Chapter 6 Annuities Chapter Objectives Students must be able to: Define What is an Annuity Explain the General Nature of Annuity and its Difference with Life Insurance Understand the Use of Annuities in Retirement Planning Differentiate Among the Different Classes of Annuities Explain the Distinguishing Characteristics of Each Type of Annuities Understand the Tax Treatment of Annuities Learn about the Use and Limitations of Annuity Malaysian Financial Planning Council (MFPC) 6-
Chapter 6 Annuities Introduction We have learnt how different types of life insurance policies can be used to neutralize the debilitating effect of premature death to families and businesses. Life insurance has as its principal mission the creation of a fund to provide for dependents. Premature death is not the only risk faced by an individual. At the opposite end of the continuum, there is also a risk of living too long where the client outlives his economic ability to sustain life-style during retirement. One of the products sold by life insurers that can be used by financial planners to deal with the risk of living too long is the annuity. An annuity, which is the functionally reverse of the life insurance concept, has as its basic function, the systematic liquidation of a fund to fund the life-style during retirement. It is necessary to note that although life insurance policies and annuities are different in function, both of these concepts are based on the same fundamental principles of pooling of risks, mortality and investment returns. It is pertinent to note that in the case of the mortality factor, annuities reverse the application of the principle the mortality table is used to calculate the chance of an insured living over a certain age rather than the chance of dying at a certain age as in the case of life insurance. An annuity insures against the penalty of excessive longevity. In other words, while life insurance protects an individual against loss from premature death, annuity protects him from outliving his ability to earn an income. Although the annuities are not actively promoted in Malaysia at the moment, changes in tax laws, demography and a shift to living benefits consideration by the public may swing the trend anytime. Annuities are very popular in countries like the United States and Japan due to various reasons such as the progressive aging of the population, low confidence in government sponsored annuity schemes, inflation and the need to increase savings for retirement. Definition An annuity is an insurance contract that provides periodic payments for a specific period of time such as a fixed period or over a lifetime. It is a product that can provide an individual a financial hedge against the risk of living too long. The payments may begin at a stated or contingent date and may be payable for a specified number of years. It can also be designed to cover the duration of a person s life or the lives of more than one person. The insured, i.e. the person whose life 6- Malaysian Financial Planning Council (MFPC)
determines the annuity payments, is called the annuitant. The monetary consideration paid to the insurer in exchange for the annuity payment is called the purchase price. Function The basic function of an annuity is to liquidate the principal sum deposited with the insurer over a defined period. The purpose is to provide the client with financial protection over the defined period, usually the lifetime of the annuitant. This ensures that the client receives a regular income that he can never outlive (as in the case of life annuities). An annuity has two phases in its life cycle. The first is the accumulation phase, and the other the liquidation phase. The accumulation stage begins when the insurance company receives the annuity premiums and the money accumulates in the annuity fund. The liquidation phase is the time period during which the annuity proceeds are paid out to the annuitant. Classification of Annuities Annuities can be classified on the following basis: Number of lives covered Here the consideration is whether the annuity payments are to be made to one life or to multiple lives ( eg covering the husband and wife) Method of premium payment. Annuities can be purchased with single or periodic premiums. The time when income payments will commence. This will depend on whether the income is paid immediately or deferred to a later time. Method of disposing the proceeds There are several ways in which the annuity proceeds can be paid out. Annuity proceeds can be distributed immediately, a deferred date or maturity date can be fixed, or payments can be made up to a certain fixed age (say, age 65). Denomination of the benefits Annuities can be denominated in various currencies such as the US dollar and Swiss franc. Malaysian Financial Planning Council (MFPC) 6-
Types of Annuities Although there are many types of annuities, not many of these are offered in the Malaysian market. Until insurers introduce more of these products, the discussion here will largely be of academic value. For the planner, there is still a need to know and understand the respective types of annuity with a view to the future when they may be introduced. Essentially, there are several types of annuities: Fixed-sum versus variable annuity Immediate versus deferred annuity Individual versus group annuity Single payment versus installment annuity Single life versus joint life annuity Pure life annuity versus annuity certain Let s look at each type in turn. Fixed-Sum versus Variable Annuity An annuity may be offered as a fixed-sum annuity or a variable annuity. In the United States, variable annuities have become increasingly more popular. In fact, it was the variable annuity that set the trend in the United States for many of the innovative life insurance products that were to follow. For variable annuity, the premiums are invested in a portfolio of listed shares, although the client may also have the option of directing their investment to a bond fund or a money market fund. The annuity has a cash value and the benefit payment will vary depending on the investment experience of the assets that are assigned under the contract. The variable annuity premiums collected are invested placed in a separate account ( from the variable life policies), where insurers have greater discretion with respect to the investment of the funds. The underlying philosophy of the variable annuity is that while the value of the investment will vary over time, the value of a diversified portfolio of common shares will change in the same direction as the price level, thus reducing the impact of rising cost of living. The variable annuity was designed as a means of coping with the impact of inflation. In Malaysia, the introduction of investment sensitive products requires the permission of the Central Bank. With investment-linked insurance products taking a hold in the market place, there is little doubt that variable annuity will be a likely product to be introduced when the annuity trend sets in. Immediate versus Deferred Annuity As stated earlier, an annuity can be classified in accordance with the commencement of the payments to the client. With the immediate annuity, the annuity will be paid for a fixed number 6- Malaysian Financial Planning Council (MFPC)
of years and thereafter as long as the annuitant lives. For deferred annuity, the payment to the client will not commence until the deferred period is up. The deferred period is a spread of years between the payment of the purchase price and the beginning date of the commencement of the annuity payment. For immediate annuity with guarantee, the annuity payments will continue after the annuitant died till the end of the guarantee period. Individual versus Group Annuity Annuity can be bought both on a group and individual basis. In Malaysia, group annuities have not been introduced although there is a need for such mechanism to fund private retirement programs. The Employees Provident Fund (EPF) had introduced a form of group annuity for its members on 1 st July 2000. The EPF together with a few life insurance companies had jointly launched 2 types of annuities - one conventional and the other on Takaful basis, on both immediate as well as deferred schemes. This scheme however had been discontinued due to various issues related to pricing, administration and sales practices. Single Payment versus Installment Annuity As noted earlier, annuities may also be classified according to the method of settling the purchase price. The annuity may be purchased with a single sum (for both immediate and deferred plans) or it may be purchased on an installment basis over a period of years. By nature, installment plans are always deferred annuities. Single-sum annuity may be for an immediate or deferred annuity. For deferred annuity, the purchase price is generally refundable with or without interest if death occurs during the deferred period, and surrender values are also allowable during this period. Single Life versus Joint Life Annuity Annuities may be grouped according to the number of lives that determine the duration of annuity payments. For single life plans, the annuitant pays a lump sum as the purchase price and in return he receives an annuity for as long as he lives. As for joint-life annuities, the annuity payments cease on the first death. Another type is called survivorship annuity, where the annuity payments are to be made until the date of death of the last annuitant. This plan will be more expensive than the single-life annuity as the survivorship plan on the average will last longer.a variation of this plan provides for a reduction in the income payments at death of the first annuitant, with lower annuity payments being continued until death of the last annuitant. Pure Life Annuity versus Annuity Certain Annuities can also be classified according to the insurer s obligation to make payments. For pure life annuity, payments are made only for the balance of the annuitant s lifetime, regardless how long that period may be. The annuity is considered fully liquidated at the annuitant s death, with nothing payable to his beneficiaries. Annuity certain is not a life annuity because it is not in anyway dependent on human life, and can exist as deferred or immediate. The annuity payments are made irrespective of whether the annuitant lives or dies. Malaysian Financial Planning Council (MFPC) 6-
Tax Treatment of Annuity To encourage development of the annuity market in Malaysia, exemption from income tax of RM1,000 ( Ringgit Malaysia: One thousand) is granted to the annuitants for annuities that are purchased from life insurance and takaful companies. The effective date for the exemption starts from the year of assessment 1995. This has an important implication to the client. If the amount received is tax-exempted, it would give a higher yield to the client compared to similar investments where the income is not tax-exempt. Annuity Income from Life Insurers and Takaful Insurers >From Year of Assessment 1995 Tax-free to Annuitants Advantages and Limitation of Annuities Advantages of Annuities Annuities provide a viable option for individuals to plan for a hassle free retirement by providing a constant income stream. Annuities can help an individual to hedge against inflation if the returns are higher than the inflation rate Annuities are suitable for individuals who are not competent in money management Annuities can be used to supplement the EPF and other in retirement planning Tax benefit for life insurers and takaful annuity products Limitations of Annuities Annuity payments may not be able to match the inflation rate and thus reduce the purchasing power during the retirement. Annuities may risk the capital especially for variable annuity. 6-6 Malaysian Financial Planning Council (MFPC)
Self Assessment 1. Which of the following is the most suited product to fill the needs of a client for retirement years? A. Whole life policy with profits B. Endowment policy maturing at age 60 C. A life annuity D. all of the above 2. What is the basic function of an annuity? A. To provide a lifetime of replacement or supplementary income immediately B. To provide for inflation adjusted living during the retirement years C. To protect against medical expenses during old age D. To guarantee a high income and an enjoyable retirement 3. Which of the following is generally true of an annuity? A. For those who expect to live long, an annuity is not a good option B. The computation for annuity is exactly the same as computing for life insurance C. A lump sum is deposited with the insurer in exchange for a stream of payments in the future D. A younger person will receive a larger annuity payment compared to an older person 4. Ah Seng purchased an annuity which entitles him to receive payments for as long as he lives. The amount he invested is considered fully liquidated on his death. This type of annuity is this called A. Pure life annuity B. Deferred annuity C. Installment annuity D. Annuity certain Malaysian Financial Planning Council (MFPC) 6-
5. For, the annuity payments cease on the first death. For, the annuity payments are to be made until the death of the last annuitant. A. survivorship annuity; joint-life B. joint-life; survivorship annuity C. Single life annuity; joint life annuity D. Immediate life annuity; survivorship annuity 6. What is the tax position of an annuity received from life and Takaful companies by the individual? A. The amount received is taxed as an income B. The amount received is taxed as a capital gain C. The amount received is not taxed as an income but as a retirement gratuity D. The amount received is tax exempt as of the year of assessment 1995 7. Which of the following is FALSE with regard to the purchase of an annuity from a life insurance company? A. With fixed-income annuities, inflation can erode the purchasing power of the annuity B. Those who cannot risk their lump sum of money should consider investing in annuity C. Converting funds saved to an annuity will ensure a regular income D. Converting savings to an annuity is a way to provide for the annuitant s heirs 8 For an annuity, the person whose life governs the annuity payments is called the, while the money considerations in exchange for the payment is called the. A. insured; order price B. annuitant; purchase price C. insured; retirement fund D. annuitant; retirement fund 6- Malaysian Financial Planning Council (MFPC)
9. An annuity may be defined as an insurance contract that provides. A. A fixed sum for a fixed period to the annuitant s heirs on his death B. A variable sum of money payable to those who have reached age 55 C. A regular payment stream for a specific period of time, either for a fixed period or lifetime D. A lump sum payment at intervals such as every 5 years 10. Which of the following are possible sources of the capital sum that can be utilized to purchase an insurance annuity? i. EPF ii. iii. Bank savings Cash values of a life policy A. i only B. ii only C. i & iii only D. All the above Answers: 1-C, 2-B, 3-C, 4-A, 5-B, 6-D, 7-D, 8-B, 9-C, 10-D Malaysian Financial Planning Council (MFPC) 6-