Ch.14 - Test 1

Annuity Taxonomy

- Accumulation period: funds are accumulated > Onset of annuity payments: immediate vs. deferred > Number of premium payments: single vs. flexible (aka, multiple) payment annuity - Liquidation (aka annuitization or distribution) period: benefits are paid out > Type of benefit payments: fixed vs. variable > Period for which payments are made: none, fixed, benefit of survivorship > Benefits of survivorship: Pure vs. guaranteed > Number of lives covered: single vs multiple

Variable Annuity: Accumulation period

- Accumulation units: bought during the accumulation period. Fluctuate in value with investment portfolio (like a mutual fund) - Death benefit: if the annuitant dies before retirement, the payout to the beneficiary will be the higher of two amounts: > the amount invested in the contract, or > the value of the account at the time of death - Liquidation period: accumulation units are converted into annuity units that also fluctuate with investments

Individual Annuities

- An annuity is a periodic payment that continues for a fixed period or for the duration of a designated life or lives - The person who receives the payments is the annuitant - An annuity provides protection against the risk of living too long, often called excessive longevity

Taxation of individual annuities: exclusion ratio

- An exclusion ratio is used to determine the taxable and nontaxable portions of the payments - Exclusion ratio = investment in the contract/ Expected return - Annuities can be attractive to investors who have made maximum contributions to other tax-advantaged plans

Joint Life Annuities

- Annuity payout may be governed by more than one life - Joint life annuity: annuity payments terminate with the death of the first covered person - Joint-and-survivor annuity: annuity payments terminate with the death of the last covered person - The annuity income is paid until the last annuitant dies

Annuity Payout Options

- Cash option: funds can be withdrawn in a lump sum or in installments > Most annuities are not annuitized - Life annuity, no refund (aka pure annuity): provides a life income only while the annuitant remains alive - Life annuity, period certain: provides a life income to the annuitant with a certain number of guaranteed payments

Deferred, Fixed Annuities

- Deferred, Fixed annuity: pays periodic income payments at some future date - Single-premium deferred annuity: purchased with a lump sum, but liquidation begins more than one payment interval from the date of purchase - Flexible (aka multiple) premium annuity: allows the owner to vary the premium payments - Longevity annuity: > Single premium deferred annuity > Benefits start only at an advanced age (e.g., age 85) > No cash value or death benefit during accumulation > Qualified Longevity Annuity Contract (funded from defined contribution retirement plan, e.g., IRA, 401k)

Fixed-Indexed Annuities

- Fixed-indexed annuity: a fixed, deferred annuity that allows the owner to participate in the growth of the stock market and provides downside protection against the loss of principal and prior interest earnings if the annuity is held to term > The participation rate is the percent of increase in the stock index that is credited to the contract > Some insurers have a maximum cap rate on the interest rate credited to your annuity > Insurers use different indexing methods to credit excess interest to the annuity > Some have a guaranteed minimum value at the end of the index period

Accumulation Period

- Immediate annuity: : premium paid one annuity payment interval before liquidation •Interest for immediate or deferred annuity: greater of guarantee or market > Death benefit for immediate or deferred annuity: greater of premiums or cash value (surrender charge may reduce cash value to less than premium. - Deferred annuity: premium paid one annuity payment interval before purchase date

Immediate fixed annuities

- Immediate fixed annuity: periodic income payments are guaranteed and fixed in amount - The first payment starts one annuity payment interval from the date of purchase - All immediate annuities are single-premium (purchased with a lump sum) - During the accumulation period prior to retirement, premiums are credited with interest on immediate and deferred annuities > Guaranteed rate: the minimum interest rate that will be credited to the fixed annuity > Current rate: if current market rates exceed the guaranteed rate, current rates are paid

Annuity Payout Options

- Installment refund option: pays a life income to the annuitant; after the annuitant's death, payments continue to a beneficiary until the purchase price has been recovered - Cash refund option: pays a life income to the annuitant; after the annuitant's death, a single payments is made to a beneficiary that equals the difference between the purchase price and payments already received - Cost of Living Adjustment (COLA) option: annuity payments automatically increase by a predetermined amount. Not a true COLA - Partial cash withdrawal option: allows owner to commute part of the annuity payment

Taxation of individual annuities: example

- Jan, age 65, purchased an immediate annuity for $108,000 that pays a lifetime monthly income of $1,000 - Based on the I R S actuarial table, Jan has a life expectance of 20 years - Expected return is 20 × 12 × $1,000 = $240,000 - the exclusion ratio = $108,000/$240,000 = 0.45 - Each year, Jan receives $5,400 tax free and $6,600 which is taxable until the full premium is recovered

Longevity Annuities

- Longevity annuity: a deferred income annuity contract in which a lump sum premium is paid today to provide lifetime income at some future date (e.g., age 85) -Provide protection against the risk of depleting your financial assets at an advanced age - They are low-cost annuities because there are no cash values or death benefits in the policy > Some insurers offer optional features that provide death benefits, inflation protection, or the option of starting payments sooner

Multi-Year Guarantee Annuity

- Multi-Year Guaranteed Annuity (M Y G A): a single premium deferred annuity that pays a fixed rate of interest, typically 3 to 10 years. - The M Y G A is similar to a bank certificate of deposit (C D) but pays a higher rate and income is tax deferred, unlike a CD where income is taxed annually - Most insurers allow the withdrawal of interest as it is earned without paying a surrender penalty - Contributions are unlimited, unlike an IRA - Annual withdrawals up to 10 percent of the balance are permissible but withdrawals over 10 percent may result in an early surrender penalty fee - To prevent adverse financial selection, a Market Value Adjustment (M V A) may increase or decrease the penalties for excess withdrawals or early surrender of the annuity - Death benefit: beneficiary receives value of account with no surrender fees

Annuity payments consist of three sources:

- Premium payments - Interest earnings - Unliquidated principal of annuitants who die early (benefits of survivor) - Actuaries use special mortality tables to calculate annuity premiums because annuitants tend to be healthy individuals

Qualified Longevity Annuity Contract

- Qualified Longevity Annuity Contract (Q L A C): a longevity annuity that is purchased with before-tax savings in a qualified retirement plan, such as an I R A or 401(k) - •Q L A Cs are exempt from the required minimum distribution (R M D) rules that govern many qualified retirement accounts

Individual Annuities: Purpose

- The fundamental purpose of an annuity is to provide a lifetime income that cannot be outlived

Variable Annuity

- Variable annuity: pays a lifetime income; income payments vary with value of investments (typically common stocks) - Purpose: provide an inflation hedge by maintaining the real purchasing power of the payments > Over the long run stocks parallel inflation

Variable annuity fees and expenses:

-Investment management charge -Administrative charge -Mortality and expense risk charge -Surrender charge - Total fees and expenses in most variable annuities are high

Longevity Annuities: advantages/disadvantages

Advantages to longevity annuities include: -Benefits kick in when other financial assets are likely to be exhausted -They are generally less expensive than traditional immediate annuities -They can be purchased with an inflation hedge Disadvantages include: -Your heirs will lose money if you die during the deferral period -Once purchased, your funds are locked up

Taxation of Individual Annuities

An individual annuity offered by a commercial insurer is a nonqualified annuity: - It does not meet IRS code requirements •It does not qualify for most income tax benefits - Premiums are not income-tax deductible - Investment income is tax deferred - The net cost of annuity payments is recovered income-tax free over the payment period, but the amount that exceeds the net cost is taxable as ordinary income - The part of each annuity payment that is free from tax is determined by an exclusion ratio

Liquidation Period

No Life contingencies: - Cash - Installment With life contingencies: - Life income (no guarantees) - Life income, period certain - Life income with refund (cash, installment) - Joint and last survivor