Variety of investment options. Guarantees protected by an insurance component. Diversified Investment Portfolio. No Limit on Annual Investment

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1 CHAPTER 8 Investment Products and Markets: VARIABLE ANNUITY CONCEPTS OF variable annuity Like an IRA that is not deductible Tax deferred investment vehicle Variety of investment options Guarantees protected by an insurance component BENEFITS Diversified Investment Portfolio No Limit on Annual Investment Upon death, beneficiaries are guaranteed face value or higher market value Pay for this VA company may permit annual payout without penalty Watch for forced annuitization Tax-deferred Growth Of Funds DRAWBACKS High Mortality and Expense Charge Depends on the contract The shares in the VA are institutional shares that might not have any load and very low expenses Contingent Deferred Sales Charges

2 If in for the long term this is not an issue If you need the cash in 4 5 years, VA is not the answer. Penalty for Withdrawal Before 59-1/2 Variable Annuity Funding Sources Where does the money come from? Liquidation of Earnings Withdrawal from taxable savings plan Life insurance death benefit proceeds Other lump sums (inheritance, sale of business) Cash value life insurance or annuities (1035 Exchanges) VARIABLE IMMEDIATE ANNUITY Assumption here is annuitization What is annuitization? Convert lump sum to a systematic cash flow Sounds like what you want. Lose control of assets / insurance company owns the cash Lose return opportunities What happens at death Nondeductible IRAs vs. Nonqualified Annuity NonQualified IRA Annuity Contributions (after-tax dollars) X X Earnings accumulate tax-deferred X X Earnings taxed upon withdrawal X X Principal can be withdrawn tax free X X

3 10% tax penalty applies to withdrawals X X before age 59 1/2 No minimum distribution at age 70½ Unlimited payments to contract X X We re all familiar with IRAs. We know that there are a variety of IRAs that we can offer our clients, including the traditional IRA (tax deductible, contributions are made with pre-tax money, annual contribution limits, etc.) and non-deductible IRAs (non-deductible contributions made with after-tax money). To give you a frame of reference, this slide helps illustrate the similarities between the non-deductible IRA which you re familiar with and a nonqualifed annuity that you may not be familiar with. First the terminology. Non-deductible contributions are made with after-tax dollars. When a variable annuity is purchased with after-tax dollars (e.g., cash, life insurance proceeds), this is considered the purchase of a nonqualified contract. For nonqualified contracts, there is no tax deduction for the amounts paid into the contract. Like a non-deductible IRA, any growth on the variable annuity contract accumulates tax deferred until the client takes a withdrawal. Consequently, no current income taxes are due on the variable annuity contract until money is withdrawn, hopefully at some point in the future when the client is in a lower tax bracket. Who May be Note: Right This for should a Nonqualified not be confused Annuity with a Roth IRA. Has Long-term savings goals and/or is planning for retirement Has reached their maximum 401(k) and IRA contribution limits Wants family protection in the form of a death benefit Wants to grow their assets tax deferred Wants ability to move among funding options tax free Wants lifetime income Has received unexpected lump sum payment and needs to invest long-term Liquidity is now a key determinate on whether the variable annuity contract can even be offered. This is a change due to misdeeds of agents taking advantage of senior citizens and others.

4 Why would brokers want to issue this type of security? MONEY!!! Variable annuities pay higher commissions than mutual funds. Who May NOT be Right for a Nonqualified Annuity Net worth is less than $100,000 IRAs and 401(k) not fully funded Short-term investors with higher liquidity needs Insufficient discretionary income/ emergency funds May need access to money prior to age 59½ 1035 exchange basics What is a 1035 exchange? Conversion from one insurance vehicle to another. Avoids tax consequences if done properly. This is a conversion of one insurance type vehicle for another. This is a non-taxable exchange.

5 Let s look at two sales ideas for the Variable Annuity regarding 1035 Exchanges. One is to defer a taxable gain and the other is to save a tax loss. Defer Taxable Gain Assume: $20,000 Premiums Paid $25,000 Cash Value $5,000 Taxable Income Upon Surrender

6 First, let s look at deferring a taxable gain and assume we have a client who has $25,000 of cash value in a life insurance policy, and they have paid $20,000 in premiums. If they were to simply surrender that contract and take the proceeds and buy a Variable annuity contract, their cost basis would be $20,000 and they would pay taxes on the gain in the contract which would be the $5,000. If they do a 1035 Exchange, the new cost basis of Variable annuity is $20,000, and there are no taxes currently due. The important thing is that the funds are directly transferred into the annuity (the money goes from one insurance company to the other so the client does not take possession of any of the insurance policy s assets). While there are many reasons to move the cash value of a life insurance policy into an annuity, it s important to remember that this type of exchange has tax implications for the beneficiary. There is no income tax due on death benefit proceeds received from a life insurance contract. However, any portion of the death benefit proceeds from an annuity contract that have not previously been taxed are taxable to the beneficiary. Save Tax Loss Assume: $20,000 Premiums Paid $15,000 Cash Value $5,000 Loss

7 Another situation that can be considered is to save the tax loss of a life insurance policy. For instance, we have a life insurance policy with $15,000 of cash surrender value, and the premiums paid total $20,000. If the client were to surrender this policy and move the proceeds to a Variable annuity policy, the cost basis is $15,000. However, if they do a 1035 Exchange into a Variable annuity policy, the cost basis of the Variable annuity policy is $20,000. Under a 1035 Exchange, the $15,000 that goes into the annuity contract can grow by $5,000 back up to its original premiums paid amount ($20,000) before growth will be considered taxable earnings. Because the $5,000 growth gets us back to the original cost basis, there would be no gain in the contract. This is the way to save a tax loss inside of a Variable annuity policy on a 1035 Exchange. Some of the rules about a 1035 Exchange: Client must exchange the entire value of an existing policy; there are no partial 1035 Exchanges. Clients cannot transfer a policy into an existing policy; you must purchase a new annuity contract. Both the owner and the annuitant under the new contract must be the same as the owner and the annuitant (insured) under the old contract. Life insurance policy loans cannot be transferred.* If they were to be exchanged for the annuity, they would become immediately taxable. You can exchange a life insurance policy for an annuity, and an annuity for another annuity, but you cannot exchange an annuity for a life insurance policy. * In some cases, it may be appropriate for the loan to be netted against the cash value.

8 Charges and Fees Asset Based Fees Mortality & Expense Risk Charge Pay for the guarantees Step-up charges Creates guarantee of upward growing portfolio value (floating floor) Fund Fees and Expenses Paid to the mutual funds Usually institutional fund classes so lower fees Contingent Deferred Sales Charges Contract Administrative Charges Now let s take a look at the charges associated with a variable annuity contract. First, there are 2 charges which are deducted daily from the assets of the separate account - in essence, from your client s contract value. Both are illustrated on an annualized basis. The mortality and expense risk charge (M&E) is 1.25%, and the sub-account administrative expense charge is 0.15%, for a total annualized cost of 1.40% of assets. These charges are designed to cover the company s expenses for providing death benefit guarantees, annuity payout guarantees and fund valuation, as well as the distribution expenses like commissions. This percentage is fairly standard in the industry, particularly in the nonqualified annuity market. The underlying funds to which a client allocates his or her money also have certain fees and expenses which go toward providing day-to-day portfolio management and paying their custodian and transfer agent. The range of these fees is generally from 0.64% to 1.64%. They vary by fund and fluctuate daily as the fund s assets increase or decrease in value. Fund expenses as of the end of the most recent calendar year are illustrated in the Fee Table of the prospectus. However, these fees are typically less than the mutual fund fees. They are referred to as institutional fees. They are the classes of funds referred to in the mutual fund section as others. There is also a $30 annual contract administrative charge that goes to pay for the cost of administering the

9 Impact of Taxes on Withdrawals Withdrawals Subject to Income Tax on Amounts Not Previously Taxed 10% IRS Early Withdrawal Penalty < 59½ EXCEPTION: Substantially Equal Payments - 72(t)/(q) Payments Must Continue for Longer of 5 Years or Age 59½ Step-Up Benefits a moving floor of the value of the contract. Not all contracts permit this.

10 Distribution of Death Benefit Proceeds Beneficiaries have right to: Annuitize Contract; or Take lump-sum payment Spousal Beneficiaries may elect to continue contract under his/her name Death benefit proceeds subject to estate and income taxes Asset Allocation Asset Allocation is the process of combining different asset classes in varying proportions to help achieve the best possible return for the lowest amount of risk Over 92% of a portfolio s return rests on Asset Allocation decisions

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13 REBALANCING A PORTFOLIO Rebalancing is not a market timing strategy Return a portfolio to a preset allocation based on risk tolerances It is a systematic approach to maintaining a consistent risk profile