Problem Set 7
List two advantages and two disadvantages of annuities.
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. 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.
Define an annuity, and identify the two phases of an 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. The first phase is the accumulation phase, which is the period over which funds are accumulated. The second phase is annuitization, which is when the funds are exchanged for a stream of income guaranteed for a period of time.
Explain the 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
Explain how annuities can be used as "longevity insurance"
Longevity insurance is a 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, ie 85. Payments (relatively large for the policy cost) then are made for life. The retiree does not have to worry about running out of money if he or she lives a long time.
Identify and briefly explain the different types of annuity benefit options
Single-life annuity options. A single life annuity only provides payments to one person. The payments from a single life annuity cease when the annuitant dies. A single life annuity has several payout options available, including: • 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. 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 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.
Generally, how are annuities taxed?
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.
Identify and briefly explain fixed annuity, variable annuity, and equity 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.
