Chapter 3 - Annuity Contract Provisions

Non-qualified vs Qualified

- qualified annuity is one where payments into the annuity by the investor are tax-deferred, similar to 401(k) plans or IRAs - a non-qualified annuity doesn't get that special treatment, and money put into it is taxed as normal

2) Charges and Fees

1) Annual Mortality & Expense (M&E) Fees 2) Standard Death Benefit Guarantee 3) General vs Separate Accounts (Investment Choices) 4) Surrender Charges

Indexed Annuity Provisions

1) Charges and Fees 2)

Variable Annuity Provisions

1) Risk and Separate Account Investments 2) Charges and Fees 3) Premium Bonus Credits - Dollar Cost Averaging and/or Automatic Asset Reallocation: Optional Product Features at No Cost 4) Optional Death Benefit Enhancement 5) Optional Living Benefit Guarantees

2) 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.

5) 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. 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.

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.

*1035 Exchange*

- 1035 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.

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), they 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

4) Surrender Charges

Each variable annuity typically has a surrender charge schedule. This is similar to the surrender charges discussed under fixed annuities.

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 one's 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.)

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 stepped-up 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, while another company offers 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. 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.

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: 1) Be appointed with an insurance company 2) Have a resident life insurance producer's license in the state in which they conduct business 3) Have a securities license (Series 6 or 7, and Series 63) 4) Have any state required variable contract license 5) 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

MVA provision

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).

1) Single Life

- 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.

Income Strategies

1) Cover Basic Expenses 2) Ladder Income Annuities

Available Riders

1) Life Insurance Riders 2) Death Benefit Income Tax Riders 3) Long Term Care Riders

Income Distribution - Settlement Options

1) Single Life (or Life Only Income) 2) Joint & Survivor (or Life Income for Two People) 3) Period Certain (or Life and Period Certain) 4) Cash Refund

3) 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.

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.

1) 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.

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.

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.

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: 1) Declared Fixed Rate Annuity / Interest Rate Guarantee 2) Renewal Rate 3) Portfolio Rates 4) Guaranteed Minimum Interest Rate 5) New Money - Two-Tiered Interest Rates

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.

3) 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 be selected 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.

4) 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%.

Withdrawal Privilege Options

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. Different insurance companies may provide different surrender charge free percentages from a low of 5% to a high of about 20%.

2) 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.

1) 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.

2) Joint & Survivor

- 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.

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.

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 ranges from ages 18 to 90.

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.

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. 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.

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. 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.

4) 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.

GMAB

- Guaranteed Minimum Accumulation Benefit - 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 0.20% - 0.40% deducted annually from the investment account

3) 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.

Charges and Fees

- The owners/annuitants of fixed annuities are usually provided 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.

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: 1) Confinement in a nursing home for 60 or 90 days or more (This is not to be confused with the Long Term Care Rider) 2) Unemployment 3) An accelerated benefit for a serious illness such as heart attack, stroke, coronary artery surgery, life-threatening cancer, renal failure or Alzheimer's disease 4) Disability resulting from injury or disease that lasts more than 90 days 5) An extended stay in a nursing facility for more than 60-90 days after confinement in a hospital 6) A terminal illness or treatment in a hospice facility with written evidence from a physician that life expectancy is one year or less 7) Death Typically, surrender charge waivers are granted by a specific rider or endorsement to the annuity contract.

Guaranteed Minimum Income Benefit (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 10% sacrifice off 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. 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.

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

Maturity date

- the maximum age for benefits to begin - 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.

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

Guaranteed Minimum Withdrawal Benefit for Life (GLWB)

A GLWB 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.

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. 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.

4) 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. Some companies permit a joint & survivor cash refund income annuity.

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 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.

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.

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. 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.

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: The amount of money The current interest rates at the time of annuitization The age and gender of the annuitant

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 72 and may be satisfied by partial withdrawals or annuitizing the contract. All IRS requirements for RMDs must be followed.

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.

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.

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.

1) 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.

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.

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. 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.

3) General vs 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.

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. 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 if a partial withdrawal or full surrender is needed (since it will cost money). 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 up-front 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 benefit

Policy Administration Charges and 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.

Interest Crediting Strategies

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. Annual Point to Point: Performance of the index is tracked during the annual contract or policy year. 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.

Premium Bonus and 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. 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: 10 - 15 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. 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.

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.

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.

Age and Gender - A Proxy for Life Expectancy

The age and gender of the annuitant governs the income payments. 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.

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: Take the full amount due under the annuity and pay taxes at that time. 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. 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). Under the SECURE Act, annuities used in retirement accounts are now subject to amended Section 401(a)(9) of Internal Revenue Code. Previously, an individual inheriting an IRA annuity had the option of choosing a payout over the course of his or her life expectancy, thus reducing required minimum distributions. Under current law, IRA beneficiaries must take distributions over a 10-year 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.