4 Hour Annuity Suitability

Transcription

1 This Document Will Help You Prepare To Take The Online Examination A Center for Continuing Education 707 Whitlock Ave, SW, Suite C-27 Marietta, GA Fax:

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3 Written by Peggy Erland. Published by Erland Education Services (formerly Erland Education Financial Services.) Edited by Patricia Hangartner Material contained in this course has previously been published by EFES under the titles Deferred and Immediate Annuities, Fixed and Equity-Index Annuities, and Variable Annuities. No part of these courses may be reproduced, transmitted in any form or by any means, electronic or mechanical, for any purpose, without the express permission of Erland Education Services (formerly Erland Financial Education Services). Although great effort has been made to ensure this publication contains accurate, timely information, it is provided with the understanding that the author is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent legal advisor should be sought. (formerly Erland Financial Education Services) 1995, 1996, 1997, 1998, 2000, 2001, 2003, 2004, 2006, 2009, 2011, 2012, 2015

4 Table of Contents Annuities... 2 INTRODUCTION... 1 CHAPTER ONE: ANNUITIES - AN OVERVIEW... 2 SINGLE PREMIUM IMMEDIATE ANNUITIES... 2 DEFERRED ANNUITIES... 2 Flexible Premium Deferred Annuities... 4 Single Premium Deferred Annuities... 4 Fixed Annuities... 4 Variable Annuities... 4 Equity-Index Annuities... 4 ANNUITIZATION OF DEFERRED CONTRACTS... 5 PARTIES TO AN ANNUITY CONTRACT... 5 Annuity Owner... 5 Annuitant... 6 Beneficiary... 6 THE ANNUITY CONTRACT... 7 ANNUITY APPLICATION... 8 Suitability Client Suitable for Annuity Purchase.. 10 Which Product if any suits the clients needs Making Client Aware of Sales Fees/Early Surrender Charges Avoid High Pressure Sales Tactics CHAPTER TWO: FIXED ANNUITY FEATURES TAX DEFERRAL Example of Tax Deferred Growth Exhibit 2. Tax Deferred Growth Probate Defined FREE WITHDRAWALS SURRENDER OR WITHDRAWAL CHARGES Market Value Adjustment CD Annuities PRINCIPAL GUARANTEE SYSTEMATIC WITHDRAWALS MEDICAL OR NURSING HOME WAIVERS OTHER SURRENDER CHARGE WAIVERS MATURITY DATE OR MAXIMUM DEFERRAL AGE PREMIUM TAX CHAPTER THREE: FIXED ANNUITY RATES THE INITIAL RATE Bonus and Base Rates... 18

5 Premium or Rate Bonuses FACTORS IN RATE SETTING Competition Product Features Commission Investments Portfolio Method Of Investing Bucket Or Banded Method Of Investing Premium Tax Interest Rate Setting Sample Interest Rate Setting Model The Phantom Rate RENEWAL RATES ADDITIONAL CONTRIBUTION RATE BAIL OUT RATES MINIMUM GUARANTEED RATE RATE VERSUS YIELD HISTORICAL RATES SETTING INTEREST RATES ON SINGLE PREMIUM IMMEDIATE ANNUITIES CHAPTER FOUR: FIXED ANNUITY PAYMENTS ANNUITY PAYMENT FEATURES AND ADVANTAGES Many Income Options Available To Meet Differing Customer Needs Guaranteed Income Lifetime Income Convenience Taxation PARTIES INVOLVED IN ANNUITY PAYMENTS Owner Annuitant Payee Beneficiary INCOME OPTIONS Life Income Life and Period Certain Income Life With Installment Refund Income Life with Cash Refund Temporary Life Income Joint and Survivor Life Income Joint and Specified Percentage to Survivor Life Income Joint and Specified Percentage to Contingent Life Income Joint and Survivor With Period Certain Income Joint and Survivor Life With Installment Refund Joint and Survivor Life with Cash Refund... 28

6 Period Certain CHAPTER FIVE: TAXATION OF FIXED ANNUITIES* Tax Deferral Withdrawals LIFO and FIFO Withdrawals Pre - 59 ½ Distributions Multiple Contracts TAX-FREE EXCHANGES Paperwork Requirements Time Delays TAXATION OF ANNUITY PAYMENTS WHO PAYS THE TAXES? Who Owes The Taxes On Withdrawals? Who Owes the Taxes on A Jointly Held Annuity and at Ownership Changes? Who Pays The Tax At Annuitization? TAXATION RULES AT DEATH Death Prior To Annuitization Death After Annuitization Non-Natural Owners Insurance Company Application Of The Distribution At Death Rules Distribution At Death Deferred Contract Type I Distribution At Death Deferred Contract Type II Distribution At Death Deferred Contract Type III ESTATE TAXATION Deferred Contract Annuitized Contract OTHER TAXATION ISSUES Taxation of Social Security Benefits Divorce Assignment of Annuities, or Pledging an Annuity As Collateral CHAPTER SIX: ADVANTAGES OF THE VARIABLE ANNUITY TAX- DEFERRAL INVESTMENT OPTIONS GUARANTEED DEATH BENEFITS VARIETY OF FLEXIBLE INCOME OPTIONS SUMMARY CHAPTER SEVEN: VARIABLE ANNUITY FUNDAMENTALS DEFERRED CONTRACTS Tax-Deferral PREMIUM PAYMENTS Flexible Premium Variable Annuities Single Premium Variable Annuities... 42

7 THE VARIABLE ANNUITY AS A SECURITY Investment Risk The Separate Account The Sub-Account VARIABLE ANNUITY ACCUMULATION UNITS ANNUITIZATION THE VARIABLE ANNUITY PROSPECTUS Variable Annuity Expenses Transaction Expenses Sample Deferred Sales Load Calculation Annual Expense Separate Account Expenses Performance Data Definition of Terms Account Valuation Method Annuitization Options Contract Provisions Sub-Account Descriptions Fixed Account Description Federal Tax Considerations ANNUITY APPLICATION CHAPTER EIGHT: VARIABLE ANNUITY SUB-ACCOUNTS TYPES OF RISK Financial or Default Risk Bond Rating Agencies Market Risk Interest Rate Risk Interest Rate Changes and Bond Prices Interest Rate Changes and Bond Term and Quality Purchasing Power Risk Economic or Political Risk Exchange Rate Risk SUB-ACCOUNT OBJECTIVES Capital Appreciation Total Return Income Preservation of Capital TYPES OF SUB-ACCOUNTS Government Sub-Account Funds US Government Sub-Account Funds US Government Treasury Sub-Account Funds Corporate Bond Sub-Account Funds High Yield Corporate Bond Sub-Account Funds... 56

8 Corporate Bond Sub-Account Funds - High Quality Corporate Bond Sub-Account Funds - General World Bond Sub-Account Funds Equity Sub-Account Funds Aggressive Growth Sub-Account Funds Growth Sub-Account Funds Small Cap or Small Company Sub-Account Funds Growth and Income Sub-Account Funds Equity Income Sub-Account Funds World Stock Sub-Account Funds Sector Sub-Account Funds Balanced Sub-Account Funds Money Market Sub-Account Funds CHAPTER NINE: VARIABLE ANNUITY FEATURES CONTRIBUTION FEATURES Dollar-Cost Averaging Regular Investment Programs Asset Allocation Programs LIQUIDITY FEATURES Penalty Free Withdrawals Nursing Home Waivers Systematic Withdrawal Programs GUARANTEED DEATH BENEFIT PROVISIONS Stepped-Up Death Benefits Assumed Percentage Increases in Account Value SUMMARY CHAPTER TEN: VARIABLE ANNUITY INCOME PAYMENTS VARIABLE ANNUITY INCOME PAYMENT FEATURES AND ADVANTAGES Many Income Options Available To Meet Differing Customer Needs Guaranteed Income Opportunity for Growth Lifetime Income Convenience Taxation PARTIES INVOLVED IN ANNUITY PAYMENTS Owner Annuitant Payee Beneficiary INCOME OPTIONS Life Income Life and Period Certain Income Life With Installment Refund Income... 67

9 Life with Cash Refund Joint and Survivor Life Income Joint and Specified Percentage to Survivor Life Income Joint and Specified Percentage to Contingent Life Income Joint and Survivor With Period Certain Income Joint and Survivor Life With Installment Refund Joint and Survivor Life with Cash Refund Period Certain CHAPTER ELEVEN: TAXATION OF VARIABLE ANNUITIES TAXATION OF ANNUITY PAYMENTS Fixed Annuity Income Payments Variable Annuity Income Payments CHAPTER TWELVE: ADVANTAGES OF EQUITY-INDEXED ANNUITIES71 TAX- DEFERRAL OPPORTUNITY FOR GROWTH GUARANTEED MINIMUM RETURN AVOIDANCE OF PROBATE VARIETY OF METHODS TO ACCESS ACCOUNT VALUES SUMMARY CHAPTER THIRTEEN: FEATURES OF EQUITY-INDEXED ANNUITIES.. 73 SECURITIES REGULATION AND EQUITY-INDEX ANNUITIES INDEX-BASED PORTFOLIOS Why Index-Based Portfolios Are Used by Money Managers STANDARD & POOR S COMMON INDEX, 1980 TO Diversification Equity Investing Low Management Fees INDEX FUNDS VS. EQUITY-INDEX ANNUITIES IMPORTANT TERMS IN EQUITY-INDEX ANNUITIES Cap Term Participation Rate Floor Averaging Compounding Vesting INDEX BENEFIT CALCULATIONS Annual Reset Method High Water Mark Method Point-to-Point Method FREE WITHDRAWALS Ten Percent of Initial Premium... 83

10 Ten Percent of Accumulated Value Ten Percent of Principal Ten Percent of the Minimum Guaranteed Value Nursing Home or Medical Waiver Withdrawals Impact of Withdrawals on the Annuity Value ANNUITIZATION PRINCIPAL GUARANTEE MINIMUM INDEX RETURNS MINIMUM GUARANTEED RATES DEATH BENEFIT HOW INSURERS PARTICIPATE IN THE EQUITY INDEX MARKET Types of Options Put Options Call Options Option Premium Income Covered Option Writing Use of Options by Portfolio Managers Increasing Yields Protection Against Loss Adding Diversification Index Options SUMMARY CHAPTER FOURTEEN: HOW ANNUITIES MEET RETIREMENT NEEDS 89 RETIREMENT Individual Retirement Accounts IRA Maximum Contribution Levels IRA Maximum Contribution Levels for Individuals 50 and Over Regular IRAs The Roth IRA Advantages of IRAs Regular IRA Eligibility Regular IRA Contribution Rules IRA Investments Types of Regular IRAs Individual Retirement Accounts Individual Retirement Annuities Spousal IRAs Premature Distributions Exceptions Required Minimum Distributions of the Regular IRA Required Beginning Date Required Minimum Amount Distribution Method Selection... 96

11 Calculating Required Minimum Distributions IRA Rollovers Partial Transfers And Rollovers Rollovers and Direct Rollovers From Qualified Plans to a Regular IRA Eligibility Rules of the Roth IRA Frequency of Contributions Contributions After Age 70 ½ Spousal Roth IRAs Excess Contributions Roth IRA Distribution Rules Using an Annuity For IRA Funds Tax Rules Fixed Annuities Used As An IRA Variable Annuities Used as an IRA Equity-Index Annuities Used As An IRA CHAPTER FIFTEEN: HOW AN ANNUITY MEETS OTHER CLIENT NEEDS111 REDUCTION OF CURRENT TAX LIABILITY INCOME LOW RISK TOLERANCE - FIXED ANNUITIES Financial Strength Standard & Poor s Insurance Rating Services Moody s Investor Service Insurance Financial Strength Ratings Duff & Phelps Credit Rating Company, Insurance Rating Service State Regulations INCAPACITY LIVING TRUSTS CHAPTER SIXTEEN: ANNUITY ALTERNATIVES CERTIFICATES OF DEPOSIT Risk Uses of CDs Maturities Tax Considerations Fees MUTUAL FUNDS Diversification Types of Mutual Fund Securities Tax Considerations Objectives Loads Fund Families Opening Requirements Risk

12 MUNICIPAL BONDS Risk Characteristics of Municipal Bonds General Obligation Bonds Special Tax Bonds Revenue Bonds Housing Authority Bonds Industrial Revenue Bonds Insured Municipal Bonds Uses of Municipal Bonds Tax Considerations Private Activity Bonds KEY DATES AFFECTING ANNUITY TAXATION Prior to August 14, August 14, 1982 and after January 19, 1985 and after After February 28, Prior to April 23, April 23, 1987 and after October 22, 1988 and after GLOSSARY

13 INTRODUCTION Competition among life insurance companies offering annuity products has resulted in the development of annuity products with features such as nursing home waivers, systematic withdrawals, and five-year surrender schedules. These products offer much more than a promise to pay in exchange for a lump sum, the traditional definition of an annuity. The many different annuity products available mean annuities are more complex than ever before, but are also more customer-friendly than ever before. This manual will discuss the basic types of annuities available, common features, taxation of annuities, ownership considerations, annuity payment options and the pros and cons to be aware of when determining whether an annuity will best meet a client s financial needs. 1

14 CHAPTER ONE: ANNUITIES - AN OVERVIEW An annuity is a contract between an insurance company and the owner or owners of the annuity policy. Premium is submitted to the insurance company for the policy and the insurance company pays a specified rate of interest to the owners for the premium submitted. There are two basic types of annuities available: deferred annuities and immediate annuities. Among deferred annuities, there are fixed and variable annuities and single premium and flexible premium annuities. Immediate annuities may also be fixed or variable. This manual will concentrate on fixed annuities, but for overview purposes, a brief discussion of variable annuities will be included. Single Premium Immediate Annuities Single Premium Immediate Annuities (SPIAs) pay income immediately (within twelve months of purchase). In exchange for a lump sum payment ( single premium ) the insurance company promises to make regular payments. The amount of these payments is based on the type of annuity the purchaser selects. There are a wide variety of immediate annuity options available, from payments over life to payments for a specified period, such as five, ten or fifteen years. Payment frequency may be monthly, quarterly, semi-annual or annual. Deferred Annuities Deferred annuities are called deferred because the annuity payments do not begin until sometime after the first twelve months from the policy opening date. In addition, earnings on the policy are deferred from taxation until withdrawn. Some insurance companies refer to this type of annuity as a retirement annuity because tax laws favor receiving payments from a deferred annuity after age 59 ½, and therefore are often 2

15 Flexible Premium Deferred Annuity Tax-Deferred Phase Annuitization Phase Flexible Premium Contributions Annuity Payments Accumulated Cash Values $$ Single Premium Immediate Annuity Single Contribution $$ Regular Annuity Income Payments $$ Exhibit 1.1. Flexible Premium Deferred Annuity, Single Premium Immediate Annuity 3

16 purchased for or during retirement years. TDA, or tax-deferred annuity, is the most common name for this type of annuity. Flexible Premium Deferred Annuities Premium payments or contributions may be made to a flexible premium deferred annuity throughout the life of the contract, or until the contract holder begins irrevocable annuity income payments. The purchaser opens a Flexible Premium Deferred Annuity (FPDA) with a single contribution, but may make additional contributions to the policy. Single Premium Deferred Annuities The purchaser makes only one contribution to a Single Premium Deferred Annuity (SPDA). Fixed Annuities A fixed annuity is an annuity to which the insurance company credits a fixed interest rate for a specified period. The annuity contract will also guarantee a minimum rate of interest. For example, the contract may have a first year rate guarantee of 6%, and a minimum rate guarantee of 3% for all following years. Variable Annuities A variable annuity (VA) is an annuity that allows the purchaser to allocate his or her contributions to a variety of sub-accounts, which in many ways are similar to a mutual fund. Instead of paying a stated rate, the variable annuity s return is based on the performance of the sub-accounts the purchaser selects. For example, the VA s Growth sub-account may return 12% over a one-year period, and the next may return -2%, depending on the performance of the growth stocks within the subaccount portfolio. Variable annuities may be either flexible or single premium products and are considered both an insurance product and a securities product. Equity-Index Annuities Equity-index annuities are annuities that offer the advantage of growth that can exceed a fixed annuity without some of the risks associated with variable annuities. Equity-index annuities provide a return that is related to a stock index, most commonly the S&P 500. The insurance company offering the annuity also provides guaranteed minimum returns, which provides the purchaser with reduced exposure to market risks. Besides these unique features, equity-indexed annuities provide 4

17 many of the same advantages as other annuities, such as tax-deferral and avoidance of probate. Annuitization Of Deferred Contracts Fixed, equity-index and variable deferred annuities include an option, or in some states a requirement, to annuitize the contract. Annuitization refers to making an irrevocable option to receive periodic payments. Payments typically will commence within one month, three months, six months or one year from the annuitization start date. The deferred contract may require that the annuitization start date (also referred to as the contract maturity date, annuity start date or maximum deferral date) be no later than a certain age, e.g. age 85. The maximum annuity start date may also be governed by state law. Parties To An Annuity Contract An annuity contract involves three different parties - the owner, the annuitant and the beneficiary. Annuity Owner The owner is the person (natural or non-natural) who owns the annuity. The annuity contract specifies certain rights of the owner, such as the ability to withdraw funds, name the annuitant and beneficiary, and determine, within contract restrictions, the annuitization date and annuitization method. Some annuity companies allow the owner to change the annuitant on a contract, or add, change or delete an owner or joint owner. The owner can change the beneficiary at any time, as long as no irrevocable beneficiary has been named. Joint Ownership Some contracts allow joint ownership. This means that the contract is owned equally by both owners, and all transactions and changes such as those listed above will require the signature of both owners. The owners may never transact on the contract independently of one another. In addition, most experts agree that all tax ramifications of the contract during the owners lifetimes are also shared equally, on a 50/50 basis. This aspect is discussed in more detail in Chapter Five. Sometimes, the intended purpose for naming a joint owner is to ensure that at one owner s death, the other owner can remain owner of the annuity contract. However, annuity contracts may contain provisions that require that a death benefit be paid to a beneficiary at the death of one owner. In addition, the Internal Revenue Code (IRC) contains restrictions on continuation of an annuity upon an owner s death. Therefore, 5

18 joint ownership on an annuity contract does not guarantee that the surviving joint owner may continue a contract. Non-Natural Owners The owner of the contract may be a natural or non-natural person. A non-natural person refers to entities such as corporations or trusts. If a non-natural person owns an annuity, however, the annuity loses its tax deferral status. The exception to this loss of tax deferral is certain trusts which are considered an agent for a natural person (e.g. a revocable living trust). Some insurance companies will not open annuity contracts for non-natural persons because of the loss of tax deferral restriction. Annuitant The annuitant is generally the measuring life on the contract. Measuring life means that in many (but not all) deferred annuity contracts, the annuitant s death ends the contract; at the annuitant s death, a death benefit is paid to the beneficiary. ( Death benefit for the purpose of this manual is defined as a payout of full contract value with no surrender charges applied.) If a life income option is selected, the insurance company s actuary staff uses the annuitant s life expectancy on an annuitized contract to determine payment levels. Life expectancy is also used to determine the length of time a deferred contract may be held for both expected profit and reserve levels. Joint annuitants are allowed on some annuity contracts. As with almost every item in an annuity contract, the ramifications of naming a joint annuitant vary, but in most cases, the contract will not pay a death benefit as long as there is a surviving annuitant. The annuitant cannot be a non-natural person. Chapter Five discusses in detail the different death distribution structures possible in an annuity contract. Beneficiary The beneficiary receives the annuity proceeds upon death of the annuitant and/or owner, as specified in the contract. Any person, natural or non-natural, may be named as beneficiary. Contract application forms normally contain room for naming both primary and contingent, or Class I and Class II, beneficiaries. Primary, or Class I Beneficiaries. Beneficiaries listed as primary will receive the annuity death proceeds, if living. More than one beneficiary may be named to share in the death proceeds at the primary beneficiary level. Contingent, or Class II Beneficiaries. Contingent beneficiaries receive the annuity proceeds only if all primary beneficiaries are deceased at the time of the death of the annuitant or owner. A contingent beneficiary should generally be included on a contract in case the primary beneficiary predeceases the annuity owner. 6

19 Beneficiary Designations. Insurance companies normally require that the beneficiaries names, relationship and designation are spelled out clearly before issuing annuity contracts. The insurance company can then be certain that the death distribution is paid as quickly as possible to the appropriate beneficiaries. Potentially unclear designations such as all children, estate, siblings, etc. should be avoided. Instead, clear designations such as John Smith, son of Randall Smith, and Rose Evers, daughter of Randall Smith or Estate of Randall Smith. should be used. Per - Capita Most insurance companies assume per capita distribution when more than one beneficiary is named in the same beneficiary class. For example, a per capita distribution when John Smith, son and Rose Evers, daughter are named would mean that John and Rose would share equally in the death distribution, if living. If only one were alive at Randall Smith s death, that one would receive the entire distribution. Per Stirpes Per stirpes is a beneficiary designation meaning that if one of the named beneficiaries within the same class is deceased at the time of distribution, that beneficiary s share goes to his children, to his grandchildren if their children were also no longer living, or to his estate if no heirs survived. Because of the potential difficulty in locating per stirpes descendants, some insurance companies will not recognize this type of beneficiary designation. Percentage Distributions Beneficiaries may be designated to receive a percentage of the proceeds. In this situation, should a named beneficiary pre-decease the annuitant and/or owner, the insurance company may assume a per capita distribution of the percentages allocated to a deceased beneficiary. The surviving beneficiaries would then share equally in the deceased beneficiary s share. When complicated beneficiary designations are requested by an annuity applicant, it is wise to check with the insurance company s legal department to determine the clearest method of describing the designation. The Annuity Contract The annuity contract contains important information and provisions and is given to the client once the policy has been issued. The annuity owner has a certain number of days from the date the deferred contract is received to review the contract. This period of time is known as the free-look period. If the owner decides not to take the policy within this period of time, the insurance company will return the contribution in full to the owner. 7

20 Contract provisions include: Defining the owner, annuitant and beneficiary, and the role each plays in the contract life. Disclosure of the interest rate guarantees and/or guarantee periods for the initial rate, the minimum rate and renewal rates. Explanation of income options and when these options may be selected without withdrawal charges. The withdrawal or surrender charge schedule and the circumstances under which charges are applied. Explanation of administrative charges, if any. Special features, such as nursing home waivers, systematic withdrawal, guarantee of principal. The actions resulting from the death of the owner, annuitant or beneficiary. Any state disclosure requirements. ANNUITY APPLICATION Before the policy can be issued, an application must be completed and premium paid to the insurance company. The application will typically include: Name, social security number, sex, birth date and address of the owner (s). Name, birth date, sex and social security number of the annuitant (s). Name and relationship of the beneficiary(ies). Some applications require the social security number as well. Type of annuity, if the company offers more than one type. Whether this annuity is replacing another annuity. Signature of owner(s). Some applications require the signature of the annuitant(s) as well. Signature of the agent accepting the application. Along with the application, additional forms may be required for disclosure purposes. If replacement of the annuity is involved, certain states require that additional information be taken from and given to the applicant. Once the insurance company receives the application and premium, unless information is missing or the parties on the application do not qualify under the contract parameters, the insurance company will issue a policy. The policy normally consists of the contract, a copy of the application, and any state disclosures required. Some contracts are issued in the field, and are referred to as field issue or instant issue contracts. The agent accepts the money on behalf of the insurance company, completes the application with the annuity owners, and attaches an application copy to a contract, which is given to the customer immediately. If the insurance company finds any errors or omissions in the application when it is received, it will send an endorsement to the contract to the agent or directly to the policy owners. The 8

21 endorsement will require that correct or missing information be supplied and that all owners sign, or the contract will be invalidated. Field issue contracts are often popular with customers, who like taking a contract with them at the time of submitting premium. SUITABILITY Suitability basically is a concept that states, is the product I am selling to my client, suitable for their needs and risk tolerance. In the discussion of annuities, which product the prospect should choose depends on a variety of factors. First, in their lifetime, has the client ever owned any private stock. Second, does the client have any CD s, held at a bank. Third, when proposing the product to your client, should another member of the family, who assists in making decisions, be present. Once the meeting with the prospect and or family member is secured, the different types of Annuities, Variable, Indexed and Fixed should be discussed, what should also be discussed are any sales fees or early surrender charges. In the annuity sales process, the client should be aware of these fees because these issues have become the focus of many consumer complaints. High pressure sales tactics and coercive sales tactics have no place in annuity sales. All proper forms should be available to the client from the insurance agent. 9

22 CHAPTER TWO: FIXED ANNUITY FEATURES Competition and customer demand have spawned a multitude of features in the fixed annuity marketplace. This chapter will discuss features commonly found in today s annuities. Interest rates will be discussed separately, in Chapter Three. Tax Deferral Deferred annuities, as noted, are tax-deferred instruments, as long as they meet requirements set forth in IRC Section 72, which defines the requirements of a taxdeferred annuity. Under these regulations, earnings from an annuity are not taxed until withdrawn. The difference between tax-deferred growth and growth on a taxable instrument can be significant, depending upon the length of time the earnings remain in the annuity, and the marginal tax bracket of the annuity owner. Example of Tax Deferred Growth Assume a customer in a 28% federal marginal tax-bracket has $7,500 to contribute to an annuity annually. Exhibit 2 compares the growth of a tax-deferred annuity for this customer paying 3.5% over twenty years to a taxable certificate of deposit, also paying 3.5% over twenty years. The annuity tax-deferred value is over $23,200 greater than a taxable account, if we assume the taxes are paid from the taxable account accumulations. [Note: This comparison is for illustration purposes within this manual only. Any illustration shown to a customer must include disclosures, such as minimum rate guarantees, and surrender charges. Numbers are rounded.] The effect of tax-deferral prior to withdrawal is significant. To determine if an annuity compares favorably to a taxable account over the entire life of the annuity, factors such as whether the contract will be annuitized, if and when withdrawals will be made, and the anticipated tax bracket of the client when withdrawals or annuity payments are taken must be considered. 10

23 Exhibit 2. Tax Deferred Growth Comparison of Tax-Deferred Growth to Growth In A Taxable Account The effect of tax-deferral prior to withdrawal is dramatic. To determine if an annuity compares favorably to a taxable account over the entire life of the annuity, factors such as whether the contract will be annuitized, if and when withdrawals will be made, and the anticipated tax bracket of the client when withdrawals or annuity payments are taken must be considered. Probate Avoidance Annuities, as life insurance products, can avoid probate: the death benefit can be paid directly to the beneficiary. If the estate of the deceased is named as beneficiary, the annuity proceeds will be probated before distribution to heirs of the estate. Probate Defined Probate is the process of ensuring property bequeathed through a will or via intestacy laws is free from creditor claims. (Intestacy laws are state statutes dictating how property is dispersed when no valid will exists at a property owner s death.) Probate is a lengthy process involving ensuring the validity of the will, appraising all property, notifying potential creditors of the death of the property owner through public notices, identifying all heirs, paying all applicable taxes, giving creditors a period of time in which to come forward with claims, and finally distributing the remaining property as the will or intestacy law directs. Many people desire to avoid probate because of the publicity, delay and expense involved: 11

24 Publicity: Each asset and debt, along with its value or liability, is listed as part of public record. Delay: Probate often takes eighteen months to two years to complete. During the time that the estate is being probated, the assets of the estate cannot be accessed by the heirs. Expense: Commonly, five or more percent of the estate s value will be assessed in probate related legal fees. Life insurance is not the only vehicle that avoids probate. Other methods include placing property in joint tenancy, in a revocable living trust, in pay-on-death bank accounts, in transfer on death brokerage accounts and making lifetime gifts to remove property from the estate. Free Withdrawals Most annuity contracts allow a certain amount to be withdrawn from the contract value without a withdrawal or surrender charge applied. This feature is commonly known as the penalty-free withdrawal feature. Common penalty-free amount options found in annuity products are: 10% of the accumulated value. 10% of premium. An amount equal to all interest earned. A cumulative free withdrawal, e.g. 10% in year one, 20% in year two if the prior year s free withdrawal was not taken, and so on. Normally, surrender charges are applied to withdrawal amounts greater than the penalty free amount. Annuity contracts with rate guarantees that extend for more than one year may have more restrictions on free withdrawal provisions than those with one year rate guarantee periods. Surrender Or Withdrawal Charges Annuities normally include an initial surrender charge period. A charge is applied for withdrawals greater than the penalty free amount for a specified period of time. For example, a contract may have a surrender charge for the first six years of the contract wherein the first year a charge of 6% is assessed on the amount withdrawn (above the free amount), the second year 5%, the third 4% and so on until after the sixth year the charge is zero. Surrender charges may be based on the accumulated value, less the free withdrawal amount, or premiums contributed, less the free withdrawal amount. The length of the surrender charge period may be the same as the rate guarantee period on the annuity. For example, a contract with a 5 year guaranteed rate may have a five year surrender charge period. 12

25 The surrender period may be based upon the date of initial contribution, policy issue date, or there may be a surrender period for each contribution. Under the first method, if a contract is opened on 1/2/05 and has a six-year surrender period, regardless of how many and when additional contributions are made, the surrender charge period will be over by 1/2/2011 (six years). Under the second method, the initial contribution would have a six-year surrender period, and each additional contribution would have its own six-year surrender period, beginning on the date the insurance company credits the additional contribution to the policy. Surrender charges do not apply if a contract is surrendered, or canceled, during the free look period. The free look period is the period of time an annuity owner has to review the policy and cancel without penalty. The free look period length can vary based on state regulation. Some states require a ten day free look period, others a free look period as long as thirty days. If a contract is surrendered during the free look period, the amount returned is principle only. The insurance company does not generally pay interest to the owner on a contract surrendered during the free look period. Market Value Adjustment Some surrender schedules incorporate a Market Value Adjustment or MVA. If current, new money rates are lower than the rate the annuity is paying at surrender, the annuity will be given a positive cash value adjustment, resulting in a higher surrender value than if no MVA was calculated. If current, new money rates are higher than the rate the annuity is paying at surrender, a negative adjustment to cash value will be made, resulting in a lower surrender value than if the MVA was not calculated. The idea behind an MVA is that the insurance company will have to pay less to replace moneys surrendered in a decreasing rate environment, so the contract value is given a positive MVA. In an increasing rate environment, the cost of new money is higher for the insurance company, so there is a negative MVA applied to the surrendered policy. CD Annuities Annuities referred to as CD annuities may not allow any withdrawals whatsoever during the rate guarantee period for that annuity. There is no surrender charge, per se. CD annuities are often bare bones annuities, with a one-, three-, five- or seven-year rate guarantee period and no free withdrawals, no nursing home waivers, and no additions allowed. Principal Guarantee Principal guarantee means that if the annuity owner makes a full surrender, he will never receive less than his principal. Two important points regarding most guarantee of principal features: 13

26 1) Surrender charges apply to withdrawals or partial surrenders which are greater than the free withdrawal amount, but less than a full surrender. 2) When partial surrenders are made, for the purposes of calculating guarantee of principal, the insurance company reduces principal by the amount withdrawn plus applicable surrender charges. Assume a $20,000 annuity is purchased which is earning 4.5%, with a five year surrender schedule of 10%, 9%, 8%, 7%, 6%, a 10% free withdrawal feature, and a guarantee of principal feature. 1) If the customer withdrew $5000 in year one, a 10% surrender charge would apply to the amount withdrawn exceeding the free amount. Assume the policy is worth $20,450 at the time of withdrawal. $2045 of the $5000 withdrawal would be the penalty free withdrawal, and $2955 would be subject to a 10% surrender charge of $ Principal, in terms of the guarantee of principal feature, is now $14, $20,000 premium, less the $5,000 withdrawal and the $ surrender charge. 2) Assume the customer then surrendered in the second year and the annuity value was $15,350. The penalty free amount of $1535 would have no charge applied, but the remaining $13,815 would be subject to a 9% surrender charge of $ resulting in a net surrender value of $12, The guaranteed principal is now $13,169 ($14,704 less $1535). Since this principal amount is more than the net surrender amount calculated at $12,571.65, the full surrender charge will not apply, and the customer will receive $13,

27 Year One: $20, $14, Year Two: $15, $13, $12, $20,000 original principal Value at time of withdrawal 45 penalty free and $2955 subject to penalty surrender charge penalty Principal remaining Value at time of surrender penalty free amount Amount to apply surrender charge surrender charge penalty Net Surrender Value Principle Guarantee Calculation: $20, , , $ Original Contribution Withdrawal Year One Surrender Charge Year One Principle Remaining (Guaranteed) Free Withdrawal Year Two Principle Remaining (Guaranteed) $13, Amount Received at Surrender The annuity owner received $5000 in year one, $1535 (free amount) and $13,169 in year two for a total of $19,704. He was charged $ in surrender charges. If the owner had surrendered the contract in one lump sum, with no prior withdrawals, he would have received a minimum of $20,000 regardless of the calculated surrender charges, since the principal was contractually guaranteed at full surrender. Note that the IRS regulations would treat the withdrawals as being comprised first of any interest in the contract even though the insurance contract treats the withdrawals as principal first for the purposes of principal guarantee provisions. Systematic Withdrawals Systematic withdrawals allow regular income to be withdrawn from an annuity, without locking the client into a payout schedule, as annuitization does. Systematic withdrawals are paid on a monthly, quarterly, semi-annual or annual basis, as the respective annuity product allows, on an automatic basis. The contract may allow the withdrawals 15

28 to be based on a percentage of the contract value, a specific dollar amount, or an amount equal to interest earned. If the withdrawals exceed the penalty-free withdrawal amount, normal surrender charges generally apply. Systematic withdrawals occur during the deferral stage; systematic withdrawal payments are not annuity payments. Systematic withdrawal payments may be stopped and started and withdrawal amounts may be changed. Systematic withdrawals can be mailed directly to the payee, and may often be deposited directly to a bank account through electronic funds transfer. The check may also be mailed from the insurance company to the customer s bank for deposit. Some annuity contracts place restrictions on the free withdrawal privilege if systematic withdrawals are taken. For example, some contracts allow systematic withdrawal of amounts equal to interest or a single withdrawal up to the free withdrawal amount without surrender charges. But, if systematic withdrawals are being taken and a random withdrawal is made, surrender charges apply. Other annuity products allow an annual random withdrawal along with systematic withdrawals, as long as the total withdrawn does not exceed the free withdrawal amount. Since the IRC states that withdrawals from annuities are comprised of interest first, monthly withdrawals can effectively remove the tax-deferral feature of an annuity. And, systematic withdrawals taken more frequently than annually will also reduce the yield on the annuity, since earnings will not be compounding upon earnings. The calculation of annuity yields is discussed further in Chapter Three. Medical Or Nursing Home Waivers Annuities may contain a Medical Waiver or Nursing Home Waiver. This feature allows withdrawing from or taking a full surrender with normally applied surrender charges waived for nursing home, Hospice or Hospital stays. The conditions to qualify under a nursing home waiver vary, but generally, a stay of a specific length, e.g. thirty, sixty or ninety days, in a qualified facility as defined by the contract, is required. The contract may apply the waiver based on the annuitant and/or owner s medical stay, and in some cases the medical stay of the spouse of the annuitant or owner may also be included in the provisions of the waiver. Most waivers are careful to specify that the confinement begin after the policy opening date, but a few available do not preclude the application of the waiver to persons in a nursing home at the time of purchase. State regulation may govern what type of facility is considered a qualified facility, the length of time required to stay in the facility before the waiver applies, and other provisions in the waiver. 16

29 Another variance in the nursing home waiver feature is whether or not the insurance company allows multiple withdrawals to be taken once the required confinement period has been met, or if a one-time only withdrawal or surrender may be made. Other Surrender Charge Waivers A few annuity products include a waiver of surrender charges based on disability of the owner and/or annuitant. Another item for which surrender charges are waived in some cases is the situation when required minimum distributions from qualified annuities exceed the penalty free amount allowed in the annuity contract. Maturity Date Or Maximum Deferral Age The maximum deferral age, also referred to as the annuitization date or maturity date, is the date when annuitization or liquidation of the contract must commence. Some states require that annuities mature by a certain age, e.g. 85. Other states allow deferral through age 100. This feature is important because some clients would like to pass the entire value of their annuities directly on to their beneficiaries. If the maximum deferral age is high enough, chances are the client will be able to do so. The maximum deferral age also impacts the maximum annuitant or owner age allowed to open the contract. For example, if a contract has a maximum deferral age of 85, and a ten-year surrender schedule, the maximum age to open the contract will likely be age 75. Some annuity products may specify a certain maximum maturity date, but, if state laws allow, the insurance company may operationally allow the holder to continue deferral of the contract to some higher age. Premium Tax Premium tax is not exactly an annuity feature, but the way in which the annuity company charges the customer for premium tax affects the desirability of a product, just as features do. Premium tax is charged by some states on annuity premium. Some states charge a front-end tax, meaning it must be paid to the state at the time the annuity contract is opened. Other states charge a back-end tax, meaning at annuitization, and in some cases, at death and surrender as well. Many companies pay for the premium tax which is due up-front, and only charge the customer at annuitization or surrender. Other companies reduce the rate of return on their products in states with high front-end tax. 17

30 CHAPTER THREE: FIXED ANNUITY RATES Fixed annuity products have several rates important to the customer: the initial rate, the rate on additional contributions (if the product is a flexible premium product), the renewal rate, the bail out rate, and the minimum guaranteed rate. The Initial Rate The initial rate is the rate earned on the initial or opening contribution to the annuity. The initial rate may be guaranteed for a wide variety of periods, depending on the annuity contract offered by the insurance company. This period may be as short as a three-month period and as long as ten or twenty years. The annuity contract itself is the best source to verify the initial rate guarantee period for any particular product. Bonus and Base Rates The initial rate may be declared as a bonus rate or as a non-bonus or base rate by the insurance company. A bonus rate is one inflated for a period of time, and is higher than the base rate the insurance company calculates would be paid as interest on the product. A typical bonus rate would be one percentage point higher than the base rate, but some products may have a one-half, two, three percent or higher bonus rate. Sometimes, to qualify for the bonus rate, certain specifications must be met. This is particularly common for products with high bonus rates. For example, the contract may have to be held for a certain length of time for the bonus rate to apply. Or, the contract may have to be distributed in a certain manner, e.g. as an annuity of at least five years. If the conditions are not met, the bonus will not be credited to the account value. Premium or Rate Bonuses Bonus rates may be either premium or rate bonuses. In the case of a premium bonus, a certain percentage of additional premium is credited to a contribution, and a stated interest rate is applied to the sum of the contribution and additional premium. For example, if a product has a one percent premium bonus and $10,000 is contributed, the stated base rate of, say, four percent would be credited to $10,100 of premium. In the case of a one percent interest rate bonus with the same base rate of four percent and $10,000 contribution, a five percent rate would be applied for the first year. 18

31 Factors In Rate Setting To further understand the difference between a bonus rate and a base rate, a basic understanding of the factors influencing what rate an insurance company will pay on a product is important. Many factors come into play in determining rates, and, very likely, no two insurance companies determine crediting rates identically. But certain commonalities may be found in the elements of rate setting. Competition Insurance companies often track rates other insurance companies are paying on competing products, especially products distributed to similar markets as their own. For example, some annuity companies focus on distribution through captive agents, some through independent agents, some through agents in financial institutions, others through agents in stock brokerage firms. The insurance company may either focus on a particular distribution market, or may design products differently for these distribution streams and the different customer bases they reach. The rate of an annuity is affected by what rate the competitive annuity products within its distribution market are paying. Product Features Product features affect the probability of certain profit margins being reached by the insurance company. For example, the length of the surrender schedule, along with the percentage charged in each year of the schedule affects the length of time an annuity is held by a client, and how much money the insurance company can count on to retain should the client surrender prior to the end of the surrender schedule. An annuity with a long surrender schedule with relatively high percentage charges each year will likely pay a higher interest rate than one with a short surrender schedule with relatively low surrender charge percentages, particularly if both products are issued by the same company. Withdrawal features also affect interest rates. The annual amount free, nursing home waivers, systematic withdrawal availability, and how soon after policy issue the product may be annuitized without penalty all factor into the equations insurance companies use to determine the rate paid. Principal guarantee, the inclusion or exclusion of administrative charges, and the length of the initial rate guarantee are also factors in rate setting. Commission Commission rate paid the agent and/or agency is another element in the interest rate setting decision. Lower commission products may have higher rates and/or features like short surrender schedules and flexible withdrawal features. Lower commission does not always mean higher rates, just as higher commission does not always mean lower rates, since the combination of features, administrative charges, and commission chargebacks all impact rates. 19

32 Investments The insurance company places the moneys received through the purchase of its products in a variety of instruments, including, but not limited to, bonds, mortgages, stocks, real estate and short-term instruments. Each company will invest its moneys differently among its mix of suitable instruments, and of course, each company s investments will have a different return. Portfolio Method Of Investing In establishing interest rates paid, some insurance companies use a return on a portfolio which consists of all moneys received from the purchases of a particular type of annuity product. For example, moneys received in 2008 for the purchase of a company s FPDA annuity and used to purchase bonds yielding 4% is mixed with moneys received in 2009 and used to purchase bonds yielding 5%. The resulting calculated investment return to the insurance company is a blend of these investment returns and it is this portfolio rate of return that is used to determine new money and renewal interest rates. This is commonly known as the portfolio method of investing and interest rate crediting. Bucket Or Banded Method Of Investing Other insurance companies use the bucket or banded method of determining a return on investment and resultant interest rate crediting. This means that moneys that are received during a particular time period are segregated in terms of investment return tracking. Money used to purchase an FPDA annuity in 2008 and invested by the company in 4% bonds would be tracked separately for interest rate crediting purposes than moneys from annuities purchased in The initial rates and subsequent rates would be all based on the return and performance of the investments purchased with each band of time (allowing for turnover and management of these investments in subsequent years). Premium Tax If front-end premium tax is charged to the purchaser of the annuity, the return on the annuity will be affected. For example, if the front-end tax were one percent, an insurance company passing that tax onto the customer may reduce the premium by one percent, and apply the full stated rate to the remaining account value. Other companies have a lower crediting rate in states with premium tax. For example, in most states a product may pay 4.5%, but in a premium tax state, may pay 4.0%. Interest Rate Setting To bring all these components together, the example below illustrates how an insurance company might calculate an interest rate. In this example, it is assumed the insurance company has determined the cost in rate for each feature. E.g. a systematic withdrawal feature costs 5 basis points (.05%) in rate, a principal guarantee feature 20

33 costs 2.5 basis points (.025%), etc. This insurance company also has an internal policy to match its competitive survey rate average for this annuity product. The example below is for explanatory purposes only. Insurance companies are as different as the people that run them, and the rate setting process varies. However, this method of calculation provides a good example of the components of the rate setting process: Sample Interest Rate Setting Model Return on portfolio: 7.500% Less: Spread (profit to insurance company): 2.000% Cost of 5 year surrender schedule: 1.000% Principal guarantee:.025% Commission paid:.500% Cumulative withdrawal feature:.150% Calculated Rate: 3.825% Competition survey rate average: 4.000% Base Rate Set: 4.000% Bonus (1 year) Rate Set: 5.000% The Phantom Rate In many ways, from the customer s perspective, the base rate on a bonus product may be somewhat of a phantom rate. Since the following years rates may be subject to the performance of the portfolio or bucket at that time, the current base rate on a bonus product may never be credited to a customer s annuity. Unless the contract specifically guarantees future rates (other than the minimum rate) after the bonus rate period has expired, the agent must be careful not to give the customer the expectation that the rate after the bonus rate has expired will be equal to the base rate in effect at purchase. Renewal Rates Renewal rates are the rates paid after the initial rate guarantee period has expired. To establish renewal rates, insurance companies use either the portfolio or the bucket method. Generally, they will take a look at the return on the portfolio or bucket, make adjustments for current experience (incidence of surrenders, deaths, withdrawals and cancellations), assess competition, and then set the renewal rate. 21

34 Renewal rates, like initial rates, may be guaranteed for a day, a quarter, a month, twelve months, a calendar year, or any other time length the insurance company determines. Some companies quote administrative policies regarding the expected renewal rates, even though this rate is not contractually guaranteed. For example, a company may have the administrative policy of renewing products within twenty basis point of the initial rate. Since this rate is not contractually guaranteed the principle of caveat emptor (let the buyer beware) applies. Reasons companies operate under administrative policies rather than guarantees for a product may be because guarantees must be backed by reserves, or because the company wants to retain the flexibility to respond to dramatic changes in the interest rate environment. Additional Contribution Rate Flexible premium annuities pay a stated interest rate for additional contributions. Many pay the new money rate. Most contracts using this method consider the new money rate in effect for initial contributions and any additional contributions made during the same rate period. For example, assume that the rate on an FPDA for new money in the month of April is 4%. All new annuities opened and any additions added during this month to existing policies will receive 4% for a one-year period. Another additional contribution rate method is to credit additions with the rate in effect at the time the annuity was opened for the first contract year, and the renewal rate in years following. Assume a contract was opened on April 1, 2008 for 4%. All additions through March 2009 will also receive 4%. On April 1, 2009, all new additions and the existing account value will be credited the renewal rate at the time: 4.25%. This latter method is often used by companies using the portfolio method of interest rate crediting, since all moneys will eventually earn the same rate, once the initial crediting period is over. Another variable in addition rate crediting occurs when a bonus rate is involved. Some companies pay additions the initial bonus rate in effect at the time the addition is made, and guarantee that rate for the normal bonus rate period (e.g. one year). Others will pay the bonus rate only on initial premium, not on additions. Bail Out Rates Some annuities offer a feature that allows the owner to surrender the annuity, or bail out of the annuity, if the rate ever falls below a certain percentage point. This point is known as the floor or the bail out rate. The amount of difference between the initial rate credited and the floor varies from product to product. The bail out rate may be stated as a specified percentage: The owner may surrender the contract in full with no surrender charges applied if the stated rate ever falls below 3.75%, or as a percentage difference from the initial rate: The owner may surrender the contract in full with no surrender charges applied if the stated rate ever falls more than 1.5% below the initial rate. 22

35 Certain conditions normally have to be met to invoke the bail out feature. For example, the owner may have to request the surrender within thirty days of the rate change. Or the owner may have to invoke the bail out the first time the rate falls to the bail out level. If the owner waits until the second time (e.g. the following renewal period), the bail out feature may not apply. Minimum Guaranteed Rate The minimum guaranteed rate is the rate the insurance company contractually guarantees to pay after the initial rate guarantee period has ended. This rate is normally stated as a percentage: 3.0%, but may be indexed: the greater of 3.0% or the one year T-bill rate. The minimum guaranteed rate may also be tiered: 3.5% in years 2-5, 4% in years 6-10, 3.0% thereafter. Certain state insurance commissioners prefer a stated, non-tiered rate, or will not allow a company to lower a product s minimum rate. Minimum rate guarantees can therefore vary for the same product from state to state. Rate Versus Yield The insurance industry commonly uses the term rate to denote what other members of the financial industry, for example banks, term yield. The quoted rate on an annuity is not a simple, non-compounded rate. It is the yield, after 360, 365, or 366 days of compounding, based usually on a daily interest rate factor. Methods of calculating the yield vary among insurance companies, but the general principal is the same: Bank customers are accustomed to the word rate meaning simple interest rate, and yield meaning return on compounded simple interest rate. The insurance industry often uses the word rate to mean annual return on compounded simple interest rate, or annual return on compounded daily interest rate factor. For example, a customer walks into a bank. The rate board sits in the middle of the bank and states 1 year CD: 2.50% rate, 2.75% yield. The bank customer knows the 1 year CD is actually going to pay them 2.75% for the 1 year term. This same customer, is speaking to an insurance agent, is told: the annuity rate is 3.50%. This customer may erroneously believe the yield will be something higher, e.g. 3.75%. This issue is especially pertinent when monthly systematic withdrawal payments equal to interest are taken from an annuity. Since money is withdrawn monthly, there is less money to compound, so the return on the annuity, instead of being 3.50% as in our example above, would be close to 3.30%. Many insurance companies have designed materials to more clearly specify that the interest rate quoted is more correctly termed yield and to include the effect of systematic withdrawals on the yield as well. 23

36 Historical Rates The issue of interest rates is many faceted, as this chapter has demonstrated. The historical crediting of new money and renewal rates on an annuity product can therefore be a valuable tool to determine the way in which the changing interest rate environment has impacted interest rate crediting on a particular product. Even if a product is new, if an insurance company is using an interest crediting model like the one discussed earlier under the heading Interest Rate Setting, a model renewal rate history may be available on the new product. The insurance company calculates what the rate would have been over the past years using the model and based on the features of the new product. Setting Interest Rates On Single Premium Immediate Annuities An immediate annuity has different elements from a fixed annuity that are involved in the determination of its interest rate. These elements are: return on investment premium tax, if applicable mortality risk for life income options administrative expense (for the processing of monthly checks or electronic funds transfer of payments) spread or profit margin commission paid Since the value of an immediate annuity is steadily decreasing, the rate paid on the immediate annuity principal is expressed as an internal rate of return. Many insurance carriers do not disclose the internal rate of return, and suggest the client compare payout amount to payout amount when determining the best immediate annuity among competing products. 24

37 CHAPTER FOUR: FIXED ANNUITY PAYMENTS This chapter will discuss receiving annuity payments through the purchase of a Single Premium Immediate Annuity (SPIA), or through annuitizing a deferred annuity. A SPIA is an annuity that will begin irrevocable periodic payments within twelve months of purchase. Annuitization of a deferred annuity refers to the commencement of irrevocable periodic payments sometime after twelve months from purchase. Annuity payments from a SPIA and an annuitized deferred contract fall under the same taxation rules in IRC section 72. Generally, the same income options are available under a SPIA contract and when a deferred contract is annuitized. The selection of an annuity option is virtually irrevocable. In other words, once payments have commenced, the contract owner cannot change to some other payment method, nor stop the payments. Some states allow a free look period for SPIAs, wherein the contract could be canceled. But a SPIA or annuitized deferred contract cannot be surrendered after this free look period as a deferred contract could be prior to annuitization. Annuity Payment Features And Advantages There are several advantageous features to annuity payments. They include the following: Many Income Options Available To Meet Differing Customer Needs A variety of annuity income options are available, including income based on a single life, joint lives, or on a certain period of time. Some insurance companies offer payout options that will increase payments annually on a specified percentage basis, to adjust for inflation or as a cost-of-living-adjustment. Guaranteed Income At annuitization commencement, the insurance company guarantees to make payments of a specific amount, and these payments will not change. The customer does not have to worry about interest rate or dividend fluctuation as he or she would with many other income-producing products. The customer selects the mode of payment. Payment mode frequencies are usually monthly, quarterly, semi-annual or annual. The owner can often decide even what day of the month payments will be processed as well. 25

38 Lifetime Income If a life option is selected, payments are guaranteed to continue for life. Payments can continue to beneficiaries under some life options as well. Convenience Along with being able to select how frequently and what day of the month payments are processed, many companies can directly deposit payments to a bank account. Taxation Unlike withdrawals from deferred annuities, which are currently taxed as being comprised of interest before principal, annuity payments are considered part interest and part principal. Therefore, taxation is spread over the payment period, rather than being levied up-front. Parties Involved In Annuity Payments When annuity payments begin, four parties may be involved: the owner, annuitant, payee and beneficiary. Owner The owner of the annuity is the person who purchases the annuity. As discussed in Chapter One, the owner of a deferred contract has several rights during the deferral stage, including the right to withdraw funds, change the beneficiary, and in some cases to add or change the annuitant. Once annuitization commences on a deferred or immediate annuity, the owner s rights are normally limited to changing the beneficiary. As noted, annuitization is irrevocable, so the owner cannot withdraw funds (aside from the annuity payments), make additional contributions, or change annuitants. Annuitant The annuitant is the measuring life on the contract. If an annuity income option is to be paid over life, it is the annuitant s, and in some cases also the joint annuitant s, life expectancy that is used to determine payment amounts. It is also the annuitant s death that causes payments to cease, or to transfer to a beneficiary. Payee Some annuity contracts allow annuity payments to be made to a payee, someone other than the owner or annuitant. The tax issues surrounding the naming of a non-owner payee are discussed in Chapter Five. Beneficiary The beneficiary receives annuity payments, or in some cases, a lump sum, upon the death of the annuitant. 26

39 Income Options Life Income The life income annuity is sometimes referred to as a straight life option or life only option. Payments under a life income annuity are guaranteed for the annuitant s lifetime and will cease at the annuitant s death. Life and Period Certain Income Life and period certain payments are guaranteed for the annuitant s lifetime, or for a certain period of time, whichever is greater. For example, if a life and ten year period certain annuity is purchased, payments will be paid for ten years, and will continue if the annuitant is still living at the end of the ten-year period. If the annuitant dies during the ten-year period, payments will continue to the beneficiary until the tenyear period expires. Life With Installment Refund Income Payments are guaranteed during the life of the annuitant and, if at the annuitant s death the sum of all payments made are less than the principal paid to purchase the annuity, the beneficiary will continue to receive payments until the principal has been depleted. Life with Cash Refund Payments are guaranteed during the life of the annuitant and, if at the annuitant s death, the sum of all payments made is less than the principal paid to purchase the annuity, the beneficiary will receive a lump sum equal to the remaining principal amount. Temporary Life Income Under a temporary life income annuity, payments are guaranteed for the annuitant s lifetime, or for a certain period of time, whichever is shorter. For example, if a temporary life and ten year certain annuity is selected, and the annuitant dies in the fifth year, payments would cease in the fifth year. If the annuitant is still living at the end of the tenth year, the payments would cease at the end of the ten year period. Joint and Survivor Life Income Joint and survivor annuities are also referred to as last survivor annuities. Payments are guaranteed during the lives of both annuitants. Payments cease upon the death of the last surviving annuitant. Joint and Specified Percentage to Survivor Life Income Payments are guaranteed during the life of the first to die. After the first death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the second to die. 27

40 Joint and Specified Percentage to Contingent Life Income Payments are guaranteed during the life of the primary annuitant under a joint and specified percentage to contingent life income. After the primary annuitant s death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the joint annuitant. This option may also be available with installment or cash refund at the death of the joint annuitant. Joint and Survivor With Period Certain Income Under joint and survivor with period certain income annuities, payments are guaranteed for a specified period or the lives of joint annuitants, whichever is greater. If there is a surviving annuitant after the period certain time frame expires, payments continue until the death of the last annuitant. If both annuitants die prior to the period certain time frame expiration, the beneficiary will continue to receive payments until the certain period is over. Joint and Survivor Life With Installment Refund Payments under joint and survivor life with installment refund annuities are guaranteed during the lives of joint annuitants, and if at the last annuitant s death the sum of all payments made are less than the principal paid to open the annuity, the beneficiary will continue to receive payments until the principal has been depleted. Joint and Survivor Life with Cash Refund Payments under joint and survivor life with cash refund annuities are guaranteed during the lives of joint annuitants, and if at the last annuitant s death the sum of all payments made are less than the principal paid to open the annuity, the beneficiary will receive a lump sum equal to the remaining principal. Period Certain Under period certain annuities, payments are guaranteed for a certain period of time. If the annuitant dies during that time, payments will continue to the beneficiary until the specified period of time expires. 28

41 CHAPTER FIVE: TAXATION OF FIXED ANNUITIES* Tax Deferral Earnings on annuities are not taxed until withdrawn, as long as the owner of the annuity is a natural person, or if the annuity is owned by a trust or an agent for a natural person. A common example of a trust that qualifies for tax deferral as owner of an annuity is a revocable living trust. The property within a living trust is generally taxed just as though it were titled under the name of the property owner. Most living trusts use the social security number of the property owner or owners, or the grantors of the trust for all tax reporting purposes. Withdrawals LIFO and FIFO Withdrawals Withdrawals from contracts opened after August 13, 1982 are considered to be made up of all interest in the contract before any principal or cost basis is withdrawn. The last money in (interest earned), is considered to be the first money out. This is known as LIFO: Last-In, First-Out. For example, assume a contract opened several months ago for $10,000 now has a value of $10,700. The owner withdraws $1000. Seven hundred of the one thousand dollar withdrawal is considered interest by the tax code, and is taxable. The remaining three hundred dollars is considered return of principal, and is not taxable. Contributions and earnings attributable to contributions made to contracts prior to August 14, 1982, are withdrawn as principal first, *Note: Although great effort has been made to ensure this publication contains accurate, timely information, it is provided with the understanding that the author and publisher are not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent legal advisor should be sought. interest last. The first money in, the premium or cost-basis, is withdrawn first. This taxation flow is known as FIFO: First-In, First-Out. Contributions and earnings attributable to contributions made after August 13, 1982, made to a contract opened prior to August 14, 1982, are withdrawn based on the LIFO distribution rules. But contributions and attributable earnings made prior to August 14, 1982 in this same contract retain their FIFO treatment. The IRS approved order of withdrawals and applicable taxation is as follows: 29

42 Withdrawn First: Pre-August 14, 1982, Cost Basis - Non-Taxable Withdrawn Secondly: Earnings on Pre-August 14, 1982 Contributions - Taxable. Withdrawn Thirdly: Earnings on Post-August 13, 1982 Contributions - Taxable Withdrawn Last: Post-August 13, 1982, Cost Basis - Non-Taxable. If a contract purchased prior to August 14, 1982, is exchanged for a contract opened after August 13, 1982, the tax treatment (FIFO) is retained or grandfathered for contributions and earnings made prior to August 14, Pre - 59 ½ Distributions Regulations surrounding annuities are meant to encourage long-term retirement savings. As such, the IRS code includes an additional ten percent tax on the earnings withdrawn prior to the owner s age 59 ½. The most common exception to this premature distribution tax are: 1) Withdrawals attributable to the owner s disability. 2) Withdrawals of pre - August 14, 1982 contributions and earnings. 3) Distributions due to death. 4) Annuity payments made from an immediate annuity. Any income option, life or period certain is exempt from the premature distribution tax. However, if a client purchases a deferred annuity, holds it for longer than twelve months, then exchanges it for an immediate annuity, this exception to the premature distribution tax will not apply. The original opening date of the deferred contract will be used as the contract start date, so the annuity payments would not be deemed as immediate annuity payments by the IRS. Payments based on the life or life expectancy of the contract holder or the joint life expectancies of the contract holder and beneficiary. These payments may not be modified for five years or until age 59 ½, whichever period of time is greater. If they are modified, the 10% tax will be due on all earnings distributed that would have been taxed if this exception did not apply. [Note: The IRS has issued a private-letter ruling which disallowed using systematic withdrawal payments based on life expectancy to meet this exception (Letter Ruling ). The reasoning used was that the owner had the right to change or stop the systematic withdrawal payments. In contrast, any sort of life annuity option excluding temporary life would comply.] Multiple Contracts Another set of tax regulations affecting the treatment of interest and withdrawals came into effect on October 21, These regulations stated that if multiple deferred annuity contracts are entered into after October 21, 1988, with the same insurance 30

43 company in any twelve-month period, the contracts will be viewed as one for purposes of determining interest earned and taxable withdrawal amounts. For example, three annuity contracts of $20,000 each are purchased through ABC insurance company on 1/2/09. Each contract earns $800 in interest in On 1/2/10, the owner requests a $2000 withdrawal from one of the three contracts. Since a total of $2400 in interest has been earned in the three contracts purchased in the same twelve-month period, the withdrawal is considered 100% interest and therefore 100% taxable. Tax-Free Exchanges An annuity contract may be exchanged for another annuity contract without tax consequences under certain conditions. The Internal Revenue Code Section 1035 contains the regulations regarding the tax-free exchange of life insurance policies, so these exchanges are often referred to as 1035 exchanges. The conditions required for a non-taxable exchange of annuities are: 1) The exchange must be made directly from the surrendering insurance company to the receiving insurance company. The policy owner may not cash in a policy, receive the money, and then buy another annuity under tax-free exchange provisions. If the exchange is not made directly from insurance company to insurance company, the distribution will be taxed like any other distribution, including any applicable pre-59 ½ premature distribution tax. 2) The new contract must be payable to the same person (or persons) as the surrendered contract. Most insurance companies interpret this portion of the 1035 code to mean that the same owner, annuitant and beneficiary designations must be made on the new contract as were in place on the old contract. This issue may get sticky if the surrendering company allowed joint annuitants or joint owners and the new company does not. Often, the receiving company s legal department can review the surrendering company s contractual provisions regarding the roles and rights of the joint owner or joint annuitant to determine if the new contract can be structured to address these same roles and rights. In other words, if the new contract ownership can be constructed to meet the same objectives, payouts, and tax ramifications as the old, most insurance companies will accept the business as a tax-free exchange. 3) Life insurance and endowment contracts may also be exchanged for annuities on a tax-free basis, but annuities may not be exchanged tax-free for a life insurance or an endowment contract Paperwork Requirements To exchange a policy, the policy owner completes surrender paperwork for the old policy. The receiving company normally has Absolute Assignment Forms or 1035 Exchange Forms that serve as a surrender request to the old company. The applicant completes and signs a new application for the new annuity contract, returns the old 31

44 policy, and in many states, signs and completes required replacement forms. This paperwork is sent to the receiving insurance company. The receiving insurance company sends appropriate copies of the signed forms and the old policy to the surrendering insurance company. The surrendering insurance company calculates cost basis in the old contract and the amounts that are attributable to pre-august 14, 1982 contributions and reports these figures to the new company for future tax reporting purposes. The surrendering carrier calculates the surrender check and sends it to the receiving carrier, who then issues the new policy Time Delays The time period to complete an exchange is commonly thirty to sixty days. The surrendering company often has conservation procedures such as notifying the original writing agent of the surrender, writing letters to the policy owner, etc., in an attempt to keep the business. The process of calculating cost basis, surrender value and issuing a check also adds to the turn-around time on an exchange. And, realistically, since the surrendering insurance company is losing business, they may prioritize existing customers transactions before to 1035 exchange transactions. Because of this delay, many companies offer a rate lock on 1035 business they receive, so that the client is guaranteed a rate for thirty to sixty days. Taxation Of Annuity Payments As noted, earnings are taxed as withdrawn from deferred contracts, but once a contract is annuitized, or if a contract is an immediate annuity, different tax rules apply. Annuity payments are taxed as part principal, part interest. The IRS has specific rules regarding the calculation of the taxable and non-taxable portions of an annuity payment. The IRS calculation determines the exclusion ratio, the ratio used to calculate the portion of each payment that is non-taxable. Since the IRS calculation for a period certain annuity is the simplest, it will be illustrated to provide a general explanation of the calculation of the exclusion ratio: 32

45 The exclusion ratio is the ratio of the investment in the contract to the expected return in the contract, and is the ratio of each payment which is not taxable. Exclusion Ratio = Investment in the Contract / Expected Return in the Contract Exclusion Ratio x Annuity Payment = Non-Taxable Amount of Payment Assume a ten year period certain annuity, purchased with $50,000 and paying $ a month for ten years. Exclusion Ratio = $50,000 Investment in the Contract / $50,000 = 83.33% exclusion ratio $60,000 [($500 x 12 mos.) x 10 yr.] Expected Return 83.33% x $500 payment = $416.65, the non-taxable portion of each payment. Who Pays The Taxes? Because of the different parties involved in an annuity, it is important to discuss which party has the tax liability at ownership changes, at annuitization, and at death. Who Owes The Taxes On Withdrawals? The owner of the contract has all rights to the contract and is considered by the IRS to have the responsibility for taxes due on withdrawals of interest and premature (pre 59 ½) withdrawals of interest. Who Owes the Taxes on A Jointly Held Annuity and at Ownership Changes? If joint owners are involved, it is generally held that the IRS views the annuity to be owned on a 50/50 basis. Therefore, each owner is liable for fifty percent of the income tax due on any withdrawal, and if one owner is over 59 ½ and the other is under, half of the interest paid out will be subject to the premature distribution tax. Another ramification of joint ownership is potential gifting. If the property used to purchase the annuity was not jointly held prior to purchasing the annuity, in other words if it was owned solely by one of the owners, for all contracts issued after April 22, 1987 a gift of 50% of the property is made at the time the joint owner is named on the annuity contract. The donor must report to the IRS gifts of over $13,000 made in one year to a donee, and gift tax may be due. And if the joint owner is added or if 33

46 ownership is changed during the life of the contract, there may also be income tax ramifications, as described in the following example: Assume Joan Smith owns a deferred annuity. She opened the contract with $30,000 and the annuity is now valued at $35,000. She wants to reduce the value of her estate, so is considering gifting the annuity to her son, James. The gift would be accomplished by removing herself as owner and naming James as the owner. Since her contract was purchased after April 22, 1987, if she gifts this property, she will be making a completed gift to James of $35,000. She will have to file an annual gift tax return and may have a gift tax liability. In addition, Joan would also be responsible for the income tax due on the gain in the contract at the time of the gift. (The insurance company is required to report to the IRS the earnings of the contract at the time of the ownership change.) Depending on Joan s specific situation, non-tax deferred property may be a more appropriate gift, since the income tax ramifications would not be so significant. If Joan were contemplating gifting a contract purchased prior to April 23, 1987, the completed gift will not be considered to be made until James cashes-in or surrenders the policy. At that time, the gain in the contract at the time of the gift will be Joan s tax liability, and the gain in the contract after the gift will be James responsibility. Because of the potential complications regarding gifting, change of ownership and joint ownership, many insurance companies only allow ownership changes between spouses or to a living trust, and limit joint ownership to spouses. Who Pays The Tax At Annuitization? An assumption often erroneously made regarding annuity policies is that the owner is responsible for taxes during the deferred stage, and the annuitant is responsible during the annuitization stage. Generally, however, regardless of the property type, tax liability is the responsibility of the owner of the property. Therefore, at annuitization, the key question is: Who owns the property? If the owner and annuitant are the same person, obviously there is no question as to ownership, nor as to tax liability. But if an annuitant is named on an annuity contract that is not the owner, and the contract is annuitized, the tax liability question is pertinent. A second question must then be asked: Who receives the annuity payments? If annuity payments are made to the owner on the contract, the tax liability is still clear: the annuitant is solely the measuring life, and the owner as the property owner, receives payments and is taxed on those payments. But, some insurance companies pay the annuitant the annuity payments, and send the IRS the tax information under the annuitant s social security number. Under this scenario, the insurance company must be viewing the naming of a non-owner 34

47 annuitant as an intended gift. For contracts issued after April 22, 1987, gain in the contract is taxable to the owner at the time of the gift, so a gift at annuitization would mean the owner would be paying tax on the gain so far, so the taxation on the annuity payments may be comparatively minimal. The IRS has not clarified the taxation of annuity payments where an annuity purchased prior to April 23, 1987, was gifted. Only the situation of surrendering a policy, as discussed in the situation with Joan above, has been specifically addressed. By far, most annuity companies make annuity payments to the owner. Or, should an alternate payee be designated by the owner, the insurance company reports the taxable earnings under the owner s social security number to the IRS (which should not be assumed to remove the owner s legal responsibility of reporting any applicable gifts to the IRS). As can be seen, if the annuity insurance carrier makes annuity payments to the annuitant, and reports the taxable portion of the payments to the IRS under the annuitant s social security number, the owner should be directed to his or her own legal expert counsel to determine when and if a gift has been made, and how income should be reported for tax purposes. Taxation Rules At Death Any contract issued after January 18, 1985 (including contracts issued via 1035 exchange after this date) must follow certain distribution rules upon the death of a contract owner. The purpose of the death distribution rules is to ensure that annuity contracts cannot continue into perpetuity and therefore defer taxes into perpetuity. Death Prior To Annuitization If the owner dies prior to annuitization start, the contract must be distributed within five years of the owner s death, or if begun within one year of the date of the owner s death, as an annuity not to exceed the life expectancy of the beneficiary. The latter option (annuitization) must be selected within 60 days of the owner s death. The annuity payments are taxed like any other annuity payments (spread over the life of the annuity). However, if the annuity election is not made within sixty days of the owner s death, the IRC regulations treat the distribution as though it were received in the year of death, and it is taxed like a lump sum withdrawal - interest taxed as withdrawn. If a spouse is named as the owner s beneficiary, the spouse can elect to continue the contract upon the owner s death. Only a spouse named as beneficiary can continue a contract upon an owner s death. The beneficiary treats taxable earnings received as unearned income, and is taxed at his or her own tax bracket, not that of the deceased owner. 35

48 Death After Annuitization There are no mandatory distribution rules for an annuitized contract at death. The terms of the annuity income option dictate what happens to the proceeds of the policy at death. If the beneficiary receives any payment that includes a taxable portion, based on the exclusion ratio in place at the annuitant s death, the beneficiary must pay taxes on that gain at his or her income tax bracket. Non-Natural Owners The IRS has clarified taxation rules for annuities owned by non-natural owners and distributions due to death from such contracts that occur after January The IRS explained that for contracts issued after April 22, 1987, the death distribution rules treat the annuitant as though the annuitant were the owner if a non-natural person is named as owner. In addition, if a primary annuitant is changed on a contract with a non-natural owner, the distribution-at-death rules apply to the contract as though the owner had died. Insurance Company Application Of The Distribution At Death Rules The January 18, 1985, distribution rules pose an interesting dilemma for the insurance company. Traditionally many insurance companies considered the annuitant as the measuring life on a deferred contract, i.e., at the annuitant s death, a death benefit (annuity contract value without surrender charges) was payable to the beneficiary. But the IRS distribution rules state that the owner s death forces a payout. Although there are no hard and fast rules regarding how an insurance company may handle this issue, generally there are three death-at-distribution contract types into which a deferred annuity will fall. These are discussed below: Distribution At Death Deferred Contract Type I This contract structure pays a death benefit at the annuitant s death and surrender value at a non-annuitant owner s death. This contract type views the annuitant as the measuring life. At the annuitant s death, full contract value, with no surrender charges, is paid to the annuitant s beneficiary. This payout must be taken as a lump sum within one year of the annuitant s death, or, if elected within sixty days, as an annuity not to exceed the life expectancy of the beneficiary. If a non-annuitant owner is named, and the owner pre-deceases the annuitant, the owner s beneficiary must follow IRS requirements and take distribution within five years, or as an annuity. If the owner s beneficiary is a spouse, the surviving spouse can continue the contract rather than take a forced distribution. If, at the time the distribution takes place any surrender charges are in force, they will be applied to the distribution value. 36

49 If a non-spouse is the beneficiary on a contract structured in this manner, many insurance companies will allow the beneficiary to keep the contract in force for the five-year period so that the surrender charge period is passed or the charges decreased. Contracts of this sort often call the owner s beneficiary the contingent owner, or the contract may state that the surviving joint owner is considered the owner s beneficiary upon the owner s death. Sometimes, contracts with this structure have a high maximum age for the owner and a lower maximum age for the annuitant. This is because the risk to the insurance company at the owner s death is mitigated by surrender charges. Distribution At Death Deferred Contract Type II This type of contract pays a death benefit at the owner s death and takes no action at the annuitant s death. This contract type goes against the typical logic of annuitant as the measuring life of the policy. Instead, it is in sync with the IRS requirements, making the owner the trigger for distribution at death. More and more new product contracts are constructed in this manner. Basically, the annuitant is nothing more than a name in the annuitant space on the application. At the annuitant s death, the owner names a new annuitant. It is upon the owner s death that the death benefit is paid. The exception under this type of contract structure occurs when the owner is a non-natural person. As pointed out earlier, under that scenario, the annuitant s death is considered the owner s death for IRS distribution purposes and these contracts will treat the annuitant as owner when a non-natural owner is named. Distribution At Death Deferred Contract Type III This contract structure pays a death benefit at either the owner s or the annuitant s death. This contract type certainly can be the easiest to set up for a client without any unsuspected consequences to the owner or beneficiary. Under this type of contract, if either the annuitant or owner dies, the full annuity value is paid to the beneficiary. If the owner dies, the IRS distribution rules apply - a spousal beneficiary may continue the contract or the distribution must be taken with five years or as an annuity not to exceed the life expectancy of the beneficiary. If the annuitant dies, the payment must be made within one year or as an annuity not to exceed the life expectancy of the beneficiary. The three contract type descriptions above are very general and have been simplified for explanatory purposes. Joint ownership, joint annuitants, restrictions regarding 37

50 spousal joint owners, and specific contract terms can alter the resultant distribution. One principle, however, is clear: naming the same person as owner and annuitant on an annuity contract can greatly simplify annuity distribution at death. Estate Taxation Deferred Contract The contract value of a deferred annuity at the death of the owner is included in the owner s estate. If a contract is jointly owned, generally only 50% of the value is included in the deceased owner s estate. If the annuity proceeds are payable to a spouse upon the owner s death, generally, the unlimited marital estate tax deduction applies. Annuitized Contract The type of annuity income selected by the owner impacts estate valuation. If a nonrefund life annuity is purchased, no value will be included in the deceased annuity owner s estate. If payment or payments continue after death to the deceased s estate, the value of these payments are included in his or her estate. If payable to a beneficiary, the amount included in the deceased s estate is based on his or her incidence of ownership in the contract. If the contract was jointly owned, 50% of the payment values are included in his or her estate. If solely owned by the deceased, 100% of the payment values are includable in the deceased s estate. Other Taxation Issues Taxation of Social Security Benefits Deferred annuity earnings (not withdrawn) are not included in the calculation used to determine the taxation of social security benefits. However, the taxable portion of annuity payments or withdrawals are considered part of unearned income, and as such, are part of the taxation of social security benefits calculation. Divorce Unlike qualified plans, the 10% premature distribution tax is not waived for distribution of annuities required under a qualified domestic relations order. However, annuities may be transferred due to divorce. Most carriers will accommodate such transfers, such as splitting a jointly held contract into two separate contracts. Assignment of Annuities, or Pledging an Annuity As Collateral The portion of an annuity assigned or pledged as collateral for a loan is viewed as a distribution, meaning earnings will generally be taxable. Premature distribution tax, if the annuity owner is under 59 ½, will also generally apply. 38

51 CHAPTER SIX: ADVANTAGES OF THE VARIABLE ANNUITY Tax- Deferral Tax - Deferral Variable annuities offer several advantages as long-term investment vehicles. The two foremost advantages are taxdeferral and the opportunity to choose among many different investment options. Other advantages include guaranteed death benefits and flexible annuity income options. A variable annuity is both a securities and an insurance product. As an insurance product, the build up of account values is free from taxation until withdrawn. Tax deferral can provide a significant impact on growth when compared to growth in a taxable product, as was discussed in Chapter Two. Investment Options Flexible Income Guaranteed Death Benefit Investment Options Variable annuities include a number of different investment options called subaccounts. Each sub-account has a specific investment objective, such as growth, total return, income or capital appreciation. The variable annuity purchaser may select the sub-accounts which best meet his or her investment objectives. As investment goals change, or market conditions warrant, account values may be redistributed within the variable annuity sub-accounts. An added advantage is that when moneys are moved from one sub-account to another, no current tax ramifications occur. This is different than transfers from mutual fund to mutual fund, even within the same fund family. Transfers among mutual funds, other than those within a qualified retirement plan or IRA, may cause current income and capital gains taxation. Investing in equity sub-accounts can act as a hedge against inflation. Historically, common stocks have generally risen as consumer price indices have risen. Inflation can reduce purchasing power significantly -- remember when bread was a quarter a loaf and gasoline under a dollar per gallon? (If not, ask your parents.) Guaranteed Death Benefits Many variable annuities include a guaranteed death benefit. Although the provisions vary, typically the minimum death benefit guarantee is a guarantee of the greater of the value of the contract at time of death or all premiums paid, less any withdrawals. Some variable annuities also include a stepped-up death benefit, wherein the contract values are frozen every certain number of years for the purposes of calculating the 39

52 death benefit. The death benefit guarantee in this case is typically the greater of the stepped-up value, the current value at the time of death or the total of all premiums paid. A guaranteed death benefit is very attractive to those concerned about the value of the assets left to beneficiaries. Variety of Flexible Income Options Variable annuities contain several income options to meet the varying income needs of the contract holder. Annuity income or annuitization options include income for life as well as income for specified periods of time. Income can normally be received every month, every quarter, or once a year, as the customer desires. Income from a variable annuity can often be taken as regular, systematic withdrawals as an alternative to, or prior to, annuitization payments. These payments can be started and stopped as necessary and can also generally be received on a monthly, quarterly or annual basis. Summary Variable annuities mix the advantages of insurance and securities. The insurance benefits of tax-deferral, death benefit guarantees and annuity income options are combined with the benefits of self-directed investing and numerous investment options normally associated with securities products. Because of these advantages, more and more variable annuities are being purchased to meet long-term investing and retirement needs. 40

53 CHAPTER SEVEN: VARIABLE ANNUITY FUNDAMENTALS A variable annuity is a contract between the annuity owner and an insurance company. It is a tax-deferred product that allows the purchaser to allocate contributions to one or more sub-accounts. A sub-account is a pool of securities invested to meet a specified objective. A variable annuity also includes the option to receive annuity income payments at a specified date in the future. The variable annuity is so-named because the return on the annuity is variable. Returns vary based on the performance of the sub-accounts selected by the purchaser. Fixed annuities are another type of annuity contract issued by insurance companies. Fixed annuities pay a fixed rate of interest, established by the insurance company. Fixed rate annuities typically guarantee the rate of interest paid on their contracts for contiguous one year periods. Deferred Contracts Most variable annuities are considered deferred because annuity income payments do not begin until sometime after the first twelve months from the policy opening date. In addition, earnings on the policy are deferred from taxation until withdrawn. If annuity income payments begin within twelve months of purchase, the IRS considers the contract an immediate income annuity. Purchases of variable immediate income annuities are less common than fixed immediate income annuities since typically the variable annuity purchaser is a longer-term investor, looking for growth. This subject is covered in more detail in a later chapter. Tax-Deferral Since a variable annuity includes the characteristics of an insurance product, the earnings within the variable annuity are not subject to taxation until withdrawn. Annuities include this tax-deferred advantage based on Internal Revenue Code Section 72. The effect of tax-deferral on an annuity s return can be quite significant, depending on the length of time the earnings remain in the annuity, and the marginal tax bracket of the annuity owner, as was illustrated in Chapter Two. 41

54 Premium Payments Two types of variable annuities are available: flexible premium and single premium. Flexible Premium Variable Annuities The purchaser opens a flexible premium annuity with a single contribution, but may make additional contributions to the policy. The contributions may normally be made at anytime during the life of the policy. Single Premium Variable Annuities The purchaser makes only one opening contribution to a single premium annuity. The Variable Annuity As A Security Variable annuities are regulated as both an insurance product and a securities product. To sell a variable annuity, both an insurance and Series 6 securities license are required. States may require either a life insurance license or a special variable annuity insurance license to sell variable annuities. Investment Risk Variable annuities are regulated as a security because the variable annuity policyowner bears investment risk: the policyowner chooses where his purchases are allocated among the sub-accounts. Fixed annuities, on the other hand, are not considered securities because the insurance company assumes the investment risk. The insurance company takes the risk that it will be able to meet the obligations of a fixed annuity contract - the initial rate guarantee, the minimum rate guarantee, and any other guarantees of the contract. Even though a variable annuity may include guarantees that equate to an insurance company risk, the preponderance of risk is assumed by the policyholder. The Separate Account The separate account is used by the insurer to hold the sub-account assets of the variable annuity. Under federal securities law, the separate account is considered a separate legal entity from the insurance company issuing the variable annuity. The separate account must be registered as an investment company under the Investment Company Act of This is the same act which governs the registration of investment companies issuing mutual funds and sets forth the requirements relating to promotion, reporting requirements, pricing of securities for sale to the public and allocation of investments within a portfolio. The separate account may be managed by a firm outside of the insurance company. It is not uncommon for a variable annuity to have more than one separate account affiliated with the annuity, and for each separate account to be managed by a different group of advisors. Typically, the separate account managers, if from outside the insurance company, are from mutual fund companies or institutional investment firms. 42

55 The Sub-Account The sub-accounts within the separate account are pools of securities, such as stocks, bonds and money market instruments. Each sub-account is managed according to an objective such as growth, aggressive growth, high yield bond or growth and income. The objective, the types of securities invested in, and risks of the sub-account as an investment are described in the variable annuity prospectus. Chapter Eight discusses the various investment objectives, risks and portfolio composition found in the most common variable annuity sub-account types. Variable Annuity Accumulation Units The return of a variable annuity is based on the value of the sub-accounts. The total value of a variable annuity s sub-account is calculated by multiplying the number of accumulation units held by an annuity owner by the value of each unit in the subaccount. For example, if Mr. Smith owns 2025 units of the ABC Annuity Special Growth Account, and each unit is worth $1.45, his account value is $2, (2025 x $1.45). The value of the separate account is calculated each day the New York stock exchange is open for trading, at the end of each trading day. Annuitization Variable annuities include an option, or in some states, a requirement, to annuitize the contract. Annuitization is an irrevocable decision to receive periodic annuity income payments. Payments will commence within one month, three months, six months or one year from the annuitization start date. The variable annuity contract may require that the annuitization start date (also referred to as the contract maturity date, annuity start date or maximum deferral date) be no later than a certain age, e.g. age 85. The maximum annuity start date may also be governed by state law. The Variable Annuity Prospectus Since the variable annuity is a security, a variable annuity prospectus must follow the requirements set forth in the Investment Company Act of 1940 and the Securities Act of The prospectus must, among other information, state the specific investment objectives of the sub-accounts, provide expense information, and a financial statement, as well as company information. 43

56 The prospectus contains important information and provisions regarding the variable annuity product. Common information found in the prospectus includes: summary of expenses performance data definition of terms account valuation method annuity income, or annuitization options contract provisions, such as purchase provisions, calculation of death benefit, exchanging units, and the free look period a description of each sub-account, including objective, investment policy, and associated risks a definition of the fixed account, if any, including initial and renewal rate guarantees federal tax considerations Variable Annuity Expenses Expenses in a variable annuity include transaction expenses, annual expense, separate account expenses and sub-account expenses. Transaction Expenses Transaction expenses are fees levied for certain transactions made by the annuity owner. Fees may be charged based on the purchase of sub-account units (making a contribution to a sub-account), the withdrawal of sub-account units, and/or the exchange of units between sub-accounts. Purchase of Sub-Account Units Most variable annuities today do not charge a fee, or sales load, at the time of unit purchases. Those that do, however, commonly charge a level percentage fee. For example ABC Variable Annuity may charge a three percent sales load for each purchase. If $10,000 were contributed to the variable annuity, $300 would be charged as a sales load, leaving $9700 to purchase units. Withdrawal of Sub-Account Units Commonly, variable annuities include a deferred sales load. For a certain period of time, for instance five years from purchase, a sales load will be charged at the time units are surrendered, or a withdrawal is made. Typically, sales load percentages decline over time. For example, the deferred sales load schedule may be six percent in the first year from purchase, five percent in the second year from purchase, four percent in year three, and so on. Level deferred sales load schedules are also found in variable annuities, for example, five percent for withdrawals made the first five years from purchase. Most variable annuities apply the sales load to each purchase made. For example, if a purchase is made at the time of opening, the deferred sales load schedule is applied to 44

57 the units purchased at that time. If a second purchase is made the following year, the deferred sales load schedule is applied to this purchase separately. When withdrawals are made, the sales load is applied on a first-in, first-out basis. Sample Deferred Sales Load Calculation Assume a variable annuity has a five year deferred sales load schedule, starting at five percent in the first 12 months from purchase, and decreasing by one percentage point each subsequent year. Deferred Sales Load Schedule Contract Year Sales Load Percentage 0 5% 1 4% 2 3% 3 2% 4 1% 5 0% A purchase of $10,000 is made to open the contract and additional contributions of $10,000 are made in contract years one and two. A withdrawal of $12,000 is made in year three. Contract Year Purchase (Withdrawal) Amount 0 $10,000 1 $10,000 2 $10,000 3 ($12,000) The sales load would be applied as follows: Amount Withdrawn: Number or Contract Sales Load Percent $12,000 Years From Purchase ($10,000) 3 2% ($ 2,000) 2 3% The first $10,000 of the $12,000 withdrawal was contributed three contract years prior to the time of withdrawal and is charged a 2% sales load. The next $2,000 is charged a 3% sales load, since the purchase of these units was made two contract years prior to the withdrawal. Exchange of Units Variable annuities may charge a fee for the exchange of units from one sub-account to another. Typically, this charge is not assessed until a certain number of exchanges or transfers have occurred, if the fee is charged at all. 45

58 Exchange or transfer privileges may include certain limitations, such as the dollar amount that may be exchanged, the frequency of transfers or exchanges, and the number of times exchanges can occur within a contract year. Annual Expense An annual contract fee is charged to each variable annuity contract holder. This fee is normally $30 - $35. This fee covers account maintenance, transaction processing, clerical services, etc., related to each contract. Separate Account Expenses Separate account expenses include mortality and expense risk charges and administration and maintenance fees. Separate account expenses are charged to all contract holders, regardless of the sub-accounts held. Mortality and Expense Risk Charges The variable annuity issuer assumes certain risks when issuing contracts, and for that, a percentage charge is assessed against the separate account daily. The mortality risk assumed by the provider is based on the promise to pay lifetime annuity income payments, regardless of how long an annuitant might live and the payment of a minimum death benefit. The expense risk is the risk that the sales load and administration fees may not be sufficient to cover the expenses related to maintaining the variable annuity contracts prior to annuitization. Administration and Maintenance Fees Some variable annuities products include a fee charged to the separate account for administration and maintenance in addition to the annual contract fee. This fee pays for issuing statements, processing transactions, calculation and monitoring of daily sub-account values, and the creation of separate account annual reports. Some variable annuity providers consider some of these charges as sub-account fees and charge a percentage to the various sub-accounts rather than to the separate account. Sub-Account Expenses Sub-account expenses are those charged to each sub-account. The amount of the expenses is related to the expense of managing the sub-account. The percentage charged varies, therefore, depending on the investment strategies and types of securities in the sub-account. Sub-accounts with higher risk objectives, such as a foreign stock sub-account normally have higher expense charges than a lower risk sub-account such as a US Government securities sub-account. The management of these higher risk sub-accounts is considered more demanding than most lower risk sub-accounts. Performance Data The prospectus includes a variety of sub-account performance data. The change in unit values at the beginning and end of the current and previous years along with the 46

59 percentage change and subsequent total return is included. The size of the subaccounts, number of units in each account and actual expense ratios are also included. Comprehensive financial data, beyond that found in the prospectus, is available from the annuity issuer, or designated accounting firm, in the Statement of Additional Information. Definition of Terms The prospectus includes the definitions for such items as accumulation units, the owner, the annuitant, the beneficiary, the contract value, the death benefit, and other terms needing explanation. Account Valuation Method The method and timing of account valuation is described in the variable annuity s prospectus. Basically, accounts are valued each day the New York Stock Exchange is open. The valuation is performed at the close of the exchange. A sub-account s unit value is set at some par value at inception, and recalculated each business day thereafter. Annuitization Options The prospectus explains annuity income and annuitization options. These options are discussed in Chapter Five. Contract Provisions Although many variable annuity contracts contain the same type of provisions, the specifications of those provisions vary, resulting in very different features and benefits. For example, most contracts allow a free withdrawal. This is a withdrawal meeting certain criteria within the contract and therefore not incurring a sales load. The terms of these withdrawals can be relatively liberal or quite restrictive. For example, two different variable annuities may each have a provision titled 10% free withdrawal. One allows a withdrawal of up to 10% of the contract value with no sales load charge as soon as the annuity is opened. In addition, if the 10% free withdrawal is not taken during a contract year, it accumulates so that in contract year two, 20% may be withdrawn, in year three, 30% and so on. The other annuity allows a 10% free withdrawal only after the first year, and then only within thirty days of the contract anniversary. If the withdrawal is not taken, it does not accumulate. Reading the prospectus carefully is critical to ensure this and other provisions are properly understood. Sub-Account Descriptions Each sub-account is described in the prospectus. The description includes the investment objectives, the investment practices, and the types of securities that may be purchased and managed. The associated risks of the securities and investment practices are also fully explained. 47

60 Fixed Account Description Many variable annuities include a fixed account option. A fixed account is not a subaccount within the variable annuity separate account. It is not registered under the Securities Act of 1933, nor the Investment Company Act of Rather, it is an account that is part of the general assets of the insurance company. The fixed account offers a guaranteed rate for a specified time period and a minimum guaranteed rate. The fixed account guarantees are an obligation of the issuing insurance company. Often exchanges or transfers from the fixed account are limited when compared to the frequency of transfers allowed from the sub-accounts. Since the insurance company guarantees rates of return for specified periods of time, withdrawals may be limited to ensure there are sufficient invested assets to meet rate guarantees. In addition, since the fixed account is an obligation of the issuing company, reserves must be set aside to meet all contract obligations and withdrawal privileges impact the amount of reserves required. Some variable annuity contracts incorporate a Market Value Adjustment, or MVA, for withdrawals from the fixed account. If current, new money rates are lower than the rate the fixed account is paying at surrender or withdrawal, the annuity will be given a positive cash value adjustment, resulting in a higher surrender value than if no MVA was calculated. If current, new money rates are higher than the rate the fixed annuity is paying at surrender or withdrawal, a negative adjustment to cash value will be made, resulting in a lower surrender value than if the MVA was not calculated. The idea behind an MVA is that the insurance company will have to pay less to replace moneys surrendered in a decreasing rate environment, so the policy is given a positive MVA. In an increasing rate environment, the cost of new money is higher for the insurance company, so there is a negative MVA applied to the surrendered policy. Federal Tax Considerations The variable annuity prospectus contains a description of the federal tax ramifications of purchasing a variable annuity. The tax issues related to the separate account and general annuity taxation rules are discussed. The customer should contact his or her own tax professional for advice for his or her specific situation. Annuity Application Before the policy can be issued, an application must be completed and premium paid to the insurance company. The variable annuity application is similar to a fixed annuity application, but has some differences. The application will include: Name, social security number, sex, birthdate and address of the owner(s) Name, birthdate, sex and social security number of the annuitant(s) 48

61 Name and relationship of the beneficiary(ies). Some applications require the social security number as well Type of annuity, if the company offers more than one type (flexible premium, single premium, IRA or qualified plan) Allocation of purchase payments among the sub-accounts Special programs such as dollar cost averaging, asset allocation, or investment by bank draft Whether the variable annuity is replacing another annuity Signature of owner(s). Some applications require the signature of the annuitant(s) as well Signature of the agent accepting the application Along with the application, additional forms may be required for disclosure purposes, or if replacement of the annuity is involved, certain states require that additional information be taken from and given to the applicant. 49

62 CHAPTER EIGHT: VARIABLE ANNUITY SUB-ACCOUNTS Central to the variable annuity are the sub-accounts. The sub-accounts are the vehicles through which the purchaser can meet his or her financial objectives. Selecting subaccounts that properly reflect a customer s objectives and risk tolerance is the variable annuity representative s most important challenge in the sale of a variable annuity. As mentioned previously, each sub-account has an objective and investment policy. Each objective and investment policy has associated risks. This chapter will review the common types of sub-accounts found in variable annuities, beginning with the common risks and objectives that are associated with the sub-account types. Types of Risk Generally, types of risks related to securities include Financial or Default Risk, Market Risk, Interest Rate Risk, and Purchasing Power Risk. Economic or Political Risk and Exchange Rate Risk are risks most often associated with international securities. Financial or Default Risk Financial risk is the risk that the underlying corporation or issuing entity will be financially unable to meet the obligations of the security. In the case of stocks, the financial risks include the risk that the corporation will be unable to pay dividends and/or will reduce or eliminate dividend payments. Financial difficulties within the corporation can also cause the value of the stock to fall, just as financial strength can drive share values up. The financial or default risk of a bond is the risk that the issuing entity, whether a corporation, a state or local government, or the federal government, will be unable to meet the obligations of the bond issue. The relative risk of default of a bond is based on the creditworthiness of the issuer. Therefore, the risk of default of a bond issued by the US government is considered to be virtually nonexistent whereas the risk of default of a small, undercapitalized corporation, or a large corporation newly reorganized to avoid bankruptcy will be considered to be quite high. Bond Rating Agencies Bond rating agencies perform credit analysis and assign ratings to bond issues. The two best known agencies are Moody s Investor Services and Standard & Poor s Corporation. Other bond rating agencies include Duff & Phelps, McCarthy, Crisanti and Maffei, and Fitch Investors Service. 50

63 The focus of the evaluation of rating agencies is the relative ability of the issuer to meet the specific obligations of the bond. Moody s and S&P assign letter ratings to the different risk levels, or grades. The higher the rating, the lower the risk of default. The different rating agencies use different descriptions for the letter grades assigned, but the industry has general terms applied to the different bond grades, as shown in the table below. General Industry Description Moody s S&P Investment Grade Prime Aaa AAA High Quality Aa AA Upper Medium Grade A A Medium Grade Baa BBB Below Investment Grade Moderately Speculative Ba BB Speculative B B Highly Speculative Caa CCC Lowest Quality C C,D Market Risk Market risk refers to the risk of price fluctuation of a particular security, securities of a particular industry group, e.g. all airlines or all pharmaceutical companies, or for the entire securities market. Financial difficulties within an industry can impact price, as can competition, regulations, public perception, political upheaval, etc. Some professionals refer to components of market risk as event risk rather than market risk to emphasize the inability to predict a risk such as the impact of a massive oil spill, a series of airplane accidents, the discovery of (another) cancer causing element found in a popular food item, etc. Interest Rate Risk When interest rates change, equities may be affected due to the relative attractiveness of competing securities. For example, if rates in long-term, prime bonds have been relatively low, a certain portion of risk averse investors may accept the additional risk for the expected additional return found in high quality stock. Once bond rates rise, these investors may return to the long-term bonds they feel more comfortable with. Interest Rate Changes and Bond Prices Bond prices are impacted by changes in interest rates. When interest rates move up or down, generally the bond price moves in the opposite direction. For example, if a 51

64 bond with a fixed rate of 7% were purchased, and rates fell to 5%, the price of the bond will rise, because investors will be willing to pay more for the 7% rate. If rates rise, the bond s price will fall because investors will pay less for the 5% rate. Interest Rate Changes and Bond Term and Quality The longer the term of the bond, or the greater the number of years to the bond s maturity, the more sensitive the bond price to interest rate changes. Since there are a greater number of years for the bond to be impacted by the rate change, the relative impact on price is greater. In addition, the higher the bond quality, the greater the relative impact of interest rates on the bond s price. Since high quality bonds have low default risk, the high quality bond s price is based primarily on its interest rate. Low quality bond, or junk bond, prices are impacted by the acceptance of default risk by the investor. Therefore, if interest rates change, the impact on a high quality bond will be relatively greater than the impact on a low quality, or junk bond. The sensitivity to rate changes are also impacted by the options of a bond, such as whether the bond is callable, and whether the rate paid, or the coupon, is a fixed rate or floating rate based on an index. Purchasing Power Risk Purchasing power risk is the risk that a security will not increase in value to keep pace with inflation, or the reduced purchasing power of currency. If a stock or bond returns 5% and the inflation rate is 6% during the same period, the security will be generating returns that result in the reduction of purchasing power. Fixed coupon bonds have a greater susceptibility to purchasing power risk than a bond with a floating coupon bond. Equities are generally considered as a hedge against inflation, since generally common stock prices have moved upward as inflation indices, such as the Consumer Price Index, have risen. Economic or Political Risk The economic and political climate of the country from which a security is issued can impact the volatility of that security. War, uprisings, or a change in government will obviously impact the economy and stability of a country and the assets within it. Trade agreements, embargoes, and multi-nation treaties can all impact the financial health of businesses within a country. Therefore, some foreign securities can include relatively high levels of economic and/or political risk. Exchange Rate Risk Exchange rate risk is a risk found only in bond sub-accounts holding bonds from outside the US. Exchange rate risk is the risk that the currency in a foreign country will decrease in value relative to other currencies, such as the dollar. If so, the bonds issued from that country will be worth less to investors from countries with stronger currency, or with currency that is relatively higher in value. Not only will the bond price be worth less if the currency decreases, but the relative value of the coupon 52

65 payments, reinvested income and capital gains will also decrease to the foreign investor. Exchange rate risk can be hedged against by foreign exchange futures and options. Or, a fund manager may choose to diversify among many countries to reduce exchange rate risk, while also reducing overall default and interest rate risks. Sub-Account Objectives The common objectives found in sub-accounts include capital appreciation or growth, current income, total return and stability of principal or preservation of capital. The subaccount managers must adhere to the sub-account s objective as stated in the prospectus. Since variable annuities are long-term investments, the objectives of most variable annuity sub-accounts reflect a long-term financial horizon of a minimum of five years. Capital Appreciation Capital appreciation is growth in the share value of the sub-account portfolio. A subaccount with capital appreciation as its objective will be comprised largely of equities. If the sub-account fulfills its objective, as the individual equity securities in the subaccount increase in value, the sub-account s value will rise, and each unit will increase in price. Capital appreciation may be expressed as an objective of long-term capital appreciation. Typically, the inclusion of long-term implies investment in common stocks of established corporations in contrast to the objective of growth or capital appreciation which can imply investment in companies with potential for significant short or intermediate term growth, such as small company stocks. Total Return Total return refers to the percentage of growth in a sub-account from both capital appreciation and dividend income. A sub-account with the objective of total return will typically invest in dividend paying securities that also have capital appreciation potential, or will seek a balance of investments to generate both income and capital appreciation. Income Income can come from dividends from common stocks, or government and corporate bonds. An objective of high current income would indicate that the sub-account is more aggressive than a sub-account seeking simply current income. Preservation of Capital This objective is never the sole objective of a sub-account. Instead it will accompany an objective of income or growth. It is an indication that the sub-account intends to follow its objective of growth or income only to the extent that it will not cause loss of capital. 53

66 Types of Sub-Accounts Generally, types of sub-accounts exist which share common investment objectives. For example, a US Government sub-account fund, or series as the variable annuity companies often call them, will generally have the objective of current income and will be comprised primarily of US Government securities. The more common sub-account fund types are described below, along with common associated risks. Government Sub-Account Funds Government bond sub-account funds invest primarily in bonds and other securities issued by the US government or government agencies. Issuing departments or agencies of the US government include the US Treasury, the Federal Home Loan Bank, the Federal National Mortgage Association (Fanny Mae), the Government National Mortgage Association (Ginnie Mae), the World Bank or International Bank for Reconstruction and Development, the Federal Intermediate Credit Banks, the District Banks for Cooperatives, the Federal Land Banks and the Inter-American Development Bank. The risk of default on government issued securities is considered to be zero. Government securities are considered the safest investment in terms of default or financial risk. However, as bonds and bond-like securities, government issued securities are still subject to interest rate, market and purchasing power risks. Depending upon the structure of the security, these risks may be minimal, as in a Treasury bond held to maturity, or very high, as in an inverse floater CMO tranch. The objective of government sub-accounts is generally current income with relatively low fluctuation in unit value. However, the objective and share volatility varies from sub-account to sub-account. Some sub-accounts are 100% invested in treasury securities, others use options, futures, CMOs and CMO derivatives. The relative risks and volatility in these different sub-accounts will obviously be quite different. US Government Sub-Account Funds US Government sub-accounts funds typically have the objective of current income, and many include the objective of capital preservation as well. Typically, US Government sub-accounts seeking current income will only allow investment in options and futures to a greater degree than those US Government sub-accounts with the objective of capital preservation. Government sub-accounts may be comprised largely of short-term, intermediate or long-term bonds, or may have portfolios of securities with a variety of maturities. The average maturity of the portfolio impacts the return and volatility of the sub-account. Generally, the shorter the maturity, the lower the volatility and return of the subaccount. However, certain short-term government securities, such as adjustable rate mortgage securities, can be volatile in sharply increasing or decreasing interest rate markets. 54

67 Government securities sub-accounts may include GNMA (or Ginnie Mae) securities. Ginnie Mae securities are generally pass-through, or participation, securities. Passthroughs are pools of mortgages wherein the investor (in this case the sub-account) owns an interest. The principal and interest payments made on the mortgages are passed through to those with a share in the pool. Mortgage securities can provide a higher rate of return than many other government issued securities, but carry the risk that the mortgagees may pay off their mortgages early, e.g. in a decreasing rate environment. This risk is known as pre-payment risk. When mortgages are paid off early, which can mean either before the terms of the mortgage agreement or before the expected pay off date, principal is returned to the investors and the interest payments cease. New mortgages purchased in the lower rate environment will pay lower interest to the pool participants. A method of reducing prepayment risk is investment in CMOs, or collateralized mortgage obligations. A CMO is a security backed by a pool of pass-throughs, actual loans, or stripped mortgage backed securities. Basically, a CMO is structured so that the underlying mortgages are placed into several classes, or tranches of bonds with varying stated maturities. The prepayment risk of the pool is spread among the bond tranches, with some tranches having less prepayment risk than the overall pool and other tranches having more. The yield on the higher risk tranches is higher than those of the lower risk tranches. A sub-account manager may purchase CMOs with the intent of reducing prepayment risk on the overall sub-account portfolio. Other mortgage securities may be found in a government sub-account portfolio to increase yields as well as hedge against interest rate risks. Derivatives such as IOS and POs, PACs and Inverse Floaters range from moderate to high risk methods of yield enhancement. The prospectus of the variable annuity should be read thoroughly to ascertain the amount of risk a sub-account is assuming by its use of derivatives. US Government Treasury Sub-Account Funds US Treasury sub-account funds hold assets comprised solely or primarily of debt issued by the US Treasury. These sub-accounts too may be short-term, intermediate or long-term. The long-term sub-accounts have the greatest volatility, and show the greatest return when interest rates fall. Because Treasury sub-accounts either limit or do without mortgage-backed securities, the risks related to prepayment as found in a Ginnie Mae sub-account are not normally found in a Treasury sub-account. And since government backed securities are considered to have no risk of default, the major risk found in a Treasury sub-account is interest rate risk. Corporate Bond Sub-Account Funds Corporate Bond sub-account Funds, as the name suggests, invest mainly in corporate bonds. A number of different types of corporate bond sub-accounts are available. 55

68 High Yield Corporate Bond Sub-Account Funds High yield corporate bond sub-account funds are often the most aggressive of the corporate bond sub-accounts. They are generally invested in corporate bonds issued by financially trouble companies. The bonds have a higher coupon rate than those of more financially stable corporations. Therefore the risk of default in a high yield portfolio is reflected in the potential for higher returns. Whether the return is ample enough for the default risk is up to the sub-account managers to determine. The subaccounts often allow, by prospectus, a percentage of the fund assets to be in common or preferred stock as well. Some funds also invest in futures and options. Again the overall portfolio composition affects the overall risk of the sub-account. Corporate Bond Sub-Account Funds - High Quality High quality corporate bond sub-account funds generally invest in investment grade corporate debt along with treasuries, and government agency securities. The risk of default in high quality corporate bond funds is low, but the funds retain the interest rate risk of all bond funds. Like government funds, corporate bond funds can be found with portfolios comprised of short term, intermediate term or long-term bonds. The average maturity of the portfolio will impact the relative interest rate risk of the sub-account since short term bonds are generally less sensitive to interest rate risk than long-term bonds. Corporate Bond Sub-Account Funds - General Corporate bond sub-account funds which are not comprised of high-yield or highquality bonds have a wide variety of objectives. Generally, corporate bond subaccounts invest primarily in investment-grade domestic corporate debt. Other investments can include US government securities, stock, foreign securities and small percentages of less than investment grade bonds. Generally, the risk levels and return of a corporate bond sub-account fund should fall somewhere between high quality and high yield corporate bond funds. However, the return, interest rate and default risks are dependent on the specific portfolio of the sub-account. World Bond Sub-Account Funds World bond sub-account funds include sub-accounts that invest solely in bonds from outside the US (also known as International bond funds) and those which also include US corporate bonds in their portfolios (also known as Global bond funds). The risks of the political and economic environment varies from country to country or region to region in the world markets. Issues such as trade agreements and embargoes, multi-nation treaties, such as NAFTA and GATT, and wars or uprisings can all have an impact on the default risk of a world bond sub-account. Because this risk is related to political events, it is known as political risk. Some countries are very stable, such as many western European nations and others have highly volatile economies and political environments, such as some eastern European nations. 56

69 World bond sub-accounts are generally considered aggressive funds. However, some sub-accounts are invested in a great deal of US bonds, only venturing into foreign markets when the risk and return trade off is ascertained to be a prudent risk by the sub-account manager. These portfolios may be considered low risk within the world bond sun-account arena. Others are highly speculative, entering newly emerging foreign markets with highly volatile political and economic environments. Equity Sub-Account Funds Equity sub-account funds are largely comprised of common stocks. The universe of equity sub-accounts is even more diverse in objective and portfolio composition than bond funds. Aggressive Growth Sub-Account Funds The primary objective of an aggressive growth sub-account fund is capital appreciation. Portfolios normally hold large amounts of small and midsize companies, with good (as defined by the sub-account managers) potential for growth. Options and futures may also be heavily utilized in aggressive growth portfolios. As the name implies, aggressive growth sub-account funds generally provide excellent opportunity for growth, but can also be highly volatile. This sub-account type is for the long-term investor able to ride out the potentially extreme fluctuations in return. Growth Sub-Account Funds The objective of a growth sub-account fund is growth of capital, or capital appreciation. The portfolio mix ranges from stocks of a wide variety of large corporations to stocks solely from established corporations in certain sectors of the marketplace, such as technology or health care. Growth portfolios are less volatile, generally, than aggressive growth funds due to their more conservative, higher quality stock portfolios. Those with portfolios with a high concentration in a particular sector are subject to more market risk than those with a more diversified portfolio. Investment in foreign stocks can also increase risk and volatility in a growth fund. Small Cap or Small Company Sub-Account Funds Small Cap stock sub-account funds invest in stocks of small to midsize companies. Generally, the objective of these sub-accounts is capital appreciation. Small company sub-account funds may seek appreciation through a values approach - the fund managers seek out securities which they determine are undervalued in price given their potential for growth - or by focusing on growth potential by picking stocks from companies which show strong earnings and revenue growth. 57

70 The amount of diversification in a small cap sub-account impacts its subjectivity to market risk -- some small cap sub-accounts are heavily invested in certain sectors. Recently, technology firms have been one such sector. Sector swings will impact subaccounts so invested more greatly than more diversified small cap sub-accounts. Small cap sub-account funds vary in overall risk and portfolio quality, so may be appropriate for the moderate to aggressive investor, with a long-term investment horizon to ride out the market s potential volatility. Growth and Income Sub-Account Funds The objective of growth and income sub-account funds is current income and capital appreciation. Generally, portfolios are comprised of high dividend stocks and convertibles. Portfolios may also include some small-cap stocks and bonds. Growth and income sub-accounts are generally considered less risky than growth subaccounts, because of the former s emphasis on stocks from large, established corporations with histories of healthy returns and dividend payments. The short-term volatility of a growth and income sub-account makes them suitable for the long-term investor. Equity Income Sub-Account Funds Equity income sub-account funds are generally considered the most conservative of the equity sub-account portfolios. Generally, an equity income sub-account fund s objective is current income and capital appreciation. Portfolios generally consist of high quality, high-dividend stock and convertibles, as well as bonds. Equity income sub-accounts generally return lower yields than a corporate bond subaccount, but over the long-term have the potential for greater total return than a corporate bond portfolio due to the capital appreciation of the stocks within the portfolio. Short-term volatility is an issue, as with all equity funds. World Stock Sub-Account Funds World stock sub-account funds include both sub-account types that invest solely in stocks issued by companies outside the US (also known as International stock funds) and those which invest in stocks from companies both inside and outside the US (also known as Global stock funds). The risks and portfolio composition is similar to those of world bond funds, except of course world stock funds invest in stocks. Sector Sub-Account Funds Sector sub-account funds are funds that invest in stocks within certain sectors, such as financial, retail, services, utilities, etc. Depending on the sector invested in, the fund may have the objective of capital appreciation or current income. For example, utility sub-accounts have the objective of current income, while precious metals sub-accounts have the objective of capital appreciation. 58

71 Sector sub-account funds are generally used as hedging instruments against purchasing power risk, against interest rate risk, or against general market risks. Sector sub-account funds as a whole tend to be volatile, since their exposure to sector swings is high. Sector funds are best used as a part of a diversified investment portfolio, for the long term investor. Balanced Sub-Account Funds Balanced sub-account funds are comprised of both bonds and equities. A balanced portfolio includes a mixture of preferred stocks, common stocks, and bonds. The objective of a balanced sub-account fund is generally to achieve long-term growth or capital appreciation and earn current income while conserving principal. Balanced sub-accounts generally have less opportunity for growth than an equity fund, but have the advantage of less volatility due to the bonds and preferred stocks in the portfolio. Through the diversification of its portfolios, default risk, market risk, interest rate risk and purchasing power risk can all potentially be reduced through a balanced subaccount fund. However, as with all general sub-account fund categories, each subaccount termed a balanced fund is different. Some balanced portfolios emphasize capital appreciation through the investment in a high percentage of growth stocks. Others seek current income and invest in conservative, high quality bonds and income-oriented stock. The investment emphasis in the portfolio will impact the types and degree of risks in the sub-account. Money Market Sub-Account Funds Money market sub-account funds are generally considered as cash equivalents: very liquid with stable unit value. However, as securities products, there is no guarantee that unit values will remain stable in a money market. If a sub-account manager were to make bad investments, it is possible that share values could drop below the $1 par unit value normally set for money market portfolio. Money market sub-account funds typically invest in short term liquid vehicles, such as short-term commercial instruments like CDs, bankers acceptances and commercial paper, short-term government securities, and short-term municipal securities. Some money market portfolios include short-term securities issued around the world, to enhance yield. Although as mentioned, there is some risk of principal in a money market subaccount, they are generally the most conservative, least risky sub-account available. If a variable annuity includes a mutual fund sub-account, it typically will not have a fixed account. 59

72 CHAPTER NINE: VARIABLE ANNUITY FEATURES When variable annuities were first introduced, available Now Playing: Variable Annuities features were pretty basic. The ability to participate in sub-accounts made up of securities and enjoy tax-deferred growth was seen as such an advantage by the product providers that little need was seen to offer many bells and whistles. As more providers entered the variable annuity marketplace, however, more features were added. Features such as dollar-cost averaging, asset allocation programs, systematic withdrawals and nursing home waivers are now common features of variable annuities. Contribution Features Besides writing a check and mailing it to the variable annuity company (or brokerdealer) with sub-account investment instructions, three other methods are available through variable annuities to manage contribution payments. These methods are dollar-cost averaging, regular investment programs through bank drafts, and asset allocation. Dollar-Cost Averaging Dollar-cost averaging is the process of making regular contributions of a fixed amount to a sub-account or sub-accounts. When unit prices are high, the amount contributed will purchase fewer units than when prices are low. Over time, this method often results in a lower average price per unit than if all units were purchased at once, or were purchased randomly over a period of time. Dollar-cost averaging features automate regular investing in the variable annuity. The dollar cost averaging programs in variable annuities generally work as follows: on a regular basis, a fixed amount is transferred from one sub-account to one or more different sub-accounts. The owner determines how frequently dollar-cost averaging transfers will occur, the sub-accounts from which the dollar-cost averaging payments will be made, and the sub-accounts to which the dollar-cost averaging payments will be made. Some variable annuities limit the sub-accounts from which dollar cost averaging transfers may be made to a money market or guaranteed rate account. A minimum balance is normally required for the sub-account from which the transfers are made, e.g. $2000 to $5000. Regular Investment Programs Another method of dollar-cost averaging is to make regular contributions through bank drafts to a variable annuity. The owner authorizes his or her bank to make automatic monthly drafts to the variable annuity. The owner designates on the contract application or special form in which sub-accounts the draft amount will be 60

73 invested. Besides the benefit of dollar-cost averaging, these programs often offer the smaller investment customer an opportunity to participate in a variable annuity. Bank draft programs often require minimum monthly contributions of only $25 to $50. Asset Allocation Programs Asset allocation is a term referring to the way in which assets are divided, or allocated, among different investment options. The goal of asset allocation is to provide the best return while reflecting a customer s risk tolerance and investment objectives. The benefit of an asset allocation program is that the customer is able to rely on the management experience of the sub-account managers to review market changes and make asset allocation decisions for them. Many variable annuities offer an asset allocation program wherein dollars will be allocated in a method determined by sub-account managers or by a computerized asset allocation model. Usually the allocation vehicles include an equity sub-account, a bond sub-account and a money-market sub-account. Or one sub-account may be used which contains equities, bonds and money-market instruments. On a regular basis, the percentage invested in the asset allocation sub-accounts is reviewed and assets are reallocated as determined by the managers or computer model. An asset allocation program within a variable annuity should not be confused with an overall asset allocation strategy for a particular client. These programs should be used within the overall financial objectives of a client, and may be found to be a suitable component of a portfolio through the customer profiling process. Liquidity Features Variable annuities include a number of withdrawal methods. A penalty free withdrawal feature is available in virtually every variable annuity (outside of variable annuities within certain qualified plans). Systematic withdrawal programs and nursing home waiver features are available in many variable annuities. Annuitization is also available on all variable annuities. Penalty Free Withdrawals As mentioned in a previous chapter, variable annuities include withdrawal features that are not subject to deferred sales loads. The terms of these withdrawal features vary. A common free withdrawal provision allows up to ten percent of the accumulated value to be withdrawn once each contract year without any sales loads or surrender penalties charged. Another common provision is the withdrawal of all interest each contract year. Some variable annuities allow penalty free withdrawals from contract start date, and others require a one-contract-year waiting period. Some may allow more than ten percent to be withdrawn, and may allow the withdrawal percentage to accumulate each year if it is not used. It is prudent to carefully check the prospectus to ensure accurate understanding of any free withdrawal provision. 61

74 Although a free withdrawal is free from any charges from the variable annuity, taxation of earnings will still occur. Once earnings are withdrawn, they are taxable as current income. The IRS views withdrawals from annuities as being comprised of earnings before any principal can be withdrawn. Nursing Home Waivers Nursing home or medical waivers are another form of penalty free withdrawal feature found in annuities. Under this type of waiver, if a contract owner (or annuitant, depending on the stipulations of the waiver), is put into a hospital, nursing home, or other qualified, as defined by the waiver, health care facility, a withdrawal or surrender of the contract can be made without normally applicable sales loads being charged. Some nursing home waivers allow multiple withdrawals, others one only. Typically, to be eligible for this waiver, the stay in the qualified facility must be from thirty to one hundred and eighty days, and the withdrawals or surrender request based on the waiver must be made within thirty to sixty days from the time eligibility is established, or from the date of discharge from the facility. Again, check the waiver language in the prospectus or contract endorsement to verify the specific terms of the waiver. Not all states allow nursing home waivers, so a variable annuity contract may have this provision in some states, but not all. Systematic Withdrawal Programs Many variable annuities offer the owner the ability to withdraw a specific dollar amount on a regular basis, or as a systematic withdrawal, from the variable annuity. Systematic withdrawal payments may be started and stopped at the owner s discretion, unlike annuitization or annuity income payments which generally may not be stopped once they commence. Two issues regarding systematic withdrawals are important to remember: 1. If the amount of the systematic withdrawal exceeds the penalty free amount available, surrender charges or deferred sales load charges will apply. 2. Systematic withdrawals can exceed or fall within current returns. Assume a systematic withdrawal program was begun upon a variable annuity s inception and the withdrawal amount requested was $500 per month. If in any month the variable annuity earns less than $500, the withdrawal will eat into either earnings from prior months, or into the principal in the annuity. This is especially important for the customer who is used to taking income from a CD to understand. The CD customer is used to receiving interest income only from a CD. The CD balance remains constant after each withdrawal. Of course, some variable annuities offer earnings only systematic withdrawal programs. 62

75 Systematic withdrawals are also often used as a means to satisfy required minimum distribution from a qualified retirement plan or IRA. Many variable annuity issuers have the capacity to calculate and distribute required minimum distributions based on the variable annuity values. This capability can be a big benefit to a customer needing required minimum distributions, since the necessary calculations can be confusing to the average taxpayer. Guaranteed Death Benefit Provisions Guaranteed death benefit provisions vary from annuity to annuity and may include stepped-up valuations, assumed percentage increases in total account valuation, or other calculations. Regardless of the specific terms of the provision, many customers find guaranteed death benefits an attractive feature of a variable annuity because they are able to protect assets for their beneficiaries. The death benefit is the amount paid upon the death of the contract owner and/or annuitant. Variable annuity contracts vary regarding when a death benefit is paid. Some contracts pay surrender value upon a non-annuitant owner s death. The surrender value of the annuity is the amount payable if the variable annuity were liquidated in full, with all applicable deferred sales loads applied. Other contracts pay a death benefit upon either the annuitant or owner s death. Again, the prospectus should be carefully reviewed to determine under what circumstances the death benefit is paid, and how the prospectus defines the calculation of the death benefit. Stepped-Up Death Benefits Stepped-up guaranteed death benefits are more and more commonly found in variable annuities. A stepped-up death benefit effectively freezes the value of the contract for the purposes of calculating the death benefit. When a variable annuity includes a stepped-up death benefit, the calculation of the death benefit is calculated by incorporating a comparison of values to derive the death benefit payable, such as: 1. the total account values on the date of death, 2. the total premiums paid, less withdrawals and surrender charges, 3. the surrender value on the date of death, or 4. the stepped-up death benefit. The stepped-up death benefit is the account value fixed at certain intervals during the contract life. For example, the interval may be every five years. Assume a contract which used the calculation described in the previous paragraph to determine the death benefit and was opened in January 2003 with a premium payment of $10,000. No other contributions are made. The account value on the fifth year contract anniversary in January 2008 was $15,500. The annuitant dies, causing a death benefit payout, in March 2009, when the account value was $14,900. Total premiums less 63

76 withdrawals totaled $10,000. The death benefit amount payable would be $15,500: the stepped-up value as of the fifth year anniversary. Assumed Percentage Increases in Account Value Some variable annuities include in the death benefit calculation an assumed increase in the account value on an annual basis. For example, the death benefit paid is based on the greater of: 1. the account value at the date of death, 2. the surrender value payable at the date of death, or 3. the total premiums paid, less withdrawals, assuming the premiums accrued interest of a certain percentage annually. Summary The variable annuity has many flexible options for making contributions and withdrawals, and contains guarantees, such as death benefit guarantees and the fixed account guarantees discussed in Chapter Two. Although long-term sub-account performance is the factor which typically leads to choosing a particular variable annuity, the availability of certain features among possible annuity choices can lead to the best fit for the financial goals of the customer. 64

77 CHAPTER TEN: VARIABLE ANNUITY INCOME PAYMENTS This chapter will discuss receiving annuity payments by purchasing a single premium variable immediate annuity, or annuitizing a deferred variable annuity. As discussed earlier, an immediate annuity is an annuity which will begin irrevocable periodic payments within twelve months of purchase. Annuitization of a deferred annuity refers to the commencement of irrevocable periodic payments sometime after twelve months from purchase. Annuity payments from an immediate annuity and an annuitized deferred contract fall under the same taxation rules in IRC Section 72 and the same income options under an immediate annuity or at annuitization are generally available, based on the specific contract provisions. Variable Annuity Income Payment Features And Advantages There are several advantageous features to annuity income payments. They include the following: Many Income Options Available To Meet Differing Customer Needs A variety of annuity income options are available, including income based on a single life, joint lives, or on a certain period of time. Annuity payments may be fixed or variable. Guaranteed Income Variable income payment options offer a guarantee that income will continue for a certain period. Fixed annuity income options guarantee the amount of each payment as well as the payment period. The owner selects the mode of payment. Frequency of payment modes are usually monthly, quarterly, semi-annual or annual. The owner can often decide even what day of the month payments will be processed. Opportunity for Growth Variable income options provide an opportunity for growth of income payments. The value of the annuity units which make up the amount of each payment may increase over time, providing a potential hedge against inflation. Many variable annuities allow the transfer of units from one sub-account to another during annuitization, leaving the ability to self-direct investments intact for the policyowner. Lifetime Income If a life option is selected, payments are guaranteed to continue for life. Payments can continue to beneficiaries under some life options as well. 65

78 Convenience Along with being able to select how frequently and what day of the month payments are processed, many companies can directly deposit payments to a bank account. Taxation Unlike withdrawals from deferred annuities, which are currently taxed as being comprised of interest before principal, annuity payments are considered part interest and part principal. Therefore, taxation is spread over the payment period, rather than being all up-front as is the case with random withdrawals and surrenders. Parties Involved In Annuity Payments When annuity payments begin, four parties may be involved: the owner, annuitant, payee and beneficiary. Owner The owner of the annuity is the person who purchases the annuity. As discussed in Chapter Two, the owner of the annuity has several rights during the deferral stage, including the right to withdraw, change the beneficiary, and in some cases to add or change the annuitant. Once annuitization commences on a deferred or immediate annuity, the owner's rights are normally limited to changing the beneficiary and authorizing the transfer of units among sub-accounts. As noted, annuitization is irrevocable, so the owner cannot make random withdrawals, make additional contributions, or change annuitants. Annuitant As with fixed annuities, the annuitant is the measuring life on a variable annuity contract. If an annuity income option is to be paid over "life, it is the annuitant's, and in some cases also the joint annuitant's, life expectancy that is used to determine payment amounts. It is also the annuitant's death which normally causes payments to cease, or to transfer to a beneficiary or joint annuitant. Payee Some annuity contracts allow annuity payments to be made to a "payee, someone other than the owner or annuitant. Beneficiary The beneficiary receives annuity payments, or in some cases, a lump sum, upon the death of the annuitant. Income Options Variable annuities offer both fixed and variable annuity income options. The income options under a variable annuity are similar to those under a fixed annuity, however, 66

79 the payment stream from a variable income option differs from a fixed income option, because the unit values of a variable annuity fluctuate over time. Fixed income options pay a fixed amount for a specified period. Generally, if a fixed option is selected, the value at the variable annuity income start date is used to purchase an annuity income plan payable based on annuity income rates in effect at the time of purchase. In essence, the units used to purchase the fixed annuity income are no longer in a variable annuity contract, but are exchanged for a new, fixed income contract. If a variable income option is selected at annuitization, the number of income units is fixed per payment, but the payment amount will vary. The units remain invested in a sub-account or sub-accounts, and therefore change in value as frequently as every business day. For example, assume a 10 year (120 month) certain variable annuity income option is selected. The owner uses 12,000 units to purchase this variable annuity income option. Each month for 120 months, 100 units will comprise the annuity income payment. The first month, each unit is worth $10.00 on the annuity income payment date, resulting in a $1000 payment. Month two each unit is worth $9.98, resulting in a $998 payment. The third month, each unit is worth $10.25, resulting in a $1025 payment. As can be seen, the variable annuity income option allows the ability to continue to participate in the performance of the sub-accounts. Generally, the owner can select both fixed and variable income options. Annuitization from a fixed account, however, would be limited to fixed options. Life Income The life income annuity is sometimes referred to as a "straight life" option or "life only" option. Payments are guaranteed for the annuitant's lifetime and will cease at the annuitant's death. Life and Period Certain Income Life and Period Certain payments are guaranteed for the annuitant's lifetime, or for a certain period of time, whichever is greater. For example, if a life and ten year period certain annuity is purchased, payments will be paid for ten years, and will continue if the annuitant is still living at the end of the ten year period. If the annuitant dies during the ten year period, payments will continue to the beneficiary until the ten year period expires. Life With Installment Refund Income Payments are guaranteed during the life of the annuitant and, if at the annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will continue to receive payments until the principal has been depleted. 67

80 Life with Cash Refund Payments are guaranteed during the life of the annuitant and, if at the annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will receive a lump sum equal to the remaining principal amount. Joint and Survivor Life Income Joint and Survivor annuities are also referred to as "Last Survivor" annuities. Payments are guaranteed during the lives of both annuitants. Payments cease upon the death of the last surviving annuitant. Joint and Specified Percentage to Survivor Life Income Payments are guaranteed during the life of the first to die. After the first death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the second to die. Joint and Specified Percentage to Contingent Life Income Payments are guaranteed during the life of the primary annuitant. After the primary annuitant's death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the joint annuitant. This option may also be available with installment or cash refund at the death of the joint annuitant. Joint and Survivor With Period Certain Income Payments are guaranteed for a specified period or the lives of joint annuitants, whichever is greater. If there is a surviving annuitant after the period certain time frame expires, payments continue until the death of the last annuitant. If both annuitants die prior to the period certain time frame expiration, the beneficiary will continue to receive payments until the certain period is over. Joint and Survivor Life With Installment Refund Payments are guaranteed during the lives of joint annuitants, and, if at the last annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will continue to receive payments until the principal has been depleted. Joint and Survivor Life with Cash Refund Payments are guaranteed during the lives of joint annuitants, and, if at the last annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will receive a lump sum equal to the remaining principal. Period Certain Payments are guaranteed for a certain period of time. If the annuitant dies during that time, payments will continue to the beneficiary until the specified period of time expires. 68

81 CHAPTER ELEVEN: TAXATION OF VARIABLE ANNUITIES The taxation rules applying to variable annuities are similar to those which apply to fixed annuities. The area in which variable annuities are taxed differently than fixed annuities is in the taxation of annuity payments. Taxation Of Annuity Payments As noted, earnings are taxed as withdrawn from deferred contracts, but once a contract is annuitized, or if a contract is an immediate annuity, different tax rules apply. Annuity payments are taxed as part principal, part interest. The IRS has specific rules regarding the calculation of the taxable and non-taxable portions of an annuity payment. Fixed Annuity Income Payments The amount of the non-taxable portion of a fixed annuity income payments is calculated using an exclusion ratio. Since the period certain IRS calculation is the simplest, it will be illustrated to provide a general explanation of the calculation of the exclusion ratio. The exclusion ratio is the ratio of the investment in the contract to the expected return in the contract, and is the ratio of each payment that is not taxable, or is "excluded" from taxation. Exclusion Ratio = Investment in the Contract Expected Return in the Contract Exclusion Ratio x Annuity Payment = Non-Taxable Amount of Payment Assume a ten year period certain annuity, purchased with $50,000 and paying $ a month for ten years. Exclusion Ratio = $50,000 Investment in the Contract [($500 x 12 mos.) x 10 yr.] Expected Return $50,000 = 83.33% exclusion ratio $60, % x $500 payment = $ is the non-taxable portion of each payment. 69

82 Variable Annuity Income Payments The expected return of the variable income annuity is unknown. Therefore, rather than using the same exclusion ratio to calculate the non-taxable portion of variable annuity income payments, the ratio used is Investment in the Contract / Number of Years Annuity Payments Will Be Made. If a life annuity is chosen, the number of years is determined by using IRS life expectancy tables. For a period certain, the certain number of years is used. Using again a 10 year period certain annuity to illustrate the calculation of the nontaxable portion of a variable annuity: $50,000 Investment in the Contract 10 Years of Annuity Payments = $5000 annual excludable amount Each year, $5000 in payments are excludable from taxation. If a variable annuity income option includes a refund option, the calculation is more complex. Since variable annuity income payments fluctuate, it is possible that the annual amount received could be less than the calculated excluded amount. If the income payments received are less than the excludable amount, the amount of the excludable amount not received may be carried over the remaining years of the annuity. For example, using the 10 year certain example above, if only $4000 in income payments were received in the fifth year, the $1000 excludable portion not received would be carried over the remaining five years. The excludable portion would then be $5200 annually rather than $5000 for the duration of the annuity. 70

83 CHAPTER TWELVE: ADVANTAGES OF EQUITY-INDEXED ANNUITIES Equity-indexed annuities are annuities that offer the advantage of growth that can exceed a fixed annuity without some of the risks associated with variable annuities. Equity-index annuities provide a return that is related to a stock index, most commonly the S&P 500. The insurance company offering the annuity also provides guaranteed minimum returns, which provides the purchaser with reduced exposure to market risks. Besides these unique features, equity-indexed annuities provide many of the same advantages as other annuities, such as tax-deferral and avoidance of probate. Tax- Deferral Equity-index annuities offer tax-deferred growth on accumulations while earnings remain in the contract. Opportunity For Growth Like variable annuities, an equity-index annuity contract has the potential to earn a return greater than a fixed annuity. Because the return is tied to an index, the return may be significantly higher than the return of a fixed annuity. In addition, as mentioned in the discussion of equities in Chapter 8, equities have commonly outpaced the inflation rate, so an equity-index annuity can have the benefit of a return that acts as a hedge against inflation. The equity-index annuity pays a return based on changes in the index to which the annuity is linked. The insurer promises to pay this return based on the index benefit formula provided for in the contract. Unlike a variable annuity, which pays a return based directly on the performance of sub-accounts, the return on most equity-index annuities is based on the returns in the insurer s general account. Unless an equityindex annuity is registered with the Securities and Exchange Commission as an investment product, the insurer uses the general account portfolio as its underlying portfolio to generate the annuity s return, not a separate account composed of subaccounts as is used in variable annuities. Guaranteed Minimum Return Non-registered equity-index annuities include a guaranteed minimum rate of return. They also include a minimum index return. Variable annuities often have a minimum death benefit guarantee (as do some equity-index annuities), but the variable sub- 71