4 Hour Annuity Suitability

Transcription

1 4 Hour Annuity Suitability A.D.Banker&Company

2 A.D.Banker&Company exam preparation and continuing education Since 1979, A.D.Banker&Company has provided high quality training to insurance and securities producers across the country. With options in all 50 states we are your one source for prelicensing and continuing education. At A.D.Banker the Choice is Yours... Classroom Webinar Online Course Self-Study Learn from the experience of other professionals Participate live from anywhere with internet access Engage interactively through interesting online courses Study and test at your own pace with a book or PDF Once licensed, producers can meet their Continuing Education requirements in all states while meeting product-specific requirements. Adjuster Annuity Suitability Crop Risk Ethics Flood General/Bridge Homeowners Valuation Life & Health LTC Partnership Medicare Property & Casualty Daily Reporting Knowledgeable Customer Service Relevant and Informative Topics Experienced Instructors State Required Training Online or Printed Exams Go to to see what is available in your area!

3 Table of Contents 4 Hour Annuity Suitability Chapter 1 Annuity History, Markets and Uses... 1 Introduction and Course Overview Market Overview Historical Development of Annuity Contracts Life Insurance and Annuities Primary Uses of Annuities Other Financial Planning Products How Annuities Compare Summary Review Questions Chapter 2 Types of Annuities and Parties to the Contract... 9 Types of Annuities How and When Premiums Are Paid In When Benefits Are Paid Out What Investment Options Are Built In Parties to the Annuity Contract Annuitant; Owner Annuitant and Owner are Different Persons Annuitant and Owner are the Same Person Beneficiary Insurance Company Review Questions Chapter 3 Annuity Contract Provisions Provisions Common to All Annuities Issue Ages Maximum Ages for Benefits to Begin Premium Payments; Surrender Charges Policy Administration Charges & Fees Loan Provisions Available Riders Death Benefits Income Distribution - Settlement Options Fixed Annuity Provisions Charges and Fees Interest Rates Regulatory and License Requirements Variable Annuity Provisions Risk and Separate Account Investments Charges and Fees Premium Bonus Credits Dollar Cost Averaging and/or Automatic Asset Reallocation Optional Product Features at No Cost Optional Death Benefit Enhancement Optional Living Benefit Guarantees Indexed Annuity Provisions Modifications of Index Performance Premium Bonus Credits Two-Tiered Annuities Regulatory and License Requirements Annuitization Amount of Money Current Interest Rates at Time of Annuitization Age and Gender - A Proxy for Life Expectancy Advantages of Annuitization Disadvantages of Annuitization i

4 Table of Contents Income Strategies Cover Basic Expenses Ladder Income Annuities The Split Annuity Review Questions Chapter 4 Taxation of Qualified and Non-Qualified Annuities Qualified Plans Defined Benefit Plans (Pensions) Defined Contribution Plans Legislation Concerning Qualified Plans & Evolution of IRAs The Role of Tax-Qualified Annuities Nonguaranteed Distribution Options from IRAs Taxation of Qualified & Non-Qualified Annuities Tax Deferral & Annuities Exception to Tax Deferral: Annuities Held by Corporations or Non-Natural Persons Payment of Premiums Cash Value Accrual Taxation Rules for Non-Qualified Annuities Taxation of Qualified Assets during the Lifetime of the Owner Taxation of Qualified Assets at Death of Owner (Spousal Continuation) Advantages of Qualified and Non-Qualified Annuities Deficit Reduction Act of 2006 Summary Review Questions Chapter 5 Suitability, Replacement, and Compliance NAIC Suitability in Annuity Transactions Model Regulation Required System of Insurer Supervision Producer Training Requirements Suitability as Defined by the Model Regulation Practical Suitability Determination Senior Suitability Information Replacement, Disclosures and Recordkeeping Requirements Indexed Annuity Regulation Variable Annuity Regulation CONCLUSION Review Questions Attachment Oklahoma Life and Health Insurance Guaranty Association Review Questions Answer Key Copyright 2013 A.D. Banker & Company, L.L.C. This course, seminar, or publication provides general information regarding the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. The publisher hereby expressly excludes all warranties ii

5 Chapter 1 Annuity History, Markets and Uses Introduction and Course Overview Annuities are popular with both the producers who sell them and the consumers who purchase them. Producers help clients achieve financial goals using the unique features and benefits annuities offer. Consumers benefit from the tax advantages and guarantees that only an annuity can provide. Insurance companies compete for investors by offering various benefits as a part of specific annuity contracts. Consumers are challenged to select benefits that will meet their needs and evaluate the cost of those benefits. Annuity products can be straight-forward and simple to understand or they can be complex and confusing, with moving parts that are derived from creative product features and benefits. In this course, we are going to examine various categories of annuity products. We will discuss what annuities are, how they work, what they do, and how regulatory changes by the National Association of Insurance Commissioners (NAIC), and the federal and state regulators have affected the sales and marketing of these insurance products. We will also examine senior suitability issues and consumer protection initiatives. Market Overview The financial industry is primarily made up of three segments insurers, brokerages, and banks who compete to increase their share of the investors dollar. As a savings and investment product, annuities provide flexibility to be used for many purposes. The primary use of an annuity is to provide retirement income. As an accumulation product, annuities are designed to be long-term investments, and are considered to be moderately liquid. The producer must first determine if an annuity is the best vehicle for the consumer to attain personal financial objectives. When the answer is yes, the producer then matches the type of annuity with the risk profile of the investor. Annuities offer a wide variety of investment choices and tax advantages; annuities are the only financial product that can produce a guaranteed income for life. Income distribution choices also give consumers the ability to leave any remaining money as a legacy. Historical Development of Annuity Contracts Annuities date back to the Roman Empire when ancient contracts known as annua promised an individual a stream of payments for a fixed term in return for an up-front payment. During the Middle Ages, monasteries and churches sold annuities. Annuities were used by city-states to borrow money, and by countries to raise money to pay for wars. The most popular form of annuity contract started in France was the tontine. Governments issued tontines in exchange for a lump sum payment and promised to make future payments only to the living survivors instead of to all tontine members. Today, the longevity income guarantee annuity is purchased at younger ages and only provides benefits at age 85, for instance, in the form of lifetime income payments, similar to Social Security. 1

6 2 4 Hour annuity suitability Life Insurance and Annuities The life insurance industry employs number experts called actuaries who study life expectancy, mortality risks, and longevity. With expertise in these areas, life insurance companies have developed products in two broad product categories: life insurance and annuities. Life insurance is protection against dying too soon. Annuities, on the other hand, provide protection against living too long by including provisions for paying out accumulated funds over a period of years or for a lifetime. What Are Annuities? Annuities are issued by life insurance companies, but an annuity is not life insurance. An annuity is a written contract between the buyer and the life insurance company In exchange for a single premium or multiple premiums, it promises a future series of regularly spaced income payments for: A specific period of time (for example: 10 years); or An extended period of time, which may be as long as an individual lives and is similar to a defined benefit pension, and is therefore protection against living too long (no chance of outliving the money). While an annuity generally provides benefits during a lifetime, an annuity may also provide benefits to heirs after death. Deferred annuities may be surrendered for cash before annuitization. Annuities have specific advantages, disadvantages, and limitations, all very important to understand. Primary Uses of Annuities Accumulation This phase is characterized by the accumulation of funds through single, flexible, or periodic premiums on a tax-deferred basis for later use. Distribution If current income is inadequate and additional income is desirable, annuity owners may take partial withdrawals or surrender the contract for the full amount, less any applicable surrender charges and/or market value adjustments. Annuitizing the contract starts regular income payments that may last for a period of years or for life, depending on the income annuity options available in the contract. An annuity contract can also be exchanged using the 1035 exchange process, to become an immediate annuity if it has more favorable annuity payout factors than those built-in to the existing deferred contract.

7 Chapter 1: Annuity History, Markets and Uses 3 Risk Management If other investment or money management options are unsatisfactory, annuities may provide attractive benefits to annuity owners. A retirement portfolio may be fully invested or highly concentrated in stocks, bonds, and mutual funds and the result may be a higher level of risk and stock market volatility than the account owner finds comfortable. Investment Investment risk weighs the possibility of the retirement portfolio declining in value. A shift of some or all retirement assets to a guaranteed annuity account may reduce the risk and provide additional peace of mind. A retirement nest egg may be concentrated in safe money in banks and credit unions. Due to low yielding accounts such as certificates of deposit and passbook savings, the nest egg may not have the capacity to grow, accumulate for the long term, and protect against inflation. The annuity s fixed account may offer a higher return on a tax-deferred basis. Inflation It is also possible that price increases will cause the retirement nest egg s income to lose purchasing power. A shift of some or all safe money assets to a guaranteed annuity may provide some added growth potential with the provision of insurance benefits to protect the money. Retirement savings may be gradually distributed through systematic withdrawals and required minimum distributions (RMDs) if in a traditional IRA account. Neither of these strategies includes a guarantee of lifetime income distribution unless funds in the annuity are annuitized. Some insurance companies even offer an inflation-adjusted payout. Longevity A long lifespan could cause a retiree to exhaust a retirement account before death, and experience a substantial decline in income as a result. A retiree who spends too much early in retirement by underestimating his or her remaining years of life could end up outliving the retirement savings. A shift of some of the retirement savings to an income producing annuity may help provide money that will last throughout lifetime and may avoid significantly lowering the standard of living later in life. Other Financial Planning Products Annuities are insurance products and as such, offer unique benefits backed by the assets of the insurance company. Other investment options offer benefits of their own, and should be compared to annuities to measure the customer s risk tolerance against long term goals. Bank Savings Accounts & Certificates of Deposit (CDs) Banks and credit unions provide passbook savings accounts, checking accounts, and time deposits such as certificates of deposit. In an attempt to generate higher interest rate returns for consumers, some banks now offer an indexed certificate of deposit that is comparable to the indexed annuity. Advantages The advantages to the consumer of time deposits such as CDs are the safety of the principal investment, being backed by the FDIC insurance, and liquidity of the monies. Currently time deposits and passbook savings accounts enjoy protection of up to $250,000 with FDIC insurance on those accounts. Fixed annuities most closely resemble CDs. Disadvantages The disadvantages to the consumer would be interest penalties for early withdrawal of time deposits, low interest rates, and current taxation.

8 4 4 Hour annuity suitability Stocks, Bonds & Related Financial Products Stocks: Long Term Gain Potential Stocks represent ownership of companies and offer the potential for gains through appreciation and income from dividends, but there is no guarantee that gains will occur or dividends will be paid. Advantages One of the main advantages of investing in the stock market is that historically, large cap stocks perform well over a long period of time, keeping in mind that past performance is not a guarantee of future returns. An individual may purchase stocks of publicly traded companies on various stock markets such as the New York Stock Exchange (NYSE) or NASDAQ; privately held companies are usually not listed on stock market exchanges. Disadvantages Among the disadvantages of stock investing is that a buyer must make buying, holding or selling decisions with each stock individually. This may be a daunting experience for many who lack the education, training, and tools to be proficient. There are no guarantees with stocks or stock market performance. History illustrates the highly volatile and unpredictable nature of the stock market in the short-run. Bonds: Regular Income Potential Bonds can be described as a long-term debt instrument, or an IOU. Various organizations sell (issue) bonds to raise money for ongoing short-term and long-term cash needs including the U.S. Treasury, government agencies, state governments, municipalities, and special districts such as sewer, water, fire, hospitals, and school districts. Advantages The advantages of bond investing include regular income potential. Bonds are often used to provide regular income as the interest from the bond is paid to the bondholder. At maturity, the bond principal is paid back in full. Finally, bonds are generally considered a safer investment than stocks. Disadvantages Bonds are subject to both interest rate and reinvestment risk. Bonds are inversely affected by general interest rates in the country. If interest rates fall, existing bonds with a fixed coupon rate may become more valuable; conversely, if interest rates rise, existing bonds may lose value. Bonds are also subject to inflation risk since the principal to be paid at maturity as well as the interest rate are set at the time of issuance and do not change. Mutual Funds: Convenience, Diversification & Professional Management Mutual funds are diversified investments with investments in stocks and/or bonds. Mutual funds have become increasingly popular, especially as the investment vehicle of choice for many retirement plans such as 401(k)s and individual retirement accounts (IRAs). Many consumers are familiar with online mutual fund investing and reviewing their accounts. Mutual funds have been designed to allow the average person to invest in the stock and bond market without having to make a series of investment decisions about which individual stock or bond to purchase as well as gaining the advantage of professional money management.

9 Chapter 1: Annuity History, Markets and Uses 5 While annuities may or may not have guaranteed principal or interest as a part of the contract, the deferred annuities provide for tax-deferred accumulation. Consider these important points with equity indexed annuities and variable annuities: A deferred index annuity will have a minimum guaranteed interest rate-guaranteed principal and may provide a higher return than fixed annuities subject to how the contract participates in an index, subject to cap rates and participation rates (and, of course, how the index performs). A variable deferred annuity may have a guaranteed interest rate for the portion of the investment that is placed in the fixed account option. The portion of the funds in other separate accounts will be subject to market volatility and may offer the potential for higher investment gains if the separate accounts perform well. Keep in mind that the separate accounts may also under-perform. Funds may be invested in high risk categories and may suffer losses as is generally the case with all securities investments. While investments such as stocks and mutual funds may have a step up in basis at the death of the account owner, annuities offer death benefits that can guarantee the return of premiums paid or payout the highest contract anniversary value. Stocks and mutual funds are subject to current taxation while annuity earnings are tax deferred. Selling stocks or redeeming mutual fund shares can trigger taxable events such as capital gains or losses. Funds withdrawn from any annuity, which are taxable, are taxed as ordinary income. Non-qualified annuities pay partially tax-free income (return of principal) along with some taxable income (gain in the contract) when money is withdrawn from the contract. In most situations, withdrawals from an annuity before age 59½ subject the owner to a 10% IRS withdrawal penalty. This rule does not apply to stock or mutual fund holdings. Real Estate Investment Trusts Investments in real estate trusts may be made by purchasing shares on an open exchange or a mutual fund that specializes in real estate. Diversified real estate investments trusts are subject to the risks of a single market segment either in specific types of buildings (shopping malls, office buildings, etc.) or a specific location. Other Investment Options Commodities, limited partnerships, promissory notes, and viatical settlements are other legitimate investment options. The summary table at the conclusion of this chapter compares them to annuity investing. How Annuities Compare Annuities offer living benefits. A common fear of people with limited financial means is described in this question: Will I run out of money before I die? While other investment vehicles offer their own features and benefits, an annuity can help alleviate customer anxiety over these specific questions. People are living longer lives today than ever before and that reality must be addressed when comparing annuities to other investment alternatives, especially in the senior market. Bank accounts may be an attractive place to save money, and have the advantages of safety and liquidity. The reality is that living off the interest while retaining the principal becomes increasingly difficult if interest rates go down while expenses increase. If the interest alone is inadequate to maintain a standard of living, a bank customer may be forced to spend down the principal, eventually draining it completely. Systematic withdrawals from mutual funds, required minimum distributions (RMDs) from IRAs, and even simple partial liquidations from retail investment accounts, all may encounter the same problem. An initial systematic withdrawal of about 4.5%, indexed for inflation, used to be considered a safe initial withdrawal rate and has been shown to work about 90% of the time over a thirty year retirement period (a 10% failure

10 6 4 Hour annuity suitability rate means the money did not last the full 30 years). Any stock market volatility may result in an average drop in stock market value. Some financial analysts recommend a 4 to 5% spending rule of thumb. However that rule of thumb withdrawal percentage should be individually evaluated in light of current market conditions. It is not only how much money is systematically withdrawn from the investment portfolio or how quickly it is used up for essential living expenses and discretionary retirement spending. Money saved for retirement can do all of those things and still support the lifestyle of the consumer for a lifetime, if the consumer is given educated investment choices. Summary Annuities are insurance company products with some unique benefits such as guarantees of income payments backed by the assets of the insurance company. Stocks, bonds, and mutual funds are investment products that offer no guarantee of principal or market returns. The level of risk may be selected by the purchaser, depending on the kind and type of annuity purchased. The following chart summarizes these financial planning retirement vehicles. How Annuities Compare to other Financial Planning Vehicles Annuities Certificates of Deposits Money Markets Savings Accounts Promissory Notes Bonds Mutual Funds Stocks FDIC insured and safety up to $250,000 Interest penalty on early withdrawal Highly Liquid, but very low yield Safety & local bank convenience The borrower s promise is only has strong as his/her character and personal assets No guarantees Steady income Subject to refinancing and interest rate risk Daily valuation, liquidity, and professional money management Potential of gain or loss in volatile markets No guarantees on principal or performance Generally considered to be risky Potential of gain or loss in volatile markets Not insured by FDIC Fixed and equity indexed annuities are backed by insurance company assets and their ability to pay State insurance guarantee associations provide limited benefits in the event of insurer insolvency Fixed annuities have minimum guaranteed interest and guaranteed principal Check insurance company ratings to evaluate their financial safety Fixed and equity indexed annuities are backed by the insurance company guaranteeing both interest and principal Fixed and indexed annuities generally provide steady accumulation that may be converted to income Fixed and indexed annuities are not considered risky Variable annuities may have gains or losses in volatile markets May have some insurance guarantees built in to reduce some risks May offer riders Variable annuities may have gains or losses in volatile markets May have some insurance guarantees built in to reduce some risks May offer riders

11 Chapter 1: Annuity History, Markets and Uses 7 Real Estate Investment Trusts Commodities Limited Partnerships Viatical Settlements How Annuities Compare to other Financial Planning Vehicles Diversified real estate investments subject to the risks of a single market segment May also provide income Highly speculative and generally considered risky Protected against large losses due to limited liability of the limited partner (can only lose amount invested) May act as a tax-shelter for some of the earnings Limited liquidity May be risky Can provide income Subject to medical underwriting and health issues for those who are terminally ill or are typically over age 65 Provides a lump-sum benefit from 3rd party in exchange for policy ownership Annuities Variable annuities may offer a real estate investment choice Fixed and indexed annuities are not considered risky Variable annuities may have some insurance guarantees built in Variable annuities may offer a commodity type investment option for diversification purposes Fixed and Indexed annuities are backed by diversified insurance company investments including bond portfolios which effectively act to guarantee the interest and principal Income options are available Most annuities do not require medical underwriting upon issuance Some companies offer larger income payouts for impaired risk annuitants based on underwriting

12 Chapter 1 Review Questions 1. How do insurance companies compete for investors in today s marketplace? a. By offering creative product features and benefits as a part of their specific annuity contracts b. By offering fixed interest rates in their annuity contracts similar to bank certificates of deposit c. By offering guaranteed cash values in their policies similar to permanent life insurance policies d. By offering the annuitant lifetime payouts resembling corporate pension plans and social security 2. What is a tontine? a. It was the earliest recorded form of employee retirement plan b. Tontine members contribute monthly and share in a payout at retirement for as long as they live c. Income payments go to the tontine member beneficiary of the last surviving member d. In exchange for a lump sum payment it promises to make a future payment to only the living survivor 3. Which ONE of the following is NOT a type of risk an annuity is designed to address? a. Inflation b. Investment c. Longevity d. Morbidity 4. What is investment risk? a. The risk that price increases will cause a decline in purchasing power b. The risk that a retirement portfolio may decline in value c. The risk that a retiree could end up outliving the retirement savings d. The risk that a change in the tax laws may minimize any anticipated benefits 5. Which ONE of the following is an advantage investments such as stocks and mutual funds have over an annuity at the time of death of the account owner? a. Exemption from any future income taxation b. A potential step up in basis c. Estate tax free transfers to the next generation d. Immediate payout to a named beneficiary 8

13 Chapter 2 Types of Annuities and Parties to the Contract Types of Annuities While the list of annuity products continues to grow, the means of classifying the products stays constant. Annuities are classified by three criteria: how premiums are paid in and accumulated, when benefits are paid out, and what investment options are selected. How and When Premiums Are Paid In Single Premium Single premium annuity contracts require the payment in a lump-sum payment to fund the annuity. Additional money may not be added to the account. Flexible Premiums Multiple premium annuities allow for premium payments over time, usually with a minimum and sometimes a maximum premium requirement. A flexible premium annuity allows a person to make payments when, how, and on the amount desired, within certain contract limitations. When Benefits Are Paid Out Immediate An immediate annuity is the best option for those consumers who want to begin receiving money immediately. It is purchased with a single premium and provides regular income payments that start no later than one year after the premium is paid. Immediate annuities include various payout options. The owner of the annuity will select the payout option that fits his/her needs. Once the payout option has been chosen, it usually cannot be changed. The payout from a fixed immediate annuity is guaranteed by the insurance company. This is an important product for a population with increasing longevity and the potential likelihood of outliving one s retirement resources (known as superannuation), or in other words, living too long. Deferred A deferred annuity that always has an extended accumulation phase of more than a year may be the best choice for a consumer who wants to receive income in the distant future. Deferred annuities include various payout options that the owner may select when he/she is ready to begin receiving income payments. These future payments are guaranteed by the insurance company. 9

14 10 4 Hour annuity suitability What Investment Options Are Built In Fixed Annuities Accumulation During the accumulation period of a fixed deferred annuity, deposited funds (less any applicable charges) earn interest at the rates set by the insurance company and defined in the contract. The money is invested in the general account of the life insurance company. Fixed annuities have a current interest rate and/or a minimum guaranteed interest rate. The life insurance company guarantees that it will pay no less than the minimum interest rate. Payout During the payout period (sometimes called the distribution or annuity phase of a deferred annuity), the amount of each income payment is generally set when the payments start and will not change in the future. With both fixed and indexed annuities, the life insurance company guarantees that during the payout period, it will pay no less than the stipulated rate, which is also defined in the contract. Variable Annuities A variable annuity includes a menu of between choices for investing the net premiums and the investment results are highly variable. Both investment gains and losses are possible. Usually, one of the investment choices is a fixed account. This is in the general account of the insurance company, and there may be restrictions or limitations moving funds into and out of this account. Money placed in the fixed account earns a known interest rate and is subject to change. Accumulation During the accumulation period of a variable annuity, the buyer decides how premiums are invested by selecting one or more separate investment accounts, depending on how much risk he/ she may wish to take. The separate accounts are generally similar to diversified mutual funds, but are isolated and separated from the general account of the insurance company, and are never comingled with other company assets. Options include: Depositing premium dollars into a stock, bond, or other account, hoping the separate accounts will perform to expectations but with no guarantees as to actual performance or investment returns Depositing premium dollars into a fixed account that receives a stipulated rate of interest, is part of the general account of the insurance company and is guaranteed

15 Chapter 2: Types of Annuities and Parties to the Contract 11 Payout The amount of each income payment may be fixed (set at the beginning of the distribution phase) or variable (changing with the value of underlying investments in the separate accounts), depending on how the contract is written and the option selected by the owner. If the variable payout option is chosen, the dollar amount of each payment will tend to vary in relation to the performance of the underlying investment accounts selected. The life insurance company guarantees that during the payout period, it will follow the payout rate method described in the contract. A variable annuity is a security and is sold with full disclosure of all risks, fees, and charges as revealed in the required prospectus. The policyowner bears all responsibility of separate account selection and the full and complete investment risk as the value of the annuity increases or decreases based on the ever-changing investment performance of the separate accounts. Indexed Annuities An indexed annuity is a hybrid fixed annuity with certain guarantees built-in and the potential for some equity gains based on the performance of an external market index such as the Standard & Poor s 500 Composite Stock Price Index (the S&P 500), or some other nationally recognized index. Some indexed annuities have a guaranteed minimum interest rate that may include a premium guarantee on a percentage of premiums paid. Often this is a 1 to 3% on 75 or 90% of the premiums paid so that over the term of the contract, the premium is essentially guaranteed to be returned in full. Indexed annuities are complex financial contracts that have characteristics of fixed deferred annuities with moving parts that may modify the percentage of gains the owner receives from external market indexes. Indexed annuities have more risk and higher potential return than a traditional fixed annuity, but less market risk (and less potential return) than a variable annuity. This is because, in the simplest sense, indexed annuities have a guaranteed principal and a variable interest rate tied to the performance of the specified index. Their return, therefore, varies as compared to a fixed annuity, but not as much as a variable annuity. Equity investment gains are possible, but not guaranteed. Index gains (if they occur) are determined by an insurance company formula that compares the selected market index to a benchmark. The amount of interest credited to the cash value, and the investment gains (if any) added to the cash value, may change annually due to market conditions, insurance company needs for capital, as reflected in adjustments to the modifying techniques (such as the participation rate, spreads or margins, cap rates, etc.), and the costs to acquire the index options, which are at the heart of the product. Ultimately the consumer has the potential to capture some, but not all, of the growth of the stock market based upon the index selected, with little to no downside risk by virtue of the interest crediting methodology and the guaranteed principal aspect of the contract. Accumulation During the accumulation period of an indexed deferred annuity, money (less any applicable charges) may earn a guaranteed minimum interest rate specified in the contract by the life insurance company and receive investment based gains from positive changes in the selected market index added to the annuity s cash value. Negative changes in the selected market index usually do not detract from the annuity s cash value; there would simply be no interest credit to the cash values.

16 12 4 Hour annuity suitability Payout During the payout period (sometimes called the distribution phase of an indexed deferred annuity), the life insurance company will provide regular income payments based on the actual cash value in the contract, or may use a two-tiered approach for distribution of accumulated cash values. Though the lump sum received may be affected by taxes, penalties, or charges, the owner always has the right to cash surrender any annuity before annuitization. Depending on how the contract is written, the insurance company may pay a regular income payment based on the full accumulated cash value at the beginning of the payout period. Generally, this is established when the payments start and will not change in the future. The life insurance company guarantees that during the payout period, it will pay no less than the stipulated rate that is defined in the contract. The insurance company may also pay a single lump sum payment to the annuitant, based on a reduced or discounted accumulated cash value at the payout time. If a single lump sum payment is selected, the life insurance company guarantees the percentage of the reduction on cash value as specified in the contract. Parties to the Annuity Contract Annuitant The annuitant is the person whose age, life expectancy, and gender is going to be used to calculate the benefits of the annuity The annuitant must be a person and may not be a corporation or a non-profit organization. The annuitant is the measuring life for annuity payment calculations, but has no rights in the contract as annuitant. Most of the time, the annuitant and owner are the same person, but this is not required. Annuitant-Driven Annuity This annuity pays the death benefit to the beneficiary upon the death of the annuitant. Some annuities purchased before 1986 are annuitant-driven; the contract language says the death benefit will be payable on the death of the annuitant. Example Assuming that the owner and annuitant are two different persons, when the death of the annuitant occurs after the annuity starting date, the annuitant s death will trigger payment of the death benefit to the beneficiary. The owner may not have anticipated this when the annuity was originally purchased. Owner The owner is the purchaser of the annuity, pays the premium, and has the right to change beneficiaries, select investment and payout options, and surrender the annuity for its cash value. The owner may be a person or may be a non-person, such as a non-profit organization or a corporation. The owner is also responsible for any taxes due upon surrender, partial withdrawal, or regular income payments. Owner-Driven Annuity This type of annuity pays the death benefit to the beneficiary upon the death of the owner. All annuities issued since 1985 are owner-driven and are required to have language that forces out the cash value on the death of the holder of the contract. The holder is not defined by the Internal Revenue Code ( 72(s)), but generally means the owner of the contract. A spouse may assume ownership of the annuity if no beneficiary is named.

17 Chapter 2: Types of Annuities and Parties to the Contract 13 Example Assuming that the owner and annuitant are two different persons, the death of the annuitant before the annuity starting date doesn t usually affect the annuity contract. The owner may simply name a new annuitant and the contract continues. However, any change in the annuitant (such as age, life expectancy, gender, etc.) may affect the future income payments. The death of the annuitant before the annuity start date does not usually affect the annuity contract. The owner may simply name a new annuitant and the contract continues. However, any change in the annuitant (such as age, life expectancy, gender, etc.) may affect the future income payments. Annuitant and Owner are Different Persons Problems CAN occur if the annuitant and owner of the annuity are different persons. Both parties should be aware of the many details involved in this type of contract, including exactly whose death will cause a death benefit to be paid: The advisor recommending the annuity Other advisors who will be involved (such as accountants and attorneys) The person buying the annuity Example Sharon wants to supplement her mother s income. She also wants to make sure that should she predecease her mother, the income stream will remain in place. Sharon asks her insurance advisor to tell her how much money it would take to fund a single premium immediate annuity to ensure her mother receives an additional $500 per month for her mother s lifetime, with a 10-year guarantee. o Sharon would be listed as the owner, because she is funding the annuity, and o Sharon s mother would be the annuitant. Sharon could list herself as the beneficiary, so that should her mother live less than 10 years, Sharon would then receive some return on her investment. Sharon s mother is elderly and the death benefit may be minimal, so Sharon can avoid incurring the gift tax by gifting her mother the entire premium amount. (Of course, Sharon should consult a tax professional for tax advice.) Annuitant and Owner are the Same Person Some situations dictate that the agent recommend naming the same person as both the annuitant and owner. When this is true, that person s death will trigger payment of the death benefit to the beneficiary along with a tax liability for any tax-deferred gain in the contract. Beneficiary The beneficiary receives the death benefit upon the death of the owner. The payment may be a lump sum payment, remaining payments, or the commuted present value of the future stream of payments the annuitant would have received, if living. It is important to note that not all annuities have beneficiaries.

18 14 4 Hour annuity suitability Example 1 A single life annuity pays income payments only during the life of the annuitant. At the death of the annuitant, payments stop. In this case, there is nothing for the beneficiary to inherit. Example 2 A life annuity with a refund options pays income payments during the life of the annuitant. At the death of the annuitant, if total payments received are less than the premiums paid, then the beneficiary inherits the balance. If the owner is the beneficiary when the annuitant dies, the owner receives the death benefit and is liable for the income tax on the tax deferred gain. If a third party is the beneficiary, the situation can be more complex. Example Husband is the owner, wife is the annuitant, and child is the beneficiary. If this were the case with an annuitant-driven annuity, and the wife, the annuitant, were to die: The child receives the death benefit; the husband receives nothing. The child will be liable for income tax on all the untaxed gain. The husband made a gift to the child of the entire death benefit and the first $14,000 (for 2013) will not be subject to gift tax under the annual gift tax exclusion. For more information, see IRS publication 950 Introduction to Estate & Gift Taxes, which may downloaded from: Insurance Company An annuity is a future promise to pay based upon a contract issued by an insurance company. An annuity is only as good as the life insurance company that issues it and stands behind it. The company s assets support a promise that may not be fulfilled for many years. Here are some key points to consider: There are certain guarantees built-in to the annuity contract. A deferred or an immediate annuity may last for many years, and the company is committed to fulfilling its promises for the entire period. The promises are backed by the company s financial strength and claims paying ability. While agents and administrative staff may come and go, what remains for the long term is the company s financial assets and its ability to keep its word to policyholders. Insurance companies are complex financial institutions with complicated accounting systems for various operating divisions each with assets and liabilities. Companies must comply with state regulatory requirements for capital. The average consumer may not be qualified to evaluate insurance company contracts, assets, liabilities, and consolidated financial statements. Insurance Company Rating Services Insurance rating service organizations specialize in evaluating insurance company assets and liabilities. They provide a scorecard to help rank insurance companies. The major rating services are:

19 Chapter 2: Types of Annuities and Parties to the Contract 15 Secure Vulnerable Highest credit quality A++, A+ (Superior) A, A- (Excellent) B++, B+ (Good) B, B- (Fair) C++, C+ (Marginal) C, C- (Weak) D E F S AAA AA A BBB (Poor) (Under Regulatory Supervision) (In Liquidation) (Suspended) Best s Financial Strength Ratings Fitch Letter Gradations Denotes the lowest expectation of default risk. Denote expectations of very low default risk. Denote expectations of low default risk Indicate that expectations of default risk are currently low BB Indicate an elevated vulnerability to default risk, Speculative B Indicate that material default risk is present, but a limited margin of safety remains CCC Indicates default is a real possibility. CC Indicates default is a real possibility. Substantial credit risk C Default is imminent or inevitable, or the issuer is in standstill. RD Denotes that Fitch s opinion of the company is that they have experienced an uncured payment default on a bond, loan or other material financial obligation but has not yet entered bankruptcy. Default D Indicates that Fitch s opinion is that the company has entered into bankruptcy or has ceased business operations. Moody s Ratings Definitions Aaa Insurance companies rated Aaa offer exceptional financial security. While the financial strength of these companies is likely to change, such changes as can be visualized are most unlikely to impair their fundamentally strong position. Strong Companies Weak Companies Secure Vulnerable Aa A Baa Ba B Caa Ca C AAA AA A BBB BB B CCC R Insurance companies rated Aa offer excellent financial security. Together with the Aaa group, they constitute what are generally known as high-grade companies. They are rated lower than the Aaa companies because long-term risks appear somewhat larger. Insurance companies rated A offer good financial security. However, elements may be present which suggest a susceptibility to impairment sometime in the future. Insurance companies rated Baa offer adequate financial security. However, certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Insurance companies rated Ba offer questionable financial security. Often the ability of these companies to meet policyholder obligations may be very moderate and thereby not well safeguarded in the future. Insurance companies rated B offer poor financial security. Assurance of punctual payment of policyholder obligations over any long period of time is small Insurance companies rated Caa offer very poor financial security. They may be in default on their policyholder obligations or there may be present elements of danger with respect to punctual payment of policyholder obligations and claims. Insurance companies rated Ca offer extremely poor financial security. Such companies are often in default on their policyholder obligations or have other marked shortcomings. Insurance companies rated C are the lowest rated class of insurance company and can be regarded as having extremely poor prospects of ever offering financial security. S & P Rating Categories Superior financial security. Highest safety. Excellent financial security. Highly safe. Good financial security. More susceptible to economic change than highly rated companies. Adequate financial security. More vulnerable to economic changes than highly rated companies. Financial security may be adequate, but capacity to meet long-term policies is vulnerable. Vulnerable financial security. Extremely vulnerable financial security. Questionable ability to meet obligations unless favorable conditions prevail Regulatory action. Placed under an order of rehabilitation and liquidation.

20 16 4 Hour annuity suitability Comparison of Insurance Company Ratings Systems A.M.Best Fitch Moody s S&P A++ A+ A AAA Aaa AAA AA+ Aa1 AA+ AA Aa2 AA AA- Aa3 AA- A+ A1 A+ A A2 A A- A- A3 A- B++ BBB+ Baa1 BBB+ BBB Baa2 BBB B+ BBB- Baa3 BBB- B BB+ Ba1 BB+ BB Ba2 BB B- BB- Ba3 BB- C++ B+ B1 B+ B B2 B C+ B- B3 B- C C- CCC+ Caa1 CCC+ CCC Caa2 CCC CCC- Caa3 CCC- CC Ca CC D C C - E,F At the time of sale, agents should be aware of the insurance company ratings for the products recommended. This is especially important if the agent has errors and omissions (E & O) professional liability insurance. Typically, E & O insurance carriers have required standards for agents to follow. These standards may include a benchmark for a minimum insurance company rating considered acceptable to the E & O carrier. Example The agent s E&O policy may require that the agent recommend a company with an A- (or better) rating from A.M. Best at the time the business is placed. Otherwise, the liability protection for the agent is void. If, in this case, the agent selects a company with a B++ (or worse rating), the agent will not have E&O liability protection for that transaction. This could have adverse professional, personal, and financial consequences in situations involving a lawsuit.

21 Chapter 2: Types of Annuities and Parties to the Contract 17 Case Study: What Should Mary Do? Facts Mary Brown at age 50 inherits the proceeds of her deceased parent s estate and uses the net proceeds (after taxes) for some long range planning to augment her retirement nest egg. Note: The amount of money does not matter for this case; the goal of this case is selecting among alternative choices and considering the importance of insurance company strength and ratings. Mary thinks her existing savings and investments will be OK until about age 75 or 80, and she estimates that her existing nest egg will maintain her standard of living until that time. At that point she may need some additional income to replace the money from her 401(k) and IRAs that she has spent in using the required minimum distributions. Consider the following options and provide advantages and disadvantages of her preferred choices. Options and Alternatives to Consider Should Mary place the money in a bank that has FDIC insurance protection? Should Mary consider a balanced stock and bond portfolio for this money? Should Mary evaluate her choices by taking into account her feelings about both investment risk and interest rate risk? Should Mary select a so-called lifestyle mutual fund to help her achieve her objectives? Should Mary consider a strategy consisting of laddered CDs and laddered bonds to supplement her retirement? Should Mary consider a deferred annuity that includes built-in annuitization values for future income? If Mary selects a deferred annuity, which kind should she purchase: fixed, variable or equity index? After considering all of the alternatives, Mary Brown decides to purchase a non-qualified deferred annuity from The American Ever-So-Solid Life Insurance Company (TAESSLIC for short). She determined this purchase met her long term requirements. Mary has entered into a long-term business relationship with the company by virtue of the contract she bought. At age 50, Mary is still working and has adequate cash flow for her immediate financial needs. She is anticipating that the annuity will accumulate in value for perhaps 25 or 30 years in the future. After that, she may need the annuity income to augment her other retirement resources. At age 75 or 80 it may be an attractive option for Mary to annuitize the accumulated value so that however long she lives she will continue to receive regular monthly income payments from the contract. If she lives an additional 15 years after that, the business relationship will have had a 40 to 45 year lifespan. From her point of view, TAESSLIC should be a strong company with adequate long-term investments to be able to make those annuity payments beginning in 25 years and lasting until she dies. If Mary lives longer, her annuity will need to continue paying her as long as she lives. This example highlights the importance of company strength in selecting a source for an annuity. The insurance annuity contract is an agreement that is purchased now, because of the future promise for the insurance company to pay later. When the transaction is viewed in its most basic terms, it s not about glossy brochures, enticing seminars, and bells and whistles. The crucial consideration is whether the company will survive long enough and continue to be strong enough in this or any future economic environment to honor its promises and ultimately make payments to its policyholders.

22 Chapter 2 Review Questions 1. An annuity that provides regular income payments that start no later than one year after the premium is paid is known as what type of an annuity? a. Deferred b. Immediate c. Non-qualified d. Tax-qualified 2. Who bears the risk of the investments in a variable annuity? a. The policy owner b. The insurance company c. The state guarantee association d. All policy owners mutually share in the risk 3. In the simplest sense, indexed annuities have a guaranteed principal and a(n) interest rate. a. Flexible b. Fixed c. Indexed d. Variable 4. Which ONE of the following best defines an annuity owner? a. The person who makes a future promise to pay which is based upon an issued annuity contract b. The person whose age, life expectancy, and gender is going to be used to calculate the benefits of the annuity c. The person who pays the premium, has the right to change beneficiaries, and to surrender the annuity for its cash value d. The person who receives any death benefit upon the death of the annuity owner 5. What makes an owner driven annuity unique? a. It pays the death benefit to the beneficiary upon the death of the owner b. It pays the death benefit to the beneficiary upon the death of the annuitant c. It pays monthly income to the owner during their lifetime d. It pays monthly income to the annuitant during their lifetime 6. A single life annuity pays monthly income during the life of the annuitant. What happens upon death of the annuitant? a. The beneficiary receives a lump sum b. The beneficiary receives nothing c. The beneficiary receives the remaining payments d. The beneficiary receives the commuted present value of the future stream of payments the deceased would have received, if living 18

23 Chapter 3 Annuity Contract Provisions Provisions Common to All Annuities Issue Ages Issue ages may vary depending on the type of annuity being issued, the issuer, and state insurance regulations. Non-qualified annuities may be issued from age 0 to age 80 (sometimes even to age 90). For tax-qualified annuities, the issue age may range from ages 18 to 90. Maximum Ages for Benefits to Begin Annuity contracts typically have a maximum age for benefits to begin, also known as a maturity date. For some non-qualified annuities this may be age 80 or 85 before the regular income payments begin. In certain cases, companies may defer the maturity date upon written request of the owner/annuitant and consent of the company. This would delay the maximum age for benefits to start. For most tax-qualified annuities, required minimum distributions (RMDs) must begin in the year following the year that the annuitant reaches age 70½ and may be satisfied by partial withdrawals or annuitizing the contract. All IRS requirements for RMDs must be followed. Premium Payments Premium payments may be a one-time, single deposit or a series of flexible premiums over a period of years. Sometimes called Single Premium Immediate Annuity (SPIA), and are typically funded with a single premium that immediately begins annuity income payments. Payments begin no later than one year from the policy date, for example, they may start within 30, 60, 90, or 180 days exchanges are another way to fund an annuity. Here an existing cash value life insurance policy or annuity is exchanged for a new annuity on a tax-free basis. An exchange of an existing annuity or permanent life policy s cash value for a new annuity brings over the cost basis of the original contract into the new contract. An advisor should only recommend an exchange when it is in the best interest of the consumer. Surrender Charges Most deferred annuities include surrender charges as a part of the contract. In exchange for the benefits contained in the annuity, insurance companies may levy a surrender or withdrawal charge if the owner withdraws funds during a specific period, typically the first seven or ten years of the annuity contract. Sometimes surrender charges are a percentage of premiums paid, but more often apply to the entire annuity account value being withdrawn. Usually the percentage declines over a set number of years specified in the contract. After a period of time, the surrender charge drops to zero, which means the annuity owner may remove money without having to pay a surrender charge. Some contracts apply the declining surrender charge to EACH premium or payment. In this situation, withdrawal amounts at different times may be subject to different surrender charges. There are some annuities that may have a surrender charge period based on the original policy date without regard for how many premiums are paid into the annuity. This approach is less commonly used by insurance companies. 19

24 20 4 Hour annuity suitability Example: 7 year Declining Surrender Charge Policy Year Surrender Charge 7% 7% 7% 6% 5% 4% 3% 0% Annuities are intended to be long-term financial tools. Having a surrender or a withdrawal charge as a part of the contract is designed to encourage annuity owners to keep funds within the contract and to seriously consider the need for a partial withdrawal or full surrender (since it will cost money). From the customer perspective: A surrender charge is a penalty that is assessed against the amount withdrawn. This is similar to an interest penalty for an early withdrawal of a time deposit (such as a certificate of deposit) at a bank. The surrender charge is designed to encourage customer loyalty so that the premium plus any accrued interest remains in the insurance contract. Investment language calls the surrender charge a potential back end load (sales charge). This is fair since these annuities are sold with no up-front sales charge (front end load) deducted from the premium paid. From the insurance company perspective: A surrender charge is a way to recover some of the upfront costs of marketing and producing annuities. These costs may include: Agent commissions and all the other operating expenses involved in issuing the contract Associated expenses with placing the annuity premium in an underlying investment designed to generate the promised benefits Example Mary Smith places $50,000 in a deferred annuity with a 7 year surrender charge period applicable to premium deposits only. In the second policy year, she needs to surrender her contract because of an emergency, the surrender charge would be 7% of her premium or $3,500. She would receive: $50,000 minus $3,500 surrender charge plus any tax deferred interest If, however, Mary s emergency occurred in the 7th year, and the surrender charge applied to the premium deposits only, the surrender charge would drop to 3% or $1,500. In this case, she would receive: $50,000 minus $1,500 surrender charge plus any tax deferred interest If Mary s emergency occurred in the 8th year or later, no surrender charge would apply. Mary would receive: $50,000 plus any tax deferred interest Market Value Adjustment When a life insurance company issues an annuity, one of the risks the insurance company faces is the possibility that the annuity owner will want to withdraw money before the maturity date and/or at a time when the market value of the investments backing the annuity are at a low point. The market value adjustment (MVA) provision in an annuity allows the contract owner to share some of that risk. The MVA is an adjustment (positive or negative) computed by a mathematical formula that measures the changes in the interest rate environment that occur after the annuity was purchased. If the annuity owner makes a full or partial surrender of a contract that has an MVA, he or she may find that money is added to the liquidation value or that money is deducted. Whether money is added or subtracted depends upon whether the interest rates in the market are higher or lower than they were at the original investment in the annuity. If interest rates in the market are higher than when the annuity was purchased, the adjustment is negative (money is deducted). If interest rates in the market are lower than when the annuity was purchased, the adjustment is positive (money is added).

25 Chapter 3: Annuity Contract Provisions 21 Surrender Charge Waivers Under certain circumstances (or triggering events) surrender charges may be waived. This means the amount of money received by the annuity owner, in a partial withdrawal or full surrender, is not reduced. These provisions vary by company and are included in the annuity contract. Some of the more common reasons for surrender charge (crisis) waivers are: Confinement in a nursing home for 60 or 90 days or more (This is not to be confused with Long Term Care Rider) Unemployment An accelerated benefit for a serious illness such as heart attack, stroke, coronary artery surgery, life-threatening cancer, renal failure or Alzheimer s disease Disability resulting from injury or disease that lasts more than 90 days An extended stay in a nursing facility for more than days after confinement in a hospital A terminal illness or treatment in a hospice facility with written evidence from a physician that life expectancy is one year or less Death Typically, surrender charge waivers are granted by a specific rider or endorsement to the annuity contract. Withdrawal Privilege Options Surrender Charge Free Window To allow some liquidity, many deferred annuities have an amount or a percentage that may be withdrawn without triggering the surrender charge. Many deferred annuities have a 10% window that allows the owner to withdraw 10% of the cash value as of the previous anniversary, or 10% of the current cash value, whichever is higher. Example If Mary Smith needed some money in the second year after purchasing her annuity, she could withdraw 10% of the account value as of the anniversary date without a surrender charge. Insurance companies may provide different surrender charge free percentages from a low of 5% to a high of about 20%. Check with the company for specific annuity contract liquidity features. Premium Bonus & Surrender Charges Some deferred annuities pay a bonus to the account based on all premiums received in the first contract year. Bonuses credited to the annuity are a way to increase the account value. Example An annuity owner deposits a total of $70,000 during the first year of the contract. If all premiums received by the insurance company earn a 4% bonus, $2,800 will be added to the annuity. In this case, any tax-deferred gain would be added to the $72,800. Bonus credits represent an incentive to the prospective annuity buyer. Often bonus annuities also provide an incentive to the selling agent in the form of higher commissions for selling bonus annuities. However, they are not without cost to the annuity owner. Often the cost of the bonus is passed on to the owner by higher surrender charges for a longer period of time: years is fairly typical, however, some bonus annuities may have a surrender charge as long as 20 years. The obvious trade-off is reduced liquidity during the time of the extended surrender charge period.

26 22 4 Hour annuity suitability Sample Deferred Annuity Surrender Charges: Client Age 70, By Policy Year, and Surrender Charge Percent Age Year Fixed Interest Annuity % Variable Annuity - No Premium Bonus % Variable Annuity - With Premium Bonus % Indexed Annuity - No Premium Bonus % Indexed Annuity - With 5% Premium Bonus % Indexed Annuity - With 10% Premium Bonus % These examples are taken from actual deferred annuity contracts illustrating surrender charges with and without a bonus. In some cases, the amount of the bonus does not fully vest to the owner s account until the surrender charge periods end. Upon partial withdrawal or annuitization during the surrender charge period, the amount of the bonus received may not be included in the partial withdrawal received or the annuity payout as regular periodic payments. Annuity owners and agents should carefully read the contract to determine if a bonus is added to the contract cash value and when it is available to the annuity owner. Policy Administration Charges & Fees Most fixed deferred annuities do not charge additional fees. If any optional annuity features are selected by the owner at the time of the purchase of the annuity, this may result in an annual deduction from cash values or at times a reduced interest rate being credited. Indexed annuities do not usually charge additional fees because participation rates, cap rates, and spreads provide the similar revenue enhancement for insurance companies. Charges for optional policy features can be incorporated into the policy participation rates, cap rates and spreads. Some will assess the owner s cash value. Variable annuities charge an annual policy fee, mortality and expense (M&E) charges, separate account fees (based on assets under management in each separate account), and fees for any optional product features selected by the contract owner. These charges and fees are disclosed in the quarterly or annual reports sent to the contract owner. They are deducted from the account values. Income (immediate) annuities have limited fees. This includes the state s premium tax when the income annuity is purchased and may also include deductions from contract values if periodic payments are commuted as a single payment during the payout period. Loan Provisions Typically, plan participants may borrow up to one-half of the account value, not to exceed $50,000. Since this withdrawal is considered a loan, it must be paid back in level payments over a period of 5 years; otherwise it will be treated as a taxable distribution subject to ordinary income taxes plus a 10% excise tax if the contract owner is younger than 59½. As a rule, non-qualified annuities do not have loan provisions due to the taxation of partial withdrawals. Tax-qualified annuities may have loan provisions if they are part of a retirement savings plan such as a 403(b) plan or 401(k) plan.

27 Chapter 3: Annuity Contract Provisions 23 Available Riders Life Insurance Riders Most annuities do not have additional life insurance death benefits other than the cash value payout at the death of the annuitant. Some annuities may, for an additional annual charge automatically deducted from annuity cash values, provide an enhanced death benefit that provides the beneficiary with a larger death benefit (such as 25-50% larger to compensate for any taxes due) at the passing of the annuitant. Death Benefit Income Tax Riders Unlike life insurance death benefits that are free from federal and most state income taxes, payouts from an annuity at the death of an annuitant (prior to annuitization) are taxable to the extent that the proceeds exceed the purchase payments. Some companies offer an income tax rider that provides an extra payout to offset any applicable taxes. For example, the beneficiary of a $100,000 annuity which was purchased years ago for $40,000 would have a tax deferred earnings buildup of $60,000 that would be taxed to the recipient upon distribution. The tax is at the beneficiary s ordinary tax rate. This is different from the steppedup value rule that applies to stock investments inherited at current value and not subject to taxation on any gain achieved during the owner s lifetime. Many death benefit tax riders pay only a portion of the tax. One company may offer a death benefit tax rider in which the beneficiary receives an extra 15% on the investment gain on the annuity; another, 40%. Some contracts pay out an additional percentage based on the entire amount payable at death. It depends on the company and the policy-rider s language. In either case, the amount may be less than the actual tax. Ironically, the extra payment is subject to income tax. Example Karen has a variable annuity in which she originally deposited $10,000. It is now worth $50,000. If she were to die, her beneficiary, George, would receive the $50,000. $40,000 of the $50,000 represents tax deferred earnings that George would be responsible for claiming as income and paying ordinary income tax. If Karen had acquired along with her annuity the 30% income tax rider, then the payout to George would be calculated as follows: Assuming the 30% only applied to the embedded gain Assuming the 30% applied to the entire account value Amount rider $40,000 $50,000 Benefit % X 30% X 30% Rider Benefit $12,000 $15,000 Account Value + $50,000 + $50,000 Total Payout $62,000 $65,000 Cost basis - $10,000 - $10,000 Amount subject to ordinary income tax $52,000 $55,000 Note: The taxation shown applies only to any annuity proceeds paid at the annuitant s death prior to annuitization, in other words, during the accumulation period. After annuity payouts begin, other arrangements prevail at the death of the annuitant. These arrangements vary from complete forfeit of the remaining balance to the company to continuation up to certain amounts or years to a named beneficiary. Taxation of annuity payouts is different from that of lump-sum proceeds paid at an annuitant s death. The fee for this benefit typically can be % charged annually against the investment account balance.

28 24 4 Hour annuity suitability Long Term Care Riders Some non-qualified annuities offer an optional long-term care rider that can be added to a deferred annuity. Generally, tax-qualified annuities IRAs and rollovers from tax-qualified accounts such as 401(k) and 403(b) plans do not allow long-term care riders. The cost for the rider is deducted from the deferred annuity accumulation. Some contracts merely waive a portion of the surrender penalty for withdrawals made because of nursing home confinement. Several companies allow a one-time withdrawal for nursing home expenses. Each contract contains specific details. The surrender charge crisis waiver provides only limited coverage for a specified time frame, similar to Medicare covering only 100 days of skilled nursing care. Generally, this rider provides the annuitant with a form of long term care insurance benefit in the event of an illness or injury that requires long term care. Conditions and coverage amounts are specified in the contract s rider, but generally this feature pays out a monthly benefit similar to a monthly annuity income payment. With the average costs for long term care at $40,000 - $70,000 annually and rising, this feature can be a valuable add-on. As in regular long term care policies, the payment is based on severity of injury or illness, inability to care for oneself, and a time-deductible (waiting period) of 60 or 90 days or longer likely applies. In some ways, this rider is a viable supplement for a free-standing LTC policy, but payment amounts and durations and other conditions vary as do the internal costs for the rider. It is also possible for some or all of the money used to pay for long-term care to be exempt from federal income taxes. Be sure to read the rider provisions carefully and consult with a tax professional. In general, the annuity is purchased with a lump-sum, usually $50,000 or more with this rider. The rider cost will be recovered from the account value like other fees are. The rider will multiply the deposit amount by a factor of 2 or 3 to determine how much of a long term care benefit the rider will pay. Death Benefits At the death of the owner/annuitant, the beneficiaries receive the full annuity cash value. General Rules Certain distributions must be made at death, similar to qualified plans at the death of the account owner. The IRS wants to prevent the extended deferral of income tax on the cash value gains inside the annuity if ownership could be passed from person to person without the gains being taxed. Owner Dies on or after the Annuity Commencement Date If the annuity owner dies on or after the annuity commencement date, but before the total contract value has been distributed, the remaining contract value must be distributed at the same rate or sooner as the owner s method of distribution at the time of death. Owner Dies before the Annuity Commencement Date The general rule is the entire contract value must be distributed within five years after the date of the owner s death. The beneficiary may select from these three choices: 1. Take the full amount due under the annuity and pay taxes at that time. 2. Make partial withdrawals over the next 5 years, pay taxes on each withdrawal, and the balance remaining in the annuity plus tax deferred interest grows until distributed within the five year period.

29 Chapter 3: Annuity Contract Provisions Continue tax deferred growth for up to five years, then take the full amount at that time, and pay all taxes due. There is an exception to the five-year rule where payments are made to a beneficiary for his/her life or life expectancy. Within one year of the owner s death, a beneficiary may: Annuitize the remaining interest over his/her life or life expectancy and receive favorable tax treatment accompanying annuity payments; or Begin withdrawals over a period not exceeding the beneficiary s life expectancy calculated by an IRS approved method and paying taxes on each withdrawal with the gain in the contract being paid out first (last in, first out LIFO). Special Spouse as Beneficiary Rules If a person is the contract owner and the spouse is the beneficiary, following the owner s death the surviving spouse is then treated as the owner of the annuity. Then, the after-death distribution rules take effect at the surviving spouse s death instead of at the original owner s death. Income Distribution - Settlement Options Single Life (or Life Only Income) A single life income annuity is the highest payout possible for one person. A life only income annuity provides income payments only as long as the annuitant is alive. At the death of the annuitant, there will be no further income payments, no subsequent payments to the estate of the annuitant or to the beneficiary; no death benefit of any kind. Example Juan elects a life only option for his annuity payout during his retirement years. Based on his age, gender, and amount he started with his monthly income payment is $750. He lives two years then dies. All payments cease. If he had lived to 98, payments would have continued until his death even though by that point, he would have received more than what he started the payout with. Joint & Survivor (or Life Income for Two People) A joint-and-survivor income annuity is a payout for two people over two life expectancies. After the first annuitant has died, the survivor may be able to receive 100%, 75%, or 50% of the payments over his/her lifetime. When both annuitants are no longer living, income payments stop completely. There are no subsequent payments to the estate of the last annuitant; neither are there payments to any beneficiary. This pays out the lowest monthly income. Example Jorge and Anita elected a Joint and 50% Survivor income payout. Based on their ages, gender, and amount the payouts were started with, they received $1,000 per month. Jorge dies after 12 years. Anita then continues to receive $500 per month for the rest of her life. After her death, there are no further payments made by the insurance company. Period Certain (or Life & Period Certain) A life income with a guaranteed period certain annuity provides income payments for the longer of either the guaranteed period selected, or the life of the annuitant. The longer the period certain is, the smaller the income payments will be. The period certain may be 5, 10, 15, 20, or even 30 years. Some companies may permit a period certain to be any number of years, such as 7 or 13 or 21.

30 26 4 Hour annuity suitability Cash Refund A life income with cash refund income annuity provides income payments for as long as the annuitant lives. If the sum of all annuity payments made is less than the single premium payment paid for this annuity, the beneficiary will receive the difference in a lump sum. If the sum of all annuity income payments is more than the single premium paid for this annuity, there will be no other income annuity payments or payments of any kind, including a death benefit, to any person, or the estate of the annuity owner or annuitant. Example Marvin, age 70, is considering his options for lifetime income. He currently has $100,000 in a CD at the bank and wants to know his options from an income annuity. Income Annuity Income for Marvin, Male, Age 70, $100,000 Single Premium Monthly Annuity Total Amount of Guaranteed Payments Tax Free Portion of Monthly Income Total Payments to Age 100 Single Life $ $0.00 $ $248, Life w/ 10 yrs Certain $ $76, $ $238, Life w/ 20 yrs Certain $ $130, $ $201, Life w/ Cash Refund $ $100, $ $219, If he selects the Single Life Income Annuity option, he will receive $ per month for as long as he is alive. Upon death, the payment stops. If he selects the Life with 10 year Certain, then he will receive $ per month for as long as he lives. If he should die at the end of year 3, then his named beneficiary will receive that monthly amount for the remaining 7 years of the 10 year Certain. If Marvin died in year 12, there would be no further payments made by the insurance company. If the annuitant were female, the monthly annuity payments would be less due to longer life expectancy. See table below and compare with the one above. Income Annuity Income for Peggy, Female, Age 70, $100,000 Single Premium Monthly Annuity Total Amount of Guaranteed Payments Tax Free Portion of Monthly Income Total Payments to Age 100 Single Life $ $0.00 $ $228, Life w/ 10 yrs Certain $ $72, $ $223, Life w/ 20 yrs Certain $ $127, $ $197, Life w/ Cash Refund $ $100, $ $208, With a Life with Cash Refund income annuity, if Peggy lives long enough to receive $75,000 in payments, then her beneficiary would receive a refund of $25,000 ($100,000 - $75,000). With a life with period certain income annuity, if the annuitant outlives the certain period, no benefit will be paid to the beneficiary. If Marvin were to die after just one month, having received just one income annuity payment, and he selected a life w/ 20 year certain income annuity, how much will the beneficiary receive at his death?

31 Chapter 3: Annuity Contract Provisions 27 Some companies permit a joint & survivor cash refund income annuity. Example Alberto has $100,000 and invests in a fixed single premium immediate annuity selecting a life with a cash refund option. Alberto lives long enough to receive $75,000 in payments from the insurance company. This leaves $25,000 from his initial payment to be refunded to the beneficiary named in the policy. If Alberto lived long enough to receive $125,000 in payments and then died, there would be no refund for the insurance company to pay. Fixed Annuity Provisions Charges and Fees Fixed annuities usually provide the owner/annuitant with an annual report of cash value as of the last anniversary date, current tax-deferred accumulation growth, a summary of any withdrawals during the current policy year, and the net cash value at the end of the policy year. Most fixed annuities do not charge for this report. Sometimes, however, there may be an annual report fee that is deducted from the cash value. If additional riders or optional policy features have been chosen by the owner, these may have a special expense charge or fee which is disclosed on the annual report. Interest Rates Life insurance companies pay tax-deferred interest on money that is placed in annuities. Some of the interest rate options an insurance company may pay are: Declared Fixed Rate Annuity / Interest Rate Guarantee At the time of the annuity application, the interest rate is set or declared by the insurance company. The interest may be guaranteed for one year at a time, or may have three to ten year multiple rate guarantees. Renewal Rate After the guarantee period is over, the contract usually receives the current renewal interest rate that the company is crediting to annuity contracts but not less than the minimum guaranteed rate specified in the contract. Portfolio Rates A portfolio interest crediting method averages the interest rate of a group of annuity contract holders over a set time period. Renewal rates will go up and down depending on the group average. In a low or declining interest rate environment, the portfolio method benefits the customer by continuing to use the older, higher interest rates in the average calculations. Guaranteed Minimum Interest Rate The guaranteed minimum annual effective interest rate at issue of the fixed annuity must be specified in the contract. This puts a floor under the future deferred annuity accumulation. The minimum annual effective interest rate has been decreasing for years and currently averages not less than 1.0%. Twenty-five years ago it would have averaged around 5%. New Money - Two-Tiered Interest Rates A new money interest crediting method uses the rates available when funds are received by the company. Renewal rates with the new money approach will stay close to the initial declared interest rate, in a fluctuating interest economy. Sometimes companies use a two-tiered approach to attract

32 28 4 Hour annuity suitability additional deposits into a flexible premium deferred annuity. The company may credit a lower interest rate to money already in the annuity and offer a higher interest rate as an incentive to receive new deposits during the current year. Regulatory and License Requirements To sell any fixed annuity product, a producer must be appointed with an insurance company, have a resident life insurance license in his/her home state, and a non-resident license in any other state where he or she conducts business. Variable Annuity Provisions Risk and Separate Account Investments Investors have considerable choice within their variable annuities with respect to the selection of separate accounts; for simplicity sake, think mutual funds. The separate accounts are the investment accounts where client money is placed by the client, i.e., annuity owner. These accounts are not a part of the insurance company general account; they are literally separated from the general assets of the insurance company. The menu of separate accounts in most variable annuities includes between 40 and 50 choices. The account owner has discretion when selecting what accounts to use and bears the total investment risk of those choices. Past market performance of all separate accounts is no guarantee of future results; variable annuity contracts are investments and subject to market forces up and down. One of the investment choices in a variable annuity is a fixed account. A fixed account is comprised of the general assets of the insurance company and may be subject to restrictions or limitations when moving funds into and out of the account. Money placed in the fixed account earns a known interest rate and is subject to change from time to time, as in once per quarter or once per year. Charges and Fees Annual Mortality & Expense (M&E) Fees Variable annuities are accumulation and distribution tools. The M&E charges generally range from 1.2% to 1.6% of the variable annuity account value. Charges cover the costs associated with having a guaranteed death benefit (designed to cover any shortage in the account value as compared to premiums paid) and guaranteed income annuity factors in the contract. In other words, the M & E creates a reserve in case of premature death during a down market or living beyond the account values. Standard Death Benefit Guarantee Upon the death of the owner, prior to annuitization and with no additional charge, beneficiaries will receive the greater of the current contract value, less any partial withdrawals and/or outstanding loan balances (if any) and bonus credits applied in the previous 12 months since the date of death, or the total of all premiums paid, less any outstanding loan balances and withdrawals. General versus Separate Accounts (Investment Choices) Money in the fixed account does not incur management fees. Each separate account has an investment management fee which typically pays for the services of the portfolio manager as a percent of assets under management. These separate account fees vary by investment manager and may be 0.25% up to about 1.5% per year. As more assets are managed by the portfolio manager, the fees tend to be reduced due to some economies of scale with a larger pool of investments being managed by a team of brokers, analysts, computer systems, and management overhead.

33 Chapter 3: Annuity Contract Provisions 29 Surrender Charges Each variable annuity typically has a surrender charge schedule. This is similar to the surrender charges discussed under fixed annuities. Premium Bonus Credits - Dollar Cost Averaging and/or Automatic Asset Reallocation: Optional Product Features at No Cost Some variable annuities include some optional benefits at no cost. For example, automatic rebalancing or dollar cost averaging may by elected by the contract owner and there usually is no cost for these options. It may be possible to transfer assets among investment choices several times a year. For example, 12 or 24 free transactions per year may be allowed without cost; any transfers above the free number may have additional transfer charges. Optional Death Benefit Enhancement Although the standard death benefit guarantee is included with the contract, some variable annuity buyers may purchase an optional benefit so their beneficiaries may receive a larger death benefit than a standard one would provide, for example, the highest contract anniversary value. Optional Living Benefit Guarantees Living benefit guarantees are for the benefit of the annuity contract owner. Death benefits (standard or enhanced) are for the beneficiaries. Each of the insurance living benefits have an associated annual insurance cost that ranges from 0.50% to 0.75% of the account value; the account owner needs to fully understand the contract provisions before agreeing to purchase any options. Note: Not all living benefit provisions are available with every variable annuity; insurance companies tend to accept one preferred living benefit and make it available to consumers through sales and marketing efforts. Guaranteed Minimum Income Benefit (GMIB) A GMIB guarantees a stated minimum return on a variable annuity, provided it meets certain conditions and is held for 8 to 12 years. This feature transfers some of the risk in a variable annuity to the issuing company by guaranteeing a minimum payment even if the underlying investments do not support it or goes to zero in value. Companies may offer to guarantee the greater of the actual account value, 5-7% compounded annual interest on the account value if the policy is eventually annuitized, or the highest contract anniversary value if the policy is eventually annuitized. The annual cost of this feature is in the range of one-half of one percent, which sounds low, but which represents a ten percent sacrifice of a gain of five percent. Plus, while the annual charge is deducted in all market conditions, the benefit may only have value in dire market conditions. Example Billy invests $250,000 in a variable annuity with a GMIB rider that guarantees the greater of the following: The actual investment account value 6% interest compounded annually on the initial premium deposit The highest contract anniversary investment account value Ten years later, due to market volatility and a long bear market, the actual value of the variable annuity s investment accounts is valued at $284,015. The highest contract anniversary value was locked in during the 4th year at $315,976. The GMIB rider produces a benefit base amount of $447,712 ($250,000 compounded at 6% for ten years) which is not cash that can be withdrawn but is an amount which can only be annuitized.

34 30 4 Hour annuity suitability Annuitizing the highest value will produce the highest monthly income. Typically, the GMIB rider can be exercised after a stated time period such as after the 7th or 10th year. Also, the rider is in effect to a specified age such as 85 or 90. Guaranteed Minimum Accumulation Benefit (GMAB) A GMAB guarantees that if account values fall below the original premiums paid, the insurance company will put a floor under the account value to guarantee principal provided the contract is held for a specific time, such as 10 years. If the account value increases in the future, some GMABs allow the guaranteed amount to be reset to the higher account value for an additional annual fee if elected on a subsequent anniversary date. It also allows for lump sum cash withdrawals of this initial investment, or the entire investment account value after a specified period of time. Some riders will lock in market value gains on the policy anniversary. Fees for the GAV rider can range from.20% -.40% deducted annually from the investment account. Example 1 Billy invests $100,000 into a 10 year variable annuity with a GAV rider. At the end of ten years, the account value is $85,000. Billy can request a withdrawal of $100,000, thereby, getting all of his money back. Example 2 Billy invests $100,000 into a 10 year variable annuity with a GAV rider. At the end of ten years, the account value is $125,000. Billy can request a withdrawal of $125,000, thereby, getting all of his premium and appreciation out of the policy. Guaranteed Minimum Withdrawal Benefit Term Certain (GMWB Term Certain) A GMWB Term Certain guarantees that an account owner may have a 100% guarantee of principal if the owner withdraws a percentage of the investment (i.e., 5.0% to 7.0%) over a period of time (such as 8 to 12 years). This rider provides a way for the annuitant to receive a guaranteed periodic income equal to the amount of premium paid. It does NOT, however, guarantee a lifetime income. Think of this as a guarantee of return of premium paid out over time in case the market crashes. Example Lynn invests $100,000 into her variable annuity with a 5% GMWB rider. The account falls to $25,000 due to a poor investment selection and deep stock market correction. She can receive $5,000 ($100,000 x 5%) per year for 20 years, guaranteed, a much better outcome than having to deal with the current account value. Guaranteed Minimum Withdrawal Benefit for Life (GMWB) A GMWB guarantees that an account owner may have a 100% guarantee of principal for a life-plus period certain (usually 20 years) basis. The income stream is often set at 5.0% and is guaranteed for life or 20 years, whichever is longer. The 5.0% withdrawal benefit may ratchet up with stock market gains but will never be reduced in case of market losses.

35 Chapter 3: Annuity Contract Provisions 31 Example Billy invests $100,000 in a variable annuity with a 5% percent LWB rider. The insurance company guarantees that $5,000 ($100,000 x 5%) per year can be withdrawn from the policy for life, even if the investment account falls to zero due to the market or account depletion. If such an event happens, the insurance company uses its own money from its reserves to continue making the payments. It is possible for insurance companies to include an option of stepping up the highest contract anniversary value to base the withdrawal on. Fees range from 0.25% to 1.00% annually. Regulatory and License Requirements Variable annuities are a security product and require a prospectus to be offered during the sales process; a prospectus reveals all legal aspects of the variable annuity. In order for agents to sell variable annuities, they must: Be appointed with an insurance company Have a resident life insurance producer s license in the state in which they conduct business Have a securities license (Series 6 or 7, and Series 63) Have any state required variable contract license Have the appropriate non-resident license as well as the insurance company appointment if conducting business in a state other than the state of residence Indexed Annuity Provisions Charges and Fees Indexed annuities rarely have charges and fees that require a separate payment from the contract owner. Charges and fees are deducted from the accumulation value or are dealt with by changing the participation rate, cap rate, or spreads, etc. Minimum Guarantee of Premium & Minimum Interest Rates Many fixed annuities feature a full 100% guarantee of premium. In comparison, indexed annuities often have a reduced premium guarantee, such as a 90% of the premium, and sometimes as low as 87.5% or 75%. A low interest rate environment will put pressure on insurance companies, narrowing the spread between what insurance companies earn on their portfolios and what they offer prospective annuity buyers. Indexed annuities do not have a guaranteed return rate because it is possible for the annuity to earn no gains if the initial index at the time of purchase is less than the market index. Some indexed annuities contain a minimum guaranteed annual interest rate on all or a portion of the guaranteed premium. Example John made a $100,000 premium payment in an indexed annuity with a guaranteed annual interest rate of 1.5%. With a reduced premium guarantee of 87.5%, $87,500 (not counting any additional indexed interest) would earn interest. ($100,000 x.875 = $87,500) If there is no gain from an index, an indexed annuity with a guarantee rate will receive at least the minimum guaranteed interest rate typically paid at the end of the contract term Interest Crediting Strategies Indexed annuities credit interest based on the greater of market-related returns based on the contract s underlying index. The design provides upside potential, or the policy s minimum guaranteed interest rate, in addition to downside protection.

36 32 4 Hour annuity suitability A market index tracks the performance of a group of stocks that represent a portion of the stock market, or in some situations, the entire market. An example is the S&P 500, an index of 500 stocks generally considered to represent the United States stock market. This is the index used by most index annuities. Aside from the S&P 500, other indexes or benchmarks may be incorporated in indexed annuity design include: The NASDAQ-100 The FTSE 100, and A blended index such as one composed of the Dow Jones Industrial Average (35%), Barclays Capital U.S. Aggregate Bond Index (35%), FTSE 100 Index (20%), and Russell 2000 (10%). The insurance company invests the premium amount over and above what is necessary to fund the contracts guarantees in index options. If the index goes up, then there is the ability to credit a portion of the gain as interest into the contract. If the index goes down, then there is no interest credit to be had from the market and no risk to the policy s cash values. Potential indexed interest is not calculated solely on the owner s choice among the index options, but on the variety of crediting methods. These crediting methods may be changed or adjusted annually, during a specified window of time, and include the following: Point to Point: This is the most intuitive indexing method. It tracks the percentage increase in the index level from the beginning to the end of the contract term. 1. Annual Point to Point: Performance of the index is tracked during the annual contract or policy year. 2. Long Term Point to Point: Performance of the index is tracked during a longer period-of-time, such as during the surrender charge period. Annual Reset: Some contracts use a variation of the point-to-point technique which is annually reset usually on the anniversary date or ratcheted up to reflect the credited return. High Water Mark: This is similar to the annual reset, with the difference being that it locks in the highest point during the year, instead of the contract anniversary date as the annual reset does. Monthly Averaging: This is sometimes used with the three crediting methods (point-to-point, annual reset, or high water mark) to smooth out peaks and valleys in the index; it tends to reduce performance. Combination Methods: Annuity contracts may provide a limited number of crediting methods to track index performance. Modifications of Index Performance Participation Rates A participation rate is the amount of index growth the annuity owner retains, ranging from 20% to 100% on a financial benchmark such as the S&P 500. Participation rates are adjusted at stated intervals, usually annually. Example If the market index goes up 10% and the contract specifies a 70% participation rate, the annuity owner receives a 7% gain (10% x 70% = 7%). Cap Rates The cap rate is the level at which the company limits the client s growth in any given year and usually ranges between 8% - 15% per year. This may be revised by the company at stated intervals, usually annually, or at the end of the contract term.

37 Chapter 3: Annuity Contract Provisions 33 Example If an indexed annuity has a 12% cap rate, and if the index goes up 34%, the contract owner will receive 12% maximum. Based on the previous example, 7% is available for crediting to the contract, but if the cap rate is set at 6%, then that is the maximum for that year. Index annuities came into existence during the nineties, and during this time, annuity owners had participation and cap rates lowered by the life insurance company. This resulted in a lower payout to the consumer. Also, spurred on by the result of years of paying little interest on traditional certificates of deposit, the banking industry has developed an indexed certificate of deposit that incorporates the index-based interest rate. Spreads A spread may not be locked in for the entire term of an annuity. A spread may start at a low rate and, over time, may be increased at the discretion of the insurance company, usually on the anniversary date. The spread may range from 2% to 10%. Some analysts view spreads as a way for insurance companies to increase profits and decrease index benefits to policyowners. Spreads may be changed by the insurance company at certain intervals, usually on an annual basis, or at the end of the contract term. Spreads may be viewed as an annual policy fee without being called a policy fee. Example In the case of an indexed annuity with a spread of 3%, if the index gained 9%, the return credited to the annuity would be 6% (9% - 3% = 6%). The spread can be thought of as a hurdle or minimum that must be exceeded before any interest can be credited to the policy. It may be necessary for the insurer to reduce participation rates to 90%, 80%, or 70% (or even less) under certain conditions as well as lower the overall cap and increase the spread. Equity indexed annuities are usually presented to consumers as being safe or at least safer than variable annuities since principal is guaranteed and only the interest is variable. Guaranteed interest rates will be unaffected by mid-term withdrawals. Depending on how much is withdrawn, the annuity owner may sacrifice some principal if the withdrawal amount exceeds the surrender free amount (or percentage) allowed by the terms of the contract. In no case will the guaranteed interest rate on the fixed portion of the equity indexed annuity be reduced. The insurance company may, at its discretion, pay a higher fixed interest rate, but never less than the guaranteed minimum. Premium Bonus Credits Some insurance companies selling indexed annuities may pay a bonus for premiums placed on deposit with the insurance company. This is an incentive to place larger amounts with the insurance company. The bonus is usually 5% or 10% of premiums paid. Some companies allow additional premiums to be paid within the first year only or only in the first 2-5 years. If bonuses are included in an indexed annuity as an incentive, surrender charges may be higher and for a longer period; this is to offset the cost of providing bonuses to annuity buyers. Commissions to agents for selling index annuities are often higher than for selling the more basic fixed annuities.

38 34 4 Hour annuity suitability Two-Tiered Annuities Some annuities use the original issue date to determine any surrender charges on later deposits and only pay one interest rate on the entire annuity regardless of when deposits were made. Other annuities, especially indexed annuities, create an internal account (or tier ) within the annuity for each subsequent deposit. Each tier would pay the interest rate in effect at deposit and have its own surrender charge based on when the deposit was made. A multi-tier crediting system is a variation of point to point where each deposit into the annuity is a tier, based on the date each deposit was received. When one of these is used to accept monthly deposits, it can be quite complicated. The annual statement could be pages long showing dozens of tiers. Regulatory and License Requirements Indexed annuities are currently regulated as insurance products by each of the states. Agents are required to hold a life insurance license in order to sell them. The Securities and Exchange Commission (SEC), in cooperation with Financial Industry Regulatory Authority (FINRA), proposed a change (in all 50 states) in the classification of indexed annuities from being regulated as insurance product to being regulated as a security. In 2010, this effort was superseded by H.R. 4173, which relegated the responsibility for regulating and overseeing equity indexed annuities as an insurance products to the states. Annuitization Annuitization is the process of converting a lump-sum of money to regular periodic income payments. All annuities have within them the potential to supply an income stream. An example of annuitization is a Single Premium Immediate Annuity (SPIA), which generates regular payments that may be annual, semi-annual, quarterly, or monthly in exchange for a lump-sum single premium. These income payments may be arranged for one lifetime (one person) or for two lifetimes (husband and wife) in the case of a joint and survivor annuity. Deferred annuities may be initially purchased for the accumulation possibilities of tax-deferred growth, but at older ages be used for the guaranteed income payout rates that are built into the contract. At the discretion of the annuity owner/annuitant, he/she may change from accumulation to distributing lifetime income. The income stream is guaranteed by the assets of the issuing life insurance company. Selecting a company with excellent financial ratings is important for peace of mind that the income payments will be made as promised. Three factors govern annuitization income potential: Amount of Money A larger amount of money deposited in an income annuity will result in greater income annuity payments. A smaller amount deposited will result in smaller income payments. Current Interest Rates at Time of Annuitization Interest rates vary on safe money from time to time. The current interest rate environment will affect the applicable interest rates used at the time of annuitization. The current interest rate will be applied to the income annuity on the policy date, and it will not change. The owner and insurance company enter into a binding agreement to pay the stipulated income payments for the life of the annuitant or the period of the contract if it s not a lifetime income annuity. Age and Gender - A Proxy for Life Expectancy The age and gender of the annuitant governs the income payments.

39 Chapter 3: Annuity Contract Provisions 35 Lifetime Payout If an insurance company issues a lifetime income annuity, the age and gender of the annuitant are the determining factor in the annuity mortality calculations. For example, men do not live as long as women (statistically speaking), therefore all else being equal, the payout to a male each month would be larger than for a female. Similarly, the older the annuitant is, the larger the monthly payment as compared to someone who is younger. Older males receive the largest monthly income check, and younger females receive the smallest. It all comes down to mortality expectations. Payout for Fixed Period of Years If the income annuity is a fixed period annuity (example: 10 years, paid monthly) instead of lifetime, the age and gender of the annuitant is not important to the annuitization calculation. Advantages of Annuitization Investing in an annuity is an attractive option for consumers looking for the assurance of a regular, predictable schedule of income, guaranteed by the assets of the issuing insurance company. An immediate or income annuity is essentially an insurance policy against the danger of outliving ones money. If a consumer lives to be 100, he or she will still receive a monthly income payment, because the guarantee is for as long as he or she lives. Annuitization eliminates stock market risk or interest rate risk on the portion of the portfolio that is annuitized. (With fixed annuity payouts, there is inflation risk.) If permitted by the insurance company, consumers may elect to have annual increases in income annuity payments to offset the effects of inflation during retirement years. However, this may require a lower initial monthly payout. Non-qualified annuities may provide partially tax-free income until the entire original basis has been paid (i.e., the gradual return of original principal.) Disadvantages of Annuitization It is a permanent decision: Each dollar annuitized will not be available for heirs or to meet other financial needs. There is a loss of gift or bequest opportunity. Loss of Control of Asset: With most immediate annuities, consumers cannot get money back once the free look time period has expired. Some insurance companies offer flexibility features, such as a liquidity option that will refund some money if certain life situations change. The trade-off is that each additional feature will likely lower the monthly income payment. Consider the annuitization election as irrevocable. Inflation Impact: If the income annuity is not indexed for inflation, a flat income payout will gradually lose buying power if inflation is a significant factor over the next 10, 20, or 30 years. Consumers will need to plan for keeping up with inflation in other investments or assets. Solvency Risk: The annuity income payments received represent a promise by the insurance company to provide income for a lifetime. This guarantee rests on the assumption that the insurance company will maintain itself as a viable business entity in perpetuity. Most insurance companies maintain adequate reserves and remain profitable; their company ratings reflect that fact. Consumers are wise to check company ratings when long term accumulation is the goal. Income Strategies Because there are a variety of settlement options from which to choose, contract owners can be flexible in how income payments will be made, once annuitization takes place. A strong retirement plan will include projected budgets as well as standard of living and legacy goals.

40 36 4 Hour annuity suitability Cover Basic Expenses Instead of annuitizing the full amount all at once, begin by annuitizing a portion of the investment portfolio. Use just enough principal to cover basic monthly expenses such as food, utility bills, insurance premiums, transportation, and a portion of actual or expected medical expenses. Leave the rest of the portfolio invested according to the indicated investment risk profile. Ladder Income Annuities Some use laddering techniques for retirement income such as laddering certificates of deposits (CDs) and/ or bonds to generate regular income and minimize risk. In a similar way, ladder income annuities by purchasing one at a starting point such as age 67, and then purchasing additional income annuities every three years (ages 70, 73, 76, etc.) so that at increasing ages, higher income annuity amounts are paid out. Each new increment moved in the income annuity, reduces stock market risk on that portion of the portfolio. The age of the annuitant is a driving force on the amount of the income payments. If income annuities are laddered, each subsequent annuity will likely pay greater income amounts, assuming the single premium is constant for each new annuity. The Split Annuity A split annuity is not a specific product, but is instead the strategic use of two different annuities. For example, combining a 10 year fixed period annuity with a deferred annuity, creates an immediate 10 year temporary income stream while at the same time growing a separate pool of money for 10 years. This allows the principal amount to be replaced by the time the fixed period annuity is exhausted. Advantages The advantage of the split annuity is income during the 10-year period and the restoration of principal after the 10 years have elapsed can then be annuitized to generate an even higher monthly income based on an older age. The advantage for the agent is writing two cases and generating new first year commissions. Disadvantages The disadvantage of the split annuity for the customer is all about suitability. Are either or both annuities suitable for the client? If it is not suitable for the client, the advantages listed do not matter.

41 Chapter 3: Annuity Contract Provisions 37 Split Annuity Concept Example Age: 67 Sex: Male Facts Income Tax Rate 28% Deferred Interest Rate: 2.6% for 7 Years Immediate Fixed Period Annuity Annual Increase: 5% Type of Funds: Non-Qualified

42 Chapter 3 Review Questions 1. All of the following are typical surrender charge waivers EXCEPT for which ONE? a. College costs b. Confinement in a nursing home for 60 or 90 days or more c. Unemployment d. Disability resulting from injury or disease that lasts more than 90 days 2. How does the annual reset method work in an equity indexed annuity? a. It locks in the highest point at the contract anniversary b. It locks in the highest point during the year c. It smooths out peaks and valleys in the index d. It s the percentage of index growth the annuity owner gets to keep 3. A beneficiary designation would not be necessary for which ONE of the following income settlement options? a. Life with cash refund b. Joint and survivor c. Life with period certain d. Joint and survivor with cash refund 4. What is annuitization? a. Selecting an annuitant at the time of application b. Designating a beneficiary at the time of claim c. Converting a lump-sum of money to regular periodic income payments d. Purchasing a tax qualified annuity for retirement 5. Which ONE of the following best describes a split annuity? a. It is a specific product available from only certain insurance companies. b. It is a concept that uses two different annuities, one to provide immediate income, the other to replace the principal amount. c. It offers the flexibility to have joint ownership. d. It is unique in that it provides for joint annuitants. 6. Which ONE of the following is a disadvantage of choosing a non-qualified fixed single premium immediate annuity? a. It is a permanent decision b. Payment is guaranteed by an insurance company c. Income is paid out for life d. Part of each payment is received income tax free 38

43 Chapter 4 Taxation of Qualified and Non-Qualified Annuities Annuities may also be classified as either qualified or non-qualified. This distinction is critical to understanding how annuities are used in retirement and how they are taxed. Simply stated, a nonqualified annuity is one purchased with money that has already been taxed. A qualified annuity is purchased with money which has not yet been taxed as income. Why is this important? First, we need to delve into qualified retirement plans to set the stage for discussing qualified versus non-qualified annuities. The difference is not in the annuity policy itself, rather it is how the tax laws affect the amount that can be deposited, when and how much must be taken out, taxes and tax penalties. Qualified Plans Employee retirement plans qualify for certain tax advantages by being offered to all eligible employees, not just to a select few. Employers, by starting and funding a qualified retirement plan, receive current tax deductions for contributions made on behalf of the plan participants. Employees typically are not taxed on these qualified plan contributions at the time they are made by the employers. As additional deposits are made from each paycheck, these funds continue to grow and accumulate over time on a tax-deferred basis. Qualified plan account values continue tax-deferred growth while the employee is still working. At retirement, qualified plan distributions become taxable income to the retired workers. Rules for qualified plans are generally found in Section 401 of the Tax Code. While the plan has an administrator, typically the plan assets are held by a trust company or custodian bank. There are seven common types of qualified plans: Profit Sharing Plans (which includes both 401(k) and Roth 401(k) plans) Stock Bonus Plans Money Purchase Pension Plans Employee Stock Ownership Plans (ESOPs) Defined Benefit Plans Target Benefit Plans Plans for Self-Employed Individuals (Keogh Plans) Other Plans: Individual Retirement Accounts (IRAs) Roth IRAs 403(b) and 457 Plans Simplified Employee Pension Plan (SEP-IRAs) SIMPLE IRAs 39

44 40 4 Hour annuity suitability Defined Benefit Plans (Pensions) Defined Benefit Plans, also known as pensions, were an important fringe benefit after World War II when employers were strictly limited by law concerning the pay raises they could provide employees. From participation in private pension plans increased from approximately 19% of the workforce to about 45%. Key Question: What is defined in a defined benefit plan? The benefit is defined; the monthly amount the retiree will receive is calculated by the plan. The pension benefit is determined by a formula and typically paid in the form of a lifetime annuity. This is a use of the classic definition of an annuity, not normally applied to private pensions or a commercially available product. Payment calculations vary. If calculated on a dollar amount per month for each year of service, this is what it would look like: Example If the amount was $50, workers with 20 years of service would receive $1,000 per month at full retirement age. Another option might use a formula, such as a percentage of final salary for each year of service: Example If 1.5% were used, workers with 20 years of service would receive $30% of their final salary (20 years x.015) for as long the retiree lives or If 2% were used, workers with 30 years of service would receive 60% of their final salary for life (30 years x.02) A pension plan rewards employees who work at the same company (or for the same union) for a prolonged period of time such as years, for example. Employees who change jobs frequently are penalized by pensions since most plans have vesting schedules. If an employee does not work at the same employer long enough to be vested in the plan, changing jobs may result in the loss of retirement pension benefits.

45 Chapter 4: Taxation of Qualified and Non-Qualified Annuities 41 Defined Contribution Plans Since the 1960s, the popularity of defined benefit plans has diminished. Although pension plans are still around and new defined benefit plans are being added each year, the rapid growth and wide acceptance of defined contribution plans has outpaced pension plans. The clear trend is that defined contribution plans are currently growing faster than defined benefit plans. The 401(k) is the Most Widely Used Defined Contribution Plan It allows employees to defer a portion of their current income in a pre-tax savings account with the convenience of a payroll deduction. 401(k) plans must follow strict regulation concerning how much the highly compensated employees (usually business owners and key managers) may contribute compared to the non-highly compensated employees (rank and file workers). Employer Matching In some defined contribution plans, management will match employee contributions up to a certain dollar amount or percentage of employee income. This tends to increase rank and file employee participation think free money. This incentive provides an additional benefit for the highly compensated employees (typically the owners, or managers of the business) by allowing a higher level of participation and tax-deferred accumulation in the plan. Portability Portability is another advantage of 401(k) plans. For employees who change jobs, the ability to rollover 401(k) account values into a new employer s plan may offer the possibility of continuous growth. Even if a new employer s plan is not set up to receive money from a previous employer, the employee may rollover his/her 401(k) account to an IRA and continue the tax-deferred accumulation until retirement. Investment Choice Many employees in 401(k) plans enjoy selecting investments. Plans usually have a menu of ten to thirty mutual funds to choose from. Employees may reallocate investments among the various choices via telephone or computer access to their accounts. Employee investment choice has a distinct disadvantage. The employee bears 100% of the risk. During good times in the stock market when growth is positive, employees are usually happy about their selections. During bad years in the stock market when growth is negative and values drop, employees have no company backup and no safety net, other than the more conservative investment choices in the plan such as a money market or stable value account, or perhaps a bond account. After Employment When an employee departs from the employer and continues to leave the funds in the old employer s plan, frequently the management fees which were paid by the former employer become a new expense to the ex-employee s 401(k) investment. A rollover to an IRA or new plan eliminates this expense. Loans Some plans include loans as a part of the 401(k) plan, which may allow employees to borrow up to half of the account value, up to a maximum of $50,000. These loans must be paid back according to a definite schedule; otherwise the loans are considered current income, and are taxable with 10% penalties (if younger than age 59½) added to the current taxes due.

46 42 4 Hour annuity suitability Despite the popularity of 401(k) plans, most employees are currently unaware of a major issue that most plans have. In a majority of cases, existing defined contribution plans do not have a mechanism for taking withdrawals at retirement. Most plans suggest that participants rollover their account balance at retirement to an Individual Retirement Account (IRA). There are no guarantees that either required minimum distributions or systematic withdrawals from mutual funds will provide adequate retirement income for the retiree s life. Legislation Concerning Qualified Plans & Evolution of IRAs Under ERISA and the Retirement Equity Act, pension plans provide for two types of survivor benefits: Post-retirement survivor benefits provide payments to the spouse of a worker who dies after retiring, under what is called a joint-and-survivor annuity. In most current plans, the choices are usually between the 50-percent option (the default choice) and more generous survivor forms, such as twothirds, 75 percent or 100 percent of the retiree s pension. When a joint-and-survivor annuity is in effect, the size of the retiree s pension is almost always lower than it would be for an unmarried or single participant. The joint-and survivor annuity spreads retirement benefits over a longer potential time frame over two life expectancies. The spouse of a newly retired worker must waive the automatic form in writing before the retiree can select another payment form. Pre-retirement survivor benefits provide payments to the spouse of a worker who dies prior to retirement. The Role of Tax-Qualified Annuities Now we turn our attention to tax-qualified annuities, which make up more than half of the annual sales of annuities. Tax qualified annuities are purchased with either pre-tax dollars or are the result of a rollover from a qualified plan, such as a defined benefit pension plan or a defined contribution plan. Deferred annuities and mutual funds may be used as funding vehicles for 401(k), 403(b), 457 deferred compensation plans, SIMPLE IRAs, traditional IRAs, and Roth IRAs. Assets from any of these plans may be transferred to either deferred or immediate annuities and, if a trustee to trustee transfer, is a nontaxable event. Distributions from all tax-qualified retirement accounts, including qualified annuities, are always taxable whenever they occur. If distributions are taken prior to age 59½, a 10% excise tax is due, in addition to ordinary income tax. Nonguaranteed Distribution Options from IRAs Required Minimum Distributions (RMDs) are required from all qualified plan assets when the account holder reaches age 70½. This will force taxable distributions from all plans, especially IRAs, since they are most often used as the distribution channel. For many retirees, however, the minimum distributions may not be adequate to support their lifestyle. If so, RMDs may be combined with income from other nonqualified retirement savings to provide a greater retirement income from both sources. Guaranteed distribution options include income annuities from a defined benefit or a defined contribution plan. Retirees may use the rollover IRA strategy to move tax-qualified funds into a guaranteed lifetime payout annuity purchased from a life insurance company. Taxation of Qualified & Non-Qualified Annuities Tax qualified annuities are generally funded with pre-tax dollars. Non-qualified annuities are generally funded with after-tax dollars. Personally held financial assets include bank accounts, mutual funds, stocks, bonds, real estate, commodities, promissory notes, and insurance company backed cash accumulation vehicles annuities. It s important to group these assets by categories so that tax-qualified accounts and non-qualified accounts are grouped together so that the consumer can better understand how taxes will impact each investment.

47 Chapter 4: Taxation of Qualified and Non-Qualified Annuities 43 The distinction between tax qualified and non-qualified annuities becomes important when lifetime income and death values are considered. Questions may include: How are annuities taxed during lifetime distribution? How are annuities taxed at the death of the annuity owner? Tax-qualified annuities are fully taxable at ordinary income rates when money is withdrawn. Non-qualified annuities have certain tax advantages when money is withdrawn. One of the advantages of non-qualified annuities is the original investment will be returned in equal tax-free installments over the payment period. These payments are not taxed since they are simply a return of principal; while the balance of monies received in annuity payments is the taxable gain or earnings. This is taxed at ordinary income tax rates, not capital gains rates (even if they come from a variable annuity stock separate account). Tax Deferral & Annuities Tax deferred compounding is an important concept that must be discussed for any tax-qualified investment. One positive effect of earning money is more money is available; the down-side about earning more money is that taxes must be paid on the gains. Delaying or deferring the payment of income tax on investment earnings provides an opportunity to earn interest on the interest. Tax-deferral is sometimes called triple compounding and can be very attractive: Interest is earned on the principal. Then, interest is earned on the interest. Finally, interest is earned on the money that would normally have been paid in taxes. In the long term, tax-deferred compounding allows the tax-deferred account or annuity to grow and accumulate faster than it would in an account that is taxed every year. Some annuity advocates contend that tax deferral is the primary advantage of annuities. It s important to remember that tax deferred is not the same as tax-free; eventually the taxes will have to be paid, but this is delayed until money is withdrawn from a tax-qualified account or a non-qualified annuity. All deferred annuities, whether they are tax qualified or nonqualified, enjoy tax deferral. Individual investors are allowed to defer taxes on qualified accounts while working, and then pay taxes when the money is withdrawn during retirement. Example Alex is 64 and in a 25% tax bracket. He has $100,000 in his 401(k), and takes a lump-sum withdrawal. Alex has a net after-tax of $75,000 ($100,000 - $25,000). If it were tax-free, he would have $100,000. Note: If ordinary tax rates increase in the future, these individuals may pay higher tax rates in retirement than during working years, although it is widely held that by the time of retirement, individuals or couples settle back into lower tax brackets, as they live off retirement investments with fewer expenses than earlier in their lives. Non-qualified annuities have an established cost basis (usually the premiums paid, less any withdrawals) and will produce some tax-free income as the cost basis is distributed on a pro rata basis along with the investment gains. Once the basis has been fully paid out (and this may take years), all subsequent payments are the investment gains from the annuity and are fully taxable. Some argue that mutual funds which hold tax-qualified accounts provide tax deferral at less cost than expense-laden variable deferred annuities with fees and charges built in. Variable annuities, however, have other important features and benefits other than tax deferral that may make variable annuities a compelling choice for some consumers. These other risk management and insurance benefits of variable annuities may include:

48 44 4 Hour annuity suitability Guaranteed lifetime income payments Family protection through the standard death benefit or the optional enhanced death benefit Living benefit provisions that may protect principal or provide a minimum guaranteed income Certain internal separate account management features such as dollar cost averaging or automatic asset rebalancing Indexed annuities may also provide some protection against down-side market risk that mutual funds do not offer. There are important calculation differences in taxable accounts, tax-free accounts, and tax-deferred accounts. Exception to Tax Deferral: Annuities Held by Corporations or Non-Natural Persons If a deferred annuity is not owned by a natural person (human being), but is owned instead by a corporation, association, or other non-natural person, the contract is not treated for tax purposes as an annuity contract and the income on the contract (annual interest or investment gain) is taxable each year as ordinary income. There are five situations where this exception does not apply. Any annuity contract that is: 1. Acquired by the estate of a decedent upon death of the decedent. 2. Held under a qualified pension, profit sharing, or stock bonus plan as 403(b) tax sheltered annuity, or under an individual retirement plan. 3. Purchased by an employer on termination of a qualified pension, profit sharing plan, or stock bonus plan or tax shelter annuity plan and held by the employer until all contract amounts are distributed to the employee or to his beneficiary. 4 An immediate annuity where payments start no later than one year from the date of purchase, and income payments scheduled to be annually or more frequently, which provides for a schedule of substantially equal periodic payments. 5. A qualified funding asset that is an annuity contract purchased from an insurance company for funding periodic payments for damages due to personal injury or sickness. An annuity contract held by a trust or other entity, as agent for a natural person, is considered held by a natural person. In this case, tax deferral applies. Payment of Premiums A key distinction of the non-qualified annuity is that it is purchased using after-tax dollars. The premium paid for the non-qualified annuity, along with any subsequent premiums, establishes the cost basis for the nonqualified annuity. In simple terms, the cost basis equals the total amount paid for an item such as a building, a home, a computer for use in business, or a financial product such as a deferred annuity. Basis is the starting point for establishing gain or loss. Cash Value Accrual The owners of non-qualified deferred annuities enjoy increasing account values each year without having to pay current taxes on the account growth. Cash accumulation value is determined without considering surrender charges and taxes are deferred until a future time when money is withdrawn from the annuity (when the account is annuitized). By comparison, non-qualified mutual funds are subject to income taxes and capital gains annually. A client may hold the same mutual fund for decades, but the portfolio manager will be buying and selling investments within the fund generating capital gains, receiving dividends from stocks, and perhaps interest from bonds. A 1099-DIV is mailed to mutual fund shareholders who receive a dividend or capital gain distribution during a given tax year.

49 Chapter 4: Taxation of Qualified and Non-Qualified Annuities 45 Taxation Rules for Non-Qualified Annuities Non-qualified annuity contracts are taxed under favorable rules according to Section 72 of the Internal Revenue Code. Amounts Received as an Annuity Amounts received as an annuity refers to a stream of regular, periodic payments (e.g., monthly, quarterly, semi-annually, or at least annually) and each payment is a combination of part return of principal and part earned interest or gain. A portion of the income payment is tax-free because it is a return of the original investment (cost basis in the contract). Once the investment in the contract has been fully recovered, all remaining annuity payments are fully taxable as ordinary income. Amounts received as an annuity are paid from deferred or immediate annuities that have been pensionized or annuitized. These annuity payments provide a certain amount each month for a fixed period, or for the life of the annuitant. Lifetime annuity payments represent protection against living too long and outliving one s retirement nest-egg. Most retirees are familiar with regular monthly income annuity payments from Social Security. Some retirees also receive a monthly pension check during retirement; these are annuity payments. Amounts Not Received as an Annuity Partial Withdrawals Partial withdrawals or amounts not received as an annuity, refer to a-once-in-awhile partial withdrawal that may include dividends, loans, withdrawals, and surrenders. Example If a non-qualified deferred annuity has a current value of $125,000, the contract owner may request a $12,000 partial withdrawal for any purpose. In this example, a partial withdrawal is not considered an annuity payment because it is not a regular, periodic payment consisting of principal and interest. Assuming that $100,000 was the original investment in the contract, then the $12,000 withdrawal would be taxable. If partial withdrawals continue at various and repeated intervals, eventually the cash value of a deferred annuity will be reduced substantially making it improbable for the owner to be able to live on reduced lifetime payments, if annuitized. Amounts Received as Interest Amounts received as interest means withdrawing the interest that has accumulated in a deferred annuity: for example, the principal remains invested with the life insurance company, but the interest is removed from the account. Taxation Rules Based on Date Premiums Paid into a Non-Qualified Annuity From time to time, Congress changes tax policy for various reasons. One of those tax law changes affected non-qualified annuities. Contributions to annuities before August 14, 1982, are taxed so that withdrawals come from principal first (tax-free), then interest gain (taxable) thereafter. This is known as first in, first out or FIFO. Contributions to annuities after August 14, 1982, are taxed interest first. If the annuity cash value exceeds the amount invested in the contract, any distributions from that annuity are taxed as ordinary income to the policyowner, because the investment or interest gain comes out of any distribution first. This is known as last in, first out or LIFO. The gain is taxable when withdrawn. Any taxable annuity withdrawals before age 59 ½ are also subject to the 10% federal income tax penalty, unless an exception applies.

50 46 4 Hour annuity suitability Note: If the annuity contract is paid out in regular periodic payments, then the basis is recovered pro rata over the life expectancy of the annuitant. Tax Treatment of Annuities Tax Qualified Individual Retirement Accounts (IRAs) 401(k), 403(b), Retirement Plan Group Annuities Non-Qualified All Other Annuities Taxation During Lifetime IRC Section 72 Taxation During Lifetime Periodic Income Payments or Partial Distributions are Always Received as Taxable Ordinary Income (since contributions were made pre-tax) Amounts Received as an Annuity *Annuity periodic payments from the systematic liquidation of a capital sum for life or lives (if joint and survivor), or it may be payments for a fixed period or fixed amount, but not for life. Fixed Annuity & Exclusion Ratio Amounts NOT Received as an Annuity From Contracts Dated & Investments Made Before August 13, 1982 Partial distribution are taxed FIFO (First In, First Out under the cost of recovery rule ) until the original investment has been recovered. Original investment comes out first and is not taxed. From Contracts Dated After August 13, 1982 Variable Annuity & Different Ratio Partial distributions are taxed LIFO (Last In, First Out) until all gain has been received. Gain comes out first and is taxed. *Annuity withdrawals prior to age 59½ will be subject to a 10% federal income tax penalty, unless an exception applies. The Exclusion Ratio The Exclusion Ratio, sometimes called the Exclusion Allowance calculation, is a formula used to determine the percentage of annuity payment that is non-taxable as a return of the original cost basis. This calculation is different for fixed deferred annuities and variable deferred annuities. If the entire value of an annuity contract is used to create a stream of periodic payments, each of those payments will be partly included as taxable income and partly excluded from taxable income as a return of principal. Fixed Annuity Payments For fixed annuities, the excluded amount is determined by multiplying the payment by a fraction (the exclusion ratio) calculated by dividing the investment in the contract by the expected return under the annuity contract. The expected return is determined by IRS tables of life expectancies and interest rates, with an adjustment for any refund feature.

51 Chapter 4: Taxation of Qualified and Non-Qualified Annuities 47 Investment in the Contract Expected Return = Exclusion Ratio Example $50,000 $200,000 = 25% 25% of each income payment is not taxed since it is accounted for as a return of premium. After all of the cost is recovered then any and all remaining payments are considered income, and taxed accordingly. Variable Annuity Payments Variable annuities are not as predictable as fixed annuities. The investments in variable annuities are in the stock and bond market, through separate accounts. The separate account investment returns are highly volatile and unpredictable as evidenced by previous track records of gains and losses. Therefore, the exclusion ratio calculation is different for variable annuities. The excluded amount is determined by dividing the investment in the contract by the expected number of payments; the denominator is the life expectancy in years from the IRS annuity tables. Example Investment in the Contract Expected Return = Exclusion Amount Mary is 70 years old. She has paid a total of $100,000 in premiums into a variable annuity. Investment in the Contract = $100,000 Life Expectancy = 16 years $100, years = $6,250 Exclusion Amount/Allowance If Mary s monthly annuity payment is $615, her annual annuity payment is $615 x 12 months = $7,380 This means that out of the $7,380 monthly payment, $6,250 is excluded from income, and $1,130 is taxable. Taxation of Non-Qualified Annuities upon the Death of the Owner Annuities in Payout Status If an owner of a non-qualified annuity dies on or after the date that an immediate or deferred annuity has been annuitized, but before the entire interest in the contract has been distributed, the remaining portion must be distributed to the beneficiary at least as quickly as the distribution method that was in effect at the time of the owner s death. If the beneficiary continues to receive payments under the same payout option that was originally in place, the original exclusion ratio will continue to apply. Annuities Not in Payout Status Deferred Annuities All deferred annuities issued after January 18, 1985, are owner-driven. Section 72(s) of the Internal Revenue Code controls distributions from annuity contracts on the death of the contract holder not necessarily the owner. The general rule for annuities not in payout status is that upon the death of the contract holder, the annuity cash value must be paid out within five years of the holder s death. The beneficiary in this situation has three choices upon the owner s death: 1. Take the amount due under the contract and pay the taxes at that time. 2. Make partial withdrawals over the next 5 years, pay taxes on each withdrawal with any contract balance continuing to grow tax deferred.

52 48 4 Hour annuity suitability 3. Within 1 year, annuitize the contract using the life of the new owner. Note: If the deceased s spouse is the sole surviving owner or beneficiary, they can also decide to continue the contract. Spousal Continuation: If the surviving spouse is the designated beneficiary, he/she may treat the decedent s annuity as his/her own as if he/she were the owner of the annuity contract from the beginning. However, spousal continuation is not available: To a surviving spouse who is trustee of a trust named beneficiary of the decedent spouse s annuity. To a beneficiary who owned an annuitant-driven annuity of which the spouse was the annuitant. Taxation of Non-Qualified Annuities upon the Death of the Annuitant An annuity is annuitant-driven when the payment of the death benefit to the beneficiary is made upon the death of the annuitant. The beneficiary generally has a 60 day window to make a decision and if the beneficiary does not elect within that window of time to take proceeds as an annuity (if the contract allows this option), the proceeds will be considered amounts not received as an annuity for taxation purposes. Proceeds above the original investment in the contract (the gain in the annuity) are taxable to the beneficiary in the year of the annuitant s death. However, if the beneficiary is the surviving spouse of the annuitant, the spousal continuation option is not available. Spousal continuation is only available when the beneficiary is the surviving spouse of a deceased holder (owner). Other Taxation Topics Concerning Non-Qualified Annuities Loans & Assignments Policy loans are usually not allowed from non-qualified annuities. Certain tax-qualified accounts such as 403(b) accounts may allow loans from annuities if annuities are a funding vehicle. Usually the maximum loan allowed is one-half of the account value, up to a $50,000 maximum. The loans must be repaid in regular intervals with payments of principal and interest over a five year period. Any assignment or pledge of any portion of an annuity contract s cash value is treated as a withdrawal from the contract. The tax treatment in this case is the same as it is for partial withdrawals from annuities Exchange of Non-Qualified Annuities & Transfers of Qualified Annuities Tax-free exchanges of non-qualified annuities and tax-free transfers of qualified annuities may occur if the required paperwork is submitted to the insurance company. Agents must disclose a replacement transaction and follow all state and insurance company procedures for replacements. Insurance companies must notify the old insurance company promptly to allow them the opportunity to preserve the business, contact the annuity owner, and review the advantages and disadvantages of the proposed replacement. The following transactions are considered 1035 tax-free exchanges: A life insurance or endowment policy to another life insurance or endowment policy An annuity to another annuity A life insurance or endowment policy to an annuity

53 Chapter 4: Taxation of Qualified and Non-Qualified Annuities 49 There are several requirements for valid 1035 exchanges: Must have the same contract owner or owners on each side of the exchange Must never exchange tax-qualified annuities for non-qualified annuities Must keep qualified and non-qualified amounts separated May transfer a tax-qualified annuity for another tax-qualified annuity Never exchange an annuity to life insurance Gifting a Non-Qualified Annuity If an annuity owner gives an annuity as a gift, the owner may have to pay income and gift tax at the time of transfer. The contract owner must include as income the difference between the cash surrender value of the contract and the owner s investment in the contract at the time of the transfer. This does not apply to gifts or transfers between spouses or former spouses due to a divorce. The IRS requires transfers between former spouses to be made pursuant to a Qualified Domestic Relations Order (QDRO). Selling a Non-Qualified Annuity The gain in the contract is taxed to the seller as ordinary income, not as capital gain. Gain is determined by subtracting net premium cost from the sales price. When an annuity is sold after maturity, the cost basis of the contract must be reduced by the aggregate excludable portions of the annuity payments that have been received. The adjusted cost basis cannot be less than zero. The taxable gain cannot be greater than the sale price. Estate Taxation of a Non-Qualified Annuity In general, a decedent s gross estate includes, among other assets, the value of annuities receivable by any beneficiary. (IRC 2039)

54 50 4 Hour annuity suitability Taxation of Qualified Assets during the Lifetime of the Owner Qualified annuities are taxed in the same way individual retirement accounts and qualified plans are taxed, at ordinary income tax rates. Capital gains tax rates do not apply. These accounts are tax deferred, not tax free; eventually the taxes will be paid. Since contributions to the retirement plan, IRA (including rollover IRAs), or tax-deferred annuity were originally made with pre-tax dollars, the basis is usually $0.00, meaning no basis exists. Consequently, all distributions are taxable whenever they occur and no matter who receives them (i.e., original account owner or a beneficiary after death of the account owner). Exception If non-deductible contributions were made to an IRA, Roth IRA, or Roth 401(k), these accounts generally have a basis that is non-taxable. They are established with after-tax contributions, not tax deductible deposits. They grow tax deferred and the eventual distributions will be tax-free under certain conditions. Distributions Taxable in the Year Received Distributions from tax-qualified annuities, IRAs or other qualified plans, prior to age 59½ are subject to a 10% penalty in addition to ordinary income tax. This tends to discourage the use of tax-qualified annuities and qualified plans as a short-term savings strategy. Distributions from age 59½ to age 70½ are subject to current taxation without the 10% penalty. Required Minimum Distributions (RMD) When the owner of a tax-qualified annuity, an IRA, or a qualified retirement plan such as a 401(k) reaches age 70 ½, he or she must begin to take required minimum distributions each year. RMD payments to the retiree are a percentage of the plan s account value as of December 31 of the previous year. The IRS uses factors based on life expectancy to calculate this percentage. The percentage increases annually as life expectancy decreases. Eventually distributions begin to invade principal, and not merely interest income or growth on the account, and the account balance will be depleted. RMDs stop when the account balance reaches $0.00. If the retiree has multiple IRAs with various mutual fund companies, insurance companies, or banks, the RMD is calculated on the aggregate account values of all accounts on December 31 of the previous tax year. A single distribution from one account or a combination of accounts may be used to satisfy the requirement. Penalty If RMDs are not taken, the penalty is 50% of the amount which should have been distributed under IRS regulations. Example Edna was required to withdraw a minimum $20,000 from her IRA this year based on her account value as of 12/31 of the previous year and her age. Unfortunately she only withdrew $15,000 by the end of this year. She withdrew $5,000 less than what was required ($20,000 - $15,000), therefore, she incurred a penalty of $2,500 ($5,000 x 50%). If the underlying investment does not equal or exceed the required rate of return, the account principal will begin to drop and the more rapidly the account value is reduced, the sooner the retiree runs out of money from this or all tax-qualified assets.

55 Chapter 4: Taxation of Qualified and Non-Qualified Annuities 51 Example Think of the problem for retirees as a result of poor market performance in An individual who retired at the end of 2007 and planned to take required minimum distributions from his/her IRAs beginning in A 30-40% drop in retirement assets during 2008, along with making withdrawals from tax-qualified accounts, resulted in a huge drop in account values: January 1, 2008 account value: $1,000,000 Planned RMDs first year of retirement: 4% (approximate first year RMD) or $40,000 Market Performance: -35% (or a loss of $350,000) December 31, 2008 year-end IRA value: $610,000 At age 70+, the retiree may have a difficult time coping with this size of loss so early in retirement. What should the individual do? Go back to work? Grin and bear it? Downsize even more? Key Annuity Advantage Converting a deferred annuity to a guaranteed lifetime payout annuity will continue the annuity payments for a lifetime (single life or join and survivor annuity). This is a unique advantage of receiving retirement annuity income payments and is the answer to the longevity risk and the fear that retirees may run out of money. Conversely, making systematic withdrawals, or taking annual required minimum distributions from an IRA will deplete the account value over time. This is especially true if the account is invested in riskier stock market accounts or when the stock market does not grow at a rate to replenish the prior year-end IRA balance. Even partial withdrawals from an unconverted deferred annuity will eventually reduce the account value. If partial withdrawals continue, the deferred annuity will eventually be depleted just like the IRA account. In fact, annuitizing a tax-qualified annuity may not only satisfy the required minimum distribution amount for that retirement asset, in many cases it will actually provide greater retirement income for life, even after paying the taxes, than a traditional IRA with RMDs. Net after taxes, the income from the annuity is usually greater. Taxation of Qualified Assets at Death of Owner (Spousal Continuation) Before the Required Beginning Date (RBD) The Required Beginning Date (RBD) for most tax qualified accounts is the year when the account owner turns age 70½. In community property states, the spouse is usually the designated beneficiary of any qualified plan, annuity, or IRA. If the account owner dies before the RBD, the spouse may inherit the account and re-title it in the spouse s name. This allows the surviving spouse to continue the tax deferred accumulation in the account. After the Required Beginning Date In this case the account owner has already begun taking RMDs and the surviving spouse must continue taking distributions every year generally based on his or her life expectancy. Non-Spouse Beneficiary A non-spouse beneficiary may transfer assets into an IRA in the name of the original owner for the benefit of the non-spouse beneficiary and will continue taking distributions, but over his or her life expectancy.

56 52 4 Hour annuity suitability Income in Respect of a Decedent (IRD) Income in Respect of a Decedent or (IRD) is income that would have been received by the person who died if he or she had lived long enough to receive it. Unfortunately, if death occurs and this money is received by a beneficiary instead of the decedent, the monies are included in the gross income of the person who receives the income at the time of the actual receipt. It may be helpful to think of IRD as the final income tax on income due the decedent, but actually paid to someone else. Taxes must be paid. Distributions from an IRA or a Qualified Retirement Plan Required distributions are the same, except that a surviving spouse beneficiary has the option of taking over the IRA as his/her own, with the distribution requirements being applied to the beneficiary as the new owner. Upon the death of a qualified plan participant, the participant s plan balance is normally paid to a beneficiary. This final distribution, regardless of how it is taken, is generally subject to income tax. If the only designated beneficiary is the participant s spouse, and the participant died prior to his/ her required beginning date, distributions to the surviving spouse may be postponed until the close of the calendar year in which the participant would have attained age 70½. Stretch IRAs and the Importance of Beneficiary Designation One of the most important aspects for life insurance and annuity (both non-qualified and tax-qualified annuity) contracts is the ability of the contract owner to name a beneficiary, or change the beneficiary if needed. The beneficiary designation determines who receives the proceeds of the life insurance or annuity. Likewise, for any retirement plan asset such as IRA, 401(k), 403(b), a 457 deferred compensation plan, defined benefit pension plan, or Keogh plan, the beneficiary designation is absolutely critical in controlling and finally determining who receives the tax-qualified assets at the death of the account owner. This is especially important because these accounts are typically started when an employee is originally hired, and unless they are updated periodically, there could be many life-event changes over a working career. A named beneficiary (not a trust or estate) generally has the right to inherit retirement plan assets and take distributions over his or her life expectancy, which is sometimes known as a Stretch IRA. A Stretch IRA allows the tax deferral to continue for more years, stretching the tax-qualified account over a longer period, resulting in greater income from the account. If there are several beneficiaries to a tax-qualified account, each beneficiary (independent of the others) may decide to take the inherited amount all at once (and pay the tax) or to stretch it over his or her life expectancy. If a trust is named the beneficiary of a retirement account, the trust beneficiaries do not have the ability to stretch the IRA over their life expectancies. There may be reasons to name a trust as a contingent beneficiary of a retirement account, but generally named beneficiaries should be primary.

57 Chapter 4: Taxation of Qualified and Non-Qualified Annuities 53 Advantages of Qualified and Non-Qualified Annuities Retirement Tax Advantages of Non-Qualified & Qualified Annuities Source of Funds Non-Qualified Annuity After Tax Money Qualified Annuity Pre-Tax Money or Rollover Money from Tax Qualified Plans (Any Type) Tax Basis Yes No Taxable When Income Received Required Minimum Distribution at Age 70½ and Older Penalties if Withdrawn Before Age 59½ Tax Deferral Partial Withdrawals Lifetime Income Possible Inflation Protection Possible Subject to Probate Court Any gain in account value over the original principal is taxed at ordinary income rates No Yes Yes Yes Yes Yes If the contract allows it Always Taxable Yes Always No Beneficiary Designation Controls if properly named Deficit Reduction Act As a result of the Deficit Reduction Act, starting in 2010, distributions made from non-qualified annuities only may be used to pay premiums for Long Term Care Insurance or expenses incurred with nursing home care. This is a form of 1035 exchange, where the cash value of the annuity pays premiums on a tax-qualified Long Term Care Insurance policy. The huge potential tax break is that part of the annuity cash value is gain that otherwise would be income taxable. Here is a way it can be withdrawn and spent without being a taxable event. Summary There is more to know about annuities than that they allow for tax-deferred accumulation or which separate accounts to choose. Depending upon whether they reside inside a qualified plan or not, knowing what type of an annuity it is, who the owner, annuitant, and beneficiary are, as well as which tax rules apply upon distribution or death play a critical role in helping consumers achieve their financial goals and objectives.

58 Chapter 4 Review Questions 1. Required Minimum Distributions (RMDs) are required from all qualified plan assets when the account holder is. a. 59 ½ b. 62 c. 65 d. 70 ½ 2. If distributions are taken from a tax-qualified plan prior to age, an excise tax is due. a. 59 ½ b. 62 c. 65 d. 70 ½ 3. In general, how are distributions from a tax-qualified retirement account treated for tax purposes? a. Tax-free b. Capital gain c. Ordinary income d. Partially taxable and partially tax-free 4. In general, how are non-qualified variable annuities taxed during lifetime distribution? a. Fully taxable at ordinary income rates b. Part of each payment is the tax free recovery of premiums paid with the balance taxed as ordinary income c. Tax free d. Fully taxable at capital gain rates 5. Tax annuities are generally funded with pre-tax dollars. a. Preference b. Deferred c. Qualified d. Free 6. The general rule for owner-driven, non-qualified annuities not in payout status is that on the death of the contract holder, the annuity cash value must be paid out within how many years of the holder s death? a. 1 b. 2 c. 3 d. 5 54

59 Chapter 5 Suitability, Replacement, and Compliance Due to litigation and government regulations, annuity suitability remains a current topic in the insurance industry. Carriers are paying closer attention to how producers are supervised and to the standards used to evaluate producer performance. Insurers are not only governed by each state s department of insurance, but companies that develop and market investment products are also regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) whose mission is to protect investors by making sure the securities industry operates fairly and honestly. In addition to the federal oversight of securities based products, the National Association of Insurance Commissioners (NAIC), a membership-based organization of the country s chief insurance regulatory officials has a mission to assist state insurance regulators, individually and collectively, in achieving the following regulatory goals: Protect the public interest Promote competitive markets Facilitate the fair and equitable treatment of insurance consumers Promote the reliability, solvency and financial solidity of insurance entities Support and improve state regulation of insurance The NAIC, working together with state insurance commissioners, developed a set of guidelines designed to assist states better address the issue of product suitability, specifically annuities. NAIC Suitability in Annuity Transactions Model Regulation The Model Regulation provides a set standards and procedures for suitable annuity recommendations and requires insurers to establish a system of supervision to review and approve producer recommendations. Many states have passed insurance legislation based on the NAIC Model, either in part or as written, to address the suitability concerns of the general market as a whole and the senior market in particular. The goals of the Model Regulation are simple; the NAIC Annuity Suitability Recommendations: Establish a regulatory framework that holds insurers responsible for ensuring that annuity transactions are suitable in the marketing and sale of annuities Require that producers be trained on the provisions of annuities in general, and the specific products they are selling Where feasible and rational, to make these suitability standards consistent with the suitability standards imposed by the Financial Industry Regulatory Authority (FINRA) 55

60 56 4 Hour annuity suitability Required System of Insurer Supervision First, the insurer is tasked with establishing a system of supervision to oversee the sale of every annuity product, recommended either by the carrier directly or by appointed producers. Each state s Insurance Department holds the insurer as the ultimate responsible party in the transaction of an annuity sale. Specifically, the insurer must make sure that before any annuity contract is issued: Recommendations must be reviewed to ensure there is a reasonable basis to believe that the transaction being recommended is suitable, including the collection of specific consumer information. The insurer must review all of the information the producer used to establish the reasonable basis for the recommendation. The insurer may require additional information if necessary to confirm the reasonable basis of a recommendation. Producer Training Requirements Once the supervision system has been outlined, producer training initiatives must be developed, monitored and evaluated to make sure every appointed producer is trained on the features, benefits and limitations of the product he or she markets for the carrier. Product specific training includes compliance with the insurer s standards for product training, prior to soliciting an annuity product. The Model Regulation also recommends a one time, minimum four credit hour general annuity training course offered by an approved education provider. (This training cannot include sales or marketing techniques or product specific information.) Regardless of the course delivery method, insurers must verify that mandated training has been completed prior to allowing a producer to sell its annuity products. Note: The NAIC Model Recommendations for producer training were not adopted in every state as written. It is important for every agent to know the resident requirements of their home state as well as the non-resident training requirements for other states in which business is conducted. Suitability as Defined by the Model Regulation Purchasing or exchanging an annuity product can have serious financial repercussions if the sale is unsuitable for the customer s needs. Perhaps the most important outcome of producer training is the ability to determine suitability through the collection of specific customer information. The Model Regulation defines and outlines the information needed in order to match a consumer s needs and current financial situation to the insurance product being recommended. The regulation is a starting point, outlining the minimum considerations of importance to carriers and consumers. Definitions Recommendation means advice provided by an insurance producer, or an insurer where no producer is involved, to an individual consumer that results in a purchase, exchange or replacement of an annuity in accordance with that advice. Suitability information means information that is reasonably appropriate to determine the suitability of a recommendation, including the following: Age Annual income Financial situation and needs, including the financial resources used for the funding of the annuity Financial experience Financial objectives Intended use of the annuity

61 Chapter 5: Suitability, Replacement, and Compliance 57 Financial time horizon Existing assets, including investment and life insurance holdings Liquidity needs Liquid net worth Risk tolerance Tax status Practical Suitability Determination Beyond mandated training requirements, insurers with decades of customer experience can offer more advanced training, further refining and isolating the specific needs and concerns of each potential client. Carrier best practices include tried and true guidelines to help producers navigate the sales recommendation process. These guidelines provide a toolkit of questions to help each potential consumer balance goals and reality, putting to paper the practical, and developing a strategy to execute a retirement plan. Every annuity transaction: a sale, exchange or replacement, must be measured against a suitability standard. If the answer to any of these questions is, Yes, the producer and insurer will have to follow regulation guidelines in order to prove suitability, should the transaction be called into question at a later date. Does this transaction Place the majority of a client s liquid assets into an annuity, especially where withdrawals are limited? Create a surrender penalty period longer than the client s life expectancy? Highlight contract benefits while omitting or minimizing negative aspects such as surrender charges, fees, annuitization requirements, forfeiture of interest, etc.? Match product features and benefits to the client s stated needs and goals? Require the policyholder to fulfill complicated contract requirements to obtain interest credited to the annuity or retain premium bonuses, especially with dual-tiered interest crediting methods? Cause the loss of valuable contract guarantees like nursing home and death benefits when one annuity is replaced with another? Offer bonuses that require the contract owner to meet complicated contract provisions to retain the bonus, especially with dual-tiered interest crediting methods Senior Suitability Information When the consumer is a senior, other factors must be recognized and carefully considered to determine product suitability. The senior market is composed of people ages 65 and older with financial and healthcare needs that are very different from those of the younger population. In most cases, a healthy, newly retired person is likely to be self-sufficient and able to manage retirement assets. On the other hand, someone over 80 is statistically more likely to have lost a spouse or developed physical limitations related to vision and hearing. Financial tasks like paying bills on time, balancing bank accounts, and effectively managing stocks, bonds, and mutual funds may be much more challenging for older consumers.

62 58 4 Hour annuity suitability Senior Risk Tolerance While the risk tolerance of any customer is important to measure, it is especially true in the senior market. Every area of risk: investment, inflation, and longevity must be closely evaluated with a senior consumer. Often the best way to understand suitability comes from asking questions. Will the senior s retirement portfolio decline in value? Losses at the beginning of retirement may be especially difficult to handle if the devaluation is not rectified quickly enough. Will price increases in the future significantly affect the purchasing power of the senior dollar? Did the retiree plan a retirement budget? Will savings and investments last? Underestimating longevity could easily end up causing the retiree to outlive retirement savings. What if long-term care is needed? Is there insurance to cover expenses or will retirement savings be drained? Senior Financial Concerns A number of concerns are common to older people. Fear, uncertainty, doubt about the future, and the importance of making prudent financial decisions must be addressed. Producers who work in the senior market MUST be aware of the questions seniors ask themselves. Answering these concerns in advance of a recommendation is the key to suitability. Social Security Should I take retirement benefits at the earliest possible age (62)? Should I wait until full retirement age (66-67) or delay it until age 70 before taking monthly retirement benefits? How do these answers affect my spouse if I am married? Will benefits be available to me whenever I retire? Will benefits be reduced when it s my turn to begin to receive them? Will my Social Security retirement benefits be enough for me to live on? Retirement Plan Distributions Defined Benefit Plans If I am eligible for a defined benefit pension... Has my benefit been fully funded and as promised? Will some unknown future event reduce the promised retirement pension payout? Does my pension benefit have a Cost Of Living Adjustment (COLA)? Will future inflation erode my buying power over the next 25 or 30 years of my retirement? How secure are pension plans that are covered by the Pension Benefit Guarantee Corporation? Defined Contribution Plans If I am eligible for a defined contribution plan (such as 401(k) or 403(b))... Will it contain enough funds for me to live on? Will I run out of money during my retirement years? Will I outlive my resources? Will I be in a lower tax bracket when I retire?

63 Chapter 5: Suitability, Replacement, and Compliance 59 Did I defer taxes at a lower tax rate when I was working, only to pay a higher tax rate when I retire? Should I consider a Roth IRA for some or all of my pre-tax retirement savings plans? Investing Retirement Plan Distributions Should I take a lump-sum benefit and manage it myself? Should I roll it over to a portfolio manager? Should I roll it over to a guaranteed account at my local bank? Which would be better for me and my retirement money? o A fixed annuity? o A variable annuity? o An indexed annuity? Is this the time to invest my retirement money in the stock market? Am I comfortable with market volatility and risk? Should I delay taking any withdrawals from my traditional IRAs or wait until Required Minimum Distributions at age 70½? Will RMDs provide the kind of regular retirement income I will require? Is there a better way to take retirement money from my plan? Surrender Charges Does my qualified plan have surrender charges if I need the money soon? How will I be affected by surrender charges, taxes, and penalties if I am forced to retire before age 59½? Health Insurance The cost of health insurance is rising. How will this cost impact my retirement savings? What will happen to government programs such as Medicare or Medicaid in the future? How will Medicare and Medicaid affect me? Can I trust the government to provide my medical insurance? Will government changes in healthcare affect me personally? o Can I keep my doctor? o Will I have to wait for treatment? o Will my choices for treatment be limited? Should I consider a supplemental medical plan to cover the gaps provided by Medicare coverage? Long Term Care How well will I age? Will I be able to remain in my current living situation? Can I afford to get sick? Will I require substantial assistance with the Activities of Daily Living (ADLs)? How long will my vision and my reflexes allow me to drive my car? Should I consider some form of assisted living eventually? What if I need a nursing home because of physical or mental limitations?

64 60 4 Hour annuity suitability Should I consider a reverse mortgage to take equity from my home to provide for my long term care? What will my eventual costs be for my long term care if an institution is the best place for receiving that kind of care? Should I purchase a long term care insurance policy? Would purchasing long term care insurance make the best financial sense for me and my family? Estate Planning What size estate do I have and what will it be in the future? If I have substantial assets, do I care that estate taxes may drain a significant portion of assets? Should I consider estate legacy planning and tax planning? What charitable interests do I have (i.e., colleges, causes, and non-profit organizations I have been active in and that I care about)? Now that I am older, should I consider buying life insurance to replace highly appreciated assets that I donate to charity? Can I qualify medically for life insurance, given my health history? Drafting legal documents and purchasing life insurance may be a drain on my retirement assets. How much should I spend on these pursuits? What will the estate and gift taxes be in the future, and will they apply to me? If the transaction is not suitable, it should not be recommended. If suitability is questionable, additional information must be collected by the producer and taken into consideration by both the producer and the insurer before a policy is issued or replaced. Replacement, Disclosures and Recordkeeping Requirements Every state establishes its own rules and regulations to govern disclosures, recordkeeping and policy replacement requirements. Most states follow the guidelines of the NAIC Model Recommendations pretty closely. Replacement A transaction in which a new policy or contract is to be purchased, and it is known (or should be known) to the proposing producer or insurer, that by reason of the transaction, an existing policy or contract has been or is to be: Lapsed, forfeited, surrendered or partially surrendered, assigned to the replacing insurer or otherwise terminated Converted to reduced paid-up insurance, continued as extended term insurance, or otherwise reduced in value by the use of nonforfeiture benefits or other policy values Amended so as to effect either a reduction in benefits or in the term for which coverage would otherwise remain in force or for which benefits would be paid Reissued with any reduction in cash value Used in a financed purchase Note: The definition of replacement is derived from the NAIC Life Insurance and Annuities Replacement Model Regulation. If a State has a different definition for replacement, the State should either insert the text of that definition in place of the definition shown or modify the definition to provide a cross-reference to the definition of replacement that is in State law or regulation.

65 Chapter 5: Suitability, Replacement, and Compliance 61 Disclosures In addition to the collection of data, certain disclosures and product information must be shared with the consumer before a sale can be approved. The Model Regulation recommends that insurers and producers specifically disclose and discuss the following information with potential customers before a policy or contract can be finalized: Potential surrender period changes and additional surrender charges Potential tax penalties if the consumer sells, exchanges, surrenders or annuitizes the annuity (always recommending that a tax professional be consulted) Mortality and expense fees Investment advisory fees Potential charges for and features of riders Limitations on interest returns Insurance and investment components Market risk Regulations further state that the insurer and producer have no obligation to a consumer related to any annuity transaction if: No recommendation is made A recommendation was made and was later found to have been prepared based on materially inaccurate material information provided by the consumer A consumer refuses to provide relevant suitability information and the annuity transaction is not recommended A consumer decides to enter into an annuity transaction that is not based on a recommendation of the insurer or the insurance producer Recordkeeping The insurer is permitted, but not required, to maintain documentation on behalf of an insurance producer. At the time of sale, producers must: Make a record of any recommendation Obtain a customer signed statement documenting a customer s refusal to provide suitability information, if any Obtain a customer signed statement acknowledging that an annuity transaction is not recommended if a customer decides to enter into an annuity transaction that is not based on the insurance producer s or insurer s recommendation FINRA The Model Regulation accepts that sales made in compliance with FINRA requirements pertaining to suitability and supervision of variable annuity transactions as meeting its guidelines and recommendations. This applies to FINRA broker-dealer sales of variable annuities and fixed annuities if the suitability and supervision is similar to those applied to variable annuity sales. The insurer is specifically required to: Monitor the FINRA member broker-dealer using information collected in the normal course of an insurer s business; and Provide to the FINRA member broker-dealer information and reports that are reasonably appropriate to assist the FINRA member broker-dealer to maintain its supervision system.

66 62 4 Hour annuity suitability Compliance Mitigation and Penalties The insurer is responsible for compliance with this regulation. If a violation occurs, either because of the action or inaction of the insurer or an appointed producer, the state insurance commissioner may order: An insurer to take reasonably appropriate corrective action for any consumer harmed by the insurer producer s violation of this regulation A general agency, independent agency or producer to take reasonably appropriate corrective action for any consumer harmed by a producer s violation of this regulation Appropriate penalties and sanctions to be assessed Any applicable penalty for a violation of this regulation may be reduced or eliminated (according to a schedule adopted by the commissioner,) if corrective action for the consumer was taken promptly after a violation was discovered or the violation was not part of a pattern or practice. Conclusion As the population continues to age, and Baby Boomers continue to pour into senior investment markets, annuity regulation and oversight will remain under close scrutiny by state and federal legislators. In this age of consumer protection, insurers and producers must continue to stay vigilant and aggressively guard the rights of their senior customers. The only reason protective legislation is ever sponsored and voted into law is when the unethical or under-educated take advantage of loopholes or new products at the expense of the consumer. Once that ball starts rolling, further regulation follows. Adhering to strong ethical principles and measuring product recommendations against the latest industry standards for proper sales is always the best way to conduct insurance business.

67 Chapter 5 Review Questions 1. Prior to recommending a particular annuity to a consumer, an insurer or producer must do which ONE of the following? a. Make reasonable efforts to obtain the consumer s suitability information b. Coach the consumer in properly answering questions contained in the application in order to get the best rate c. Make sure that the check is payable to the insurer in the proper amount d. Provide copies of all licenses to the consumer along with a business card 2. What must a producer do if a consumer refuses to provide certain relevant information but moves forward with an annuity purchase nevertheless? a. The producer must obtain home office approval prior to application completion before moving forward with the transaction b. The producer must obtain a signed acknowledgment indicating that this annuity transaction was not based on the producer s recommendation c. The producer may only submit the application for the annuity if it is an established customer d. The producer must refuse to do business with consumers who do not provide the necessary information in which to make a recommendation 3. Under the Model Regulation what is the producer required to have prior to soliciting an annuity? a. The appropriate securities registrations b. Completion of a 40 credit hour general annuity training course c. Adequate insurer product specific and compliance training d. Five training sales with a qualified supervisor 4. How can a violation of the suitability regulations be reduced or eliminated? a. If there was no actual financial harm to the consumer and an offer of restitution was made b. If the licensing exams are successfully retaken with enhanced passing scores c. If the appropriate fines are paid promptly d. If corrective action for the consumer was taken promptly after a violation was discovered or the violation was not part of a pattern or practice 63

68 Attachment Oklahoma Life and Health Insurance Guaranty Association History & Purpose The oklahoma life & Health Insurance Guaranty Association is a statutory entity created in 1981 when the oklahoma legislature enacted the oklahoma Guaranty Association Act. The guaranty association is composed of all insurers licensed to sell life insurance, accident and health insurance, and individual annuities in the state of oklahoma. In the event that a member insurer is found to be insolvent and is ordered to be liquidated by a court, the Guaranty Association Act enables the guaranty association to provide protection (up to the limits spelled out in the Act) to oklahoma residents who are holders of life and health insurance policies and individual annuities with the insolvent insurer. Coverage Limitations The Guarantee Association Act established limits on benefits as follows: a. The Association cannot pay more than the insurance company would owe under a contract or policy b. $100,000 maximum cash surrender value c. $300,000 maximum for life or health insurance benefits or for the present value of an annuity contract, regardless of the number of policies in effect with the same company or the difference types of coverage. Exclusions Restrictions on Use The law prohibits insurance agents and companies from using the oklahoma guaranty association in any advertising. The guaranty association is not and should not be a substitute for your prudent selection of an insurance company that is well managed and financially stable. Agents are prohibited by statute from using this Web site or the existence of the guaranty association as an inducement to purchase insurance. Advertising Prohibition Policy section 2043 Advertising prohibited--exemptions--preparation of summary document Disclaimer--Notice of noncoverage (A) No person, including an insurer, agent or affiliate of an insurer shall make, publish, disseminate, circulate or place before the public, or cause directly or indirectly to be made, published, disseminated, circulated or placed before the public, in any newspaper, magazine or other publication, or in the form of a notice, circular, pamphlet, letter or poster, or over any radio station or television station, or in any other way, any advertisement, announcement or statement which uses the existence of the oklahoma life and Health Insurance Guaranty Association of this state for the purpose of sales, solicitation or inducement to purchase any form of insurance covered by the oklahoma life and Health Insurance Guaranty Association Act. Provided, however, that this section shall not apply to the oklahoma life and Health Insurance Guaranty Association or any other entity which does not sell or solicit insurance. 64

69 Chapter 1 Review Questions Answer Key 1 A Insurance companies compete for investors by offering creative product features and benefits as a part of their specific annuity contracts. 2 D In exchange for a lump sum payment, it promises to make a future payment to only the living survivors. When the next to last participant in the tontine pool died, the sole surviving member received the entire remaining principal. 3 D Annuities are designed to address inflation, investment, and longevity risk. Morbidity risk is addressed by disability and health insurance. 4 B Investment risk is the risk that the retirement portfolio may decline in value. 5 B Investments such as stocks and mutual funds may have a step up in basis at the death of the account owner. Chapter 2 1 B An immediate annuity provides regular income payments that start no later than one year after the premium is paid. 2 A The policyowner bears all responsibility for separate account selection and the full and complete investment risk as the value of the annuity increases or decreases based on the ever-changing investment performance of the separate accounts. 3 D In the simplest sense, indexed annuities have a guaranteed principal and a variable interest rate. 4 C The owner is the purchaser of the annuity, pays the premium, has the right to change beneficiaries, and to surrender the annuity for its cash value (if any). 5 A It pays the death benefit to the beneficiary upon the death of the owner. 6 B At the death of the annuitant, payments stop. In this case, there is nothing for the beneficiary to inherit. Chapter 3 1 A Some of the more common reasons for surrender charge waivers are: Confinement in a nursing home for 60 or 90 days or more Unemployment An accelerated benefit for a serious illness such as a heart attack, stroke, coronary artery surgery, life-threatening cancer, renal failure or Alzheimer s disease Disability resulting from injury or disease that lasts more than 90 days An extended stay in a nursing facility for more than days after confinement in a hospital A terminal illness or treatment in a hospice facility with written evidence from a physician that life expectancy is one year or less 2 A The annual reset method usually resets on the anniversary date, or is increased to reflect the credited return. It locks in the highest point on the contract anniversary. 3 B A joint and survivor income annuity is a payout for two people over two life expectancies. Only when both Annuitants die, do income payments stop. There are no subsequent payments to the estate of the last Annuitant or payments to any beneficiary. 4 C Annuitization is the process of converting a lump-sum of money to regular periodic income payments. 65

70 Review Questions Answer Key 5 B A split annuity uses two different annuities (for example, a 10-year fixed period annuity and a deferred annuity) to create an immediate 10-year temporary income stream, while at the same time growing a separate pool of money for 10 years so that the principal amount is replaced by the time the fixed period annuity is exhausted. 6 A It s a permanent decision. Each dollar annuitized won t be available for heirs or to meet other financial needs. There is a loss of gift or bequest opportunity. Chapter 4 1 D Required Minimum Distributions (RMDs) are required from all qualified plan assets when the account holder is 70 ½. 2 A Distributions from all tax-qualified retirement accounts, including qualified annuities, are always taxable whenever they occur. If distributions are prior to age 59½, a 10% excise tax is due, in addition to ordinary income tax. 3 C Distributions from all tax-qualified retirement accounts, including qualified annuities, are always taxable whenever they occur as ordinary income. 4 B The original investment (also known as the premium or the investment amount) will be returned in equal tax-free installments over the payment period. Contributions, also called cost basis, are not taxed since they are the return of principal; while the balance of monies received in the annuity payments is the taxable gain or earnings. This is taxed at ordinary income tax rates, not capital gains rates. 5 C Tax qualified annuities are generally funded with pre-tax dollars. 6 D The general rule for annuities not in payout status is that on the death of the contract holder, the annuity cash value must be paid out within five years of the holder s death. Chapter 5 1 A In general terms, prior to recommending a particular annuity to a consumer, an insurer or producer must make reasonable efforts to obtain the consumer s suitability information. 2 B A producer or insurer must record any recommendation made or obtain a customer signed statement documenting his or her refusal to provide suitability information; or a consumer signed statement acknowledging that an annuity transaction is not recommended and that it is not based on the producer or insurer s recommendation. 3 C The producer is required to have adequate product specific training, including compliance with the insurer s standards for product training, prior to soliciting an annuity product. 4 D Any applicable penalty for a violation of this regulation may be reduced or eliminated if corrective action for the consumer was taken promptly after a violation was discovered or the violation was not part of a pattern or practice. 66

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