Ch. 6 - Annuity Products

life expectancy

general rule: the younger an annuitant is, the longer life expectancy as compared to an older annuitant

liquidity feature

great number of deferred annuities provide 10% of the account value each year (to be able to access the cash values without incurring a surrender charge) → growing number of deferred annuities are never annuitized

taxation of tax qualified & non-qualified annuities

- distinction becomes important when lifetime income and death values are considered - tax-qualified annuities are fully taxable at ordinary income rates when money is withdrawn non-qualified annuity tax advantages when $ withdrawn - original investment will be returned in equal tax-free installments over the payment period - payments are not taxed since they are simply a return of principal while the balance of monies received in annuity payments is the taxable gain or earnings - taxed at ordinary income tax rates

Deficit Reduction Act

- distributions made from non-qualified annuities only may be used to pay premiums for long-term care insurance or expenses incurred with nursing home care → a form of 1035 Exchange, where the cash value of the annuity pays premiums on a tax-qualified long-term care insurance policy - huge potential tax break is that part of the annuity cash value is gain that otherwise would be income taxable; but this way it can be withdrawn and spent without it being considered a taxable event

unit refund option

- exact amount of payment received would not be known in advance, but any remaining units would potentially be available for a refund - remaining units would be converted into cash at the net asset value per unit and paid out to the beneficiary

fund expenses

- 12b-1 fees and other management-related fees. International - emerging markets and small cap funds charge more than large cap or index funds - average contract owner can expect to pay 1 - 3% per year in combined fees, which are deducted periodically from the contract value

dollar-cost averaging

= investing the same dollar amount into one or more investments regardless of the unit prices over an extended period of time - key is the ability to continue to invest even as prices fall - more units are purchased when prices are down than when prices are up - over time the average cost paid per unit will tend to be less than the average price paid per unit

insurer

= issuing insurance company that promises to pay out income benefits that can last a person's lifetime

fixed period option

= length of time over which payments are to be made is specified, and the insurer determines the payment amount that fits the duration - insurance company credits interest to the declining amount at a predetermined rate - for variable annuities, a similar option offered by some companies would be to initially determine how many annuity units would have to be liquidated each month so that by the end of the fixed period of time there would be none left

variable annuity payouts

- amounts will fluctuate depending upon the underlying performance of the investment fund(s) - guarantees the number of annuity units that will be redeemed but not the value of the units - if the original number of annuity units is exhausted, the insurance company must pay out an amount equal to what that fixed number of annuity units would be worth and pay the annuitant for as long as he/she is alive

accumulation units (of separate accounts)

- conceptually similar in nature to the shares of a mutual fund - at the end of every business day: value of net assets of each separate account ÷ # of outstanding units = net asset value per unit

annuity units

- deferred annuity: when cross the point of annuitization transitioning from the accumulation phase into the distribution phase, must redeem all of the accumulation units and use the cash generated to buy annuity units from the insurance company → this step should not be taken lightly because it is irrevocable - immediate annuity: simply buys the annuity units with the single premium from the outset

tax deferred compounding

- delaying or deferring the payment of income tax on investment earnings provides an opportunity to "earn interest on the interest" - allows the tax-deferred account or annuity to grow and accumulate faster than it would in an account that is taxed every year a.k.a. triple compounding - benefits - interest is earned on the principal - then interest is earned on the interest - finally, interest is earned on the money that would normally have been paid in taxes

fixed amount option

= allows the annuitant to select a dollar amount to be disbursed monthly, quarterly, semi-annually, or annually until the proceeds are exhausted, at which point the payments end - insurer credits the decreasing amount it is holding with interest, so even at low rates, there will be more than 100 payments - annuitant may name a beneficiary to receive the payments in the event of his/her death if a balance remains unpaid - beneficiary can also call off this option at any time and receive the balance in a lump sum

period certain option

= annuitant would receive guaranteed payments for life - if he/she should die prior to the end of the stated time period certain, the balance of those years would be payable to the named beneficiary - if he/she has outlived the period certain, then no further values are paid out to anyone

re-investment basis

= any portfolio earnings remain in the fund - value of the accumulation units can rise due to appreciating securities prices - of accumulation units can increase reflecting any dividends, interest, or realized capital gains that have been essentially reinvested in additional accumulation units

income payout phase

= begins when the policyowner decides to start taking income from his annuity policy - instead of taking one of the income payout choices, the policyowner can elect to take partial withdrawals from the policy or completely cash-out or surrender the annuity contract → would trigger a taxable event, and the integral benefit of the annuity would not be realized

stretch IRAs

- SECURE Act established a new 10-year limit on inherited IRAs and defined contribution plans - IRAs inherited before 12/31/2019 can legally maintain their "stretch" status - if a trust is named the beneficiary of a retirement account, the trust beneficiaries do not have the ability to stretch the IRA over their life expectancies exception: eligible designated beneficiaries (EDBs) - surviving spouses - minor children until the become of legal age (but not grandchildren) - disabled individuals (under strict IRS rules) - chronically ill individuals - individuals no more than 10 years younger than the IRA owner (generally, applies to siblings around the same age as original IRA owner)

fixed annuity payouts

- amount, often monthly, remains the same ("fixed") for the duration of the payout - "inflation" payout option = starts the payout lower than would otherwise be the case → allows the insurance company to create a reserve from which to payout a larger amount than otherwise would be the case in later years - biggest risk for annuitants choosing a fixed payout like this is if there is any real inflation, where the prices of consumables and other products and services are increasing, the purchasing power of each fixed payment will decline with no hope of recovering, resulting in a lower standard of living

non-qualified annuities

- generally funded with after-tax dollars - annuities offer tremendous flexibility when used as private, informal retirement supplements - no contribution limits: can contribute as much as he/she wants to take advantage of tax deferred compounding - subject to much less government regulation - does not require a withdrawal at all - owner can bequeath the untouched annuity in full to his/her beneficiary at death have an established cost basis (usually the premiums paid, which have already been subjected to income taxation, less any withdrawals) and will produce some tax-free income as the cost basis is distributed on a pro rata basis along with the investment gains. Once the basis has been fully paid out (and this may take 15-20 years), all subsequent payments are the investment gains from the annuity and are fully taxable at ordinary income tax rates.

tax qualified annuities

- generally funded with pre-tax dollars - some argue that tax-qualified accounts which hold mutual funds provide tax deferral at less cost than expense-laden variable deferred annuities with fees and charges built in cost basis for the non-qualified annuity = premium paid for the non-qualified annuity + any subsequent premiums = total amount paid for a deferred annuity

settlement/payout options

- interest option = allowing the insurance company to act as a "banker" - fixed amount option = receiving the money in certain equal payments until the principal is exhausted - fixed unit option = receiving the value of an equal number of annuity units until the original number of units is exhausted - fixed period option = spreading payments over a certain time period - life annuity option = spreading it over an annuitant's lifetime - joint annuity option = spreading it over two annuitant's lifetimes

distribution phase

- life annuity = payments will continue as long as the annuitant lives → payout amounts are based on actuarially calculated life-expectancy figures, which generate income streams that cannot be outlived - income payout phase = accumulated funds in a deferred annuity are turned over to the insurance company in exchange for an income stream instead of cashing out the annuity, paying any taxes owed, and spending the balance

premiums

- lump sum or periodic basis - no regulatory limit to the amount that may be invested - contributions are not tax-deductible, unless the annuity is deposited into an IRA or qualified plan (which is often the case) potential penalties for failure in periodic commitment: - interest rates reduced - internal charges increased - minimum account values established by a certain deadline

required minimum distribution (RMD)

- payments to 72+ y/o retiree are a percentage of the plan's account value as of December 31 of the previous year - IRS uses factors based on life expectancy to calculate this percentage - percentage increases annually as life expectancy decreases - eventually distributions begin to invade principal, and not merely interest income or growth on the account, and the account balance will be depleted → requirement stops when the account balance reaches zero - multiple IRAs: amount is calculated on the aggregate account values of all accounts → single distribution from one account or a combination of accounts may be used to satisfy the requirement - penalty is 50% of the amount which should have been distributed under IRS regulations

joint annuity option

- payout is over two, not one, lifetimes - payouts will be lower with joint life versus life only because the anticipated payout time period could be longer - survivor benefit can be a fraction (e.g. ½) or the entire amount that was originally coming in - since there are two lives involved there is likely going to be a difference between the ages of the two persons which makes the calculations a bit more complex - policyowner may allow the annuitant to decide which option to select or may have pre-selected it for them Some annuities allow changes or withdrawals once an option is selected and payments have begun if it is not a life payout. Those that do allow withdrawals usually charge a fee and then re-adjust payout figures based on the reduced amount still in the account. Most companies do not allow any changes once a life payout is selected. It is considered an irrevocable election. Payout options are the same for immediate and deferred annuities, whether fixed or variable.

separate/sub-accounts

- premiums are pooled with insurance company's other variable annuity investors - managed by insurance company's investment managers, or are overseen by 3rd party portfolio managers who make investment decisions within the parameters of each separate account - investments and trades executed within these categories are guided by each account's objectives and restrictions - each investor gets the same percentage yield, or return per unit as everyone else in the subaccount

income payment factors

- principal amount - age of the annuitant - sex of the annuitant

credit methods (indexed annuity)

1. annual reset = annuitant is credited with a return each year the market index exceeds its previous year's level; if it does not, then no gain is credited, but no loss it taken either. 2. point-to-point = measures the change in the index from the start of the contract to the end of the term; in a continuous bull market, point to point indexed annuities will usually offer the highest returns 3. high water mark with look back = "look back" over the term for the highest anniversary value for determining the amount of interest credit.

1035 exchanges & transfers

- tax-free exchanges of non-qualified annuities and tax-free transfers of qualified annuities may occur if the required paperwork is submitted to the insurance company producers must - disclose a replacement transaction - notify the old insurance company promptly to allow them the opportunity to: preserve the business, contact the annuity owner, and review the advantages and disadvantages of the proposed replacement allowed exchanges - life insurance or endowment policy to another life insurance or endowment policy - one annuity to another annuity - life insurance or endowment policy to an annuity requirements - have the same contract owner or owners on each side of the exchange - never exchange an annuity to life insurance - never exchange tax-qualified annuities for non-qualified annuities - keep qualified and non-qualified amounts separated

taxation of qualified assets during owner's lifetime

- taxed, at ordinary income tax rates - capital gains tax rates do not apply - since contributions were originally made with pre-tax dollars, the basis is usually zero → all distributions are taxable whenever they occur and no matter who receives them (i.e., original account owner or a beneficiary after death of the account owner) - distributions after age 59½ are subject to current taxation without the 10% penalty

tax deferral

- taxes are not paid on earnings every year - individual investors are allowed to defer taxes on qualified accounts while working and then pay taxes when the money is withdrawn during retirement money inside a fixed annuity earns interest on principal and interest. The returns on investment sub-accounts take place within a variable annuity. While an individual will have to pay taxes at some point (in other words, when withdrawn from the annuity), he/she is getting temporary use of the government's money, and it's earning interest by virtue of this tax deferral

variable vs. indexed annuity

- variable cash values are not backed by the insurance company's general account when invested in funds within the insurance company's separate accounts → only exception is any premium deposits and cash values held in the policy's fixed account option, if available - investors make their own choices vs. company invests independent of the contract holder

phases (deferred annuity)

1. accumulation phase = when the policyowner makes one or more premium payments into the contract. The intent is to allow earnings on the premium deposits along with any additional premium deposits to grow at interest in a fixed annuity or based on stock and/or bond market fund performance in a variable annuity on a tax-deferred basis. 2. distribution phase = when the premium payments stop and the accumulated value is used to purchase an income pay-out from the insurance company The income payments can be fixed or variable and for a limited period of time or for a lifetime. Income payments can have favorable income tax treatment, for example, the cost basis (after-tax premium payments) is recovered without having to pay any income taxes.

interest option

= insurance company holds the money in an internal account in the name of the annuitant, paying out the interest on a periodic basis - potential drawback is the lack of FDIC surety, but all states have Guaranty Associations in place to protect against insurer insolvency for assets held in the general account up to specified dollar limits

parties involved in contract

= insurer, the contract owner, the annuitant, and the beneficiary - not necessarily four separate persons - if the contract owner involves an entity, the entity can only be the contract owner and/or beneficiary and living individuals must be named as the annuitant - in order to change the insurer, the owner would need to change insurance companies, which means policy surrender, or a 1035 exchange replacing the old policy with the new one

annuity

= contractual agreement between an insurer and a policyholder/annuitant to make periodic payments that continue during the lifetime of the annuitant or for a specified period of time - function like a "personal pension" - primary function of an annuity is to protect the investor against the risk of outliving his/her income by offering a guaranteed payout the contract owner cannot outlive - no other financial product is designed to do this → only a mortality-based product like an annuity can make this guarantee can be fixed or variable. Funding can come from a lump sum of money, periodic, or flexible premiums. Income distributions can begin immediately or can be deferred until retirement. Income payments can be paid out to one or more persons. Current account or residual values can be paid out to named beneficiaries upon death of the annuitant and/or policyowner benefits: - offer tax-deferred earnings - guarantee a lifetime income - potential to maintain real purchasing power - distribute funds to named beneficiaries upon death, thus avoiding probate - for some uninsurable individuals, can offer a limited form of survivor protection through the use of settlement (payout) options or death benefit riders

annuitizing the annuity at the point of annuitization

= converting the accumulated cash values into a stream of income payments based on the available income payout choices is essentially the same as buying a single premium immediate annuity at the end of the accumulation period

deferred annuity

= delays the income payout in favor of an extended period of asset accumulation This type of annuity can be either fixed or variable. The deferred annuity can be funded with either a single or flexible premium. The actual name for this type of annuity can be single premium deferred annuity or SPDA, or flexible premium deferred annuity or FPDA. Its purpose is to allow the policyowner a chance to deposit funds and benefit from the magic of compound interest or earnings along with tax-deferral to accumulate a large amount of money to potentially convert into an income stream, most likely at retirement. Periodic purchase payments are permitted in certain classes of deferred annuities.

fixed unit option

= determine how many annuity units the annuitant would like to liquidate out of the original balance → 1st income payment = multiplying the number of units by the value per unit → that number of annuity units will be liquidated every month until there are no more annuity units left at which time payments will end - value of each unit will fluctuate in value based upon the investment performance of the underlying investment funds - beneficiary can be designated to receive the future payments in case the annuitant dies with a balance of annuity units remaining

(fixed) indexed annuity

= guarantees a fixed minimum return and protection of principal with interest earnings tied to the performance of one or more indices such as the S&P 500, the NASDAQ or the Dow Jones Industrial Average - contract owner receives a share of the index or indices growth, if there is any, in terms of an interest credit to the annuity, while avoiding any possible negative returns if no market gains of any kind were realized during the term, based on the index chosen, then the contract owner might get a 3% increase on all or part of the premium deposited. The rate that will be paid in this scenario will generally be much less than the prevailing fixed annuity rates and could most accurately be described as a consolation rate. It will provide the owner with a nominal gain in return for keeping the contract invested with no gain for the full term. insurance companies fund by investing the contract premiums in a combination of derivatives and guaranteed investments. If the market goes up, the derivatives will increase enormously in value, thus providing the upside necessary to credit the contract owners accordingly. If the market decreases or stays flat, the guaranteed investments will provide the consolation interest instead as the derivatives will not go up in value or might even go down and expire worthless.

guaranteed minimum income benefit (GMIB) rider

= guarantees conservative rate → investment portfolio should be invested more aggressively so there's some chance of reaping excess growth above and beyond the guaranteed rate - often require annuitization, which irrevocably locks the contract into a set payment schedule that cannot be altered. This means that if the investor's income needs change after payout begins, he/she cannot alter the income from the annuity to accommodate those needs

surrender charges

= imposed if the investor moves the money from the policy within a certain number of years from policy issuance or premium deposit - decreases with time until it no longer exists - most contracts today offer a free withdrawal window of 10% per year without penalty as well as total liquidity provisions for such things as nursing home expenses - if the contract owner is below age 59½, then the 10% early withdrawal penalty assessed by the IRS, still applies

immediate annuity

= income payments commence within one year after purchase This type of annuity can be fixed or variable. Immediate annuities can only be funded with a lump-sum or a single premium. The actual name for this type of annuity is a single premium immediate annuity or SPIA. Its purpose is to convert a specific amount of money into an income stream almost immediately. Typically, payments begin no sooner than one month after purchase. Income payments can also be scheduled to be received by the annuitant quarterly, semi-annually, or annually. Immediate annuities are more commonly purchased by people who are close to retirement or by those who have received some form of settlement.

rebalancing

= initial asset allocation between the various funds offered within the contract is preserved by automatically reallocating the growth of each fund from the higher-returning funds to the lower performing ones Over time, this can be an extremely effective method of profiting from normal market cycles among various sectors, by moving out of investments that have risen in value into those which have fallen in value (forcing investors to sell high and buy low). Asset classes seem to move in and out of favor over market cycles. The reallocation to the target asset allocation is a means of preserving the initial risk-reward characteristics of the portfolio

percentage limitations (indexed annuity)

= instead of the absolute kind of limit imposed by a cap, the investor may only get 70% of the market index gain in a given year, although there may not be any ceiling on the dollar amount of gain e.g. if the market index goes up 30% in one year, for example, the investor will get 70% of that 30% gain, which comes to 21%.

cash refund option

= insurance company guarantees that the annuitant will be paid for life - if he/she should die prior to recovering all of the initial deposit of the proceeds, then any remaining amount is paid out in a lump-sum to the named beneficiary - the more there is a guarantee, the more it costs, therefore, the lower the net payment

variable annuity

= long-term investments primarily designed to meet retirement or other long-range goals and are not suitable for meeting short-term goals because of potential adverse tax consequences and insurance company imposed surrender charges which may apply for withdrawing funds from the policy early - during accumulation phase, payments may be allocated into various investment funds - possibility of greater accumulation and higher payout amounts through the investment option choices - opportunity for diversification within one overall contract - convenient and efficient way for individuals at all investment levels to participate in a wide array of investment opportunities—especially the foreign stock and bond markets, which would normally be inaccessible to the average investor because of the time, expertise, or expense needed to do this correctly - separate account investments function much like mutual funds advantages to having the accounts "inside" an annuity - exchanges between investment funds - rebalancing portfolios take place without triggering a taxable event - tax deferred growth benefits - guaranteed lifetime income payments - family protection through the standard death benefit or the optional enhanced death benefit - living benefit provisions that may protect principal or provide a minimum guaranteed income - certain internal separate account management features such as dollar cost averaging or automatic asset rebalancing

cap rate (indexed annuity)

= maximum amount of gain which may be paid to the owner in a given year The excess gain goes to the insurance company to cover costs, such as the acquisition costs of the derivative securities which are the engine of the product. The more volatile the markets are, the more costly these securities become.

death benefit rider

= most beneficiaries in modern contracts will receive the highest of the current contract value, the highest anniversary contract value, or a hypothetical amount based upon a fixed interest rate, if the current value of the contract is less than that - any withdrawals the annuitant received are, of course, subtracted from the calculation of these amounts

life annuity option

= payment amount is based on the annuitant's life expectancy annuitant cannot outlive the income stream, which is not the case with fixed amount, fixed unit, or fixed period options. In a pure life annuity, payments will continue indefinitely even if the recipient lives well beyond life expectancy, but any balance remaining at an early death is forfeited to the company. The life only option would generate the highest monthly payment option for payouts that would last a lifetime. Any balance is retained by the insurance company as a reserve to be used to pay to those that live beyond normal life expectancy. This option should be considered only if there is no other reasonable and practical way to meet an income objective or if there are no beneficiaries to pass along any residual funds to

annuitant

= person upon whose life expectancy—based on age and sex—is used by the insurance company to determine the annuity payments the insurance company has guaranteed to payout as long as he/she is alive - often, the annuitant is also the contract owner, but they can be different persons possible that two people, such as a husband and wife, to be designated as co-annuitants, in which case lifetime payments would continue as long as at least one of them is alive. The annuitant may be the policyowner or a non-owner annuitant such as a spouse, parent, child, relative, or friend, virtually anyone. The only qualification is that the named consenting annuitant is a living person under whatever maximum age an insurer's contract specifies Unless the annuitant is the contract owner, he/she has no say in or control of the annuity contract. The non-owner annuitant cannot make withdrawals, any changes in the policy, or terminate the contract.

fixed annuity

= provide a guaranteed rate of interest on the invested principal and also provide fixed, guaranteed annuity payments upon annuitization (payout) - have set rates, maturities, and early withdrawal penalties - insurance company's general accounts are backed by State Guarantee Associations, although producers cannot use this in sales presentation - pay fixed current interest rates on premium deposits and on accumulated interest as determined by the insurance company - current interest rate credits are in excess of what the insurance company's guaranteed minimum rate is and are usually guaranteed for one year - cash values are backed by the insurance company's general account and guaranteed based on the insurance company's ability to pay its claims when they come due (when the policyowner decides to annuitize the policy based on the annuitant's life expectancy) In some contracts that allow for periodic or flexible premiums, the rate can change monthly for any new deposits, but for any previous deposits it will stay at the fixed rate for a year, renewing after 12 months at whatever the rate is then. There are still other contracts that guarantee the current interest rate credited will be good for the term of the contract, meaning the surrender charge period, such as 3, 5, 7, or 10 years. At that point, a new current interest rate is declared and is good for a specified period of time.

beneficiary

= receives the annuity proceeds upon the death of the annuitant or the policyowner depending upon the language written into the policy - can be children, friends, relatives, spouses, neighbors, trusts, corporations, or partnerships.

basis

= starting point for establishing gain or loss

contract owner

= typically an individual, or a married couple, as co-owners; but it can also be a non-natural "person" such as a trust or partnership (pecial tax rules apply to annuities owned by non-natural entities) rights: - adding deposits to the annuity - making investment decisions and transfers within the variable annuity - designating and changing the beneficiary - selecting the settlement or payout options - withdrawing part of the cash values or surrendering the policy to receive all of the cash values - name a new owner - gift contract to anyone or any entity at any time (subject to taxation rules)

payment options

Lump Sum Distribution - A one-time payment Periodic Distributions - Take money only when needed Systematic Distributions - A fixed amount is sent at regular intervals

components for policy comparison (indexed annuity)

Minimum Interest Rate Guarantee - Most contracts guarantee 3% interest on 80% - 90% of the premium paid. This is viewed as a worst case scenario if over the term of the policy the index and crediting method selected does not perform well at all. Maximum Limit on Earnings/Cap Rate - Many indexed annuities place a limit on the amount that can be earned each year. If an index goes up 20%, the contract owner may only receive 12-14%. The cap is based on the carrier and the contract. Earnings on Market Increases/Participation Rate - Most contracts pay anywhere from 60% to 100% of the gain when the market goes up, excluding dividends. Some insurers may change this percentage from one year to the next. Surrender Amount - Some insurers credit the contract owner with all or a portion of the total earnings while others pay only the guaranteed minimum return if the policy is surrendered prior to the end of the term of the policy

death benefits

Proceeds from annuities pass directly to beneficiaries without the delay, expense, and publicity of probate. This mirrors the way that life insurance death claims are paid. This is a great advantage when an estate is going through a time-consuming legal process.

medically underwritten annuities

consider the effects of certain medical conditions on the expected life expectancy of the annuitant. This can lead to higher than standard income payouts reflecting the potential shortened amount of time the income payouts are likely to last. This does not necessarily mean that this adjusted payout is competitive with other companies who do not base payouts on medical underwriting. It may be a way to obtain a higher payout with the existing company than would otherwise be the case

distribution phase (immediate annuity)

no time for accumulation or the ability to make additional premium payments. The intent is to generate income payments almost immediately (usually one month, but not more than one year from purchase). The income payments can be fixed or variable and for a limited period of time or for a lifetime. Income payments can have favorable income tax treatment. For example, the cost basis is recovered without having to pay any income taxes.

assumed investment rate (AIR)

purposes: 1. help set the first month's dollar income payout 2. act as a benchmark or hurdle to determine whether the current month's check is lower, the same, or higher, than the previous month's check If the annuity policy offers more than one assumed investment rate, for example 3%, 4%, or 5%, the first consideration is how much money is needed right away. If more is desired, then select the highest assumed interest rate available. If the smallest can meet the immediate income objective, then choose the smallest. The one selected at the outset will have a major impact on future cash flow in the long run. The higher the assumed interest rate, the higher the investment performance must be achieved in order for the payments to increase. The lower the assumed interest rate, the lower the investment performance must be achieved in order for the payments to increase. The higher the assumed investment return has a lower chance of future payment increases, and the lower the assumed investment return has a higher chance of future payment increases