Annuity Products & Features

Transcription

1 Annuity Products & Features Course Manual 6 credit hours Online Non-Interactive

2 Important Information Annuity Products & Features - 2 Course Intent Mountain CE, LLC does not render legal services or advice. This course is not intended as an authority on legal matters. The purpose of this course is to provide continuing education (CE) for insurance licensees. We have attempted to provide the most accurate information available. As rules, regulations, and industry practices change, some aspects of this course may become outdated. This course will be updated on a periodic basis as deemed necessary. Terms of Use This course is the sole property of Mountain CE, LLC. This course cannot be duplicated, copied, reproduced or used for any other purpose without the consent of Mountain CE, LLC. CE Credits This is a non-interactive (non-classroom) CE course. It does not qualify for classroom equivalent credits. To obtain CE credits, you must read and study this course manual and then pass an exam to demonstrate what you have learned. For further instructions, visit our web-site at

3 Table of Contents Annuity Products & Features - 3 Unit One Fundamentals... 7 What is an Annuity?... 8 What is an Annuity?... 9 Parties Involved Accumulation and Liquidation Similar to Life Insurance Different than Life Insurance Classifications of Annuities Immediate vs. Deferred Immediate vs. Deferred Number and Frequency of Premium Payments Number of Lives Covered Accumulation Method Liquidation Period Payout Options Unit Two Accumulation Period Accumulation Period Defined Start and End of Accumulation Period Pay-In Options Accumulation Method Taxation Unit Three Liquidation Period Liquidation Period Defined... 28

4 Annuity Products & Features - 4 Start of Liquidation Period Payout Frequency Options Payout Options Pure Life Life with Period Certain Life with Installment Refund Life with Cash Refund Fixed Period Certain Fixed Amount Certain Joint and Survivor Amount of Regular Payment Choosing Payout Options Taxation Unit Four Immediate Annuities Immediate Annuities Overview Guaranteed Income Social Security Employment Promises Demographic Shifts Appeal of Immediate Annuities Advantages of Immediate Annuities Disadvantages of Immediate Annuities Risk Capital Lump Sum Immediate Defined... 53

5 Annuity Products & Features - 5 Payout Options Immediate Annuity Example Immediate Annuity Example Immediate Annuity Example Unit Five Deferred Annuities Deferred Annuities Overview What is Deferred? Accumulation Period Withdrawals and Surrenders Withdrawal and Surrender Charges Other Charges Death of the Annuitant Annuitization Liquidation Period Advantages of Deferred Annuities Disadvantages of Deferred Annuities Deferred Annuity Example Deferred Annuity Example Deferred Annuity Example Deferred Annuity Example Unit Six Traditional Fixed Annuities Accumulation Method What is a Fixed Deferred Annuity? Interest Rates Determining Interest Rates... 78

6 Annuity Products & Features - 6 Bailout Provision Market Value Adjustment (MVA) Traditional Fixed Example Traditional Fixed Example Traditional Fixed Example Unit Seven Equity-Indexed Annuities (EIAs) Accumulation Method What is an Equity-Indexed Annuity? What is an Equity-Indexed Annuity? Stock Market Index State and Federal Regulation Status of Regulation Crediting Formula Index Term Indexing Method Indexing Method Annual Reset (Ratchet) Indexing Method High-Water Mark Indexing Method Point-to-Point Participation Rate Cap Floor Averaging & Interest Compounding Spread Vesting

7 Unit One Fundamentals

8 What is an Annuity? Unit 1 Fundamentals - 8 If we conducted a survey of 10 random people and asked them what an annuity is, probably only about one or two could correctly describe an annuity and where to buy one. Interestingly, however, there is a lot of money in annuities. Americans have $1.6 trillion of their retirement assets in annuities (not including annuities held by IRAs, 403(b) plans, 457 plans, and private pension funds). Source: (2012).

9 What is an Annuity? Unit 1 Fundamentals - 9 There are a wide variety of annuity products that have a diverse range of uses. Generally, an annuity is a contract sold only by an insurance company (also known as a carrier) that can: Provide a guaranteed income for a specific period of time or for the rest of the annuitant s life Help prevent a person from outliving their assets Provide tax-deferred growth Be used to save money for retirement Be used to accumulate assets and then liquidate the assets at a later date There are about 1,000 insurance companies in the United States that sell annuities, and the number of different variations of annuities is nearly endless. This class presents the features and characteristics most commonly found in fixed (not variable) annuities sold in the United States.

10 Parties Involved Unit 1 Fundamentals - 10 An important step in understanding annuities is being aware of the people and entities involved in an annuity contract. Annuitant Owner The person whose age and life expectancy determines the amount or duration of annuity payments; is also usually (but not always) the person who receives the annuity payments The person or other legal entity that owns and has control of the annuity; the owner can be (but doesn t have to be) the annuitant Beneficiary The person or other legal entity that receives a death benefit from an annuity upon death of the annuitant

11 Accumulation and Liquidation Unit 1 Fundamentals - 11 Another critical step is understanding the two periods of time that an annuity may have. Accumulation Period Liquidation Period The period of time when premium payments are paid into the annuity and grow tax-deferred All deferred annuities have an accumulation period; immediate annuities do not have this period The period of time when regular payments are paid out from the annuity Immediate annuities have a liquidation period; deferred annuities can have a liquidation period, but some do not

12 Unit 1 Fundamentals - 12 Similar to Life Insurance In some ways annuities are similar to life insurance policies. For example: Both are sold by life insurance companies Both use the pooling technique; money from a large number of people is collected and invested by the insurance company; then if a member of the pool has an unforeseen event, he or she is compensated Both are based on the principle that the length of a human life is unpredictable Both use mortality tables based on the probability that a person with certain characteristics will live or die at specific times in the future; these mortality tables help to determine the premiums paid in and also the benefits paid out Both can be used to grow cash value that is tax-deferred

13 Different than Life Insurance Unit 1 Fundamentals - 13 Despite the similarities just explained, annuities are also very different than life insurance in some ways. Life Insurance Primary purpose is to protect against loss of income due to premature death People who live beyond their normal life expectancy compensate beneficiaries of those who die early Annuities Although annuities have many purposes and uses, a primary purpose is to protect a person from the risk of outliving their assets due to living a long time People who die early compensate those who live beyond their normal life expectancy

14 Classifications of Annuities There are many ways to classify annuities. They include: Unit 1 Fundamentals - 14 Immediate vs. Deferred Accumulation Period Growth Number and Frequency of Premium Payments Number of Lives Covered Liquidation Period Payout Options

15 Immediate vs. Deferred Unit 1 Fundamentals - 15 Although there are many variations, all annuities fall into one of two categories that relate to the time when regular annuity payments begin: Annuities Immediate Annuities Deferred Annuities

16 Immediate vs. Deferred Unit 1 Fundamentals - 16 Below is a brief comparison of immediate and deferred annuities. Each will be explained in more detail later in this class. Immediate Annuities The premium payment (principal sum) is exchanged for a promise by the carrier to provide a regular stream of income payments.* The regular payments start within a year and may last a lifetime or a specified period. Immediate annuities are also called income annuities. Deferred Annuities Money grows tax deferred during the accumulation period. The accumulated assets can be exchanged for a promise by the carrier to provide a regular stream of income payments that start more than one year after original purchase.* * The time during which the regular stream of income payments is received by the client is called the liquidation period.

17 Unit 1 Fundamentals - 17 Number and Frequency of Premium Payments Annuities can be classified based on the number and frequency of payments into the annuity. Immediate Annuities Immediate annuities are purchased with a one lump sum premium payment. Deferred Annuities Deferred annuities can be purchased with: One single lump sum payment A series of scheduled regular payments Flexible irregular payments

18 Number of Lives Covered Unit 1 Fundamentals - 18 Although many annuities cover only one life, it is possible for an annuity to cover more than one life. Single-Life Annuity Only one annuitant Single-life is the most common Joint-Life Annuity * Two or more annuitants ** The stream of regular income stops when the first annuitant dies Joint-and-Last-Survivor Annuity Two or more annuitants ** The stream of regular income continues as long as any annuitant is still alive * Joint-life annuities are not common ** It is common to have two annuitants; it is not common to have more than two annuitants

19 Accumulation Method Unit 1 Fundamentals - 19 During the accumulation period of a deferred annuity, premiums are paid into the annuity and the value of the annuity grows tax-deferred. The amount of growth potential depends on the accumulation method which can be: traditional fixed, equity-indexed, or variable. (An equity-indexed annuity is a type of fixed annuity.) The amount of growth also depends on the applicable fees charged by the carrier. Accumulation Method of Deferred Annuities Fixed Variable Traditional Fixed Equity-Indexed

20 Liquidation Period Payout Options Unit 1 Fundamentals - 20 During the liquidation period, there are many options related to how the annuity can be paid out. Carriers use different names to describe the payout options they offer. Nonetheless, most payout options fall into one of these categories which will be explained in more detail later in this class. Pure Life Life with Period Certain Life with Installment Refund Life with Cash Refund Fixed Period Certain Fixed Amount Certain Joint and Survivor

21 Unit 2 Accumulation Period - 21 Unit Two Accumulation Period

22 Accumulation Period Defined The accumulation period (or phase) of an annuity is the time during which the client makes one or more premium payments into a deferred annuity. During this period, an annuity is like a barn that stores feed to be used at a later date. The accumulation period can also be called: Pay-in period Deferred period Unit 2 Accumulation Period - 22

23 Unit 2 Accumulation Period - 23 Start and End of Accumulation Period Immediate annuities do not have an accumulation period. That s because they are purchased with one lump sum and then immediately enter the liquidation period. In contrast, all deferred annuities have an accumulation period; it starts once the first payment has been made. During the accumulation period, subsequent payments can be added and the money accumulates. Deferred annuities remain in the accumulation period unless the annuitant decides to annuitize, at which point the annuity enters the liquidation period. Most deferred annuities are never annuitized, primarily for these reasons: Instead of annuitizing, the annuitant can take regular or sporadic withdrawals The annuitant can die or decide to surrender it before annuitization A deferred annuity can be purchased with the intent of never annuitizing it as could be the case for a wealthy person who wants a safe and secure place to put away money for his or her heirs

24 Pay-In Options Unit 2 Accumulation Period - 24 During the accumulation period, annuity premiums can be paid with a single payment or with installment payments. With installment payments, there are a series of premiums paid. They can be flexible premium contracts in which the client can pay as much as he or she wants whenever he or she wants within certain limits. Other installment plans are scheduled premium contracts that dictate the size and frequency of the premium payments. Single Premium Pay-In Options Installment Premium Flexible Premium Scheduled Premium

25 Accumulation Method Unit 2 Accumulation Period - 25 During the accumulation period of a deferred annuity, premiums are paid into the annuity and the value of the annuity grows tax-deferred. The amount of growth potential depends on the accumulation method which can be: traditional fixed, equity-indexed, or variable. The amount of growth also depends on the applicable fees charged by the carrier. Traditional Fixed The value grows at interest rates set by the carrier. The carrier guarantees that it will pay no less than the minimum rate of interest specified in the annuity contract. Equity-Indexed (Fixed) The value grows at rates that are linked to an equity index, such as the S&P 500. A minimum interest rate is guaranteed, so this annuity is considered to be a fixed annuity not a variable (securities) contract. Variable The assets of the annuity are placed into a separate account managed for the client by the carrier. The client chooses how the assets are invested (such as stock or bond mutual funds). The return is variable, so there are no guarantees.

26 Taxation Unit 2 Accumulation Period - 26 Tax treatment of a deferred annuity during the accumulation period depends on whether the source of the premium paid into the annuity is non-qualified funds, qualified Traditional (IRA) funds, or qualified (Roth IRA) funds. Non-Qualified Qualified (Traditional IRA) Qualified (Roth IRA) If non-qualified money is used to pay the annuity premium, the individual does not get a tax deduction on the amount paid into the annuity; accumulated interest grows taxdeferred it is subject to income tax only when it is received as income. If qualified (Traditional IRA) money is used to pay the annuity premium, the individual receives a tax deduction on the amount paid into the annuity; accumulated interest grows tax-deferred it is subject to income tax only when it is received as income. If qualified (Roth IRA) money is used to pay the annuity premium, the individual does not get a tax deduction on the amount paid into the annuity; accumulated interest grows tax free and is not taxable if certain conditions are met.

27 Unit 3 Liquidation Period - 27 Unit Three Liquidation Period

28 Unit 3 Liquidation Period - 28 Liquidation Period Defined The liquidation period (or phase) of an annuity is the time during which regular payments are paid out from the annuity. During this period, an annuity is like a machine that produces cash at regular intervals. The liquidation period can also be called any of these terms that mean essentially the same thing: Annuity period Annuitization period Payout period Distribution period Income period Income payout period

29 Unit 3 Liquidation Period - 29 Start of Liquidation Period All immediate annuities have a liquidation period that begins immediately (within one year of the purchase date). In contrast, a deferred annuity may-or-may-not have a liquidation period. If it does have a liquidation period, it will begin after the accumulation period is over. The point in time when a deferred annuity switches from the accumulation period to the liquidation period is called the maturity date or the date when the annuity is annuitized. Think of it as the point in time when the switch is flipped that turns on the cash making machine. In reality, however, most deferred annuities are never annuitized, primarily for these reasons: Instead of annuitizing, the annuitant can take regular or sporadic withdrawals The annuitant can die or decide to surrender it before annuitization A deferred annuity can be purchased with the intent of never annuitizing it as could be the case for a wealthy person who wants a safe and secure place to put away money for his or her heirs

30 Payout Frequency Options Liquidation Period - Payout Frequency Options Unit 3 Liquidation Period - 30 The frequency of payments during the liquidation period can be monthly, quarterly, semi-annually, or annually. Choosing the annually payout option would result in the highest amount paid, since the carrier is able to invest the money longer before it must pay out the money. However, monthly is the most common payout option chosen. That s because many recipients like a more consistent steady stream of income. Furthermore, the more frequent the payout, the sooner the money is in the hands of the client. Monthly Quarterly Semi-annually Annually

31 Payout Options Unit 3 Liquidation Period - 31 Carriers name their payout options differently, but most payout options are similar to these. Not all carriers offer all options. Pure Life Life with Period Certain Liquidation Period - Payout Options Life with Installment Refund Life with Cash Refund Fixed Period Certain Fixed Amount Certain Joint and Survivor

32 Unit 3 Liquidation Period - 32 Pure Life If the pure life payout option is chosen: The carrier makes regular equal payments as long as the annuitant lives regardless of how long the annuitant lives Payments cease upon the death of the annuitant regardless of how soon in the annuitization period the death occurs Example 1 Example 2 For $300,000, at age 65 David purchased an immediate annuity with a pure life payout option paying $1,700 per month. The annuity will keep paying David that amount even if he lives to be 100 or more. Sandra had a deferred annuity with accumulated assets of $750,000. She decided to annuitize the annuity at age 70 and chose the pure life payout option. Sandra received two monthly payments of $4,350 each; she then died in an accident. The carrier will not make any payments to her heirs, beneficiaries, or estate.

33 Unit 3 Liquidation Period - 33 Life with Period Certain If the life with period certain payout option is chosen: The carrier makes regular equal payments as long as the annuitant lives regardless of how long the annuitant lives Payments are guaranteed for a specified period of time even if the annuitant dies before the specified period of time is over Example Jorge had a deferred annuity with accumulated assets of $950,000. He decided to annuitize the annuity at age 68 and chose life with period certain of 10 years. Jorge received 37 monthly payments of $5,500 each; he then died in an accident. The carrier will continue to make monthly payments of $5,500 to Jorge s beneficiary until it has made a total of 120 payments (10 years of payments).

34 Unit 3 Liquidation Period - 34 Life with Installment Refund If the life with installment refund payout option is chosen: The carrier makes regular equal payments as long as the annuitant lives regardless of how long the annuitant lives Payments are guaranteed to be paid until the entire principal sum has been paid by the carrier if the annuitant dies before the entire principal sum has been paid, payments will continue to be made to the annuitant s beneficiary Example Margarita purchased an immediate annuity for $600,000 at age 57. She chose the life with installment refund payout option. Margarita received 104 monthly payments of $2,575 each; she then died. The carrier will continue to make monthly payments of $2,575 to Margarita s beneficiary until the original purchase price of $600,000 has been entirely paid back to Margarita and her beneficiary.

35 Unit 3 Liquidation Period - 35 Life with Cash Refund If the life with cash refund payout option is chosen: The carrier makes regular equal payments as long as the annuitant lives regardless of how long the annuitant lives If the annuitant dies before the entire principal sum has been paid out in regular payments, a lump-sum payment will be made to the annuitant s beneficiary; the lump-sum payment will be equal to the principal sum minus the sum of the payments already paid Example Francois had a deferred annuity with accumulated assets of $400,000. He decided to annuitize the annuity at age 64 and chose life with cash refund. Francois received 100 monthly payments of $1,800 each; he then died. The carrier will pay a lump sum payment of $220,000 to Francois beneficiary: 400,000 (100 x 1,800) = 220,000

36 Unit 3 Liquidation Period - 36 Fixed Period Certain If the fixed period certain payout option is chosen: The carrier provides a certain number of regular equal payments for a certain period of time Payments cease at the end of the period Payments are not life contingent; payments are made during the period regardless of whether or not the annuitant is alive Example Debra retired from her job at age 55, and she purchased an immediate annuity with a payout option of 10-year period certain for $250,000. She will receive monthly payments of $2,300 for 10 years until she is 65 around the time Social Security and Medicare kicks in. If Debra were to die before the 10 year period is over, her beneficiary will receive the monthly payments.

37 Unit 3 Liquidation Period - 37 Fixed Amount Certain If the fixed amount certain payout option is chosen: The annuitant determines the payment amount to be received; then the carrier calculates how long the payments will last (based on the principal sum being annuitized and estimated earnings); the carrier keeps paying that amount until all payments have been made Payments are not life contingent Example Roberto retired from his job at age 65 and then annuitized his deferred annuity worth $600,000. Roberto wants $4,000 per month for as long as it lasts. The carrier determines Roberto can receive that payment for 14 years and 5 months (based on the principal sum of $600,000 and its estimated earnings). If Roberto dies before receiving all the monthly payments, his beneficiary will continue to receive the payments until all have been made.

38 Unit 3 Liquidation Period - 38 Joint and Survivor If the joint and survivor payout option is chosen: The carrier will pay equal regular payments to the payee and joint payee while both are living, and Upon the death of the first payee, the carrier will continue regular payments to the surviving payee for as long as that payee is living; the regular payments paid to surviving payee could be: (a) the full amount that was paid while both payees were living; (b) two-thirds that amount; (c) one-half that amount; or (d) some other amount. Example Don and Donna purchased an immediate annuity with a payout option of joint and two-thirds survivor. Don and Donna received monthly payments of $4,500 while they were both living. Once Don died, Donna continued to receive a monthly payment of $3,000. Once Donna died, the payments ended.

39 Amount of Regular Payment Which payout option will provide the most money paid out? It depends! Unit 3 Liquidation Period - 39 Compared to the other life contingent payment options, the pure life option provides the highest regular payment amount. However, pure life also carries the most risk to the annuitant s estate and family, since all payments are terminated upon the annuitant s death.

40 Unit 3 Liquidation Period - 40 Choosing Payout Options The owner of the annuity chooses the payout option at these points in time: For immediate annuities: when the annuity is purchased For deferred annuities: when the annuity is annuitized (also called the maturity date or the annuity date) Once the payout option has been chosen and the payments have started, can the payout option be changed? Although there might be some exceptions to the rule, generally the carrier will not allow the payout option to be changed after the payments have started.

41 Taxation Unit 3 Liquidation Period - 41 Taxation of income received from an annuity during the liquidation period depends on whether the source of the premium paid into the annuity was non-qualified funds, qualified (IRA) funds, or qualified (Roth IRA) funds. Non-Qualified Qualified (Traditional IRA) Qualified (Roth IRA) If non-qualified money was used to pay the annuity premium, a portion of each payment received from the annuity during the liquidation period will be taxable. The amount considered return of principal is not taxable. The amount considered interest income is taxable. If qualified (Traditional IRA) money was used to pay the annuity premium, the entire amount of each payment from the annuity during the liquidation period will be taxable. The amount considered return of principal is taxable, and the amount considered interest income is also taxable. If qualified (Roth IRA) money was used to pay the annuity premium, the entire amount of each payment from the annuity during the liquidation period will NOT be taxable as long as certain conditions are met.

42 Unit Four Immediate Annuities

43 Immediate Annuities Overview Unit 4 Immediate Annuities - 43 Immediate annuities also called single premium immediate annuities (SPIAs) are always purchased with a single lump sum payment. They are named immediate, because immediately after purchase they enter the liquidation period in which regular income payments begin. Single Premium Paid In Regular Payments Paid Out During the Liquidation Period

44 Guaranteed Income Unlike other financial products, immediate annuities (and deferred annuities that have been annuitized) can provide a guaranteed income for the remainder of a person s life. Unit 4 Immediate Annuities - 44 Annuities are sold only by insurance companies, whose solvency (ability to pay benefits) is highly regulated by the state departments of insurance. Furthermore, benefits are guaranteed by the state Life & Health Insurance Guaranty Association. (Note: state law prohibits insurance agents and insurance companies from making any advertisement, announcement, or statement written or oral, which uses the existence of the association for the purpose of sales, solicitation, or inducement to purchase any form of insurance.) Due to changes in the financial landscape and demographic shifts, sources of a guaranteed income in retirement are becoming a rarity. These shifts and changes are explained on the next pages.

45 Unit 4 Immediate Annuities - 45 Social Security Since its inception in the 1930s, Social Security has provided the promise of an income for life. That promise has some limitations and concerns: According to Social Security was never meant to be the only source of income for people when they retire. Social Security replaces only about 40 percent of an average wage earner s income after retiring, and most financial advisors say retirees will need 70 percent or more of pre-retirement earnings to live comfortably. To have a comfortable retirement, Americans need much more than just Social Security. They also need private pensions, savings and investments. reports that the Social Security trust fund reserves will be exhausted in 2033, three years earlier than projected previously. Thereafter, Social Security tax income would be sufficient to pay only about threequarters of scheduled benefits through 2086.

46 Employment Promises Unit 4 Immediate Annuities - 46 In addition to Social Security, defined benefit retirement plans (also known as traditional pension plans) have promised an income for the remainder of a retired person s life. However, these traditional pension plans are becoming less and less common. According to the Pension Benefit Guaranty Corporation ( there are about 38,000 insured defined benefit plans today compared to a high of about 114,000 in Furthermore, the U.S Bureau of Labor Statistics ( reports that today only about 18 percent of private industry employees are covered by a defined benefit plan compared to 35 percent 20 years ago. In order to have an adequate income during retirement, a person can attempt to keep working as they get older. However, that might not be an option due to declining: health, job skills, and time since the person may need to care for a family member that is elderly or has a disability.

47 Demographic Shifts Unit 4 Immediate Annuities - 47 Americans are getting older. Baby boomers, defined as persons born between 1946 and 1964, number approximately 76 million today and account for about one-quarter of America s population. The first baby boomer turned 65 in 2011 the last will turn 65 in According to the percentage of Americans over age 65 was 12.4% in 2000 and is expected to skyrocket to 19.3% in Percent of Population -65 Years & Over Source: U.S. Census Bureau Given these statistics, in the 15.0 coming decades there will be a 10.0 significant increase in the 5.0 percentage of older 0.0 Americans and a significant decrease in the percentage of younger workers. This is a formula of great concern: there will be more older people without an adequate income to support themselves and less younger people working to provide the support that older people need.

48 Appeal of Immediate Annuities Unit 4 Immediate Annuities - 48 Recapping the income concerns for older Americans presented in the previous pages: Social Security s long-term stability and ability to provide an adequate income during retirement is in question. Employer-sponsored defined benefit pension plans do not provide the same peace of mind that they once did. Older workers can attempt to keep working but may be forced to quit due to various reasons. In the coming years, there will be a larger number of older people without an adequate income to support themselves and less younger people working to provide the support that older people need. Unlike other financial products, immediate annuities (and deferred annuities that have been annuitized) are appealing for many Americans, because they can provide a guaranteed income for the remainder of a person s life.

49 Advantages of Immediate Annuities Unit 4 Immediate Annuities - 49 There can be many advantages for clients with immediate annuities (and deferred annuities that have been annuitized). Immediate annuities: Come with a guarantee provided by an insurance company a very strong financial institution whose solvency is regulated by the state departments of insurance Can eliminate the risk of living a long time and outliving one s savings Can eliminate the risk of investment loss that other financial products (e.g. mutual funds, stocks, bonds, real estate) have when markets decline Can eliminate the risk of interest rate changes that other financial products (e.g. short-term Treasury bills, money market funds, shortterm bonds) have when interest rates drop Are tax-advantaged; regardless of whether the money used to purchase an immediate annuity is qualified or non-qualified, all growth is tax-deferred or in the case of a Roth IRA (if certain conditions are met), the growth can be tax free

50 Unit 4 Immediate Annuities - 50 Disadvantages of Immediate Annuities Despite their advantages, immediate annuities (and deferred annuities that have been annuitized) are not without their drawbacks. Immediate annuities: Are not liquid; once a lump sum has been exchanged for a steady stream of income, generally the carrier will not reverse the transaction, and the flow must continue per the terms of the contract Do not provide an opportunity for additional growth beyond the terms of the agreed upon contract; the payout amount is guaranteed no more, no less Provide a fixed benefit that might not keep up with inflation unless an inflation adjustment option is purchased

51 Risk Unit 4 Immediate Annuities - 51 All financial products come with risks that either the client or the financial institution must bear. This chart summarizes the risks associated with immediate annuities. Risk Living a Long Time Investment Loss Interest Rate Changes Inflation Who Bears the Risk? Carrier Carrier Carrier Client Unless an inflation adjustment option is purchased From the client s perspective, an immediate annuity is a very conservative product, since the carrier bears most of the risk.

52 Unit 4 Immediate Annuities - 52 Capital Lump Sum Unlike deferred annuities, immediate annuities do not have an accumulation period. Therefore, the purchaser of an immediate annuity already has a capital lump sum available when the contract is made. Examples of capital lump sum sources include: Car accident lawsuit settlement Medical malpractice lawsuit settlement Divorce settlement Sale of a business Sale of a home Inheritance Life insurance death benefit Company pension plan lump sum distribution 401k transfer IRA transfer

53 Immediate Defined Unit 4 Immediate Annuities - 53 Immediate is defined as within one year of the purchase date, and therefore, the steady stream of income payments from an immediate annuity will start within one year of purchase. If the contract calls for a monthly payout frequency, then normally the first income payment will be made one month after purchase. If the contract calls for an annual payout frequency, then normally the first income payment will be made one year after purchase.

54 Payout Options Unit 4 Immediate Annuities - 54 The annuity payout options were explained in detail in Unit 3 Liquidation Period. These payout options apply equally to immediate annuities and also deferred annuities that have been annuitized. Here is a review: Pure Life Life with Period Certain Liquidation Period - Payout Options Life with Installment Refund Life with Cash Refund Fixed Period Certain Fixed Amount Certain Joint and Survivor

55 Immediate Annuity Example 1 Ronnie is retiring at age 67. His assets include: $300,000 employer pension plan $450, k $200,000 IRAs $275,000 home (no mortgage) Unit 4 Immediate Annuities - 55 Ronnie will begin to receive social security payments that will replace only about 40% of his working income. He is in excellent health and is concerned about outliving his money, since there is longevity in his genes. Ronnie decides to take the $300,000 from his pension plan and purchase an immediate annuity that will generate an income of $1790 per month for the rest of his life even if he lives to be 100 or beyond. If Ronnie lives to be 92, for example, the annuity will generate more than a half million dollars of steady income, calculated as follows: $1790 x 12 months x 25 years = $537,000

56 Immediate Annuity Example 2 Unit 4 Immediate Annuities - 56 Ronnie s twin sister Rhonda is also retiring at age 67. Her financial situation and health condition is similar to Ronnie s. Like her brother, Rhonda decides to take $300,000 from her pension plan and purchase an immediate annuity that will generate an income for the rest of her life. Will Rhonda s monthly payment be more or less than Ronnie s? A woman has a higher life expectancy than a man. Since Rhonda is mathematically more likely to live longer and receive more monthly payments than her brother, the carrier will pay her less per month. Rhonda s immediate annuity will pay her $1625 per month which is $165 less than Ronnie s monthly payment.

57 Immediate Annuity Example 3 Unit 4 Immediate Annuities - 57 The Doe family was involved in a tragic accident. John Doe and his wife Mary were both fatally injured when their car was struck by an ACME Concrete, Inc. truck that went through a red light. Ten-year-old daughter Ashley was critically injured, leaving her with a shortened life expectancy and in need of special care for the rest of her life. ACME Concrete, Inc. was determined to be negligent for $1 million in damages. The settlement provided money for damages including John and Mary s final expenses and Ashley s medical bills. The structured settlement also stipulated that ACME Concrete s insurer purchase an immediate annuity to provide a steady stream of monthly income for Ashley to receive the care she needs for the rest of her life. Since Ashley has a shortened life expectancy and likely to receive less monthly payments than otherwise the carrier might agree to issue a substandard immediate annuity. A substandard annuity provides a higher monthly income relative to the lump sum premium paid. (While some carriers specialize in substandard annuities, many do not offer them.)

58 Unit Five Deferred Annuities

59 Deferred Annuities Overview Unit 5 Deferred Annuities - 59 Deferred annuities can be purchased with one or more payments. Deferred annuities always have an accumulation period. If there is a liquidation period, it will begin after the accumulation period is over. One or More Premiums Paid In; Money Grows Tax Deferred During the Accumulation Period Regular Payments Paid Out During the Liquidation Period

60 What is Deferred? Unit 5 Deferred Annuities - 60 There are two things about deferred annuities that are deferred. Deferred Taxes The money in a deferred annuity can grow as a result of interest or investment income. This growth is tax-deferred; therefore, a main attraction of deferred annuities is the tax advantages. IRAs and 401(k)s are also tax advantaged, but tax advantaged contributions are limited only to a certain amount of earned income from a job. Deferred annuities are a good choice for those who have maxed out their IRA and 401(k) contributions and those who have unearned income. Deferred Income Deferred annuities are intended for people who have long-term financial goals and do not have an immediate need for the money at the time it is placed into the annuity. Deferred annuities are best suited for individuals who want to: (a) have a safe place for extra money they don t need, (b) save money for retirement, (c) defer income to a later date, or (d) pass money to their heirs.

61 Unit 5 Deferred Annuities - 61 Accumulation Period All deferred annuities have an accumulation period during which: Premiums are paid into the annuity; premium payments can be made with one lump sum, multiple regular payments, or multiple irregular payments The value of the annuity grows tax-deferred; this is true regardless of whether the source of the funds used to pay the annuity premium is non-qualified or qualified money The amount of growth potential and safety of the principal depends on whether the annuity is a fixed, equity indexed, or variable annuity. It also depends on the applicable fees charged by the carrier.

62 Unit 5 Deferred Annuities - 62 Withdrawals and Surrenders Deferred annuities are considered long-term contracts. A client who puts money into a deferred annuity should do so only if he or she will not need the money in the foreseeable future. Taking money out of an annuity soon after putting it in will result in a charge. Circumstances do change, however, and sometimes it is necessary for a client to have access to an annuity s value during the accumulation period before it has been annuitized: Withdrawal is when the client takes out part of the annuity s value Surrender is when the client takes out the entire value of the annuity

63 Withdrawal and Surrender Charges Unit 5 Deferred Annuities - 63 Withdrawal and surrender charges can be significant. The carrier may calculate the charge as: A percentage of the value of the contract A percentage of the premiums paid in A percentage of the amount being withdrawn or surrendered Usually the longer the contract has been in force, the lower the withdrawal or surrender charge will be. After a specified number of years (perhaps seven or eight) withdrawal and surrender charges may be completely eliminated. Many deferred annuities have a limited free withdrawal feature. That allows the client to make one or more withdrawals during the accumulation period without a charge. The amount of the free withdrawal is usually limited to a percentage (typically 10%) of the contract value. If a larger amount is withdrawn, withdrawal charges may apply. Some carriers waive withdrawal charges in certain situations (e.g. nursing home confinement, terminal illness, or death).

64 Unit 5 Deferred Annuities - 64 Other Charges In addition to withdrawal and surrender charges, most annuities have charges associated with selling and servicing the annuity. These charges may include: Contract Fee a flat dollar amount, either charged once when the contract is issue, or charged each year Transaction Fee a flat dollar amount charged per premium payment or other transaction Percentage of Premium Charge a percentage deducted from each premium paid (also called a load ); the percentage may be lower after the contract has been in force for a specified number of years or after total premiums paid have reached a specified amount

65 Unit 5 Deferred Annuities - 65 Death of the Annuitant At the time a deferred annuity is purchased, the owner is allowed to designate a beneficiary. The beneficiary designation can be changed at any time before the annuitant s death. If the beneficiary has been designated as irrevocable, then the beneficiary cannot be changed without the consent of the irrevocable beneficiary. If the annuitant dies during the accumulation period before a deferred annuity has been annuitized usually the carrier will pay the beneficiary a death benefit that is equal to one of the following amounts (whichever is greater): The cash value of the annuity The amount of premiums paid into the annuity If a beneficiary was not named, or if the beneficiary predeceased the annuitant, the death benefit will be paid to the annuitant s estate. Having the death benefit paid to the annuitant s estate is usually not desirable, since the proceeds will have to go through probate and could take months or years for the money to be distributed.

66 Unit 5 Deferred Annuities - 66 Annuitization Annuitization is the term used to describe the process of taking the funds amassed during the accumulation period and exchanging it ( flipping the switch ) for a steady stream of guaranteed income known as the liquidation period. Generally, once a deferred annuity has been annuitized and it transitions from the accumulation period to the liquidation period, the process cannot be reversed. In reality, however, most deferred annuities are never annuitized, primarily for these reasons: Instead of annuitizing, the annuitant can take regular or as needed withdrawals The annuitant can die or decide to surrender it before annuitization A deferred annuity can be purchased with the intent of never annuitizing it as could be the case for a wealthy person who wants a safe and secure place to put away money that will be passed to his or her heirs upon death

67 Liquidation Period Unit 5 Deferred Annuities - 67 The annuity payout options were explained in detail in Unit 3 Liquidation Period. These payout options apply equally to immediate annuities and also deferred annuities that have been annuitized. Here is a review: Pure Life Life with Period Certain Liquidation Period - Payout Options Life with Installment Refund Life with Cash Refund Fixed Period Certain Fixed Amount Certain Joint and Survivor

68 Advantages of Deferred Annuities Unit 5 Deferred Annuities - 68 In Unit 4, some advantages of immediate annuities (and deferred annuities that have been annuitized) were listed. Here is a reiteration of some advantages of deferred annuities: They come with a guarantee provided by an insurance company a very strong financial institution whose solvency is regulated by the state departments of insurance They are tax-advantaged; regardless of whether the money used to purchase an immediate annuity is qualified or non-qualified, all growth is tax-deferred or in the case of a Roth IRA (if certain conditions are met), the growth can be tax free Compared to the other safe places to put money (short-term Treasury bills, money market funds, short-term bonds), the interest rate provided by deferred annuities can be quite favorable

69 Disadvantages of Deferred Annuities In Unit 4, some disadvantages of immediate annuities (and deferred annuities that have been annuitized) were listed. Here is a recap of some disadvantages of deferred annuities: Most deferred annuities have charges associated with selling and servicing the annuity, such as contract fees, transaction fees, and percent of premium charges; these charges make deferred annuities unattractive as short-term financial products Unit 5 Deferred Annuities - 69 Withdrawals and surrenders during the first several years of the accumulation period may be subject to withdrawal and surrender charges Generally, once a lump sum has been exchanged for a steady stream of income, the carrier will not reverse the transaction, and the flow must continue per the terms of the contract

70 Deferred Annuity Example 1 Beatrice was a successful self-employed realtor. At age 40 she started saving for retirement by putting $800 a month into a deferred annuity and did so religiously for 25 years. Now at age 65, Beatrice has a deferred annuity with a value of $312,000. She has decided to annuitize it and chooses the life with period certain of 10 years payout option. Unit 5 Deferred Annuities - 70 Beatrice will receive monthly payments of $1,576 for as long as she lives. If she dies less than 10 years from the date of annuitization, her designated beneficiary (husband Charlie) will continue to receive monthly payments of $1,576 until a total of ten years of payments have been paid to Beatrice and Charlie combined.

71 Deferred Annuity Example 2 Oscar and Henrietta are wealthy retirees. Quite frankly, they have more money than they need. In addition to investing in mutual funds and giving money to their children, grandchildren, and charity, they decided to each put a $250,000 lump sum into a deferred annuity. They like the safety that deferred annuities provide, plus the interest rate isn t all that bad compared to other safe places to put money (such as short-term Treasury bills, money market funds, and short-term bonds). Unit 5 Deferred Annuities - 71 Down the road if they ever really need the money, Oscar and Henrietta can annuitize their deferred annuities, make withdrawals, or surrender them. Otherwise when they die, the death benefit will be paid to the beneficiaries they name.

72 Deferred Annuity Example 3 Ernie was a successful self-employed plumber. At age 30 he started saving for retirement by putting $4000 a year into a traditional IRA deferred annuity and did so religiously each year. Being self-employed, his plan was to annuitize the deferred annuity at age 65 and receive a monthly income payment for the rest of his life. Tragically, however, Ernie died in a car accident at age 57. When the deferred annuity was purchased, Ernie had named is wife Patty as the beneficiary. Upon her husband s death, Patty received the accumulated value of the annuity which was $124,000. Unit 5 Deferred Annuities - 72

73 Deferred Annuity Example 4 Unit 5 Deferred Annuities - 73 Beatrice was a school teacher. When she was 62 Beatrice inherited 500,000 from her mother, and she put the money into a flexible premium deferred annuity. When she was 67 Beatrice s husband died, and she took the $750,000 death benefit and added it to the deferred annuity. At age 80 when Beatrice went to live in a nursing home, her annuity had accumulated to $1.4 million. She then annuitized it and chose the life with installment refund payout option, proving an income payment of $9,600 each month for as long as she lives. If she dies before the entire $1.4 million has been paid, payments of $9,600 will continue to be paid to her children beneficiaries until payments totaling the $1.4 million have been paid. Although Beatrice s nursing home care is very expensive, the $9,600 per month is more than enough to pay for it. Beatrice and her children have the peace of mind knowing that the payments will continue for as long as Beatrice lives and will not have to rely on Medicaid to pay for her care. Furthermore, the installment refund feature guarantees that the entire $1.4 million will be paid back to Beatrice and/or her family.

74 Unit Six Traditional Fixed Annuities

75 Accumulation Method Unit 6 Traditional Fixed Annuities - 75 A deferred annuity can be classified as: traditional fixed, equity-indexed, or variable. This unit focuses on traditional fixed and the next unit on equityindexed. Variable annuities are considered securities, and only life insurance licensees that also have a variable contracts license are allowed to sell them; therefore, they will not be explained further in this class. Traditional Fixed The value grows at interest rates set by the carrier. The carrier guarantees that it will pay no less than the minimum rate of interest specified in the annuity contract. Equity-Indexed (Fixed) The value grows at rates that are linked to an equity index, such as the S&P 500. A minimum interest rate is guaranteed, so this annuity is considered to be a fixed annuity not a variable (securities) contract. Variable The assets of the annuity are placed into a separate account managed for the client by the carrier. The client chooses how the assets are invested (such as stock or bond mutual funds). The return is variable, so there are no guarantees.

76 What is a Fixed Deferred Annuity? Fixed deferred annuities offer a guaranteed rate of return for the life of the contract. In contrast, variable deferred annuities do not have such a guarantee. Unit 6 Traditional Fixed Annuities - 76 Interestingly, although all fixed deferred annuities offer a guaranteed rate of return for the life of the annuity most do not provide a fixed rate of return for the life of the annuity the interest rate can change from time-to-time. Fixed deferred annuities include traditional fixed and equity-indexed annuities. Nonetheless, traditional fixed deferred annuities are commonly referred to simply as fixed annuities by insurance professionals while equity-indexed fixed deferred annuities are usually called equity-indexed, fixed-indexed, or simply indexed annuities. Fixed Annuities Traditional Fixed Equity-Indexed

77 Interest Rates During the accumulation period of a traditional fixed deferred annuity, the client s money earns interest at rates set by the carrier which can change. How and when the interest rates can change varies greatly by carrier they also can vary greatly by product within a carrier. Unit 6 Traditional Fixed Annuities - 77 The next page lists how and when the interest rate can change. Although there are a seemingly indefinite number of ways that carriers change the interest rate, the list identifies features that many traditional fixed deferred annuities have in common.

78 Determining Interest Rates Unit 6 Traditional Fixed Annuities - 78 Considerations for determining the interest rate of a traditional fixed deferred annuity include: When the contract is first issued, the interest rate is normally locked in during the initial interest rate guarantee period for a certain number of years typically ranging from one to ten years. Some carriers call it a base interest rate. There may be a first-year interest rate bonus such as 0.25% or 1.00%. Some carriers call it an additional interest rate. After the initial interest rate guarantee period is over, the interest rate will be reset, and the contract will receive a renewal interest rate that can change annually. Some carriers call it the current interest rate. The renewal interest rate cannot be less than the minimum guaranteed interest rate stated in the contract typically between 1.00% and 4.00%. Some carriers pay a higher interest rate for larger accounts.

79 Bailout Provision Some traditional fixed deferred annuities have a bailout provision or escape clause. If the renewal interest rate falls below the bailout interest rate for a particular annuity purchase payment, the client may withdraw that money with no withdrawal charge if the withdrawal is within 30 days of the renewal date. Unit 6 Traditional Fixed Annuities - 79 Although the bailout provision allows withdrawals without a withdrawal charge, withdrawals could be subject to income tax. Furthermore, if the withdrawal occurs before age 59½, an additional 10% federal income tax penalty may apply. The earnings are withdrawn and taxed first which is considered last-in-first-out (LIFO) for tax purposes.

80 Market Value Adjustment (MVA) Some traditional fixed deferred annuities are subject to market value adjustment (MVA). If an annuity is subject to MVA and the client surrenders the annuity or takes a withdrawal before the initial interest rate guarantee period is over, an adjustment is made. The actual amount the client receives can be more or less than the account value: it depends on the current market interest rate compared to the interest rate at the time the annuity was purchased. MVA Example Unit 6 Traditional Fixed Annuities - 80 James purchased a traditional fixed deferred annuity with an MVA in 2007 when interest rates were higher than when he surrendered the annuity in 2012 two years before the initial interest rate guarantee period was over. Since interest rates dropped, James will likely receive an amount more than his account value. If interest rates would have increased from 2007 to 2012, James would likely receive an amount less than his account value.

81 Traditional Fixed Example 1 Unit 6 Traditional Fixed Annuities - 81 Here is a hypothetical example of the features of a traditional fixed deferred annuity. Pay In Option One lump-sum premium payment Minimum Payment $10,000 Interest Rate First Year Bonus Withdrawals The initial interest rate guarantee period is for one or five years (the client can choose one or five on the application). After the initial interest rate guarantee period is over, the interest rate is reset each year to the current market interest rate. This rate cannot be below the guaranteed interest rate. 1.00% extra interest is given during the first year only. Up to 10% of the account value may be withdrawn without charges.

82 Traditional Fixed Example 2 Unit 6 Traditional Fixed Annuities - 82 Here is a second hypothetical example of the features of a traditional fixed deferred annuity. Pay In Option Flexible premiums one or many payments can be made Minimum Payment $1,000 min. initial payment; $100 min. subsequent payments Interest Rate First Year Bonus Withdrawals The interest rate is set to the current interest rate at the beginning of each contract year and is guaranteed for the remainder of that contract year. The interest rate cannot go below the minimum guaranteed interest rate, which is set at the time of contract issue and will not be less than one percent or greater than three percent. None Up to 10% of the account value may be withdrawn without charges. Amounts withdrawn above the 10% of account value are subject to surrender charge: 7% during first year, 6% during second year, 5% during third year, 4% during fourth year, 3% during fifth year, 2% during sixth year, 1% during seventh year, 0% thereafter.

83 Traditional Fixed Example 3 Unit 6 Traditional Fixed Annuities - 83 Here is a third hypothetical example of the features of a traditional fixed deferred annuity. Pay In Option One lump-sum premium payment Minimum Payment $5,000 Interest Rate First Year Bonus Withdrawals The initial interest rate guarantee period is for five years. After the initial interest rate guarantee period is over, the interest rate is reset each year to the current market interest rate. This rate cannot be below the guaranteed interest rate. None The amount equal to the interest earned in the previous contract year may be withdrawn without charges. Withdrawals above that amount are subject to surrender charges as follows: 7% during the first year, 6% during the second year, 5% during the third year, 4% during the fourth year, 3% during the fifth year, 0% thereafter. Amounts withdrawn may be subject to market value adjustment (MVA).

84 Unit Seven Equity-Indexed Annuities (EIAs)

85 Accumulation Method Unit 7 Equity-Indexed Annuities (EIAs) - 85 Based on the accumulation method used, a deferred annuity can be classified as: traditional fixed, equity-indexed, or variable. The last unit focused on traditional fixed and this unit will focus on equity-indexed. Traditional Fixed The value grows at interest rates set by the carrier. The carrier guarantees that it will pay no less than the minimum rate of interest specified in the annuity contract. Equity-Indexed (Fixed) The value grows at rates that are linked to an equity index, such as the S&P 500. A minimum interest rate is guaranteed, so this annuity is considered to be a fixed annuity not a variable (securities) contract. Variable The assets of the annuity are placed into a separate account managed for the client by the carrier. The client chooses how the assets are invested (such as stock or bond mutual funds). The return is variable, so there are no guarantees.

86 Unit 7 Equity-Indexed Annuities (EIAs) - 86 What is an Equity-Indexed Annuity? Fixed deferred annuities include equity-indexed annuities (EIAs). EIAs are considered fixed, because they come with a guarantee that variable products do not have: The value of a EIAs cannot drop below a guaranteed minimum. Fixed Annuities Traditional Fixed Equity-Indexed The biggest difference between EIAs and traditional fixed annuities is this: With EIAs the amount of credited interest is calculated using a stock market index such as the S&P 500. Some insurance professionals refer to EIAs as fixed indexed annuities or simply as indexed annuities. They reason that by eliminating the word equity from the name, it helps to mitigate any incorrect assumptions that these are variable products that invest directly in equities (stocks).

87 Unit 7 Equity-Indexed Annuities (EIAs) - 87 What is an Equity-Indexed Annuity? An EIA, like other fixed annuities, promises to pay a minimum guaranteed interest rate. That rate will not be less than the minimum guaranteed rate even if the interest rate that is based on the index is lower. According to When EIAs were first sold in the mid-1990s, the guaranteed minimum return was typically 90 percent of the premium paid at a 3 percent annual interest rate. More recently, in part because of changes to state insurance laws, the guaranteed minimum return is typically at least 87.5 percent of the premium paid at 1 to 3 percent interest. However, if you surrender your EIA early, you may have to pay a significant surrender charge and a 10 percent tax penalty that will reduce or eliminate any return.

88 Stock Market Index Unit 7 Equity-Indexed Annuities (EIAs) - 88 An EIA uses a formula to credit interest which is based on changes in the stock market index that is used. A stock market index tracks the performance of a group of stocks. Some well-known stock market indexes include: Dow Jones Industrial Average (DJIA) Nasdaq Composite Index S&P 500 Composite Stock Price Index NYSE Composite Index Wilshire 5000 Total Market Index Russell 2000 Index According to Most EIAs are based on the S&P 500, but other indexes also are used. Some EIAs even allow investors to select one or more indexes.

89 State and Federal Regulation Unit 7 Equity-Indexed Annuities (EIAs) - 89 Over the past several years, there has been controversy and contention about whether equity-indexed annuities should be considered: Fixed annuities (regulated by the Utah Department of Insurance), or Variable annuities (regulated by both the Utah Department of Insurance and the United States Securities and Exchange Commission).