how annuity commissions shape the advice you hear looks at the incentive side.

Where to find the bonus in the paperwork

The bonus rarely sits in one place. Look for it in four parts of the contract package:

• The contract's data page, which usually lists the bonus percentage and the vesting schedule.
• The surrender charge section, where the schedule for a bonus version may differ from the standard one.
• The withdrawal and annuitization provisions, where recapture is typically described. Phrases such as "bonus recapture," "vested percentage," "forfeiture" and "unvested premium bonus" point to it.
• The disclosure statement or buyer's guide, which explains in plain terms what the bonus does and does not guarantee.

Read the recapture clause twice. Some contracts forfeit unvested bonus only on a full surrender, and some also forfeit it on partial withdrawals above the free amount, on annuitization before a set year, or on a transfer. A few also forfeit the interest earned on the bonus. The wording decides, and a summary from a seller is not a substitute for the clause.

What to ask before choosing a bonus contract

1. What is the bonus, and when does it vest? Is vesting by year, and is it lost or kept on death?
2. Under what events is the bonus recaptured (surrender, annuitization, withdrawals above the free amount)?
3. What is the surrender schedule, and how does it compare with a similar contract without a bonus?
4. What are the crediting rate or cap, participation rate and spread, and which of them can change?
5. Do fees differ between the bonus and no-bonus versions?
6. Is there a no-bonus version of the same product, and what is the difference in terms?
7. Is the bonus applied to each additional premium, or only to the first?
8. What does the contract say about the bonus in the free-look period?
9. What is the seller paid on each version?

Ask for the answers in writing, and ask the seller for a side-by-side projection that shows both versions with the same assumptions. A fee-only planner or a tax professional can check the work without a commission at stake. If the sale does not match the written terms, your state insurance department takes complaints.

Key takeaways

• A premium bonus is paid for through lower crediting rates or caps, longer surrender periods, vesting or recapture, and sometimes higher fees.
• The bonus is part of the gain for tax purposes; your cost basis stays equal to the premium you paid.
• Compare contracts over your actual holding period, with exit costs included; in the invented example, the lead from a 5 percent bonus disappeared after five years.
• Leaving early can forfeit unvested bonus and trigger surrender charges together, which can leave you near your original deposit.
• A bonus can suit money that will not be touched for the full period, but it rarely justifies replacing an existing annuity.