The Basics of Annuities: Planning for Income Needs

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1 May 2014 The Basics of Annuities: Planning for Income Needs summary the facts of retirement Earning income once your paychecks stop that is, after your retirement requires preparing for what s to come and having a sense of confidence about what you are going to live on. In this postpension era, that means devising a plan of your own one built on the retirement you envision and that also takes into account rising medical costs, longer life spans and inflation. It also requires a portfolio that smartly generates income, as you need it. Such a portfolio may call for annuities, which guarantee income over specified periods. Consider these facts and you will see why providing for an adequate post-retirement income can be a challenge: Fact: Over the past two decades, inflation has averaged 2.43%. At that rate, a dollar loses more than a quarter of its real value after ten years, and almost half after 20 years. So even if you reduce your spending in retirement, you will probably need a significantly higher income than you do now. 1 Fact: According to Social Security Administration estimates from 2013, if present trends continue, the Social Security Trust Fund may be exhausted by 2033 (see for more information). Fact: Traditional pension plans mostly have been replaced by 401(k) accounts and other so-called defined contribution plans, which place investment risk and longevity risk on the employee, not the employer. Fact: According to recent studies, more Americans are celebrating their 100th birthday, than have done so in the past three decades. You could easily spend more time in retirement than you did working. 2

2 Income Beyond the Paycheck Annuities are insurance contracts that guarantee 3 you an income stream that can last as long as you live and, typically, provide a death benefit for your named beneficiaries. Annuities allow you to save and grow your money on a tax-deferred basis, and then receive regular income payments later, after you retire. Some annuity contracts offer a fixed rate of interest, while others make it possible for you to invest in diversified portfolios of stocks, bonds or other investment strategies. Many annuities also offer a variety of living and death benefit options, usually for additional fees. It can t be emphasized enough that there is no substitute for a comprehensive retirement savings program that takes full advantage of other tax-favored vehicles, such as 401(k) accounts and IRAs. Additionally, an annuity can be a valuable supplement to such plans particularly because there are no IRS limits on your ability to use after-tax dollars to fund annuity contracts. 4 However, they may include unfamiliar features and carry additional expenses, relative to non-insurance investments, such as mutual funds. Read on and we ll briefly describe some of the more common annuity types and discuss their potential benefits as well as their costs. What Is an Annuity? An annuity is a contract with an insurance company that, in exchange for a purchase payment and fees, agrees to pay you income for a specified period of time or for the rest of your life. Starting at retirement, or any other date you choose, you receive regular income payments based on the value of the annuity. The issuing insurance company guarantees your payments. This provides a type of protection for your retirement income. Annuities allow you to invest money on a tax-deferred basis. On nonqualified assets, this means you don t pay current taxes on any gains until they are withdrawn, so your money can compound and grow faster than in a taxable account. Also, by the time you are ready to begin withdrawing from your annuity, you may be in a lower tax bracket. What Type of Annuity Is Right for Me? That depends on your specific financial situation, marital status, projected income needs, etc. One key issue is timing. In general, annuities fall into two categories: immediate or deferred. As the name implies, immediate annuities begin providing income soon after they are purchased, usually within a year. The insurance company guarantees payments for a specified period of time or for life. However, only the portion of your income payment that represents interest is subject to taxation. Deferred annuities, on the other hand, allow your contributions to grow over time on a tax-deferred basis, and then pay out benefits later after you have retired, for example. While deferred annuities are typically designed to be long-term investments, the contracts allow you to access at least a portion of your money annually without a charge. However, withdrawals of any gains are taxed as regular income and, if taken before age 59½, a 10% federal tax penalty also may apply. Annuities don t eliminate inflation, market volatility or unpredictable events. They can, however, help fill a void in your retirement strategy by providing a guaranteed stream of income that can last a lifetime. 2 Morgan Stanley 2014

3 Types of Annuities POTENTIAL BENEFITS WHO SHOULD CONSIDER DEFERRED ANNUITIES Tax-deferred savings Investors looking for an additional tax-deferred way to save for retirement Deferred Variable Annuity Deferred Indexed Annuity Wide range of investment portfolios with growth potential options Guaranteed minimum accumulation value with equity index-linked returns, potentially higher than fixed rates Investors who are comfortable with potential earnings that will fluctuate based on investment performance Investors who want a protected investment floor with the ability to partake in the potential benefits of a market-linked vehicle Deferred Fixed Annuity Guaranteed fixed rate of return Investors looking for tax-deferred investments that offer protection from market volatility IMMEDIATE ANNUITIES Variable Income Annuity Fixed Income Annuity Purchased with a single payment, provides income that begins right away Guaranteed lifetime income payments with growth potential to help keep pace with inflation Guaranteed lifetime income with pension-like, steady payments Investors who want to use their accumulated savings to provide a stream of retirement income Investors looking for income that has the potential to grow over time or investors who can withstand fluctuations in their income based on investment performance Investors looking for a guaranteed income stream Deferred Annuities: Fixed, Indexed or Variable Fixed Annuity: The issuing insurance company guarantees a set interest rate on the payments made during the accumulation phase. This allows you to lock in a rate of return for a predetermined period of time. During the payout phase, the dollar amounts of each payment are also fixed. Your Financial Advisor can help you look for a competitive rate based on your needs. A type of fixed annuity, called a market value adjusted annuity, or MVA, guarantees a fixed rate of return unless total withdrawals exceed an amount stipulated in the contract. If withdrawals in excess of this free withdrawal amount are made or if the contract is surrendered early the value of the contract and the size of the payout will be affected by the relationship between current interest rates and the contract s guaranteed rate of return. Generally, if, for example, interest rates have increased since you purchased the contract and you take more than the free withdrawal amount, the deduction from your account will be greater than your actual withdrawal. Conversely, if interest rates have decreased, the deduction will generally be less than your withdrawal. Indexed Annuity: This type of annuity, also known as an equity-indexed annuity or fixed-indexed annuity, typically provides an investment return based on a formula that is linked to one or more equity indexes, such as the S&P An indexed annuity provides a guaranteed minimum accumulation value, or floor, and may also offer death benefit protection as well as a variety of payout options. The index used, the for- mula that determines the indexed rate and the guaranteed minimum value, or floor, can all vary depending on the insurance company and product selected. Your Financial Advisor can help you determine a suitable product based on your investment objectives and retirement income needs. Variable Annuity: You choose from a range of investment portfolios known as sub-accounts that are invested in stocks, bonds and other investment strategies. Your investment returns fluctuate and the value of your contract at the end of the accumulation period, will depend on your portfolio s investment performance. However, many variable annuities include a feature that guarantees your beneficiary a minimum payment, even if a market downturn has reduced the value of your account at death. Morgan Stanley

4 Payment Options deferred annuity s life cycle has A two phases: the accumulation, or pay-in phase and the distribution or pay-out, phase. During the accumulation phase, your account grows tax-deferred. Depending on the terms of the contract, you may be able to make additional contributions. To move from the accumulation phase to the distribution phase assuming you don t choose to withdraw the funds entirely as a lump sum payout you would elect to annuitize the contract. Annuitizing your account entails converting its current value into a stream of future income payments. You also choose how you ll receive that income. Your payments will be based on the value of the contract, adjusted for previous withdrawals. Your age may also be a determining factor. Immediate annuities and deferred annuities often offer the same payment options. The most common are: Period Certain: Income is guaranteed to you for a predetermined period of time. Life Only: You ll receive income for the rest of your life. Life with Period Certain: Income is guaranteed to you for the rest of your life or for a predetermined period of time, whichever is longer. If you die before receiving the minimum guaranteed payments, the remaining payments pass to your designated beneficiary or beneficiaries. Joint and Survivor: Income is guaranteed for the lifetime of two people (typically spouses) for as long as either is alive. Customizing Your Annuity While annuities provide the satisfaction of knowing you will have guaranteed income you can t outlive, many annuities offer additional benefits that can be purchased at an additional cost. These include both living benefits and death benefits. In addition to the insurance company, there are three parties associated with an annuity contract: Owner: The individual, joint owners or trust that purchases the contract. The owner controls the contract and can contribute or withdraw funds and change the investment allocations (variable annuities only). The owner can also change the named beneficiary. Annuitant: The person whose age and life expectancy the payments are based on during the payout phase. Beneficiary: The individual(s) or entity to whom the death benefit, if any, is paid. You may be both the owner and the annuitant of an annuity contract. 4 Morgan Stanley 2014

5 Living benefits are certain principal and income guarantees that can help protect your investment from a declining market. Living benefits, each with a distinct objective, are described in the chart on page 6. Death benefits are designed to provide assets to your named beneficiary and guarantee a minimum return. Should you pass away before receiving income from your annuity, your beneficiary will generally receive the greater of either your purchase payments or the contract value (adjusted for withdrawals). For an additional fee, contracts may include features such as: Percent Roll-Up Death Benefit: Usually the greater of a return of total investment adjusted for withdrawals, the contract value or the initial investment compounded annually by a stated percent. Maximum Anniversary Value Death Benefit: Usually the greater of a return of the total investment adjusted for withdrawals, the contract value or the highest value on any specified anniversary. Combination Death Benefit Option: Usually the greater of the current contract value, the percent roll-up death benefit or the maximum anniversaryvalue death benefit. Earnings Enhanced Death Benefit: Usually an amount added to the value of any death benefit payable. This is typically a percentage of any investment gain, subject to a cap. It is important to remember that these benefits are optional and involve additional costs. The actual guarantees they provide will vary by contract, as will the fees. Investors should carefully weigh the costs against the benefits before adding these features to their annuity contracts. Pricing Considerations With Variable Annuities Typically, variable annuities have differing pricing structures. The structure you choose should be based on the cost and on the amount of time before you plan to begin taking withdrawals. B-share annuities do not have an initial sales charge, but do have a contingent deferred sales charge, also known as a surrender charge. This declines each year you own the contract and typically reaches zero in six to eight years. Bonus, or premium enhanced, annuities offer credits on the amount you invest, which will be considered earnings upon withdrawal. They generally have higher mortality and expense ( M&E ) charges and longer surrender periods than B-share annuities. C-share annuities typically do not have initial sales or surrender charges* and thus provide investors with immediate access to their investment funds without penalty. However, they will also have higher M&E charges than B-share annuities. L-share annuities have a surrender-charge period ranging from three to four years. The initial M&E charges are generally higher than a B-share annuity but lower than a C-share annuity. *Surrender charges may apply in certain instances. Morgan Stanley

6 Description of Living Benefits LIVING BENEFITS BENEFIT DESCRIPTION ADDITIONAL CONSIDERATIONS Guaranteed Minimum Accumulation Benefit ( GMAB ) Generally, this benefit guarantees the return of your purchase payments or a higher stepped-up value at the end of a waiting period, typically, ten years from issue or last step-up, regardless of your investment performance. If your contract value is below the guaranteed amount at the end of the waiting period, the insurer will increase your contract value to equal the guaranteed amount (adjusted by any withdrawals). At the end of the waiting period, the benefit may be renewed for another waiting period, depending on the terms of the contract. If the benefit is not renewed, your purchase payments will become subject to market risk and may lose value. Additionally, some contracts require that all of your assets be allocated in specified investment options during the waiting period, and deviation from these investment options may result in material reduction or termination of this benefit. Guaranteed Minimum Income Benefit ( GMIB ) Generally, this benefit guarantees a lifetime income stream when you annuitize the GMIB amount (after a seven-to-tenyear waiting period), regardless of your investment performance. The GMIB amount is generally based on the greater of your current contract value, your purchase payments (adjusted pro rata or dollar-for-dollar by any withdrawals) compounded annually at a rate of 4% to 8% (often referred to as the roll-up value), or it may equal the greater of the contract s highest anniversary value or the roll-up value (roll-up/ anniversary value may be adjusted pro rata or dollar-for-dollar by withdrawals). The GMIB amount must be annuitized. It is not available as a lump-sum payment. The income stream is often limited to payments for life with a minimum number of payments guaranteed. The GMIB income stream is determined by applying the GMIB payout rates to the GMIB amount, although you may receive a higher income stream by annuitizing under the regular provisions of your contract. In this case, the GMIB provides no additional benefit. Additionally, some contracts require that all of your assets be allocated in specified investment options during the waiting period, and deviation from these investment options may result in material reduction or termination of this benefit. Guaranteed Minimum Withdrawal Benefit ( GMWB ) / Guaranteed Lifetime Withdrawal Benefit ( GLWB ) Generally, these benefits guarantee a return of your purchase payments over a specified number of years or over the lifetime of an individual or an individual and spouse through a series of annual withdrawals. Certain benefits may provide for a higher stepped-up benefit base via a 3% to 8% annual roll-up of your benefit base and / or an annual reset based on positive market performance. During the withdrawal period, withdrawals in excess of the benefit withdrawal limit (3% to 7%) may negatively affect the guarantee. Additionally, some contracts require that all of your assets be allocated in specified investment options, and deviation from these investment options may result in material reduction or termination of this benefit. Generally, there is no waiting period to begin withdrawals, but liquidity limitations based on current age or before age 59½ may apply. Withdrawals not taken generally do not accumulate or carry over to the next year. Note: All living-benefit guarantees are backed only by the claims-paying ability of the issuing insurance company. 6 Morgan Stanley 2014

7 Consult your tax advisor if you are unsure whether a variable annuity for an IRA rollover makes sense for you and for all other matters involving taxation and tax planning. Other Benefits of Annuities Unlimited Contributions: Unlike other tax-sheltered plans, such as 401(k)s and IRAs, there are no IRS limits on tax-deferred contributions to nonqualified annuities. 6 While you should fully fund your retirement plan(s) first, an annuity may be an appropriate investment for other assets. Longer Tax-Deferral: While many retirement plans require distributions to begin after reaching age 70½, nonqualified annuities allow you to defer withdrawals until age 90 (or longer in some cases). Tax-Free Transfers: Variable annuities allow you to move money between investment options without incurring current income-tax liabilities. As your goals change, you can invest as aggressively or conservatively as you want. 7 No Annual Tax Reporting: For individuals, no annual IRS forms need to be filed until you actually make a withdrawal from your annuity. Annuities held inside a qualified retirement plan (such as an IRA) will have their December 31 entire interest value reported to the IRS automatically, for the purpose of calculating your required minimum distribution. May Avoid Probate: By naming a beneficiary or beneficiaries to your annuity contract, you can ensure that any death benefits will be transferred directly to them, bypassing probate and increasing privacy. (Probated estates allow public access to records of the probated assets, for both values and beneficiaries.) Tax-Free Exchanges: You can exchange one annuity contract for another or a life insurance contract for an annuity by having your Financial Advisor do a 1035 Exchange. This may be appropriate if your contract is older and does not provide access to the full range of living and death benefit options now available, or if the performance of your variable annuity sub-account options has been subpar. While this type of exchange is currently considered a tax-free event, there may be surrender charges. Should You Consider a Variable Annuity for an IRA Rollover? If you are retiring or changing jobs, you may wish to transfer assets from your existing qualified plan such as a 401(k) or 403(b) account to an IRA. You can do this without tax penalty, allowing your assets to continue growing on a tax-deferred basis. However, holding a variable annuity in a tax- advantaged retirement plan, such as an IRA, offers no tax advantages beyond those already provided by the plan itself. For this reason, you should only consider rolling retirement assets into a variable annuity if it makes sense because of the annuity s other features, and only if you are willing to bear the additional costs of an annuity to receive those benefits. The Next Step Whether your retirement is years or months away, or even here today, you need a strategy that will provide a dependable income stream. As part of a comprehensive retirement plan, annuities have much to offer. Your Financial Advisor can help you determine if an annuity is right for you. So, whether you re interested in reviewing your wealth management goals, have specific questions about your retirement or estate plan, or would like to know more about the benefits of annuities, contact your Financial Advisor today. Morgan Stanley

8 Counting the Costs Because of their unique benefits, annuities typically have costs not associated with other investments. These charges cover the expense of contract administration, management, and the costs associated with beneficiary protection and income options. Your Financial Advisor can work with you to help you get the guarantees and benefits you are looking for while keeping costs in mind. The most common fees associated with annuities are: Surrender Charges: Generally, a percentage of the amount withdrawn that decreases annually if you withdraw more than the free withdrawal amount before a stated period of time. Mortality and Expense Risk Charge: An annual fee assessed on variable annuities on a daily basis to cover the insurance company s risk that actual mortality rates will be lower than expected. Administrative Fees: These charges cover record keeping, statements and customer service, and are only assessed on variable annuity products. Contract Maintenance Fees: Fixed annual fees that are charged on contracts with values below a predetermined amount, such as $50,000. These fees only apply to variable annuity products. Underlying Sub-Account Expenses: These include management fees paid to the investment adviser, who is responsible for making investment decisions affecting your annuity. These fees, which are similar to the management fees on a mutual fund, will reduce the return on your investment. Sales Compensation: When you purchase an annuity through your Financial Advisor, the insurance company pays Morgan Stanley a commission. Morgan Stanley, in turn, pays part of this commission to your Financial Advisor. The commission amount is based on the product you choose, your age and the amount of money you invest. Morgan Stanley Smith Barney LLC offers insurance products in conjunction with its licensed insurance agency affiliates. Annuities are long-term investments designed for retirement purposes and are subject to investment risk, including the possible loss of principal. Withdrawals and distributions of taxable amounts are subject to ordinary income tax and, if made prior to age 59½, may be subject to an additional 10% federal income tax penalty. Early withdrawals will reduce the death benefit and cash surrender value. Additionally, exchanging annuities may result in surrender charges and a new surrender change period. New surrender charges may be imposed with a new contract; and the new contract may be subject to additional insurance and investment-related fees as well as increased risk. All guarantees are based on the claims-paying ability of the issuing insurance company. Variable annuities are sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges and expenses, and other information regarding the variable annuity contract and the underlying investments, which should be considered carefully before investing. Prospectuses for both the variable annuity contract and the underlying investments are available from your Financial Advisor. Please read the prospectus carefully before you invest. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters. 1 Consumer Price Index, U.S. News & World Report, What People Who Live to 100 Have in Common, January Guarantees are based on the claims paying ability of the issuing insurance company. 4 The issuing insurance company may restrict premiums on the contract. 5 The Standard & Poor s 500 Composite Stock Price Index (S&P 500) tracks the performance of the 500 largest US publicly traded securities. 6 Annuities can be held in tax-qualified retirement plans such as IRA accounts. These are called qualified annuities and are funded with pretax dollars. Annuities purchased with after-tax dollars and not held in a qualified plan are called nonqualified annuities. Qualified annuities provide investors with the same insurance benefits offered by nonqualified annuities. They do not, however, provide any additional tax benefits. Tax deferral is provided by the qualified plan itself. 7 There may be fees associated with these transfers Morgan Stanley Smith Barney LLC. Member SIPC. CRC IN2275 CS /14