Module 1 C7 Insurance - Annuities

What role did defined benefit plans play in retirement income when they were prevalent?

When defined benefit plans were prevalent, the risk of superannuation was pooled together. The defined benefit plan was responsible for paying a fixed pension for as long as the retired participants lived.

Impact of Social Security retirement benefits on superannuation.

Social Security retirement benefits mitigate the risk of superannuation

Three disadvantages of annuities

• Complexity - the complexity associated with annuity contracts is often difficult for investors to understand. • Costs and fees - a major disadvantages of annuity contracts is the costs and fees charged by the insurance company to issue the contract and undertake the longevity risk obligation. • Tax consequences - all distributions of income in excess of basis are considered ordinary income, and are subject to tax at the taxpayer's highest ordinary income tax rate.

Four types of annuity benefit options

1) Single Life 2) Joint Life 3) Term Certain 4) Options

difference between a flexible premium annuity and a single premium annuity

A flexible premium annuity allows the insured the option to vary premium deposits over time. A single premium annuity is an annuity purchased with a single lump sum.

Define joint and survivor life annuities.

A joint and survivor annuity promises to make payments over the lives of two or more annuitants, and annuity payments are made until the last annuitant dies. Joint and survivor annuities are commonly used to fund the retirement cash-flow needs of married couples.

Annuity

An annuity is a contract that is designed to provide a specified income that is payable at stated intervals for a specified period of time. Annuities can be characterized based on several factors, such as the length of payout (term certain), frequency and flexibility of premium (single premium or flexible premium), the timing of when income is payable (immediate or deferred), tax considerations and types of investment returns.

annuity payout period

An annuity may provide payments for a fixed term such as 20 years (term certain) or for an indefinite term such as the lifetime of the annuitant (life annuity). Payments may also be based on the life expectancy of two people, such as a husband and wife.

difference between an immediate annuity and a deferred annuity

An immediate annuity is created when the contract owner trades a sum of money in return for a stream of income that begins immediately. A deferred annuity is an annuity contract that does not begin distributions immediately, but waits until some future time to start payments.

What major risk to retirement income do annuities mitigate?

Annuities mitigate against the risk of superannuation, presuming the annuity benefit period is for the life of the annuitant or the joint lives of the annuitants.

When is an annuity included in a decedent's estate?

If an annuity contract had been annuitized by the owner prior to death for the life of the owner, there is no residual value at the date of the owner's death, and therefore nothing is included in the gross estate for estate tax purposes. Only annuities owned by an individual that had not yet been annuitized, and annuities making term-certain payments extending beyond the date of the original annuitant's death, will be included in the estate of the annuitant at its date of death value.

What are the estate planning issues regarding holding a single-life annuity versus a joint and survivor annuity?

If the annuity has been annuitized and is a single-life annuity with the decedent as the annuitant, the value at death will be zero, and therefore nothing will be included in the decedent's gross estate. If the annuity is an annuitized joint and survivor annuity owned by the decedent, the present value of the remainder interest will be included in the decedent's gross estate. If the annuity has not been annuitized and the owner is the decedent, the fair market value of the annuity will be included in the decedent's gross estate.

impact of inflation on retirement income

Inflation erodes purchasing power of a fixed stream of income in retirement.

How are annuities subject to income tax?

The extent to which distributions from an annuity contract are subject to income tax is determined by reference to the annuitant's basis in the contract. Basis represents after-tax dollars that were invested in the contract. An annuitant who has basis in an annuity contract will receive his basis back income-tax free over his actuarial life expectancy. Distributions from annuity contracts in excess of basis are subject to income tax at ordinary tax rates. If an annuity owner surrenders the contract, the distribution is taxable to the extent that the distribution exceeds the owner's basis in the contract.

Describe the impact of the shift from defined benefit plans to defined contribution plans for retirees

The risk of outliving resources was mitigated with shared risk in defined benefit plans. Defined contribution plans require retirees to be responsible for the funds they have accumulated and must determine how to make those funds last throughout their retirement.

6 risk factors to consider when selling an annuity in the secondary market

Transactions costs, including brokerage commissions, legal and notary fees, and administrative charges, may all be deducted from the lump sum proceeds. • Is the transaction legal? Federal or state law may restrict or prohibit retirees from assigning their pensions to others. The secondary sale of a structured settlement frequently must be approved by a court in keeping with the Uniform Periodic Payment of Judgments Act. • Is the transaction worth the cost? This is a simple comparison of the present value of the annuity stream discounted at the federal AFR and compared to the lump sum payment net of all fees and costs offered by the factoring company. • What is the reputation of the factoring company? • Will the factoring company require life insurance? Should the annuitant die before all payments that were assigned to the factoring company had been received, funds will be paid from the life insurance policy to cover any remaining balance. Purchasing life insurance will add to the annuitant's transaction expenses and reduce the lump sum payout. • What are the income tax consequences? The lump sum payments received may be subject to federal and state income tax. • Does the sale fit the annuitant's long-term financial goals? There may be better alternatives than selling a structured annuity.

Longevity insurance

sophisticated name for a deferred annuity purchased by an individual at or before retirement that will not begin to make payments until that person reaches an advanced age

difference between a fixed annuity, a variable annuity, and an equity indexed annuity.

• A fixed annuity provides payments of a fixed dollar amount that is typically determined when the annuity payments begin. The income is fixed based on the guaranteed returns provided by the insurer in the account. • Variable annuities offer a variable rate of return based on the overall return of the investment options that are chosen. Variable annuities offer potentially higher returns than fixed annuities, but they also carry a greater risk of loss. • An equity indexed annuity has characteristics of both fixed and variable annuities. It offers a minimum guaranteed interest rate combined with an investment return linked to the performance of a specific equity based market index, such as the S&P 500.

Five advantages of an annuity contract

• Annuities provide investors with a way to accumulate wealth on a tax deferred basis, while preserving capital. • Individuals concerned with the possibility of outliving their retirement savings may transfer that longevity risk to an insurance company by purchasing an annuity. • Annuities also provide an opportunity to defer income taxation on the investment earnings in the contract beyond the limitations imposed on ordinary qualified plans and IRAs. • An ancillary benefit to tax deferral is the ability to rebalance the portfolio inside of the annuity contract without incurring any immediate income taxation on asset sales. • Annuities also provide another advantage when unexpected creditor issues arise. Federal law exempts all qualified retirement plans and IRAs from a bankruptcy estate. This exemption means that qualified plan assets and IRA assets are protected from creditors. Annuities are protected from creditors in some states. For example, Louisiana protects all life insurance and annuities.

Prime benefit of a term certain (or period certain) annuity

While a term certain will only make payments for the specified period of time, a term certain option can be combined with a life annuity. Unlike a straight life annuity, which does not guarantee a minimum number of payments, a life annuity with a term certain provision ensures that the annuitant or his heirs receives a minimum number of payments or, alternatively, if the annuitant lives for a long time, the annuitant will receive a lifetime of income.

Five common fees and charges associated with variable annuities?

• Mortality and expense risk charges - These charges compensate the insurance company for insurance risks and are deducted from the value of the contract. These expenses cover the risk of annuitants living too long. The fees for death benefits are included in mortality and expense risk charges. The typical mortality and expense risk charge ranges from 1.15% to 1.85% annually. • Administrative and distribution fees - These cover the costs associated with servicing and distributing the annuity. These fees typically range from 0% to 0.35% annually. • Annual fee - An annual fee is a flat fee charged for record keeping and administration. The fee typically ranges from $30 to $50 and is charged on the contract anniversary date. This fee is regularly waived for contract values of $50,000 or more. • Subaccount fees and expenses - These fees and expenses are charged to the investment sub accounts inside the annuity (mutual funds), and include investment management fees. Additional expenses include the cost of buying and selling securities within the sub accounts. These are asset-based expenses that will vary by subaccount, but typically range from 0.7% to 2.5% annually. • Surrender charges - Surrender charges are sometimes known as contingent deferred sales charges. Most variable annuities do not have an initial sales charge. However, insurance companies often assess surrender charges to annuitants who liquidate their contract during the surrender period. The surrender charge is typically a percentage of the amount withdrawn and declines gradually during the surrender period. A typical surrender charge is 7% to 9%, decreasing over the surrender period to 0%. Variable annuities are offered by share class with B shares typically having a 6 to 8-year period of surrender charges for each contribution, L shares having a 3 to 4-year surrender charge period for each contribution, and C shares having no surrender charge period making them fully liquid. The B shares typically have slightly lower fees.

Four types of single-life annuity options.

• Straight or pure life annuity option - provides a stream of income to the annuitant for life. • Installment refund annuity option - provides for the insurer to continue periodic annuity payments after the annuitant has died until the sum of all annuity payments equals the original purchase price of the annuity. • Cash refund annuity option - guarantees a full recovery of premium with any remaining balance being paid in a lump-sum payment at the annuitant's death. • Term certain annuity option - provides annuity benefits for a specified period of time. Once the final payment is made, the annuity payments are complete.

Four parties to an annuity

• The annuitant is the individual upon whose life the contract is dependent. It is generally the life expectancy of the annuitant that affects the timing and amount of payout under the contract. • The beneficiary is entitled to the death benefit (assuming there is one). • The owner owns the annuity contract and names the annuitant and beneficiaries. The owner could also be the annuitant and/or the beneficiary. It is also possible that the owner is not necessarily be an individual, but possibly a trust or a company. • The insurance company issues the contract.