Chapter 11 Annuities

the time when the annuitant receives benefits from the annuity

liquidation period

_____________ refers to a class of pure deferred annuities that provide a future income stream during the distribution period, which typically begins at a relatively advanced age such as 85. Although __________________ tends to offer bigger payouts than other alternatives, survivors receive no benefit if the annuitant dies before the distribution period begins

longevity insurance

a class of pure deferred annuities that provide a future income stream during the distribution period, which typically begins at a relatively advanced age such as 85. Survivors receive no benefit if the annuitant dies before the distribution period begins.

longevity insurance

Purchases of annuities have a generally ____________ mortality rate than others (like reverse adverse selection)

lower

A pure annuity provides the maximum income per dollar of outlay, and for that reason, it is perhaps most suitable for people with

only a limited amount of capital.

an agreement that provides periodic—usually monthly—income payments that continue as long as the annuitant lives but terminates at the person's death; also referred to as a straight life annuity

pure annuity (straight life annuity)

Bonus

Bonus, which is a percentage of the first-year premiums received that is added to the contract value. Typically, the bonus amount plus any earnings on the bonus are subject to a vesting schedule that may be longer than the surrender charge period schedule.2, 3 Given the typical vesting schedule, the bonus may be entirely forfeited upon surrender in the first few contract years.

Cap

Cap, which is an upper limit put on the return over a certain time period. For example, if the index returned 10% but the annuity had a cap of 3%, you receive only a maximum 3% rate of return. Many indexed annuities put a cap on the return.

taxes on annuities

During accumulation Period · amounts received during accumulation period are taxable to the extend of income earned (LIFO) · 10% tax on withdrawals before 59 ½ During liquidation period · Amounts received during liquidation period= Exclusion ratio= amount invested/ amount expected to be received as a life annuity · Exclusion ratio x payment = tax free return of principal · You put 500k into an annuity and have payments coming out $10,000 a month. 40% is earnings 60% is return of principal. $6,000 is tax free $4,000 is taxable

how might an annuity guarantee a lifetime income to an individual?

If the annuitant is willing to pool savings with those of other annuity owners, the administering agency can provide all the participants with an income of a specified amount as long as they live—regardless of longevity. This arrangement implies the willingness of participants to have all or a portion of their unliquidated principal at the time of death used to supplement the principal of those who live beyond their life expectancy. T herefore, each payment under an annuity is composed partly of the annuitant's principal, partly of the unliquidated principal of other annuitants who die early, and partly of investment income on these funds

based on the same principles: life insurance vs annuities

Life insurance and annuities are based on the same fundamental pooling, mortality, and investment principles. First, both insurance and annuities use the pooling technique. In insurance, all make contributions so that the dependents of those who die prematurely are partially compensated for loss of income. In annuities, those who die prematurely contribute on behalf of those who live beyond their life expectancy and would otherwise outlive their income. Second, both life insurance and annuity costs are based on probabilities of death and survival as reflected in a mortality table. Finally, under both arrangements, premiums are discounted for the compound interest that the insurance company will earn.

Participation rate

Participation rate, which is the percentage of the index's return the insurance company credits to the annuity. For example, if the market went up 8% and the annuity's participation rate was 80%, a 6.4% return (80% of the gain) would be credited. Most indexed annuities that have a participation rate also have a cap, which in this example would limit the credited return to 3% instead of 6.4%

primary function: life insurance vs annuities

The primary function of life insurance is to create an estate or principal sum; the primary function of an annuity is to liquidate a principal sum, regardless of how it was created.

how is an annuity used in a typical structured settlement

The usual structured settlement uses an annuity to provide periodic payments that meet the recipient's financial needs as much as possible. The periodic payments of income are received tax free by the claimant during his or her life and by the claimant's beneficiaries thereafter for the balance of any guarantee period. All timing decisions, as well as the exact amount of money, are predetermined by the defendant and its insurer, who are the legal owners of the annuity. Structured settlements might be more useful than a lump sum in replacing a lost income stream and addressing specific needs, such as the ongoing expense of medical treatments or household help, that require a continual and ongoing source of funding.

______________ includes a promise to return all, or at least part, of the purchase price of the annuity in some manner.

a refund annuity

• the person whose life is the measuring life for an annuity

annuitant

Mortality rates for most people, including annuitants, have been ________________

declining

any type of annuity that promises to return (in one manner or another) a portion or all of the purchase price of the annuity

refund annuity

an annuity for which future benefits increase, possibly at a compound annual rate. Often used in structured settlements.

step rate annuity

a deferred annuity that allows the annuity purchaser to participate in the investment of the annuity funds by determining how much of the contribution will be invested in a series of accounts

variable annuity

pread/margin/asset fee

which is a percentage fee that may be subtracted from the gain in the index linked to the annuity. For example, if an index gained 12% and the spread fee was 4%, then the gain credited to the annuity would be 8%.

A higher percentage of annuitants are (men/women), who have greater average longevity than (men/women).

women, men

Accumulation Units versus Annuity Units in a Variable Annuity

• Accumulation units: The number of units bought and the value of each unit vary depending on when the purchases are made. • Annuity units: The number of annuity units distributed periodically is constant, but the value varies depending on when the distributions are made.

The types of fees and charges that may be associated with an annuity

• Mortality and expense charge. This charge covers the guarantees provided by the contract—guarantees that a certain amount will be paid for the life of the annuitant, any death benefits payable to the beneficiary, and any expense limitation guarantees. • Investment management fee. This fee is assessed to cover investment management services. • Administrative charge or maintenance fee. A charge may be assessed to cover the cost of record-keeping and mailing periodic reports to the annuity owner. • Front-end load. An amount may be charged when the annuity is purchased to compensate the insurer for sales commissions and other expenses involved in marketing and setting up the account. • Surrender charge or back-end load. An annuity owner who withdraws money during the early years of an annuity's accumulation period may face a substantial

According to one insurer, an accumulation of $____________ is required to provide an income of $100 per month on a joint-and-last-survivor basis to a man and a woman both aged 65.

18,469

How are annuities classified by: method of purchase?

A deferred annuity can be purchased with either a single premium or periodic premiums. immediate annuity is single premium

joint and two thirds annuity

A joint-and-two-thirds-annuity is a modification of the joint-and-last-survivor annuity that decreases annuity income to the survivor to two-thirds of the original amount. Joint-and-two-thirds-annuities are commonly used to provide a life income to married couples under the assumption that a surviving spouse does not require as much income as the two annuitants.

How are annuities classified by: time when benefits begin?

An immediate annuity makes the first benefit payment one payment interval after the date of purchase. Under a deferred annuity, more than one payment interval will elapse after purchase before the first benefit payment is due.

How are annuities classified by: amount of annuity payment?

Annuity payments may be fixed, providing a fixed number of dollars for each benefit payment, or they may be variable, providing payments based on the investment performance of the assets underlying the annuity

questions to ask when evaluating a short term interest rate

At what rate will funds accumulate? • For how long does the rate apply? • After the rate expires, is a subsequent rate guaranteed? • What will the effect of withdrawals be on the rate? • After the rate expires, can the contract be terminated without a surrender charge?

critics of VAs say

-question whether continuing inflation is inevitable, and even if it is, whether common stock investments provide an effective hedge against rising prices in the short run. -absence of any guaranteed minimum interest rate credit as an important disadvantage of the variable annuity.

The refund feature in a refund annuity can take two general forms:

1. a promise to provide at least a certain number of annuity payments whether the annuitant lives or dies, 2. promise to refund all or a portion of the purchase price in the event of the annuitant's early death.

How are annuities classified by: plan of distribution?

1. pure annuity basis, which provides periodic income payments that continue as long as the annuitant lives but terminate at that person's death. 2. A refund annuity is any type that promises to return, in one manner or another, a portion or all of the purchase price of the annuity.

How are annuities classified by: parties in the contract?

1. single-life annuity, 2. or it may cover two or more lives. -A jointlife annuity provides that the income ceases at the first death among the lives covered. -A joint-and-last-survivor annuity provides that the income ceases only at the last death among the lives covered.

(T/F) An installment refund annuity promises to keep paying installment benefits to the annuitant and/or beneficiary until the total equals the purchase price of the annuity plus interest at a guaranteed rate.

False. An installment refund annuity makes payments for the life of the annuitant. If the annuitant dies before receiving monthly payments equal to the purchase price of the annuity, the annuity also pays installment benefits to the annuitant's estate and/or beneficiary until the total equals the purchase price of the annuity.

ethical issues involved in recommending annuities

High sales commissions have led sales representatives to overplay the benefits of annuities and downplay the substantial fees and lack of liquidity involved in an annuity. The NAIC model regulation requires that an insurance producer or insurer should have reasonable grounds for believing that a proposed annuity is suitable for the consumer based on facts the consumer provides concerning his or her needs, financial situation, investments, and other insurance products. Before executing an annuity sale, the insurer or producer should also make reasonable efforts to obtain information concerning the consumer's financial status, tax status, and investment objectives as well as other reasonable information.

The participation rate and the guaranteed interest rate are linked. (higher/lower) participation rates may be available from some insurers if the purchaser accepts a (higher/lower) guaranteed interest rate

Higher Lower

charitable gift annuity example

Under a charitable gift annuity agreement, Lynn would donate cash or other assets to the institution. In exchange for the gift, the institution would provide Lynn with fixed payments for life. Because Lynn's donation is an irrevocable gift, she would be entitled to an immediate income tax deduction based, in part, on the value of the donated asset. A further benefit is that assets used to fund the gift annuity are generally removed from Lynn's taxable estate. Besides realizing immediate tax benefits, Lynn would receive a periodic annuity payment. The payment may be annual, monthly, or at some other interval. Only part of these payments is taxable income, because a portion of the payments is deemed to be a tax-free return of the donor's gift during the donor's expected lifetime under federal tax regulations. Benefits to the institution are any difference between its earnings and its costs of providing periodic payments. The institution also benefits from the residual value of the donated property, if any, after Lynn's death.

_________________________ is considered to be fully liquidated upon the death of the annuitant, regardless of how soon after the beginning of the liquidation period death may occur.

a pure annuity or straight life annuity

the time period within which expenses used to satisfy a per-cause deductible must be incurred for each illness or accident

accumulation period

a specific segment of invested funds in a deferred variable annuity that will increase with investment performance; it is similar to the net asset value of a mutual fund

accumulation units

the life annuity certain can be viewed as a combination of two components:.

an annuity certain and a pure deferred life annuity

the annual payment of an allowance or income for a lifetime or a specified number of years

annuity

a contract that provides an income for a specified number of years, regardless of life or death. The payments are not linked to the duration of a specified human life.

annuity certain

a measure for valuing a variable annuity during its liquidation stage. The dollar value of each unit fluctuates with the investment performance of the separate account underlying the annuity.

annuity units

an option that allows an annuitant, at the start of the liquidation period, to withdraw the funds in cash, rather than as an annuity

cash option

The more frequent the periodic payments, the more _________________the annuity for the owner.

costly The insurer must charge more due to the greater expense of writing frequent checks, the loss of interest earnings by the insurance company, and the greater probability that the annuitant will live to receive at least some of the payments.

an annuity contract that starts payment in the future beyond the first contract year

deferred annuity

in charitable gift annuities, The client's tax deduction is not the value of the donated asset, but rather the

difference between the date-of-gift value of the asset and the present value of the annuity contract as determined by IRS tables that take into account both the age of the donor and the applicable federal interest rate

On any valuation date, the value of each accumulation unit is determined by

dividing the market value of the common stock underlying the accumulation units by the aggregate number of units

the ratio or percentage applied to an immediate annuity payment to determine how much of the payment is excluded from income taxation

exclusion ratio

(T/F) refunds are available for pure annuities

false

an annuity that provides a stated periodic dollar benefit, regardless of the insurer's investment return

fixed annuity

an annuity that must be purchased with a single premium because it begins to pay periodic benefits at the end of the first payment period (such as one month) following the purchase date

immediate annuity

The _________________ is a percentage of the defined increase that will be used to calculate the crediting amount. The insurer sets this _________________, which is subject to change. Some companies do not even specify the current _________________ in their promotional materials. Often, the _________________ is guaranteed for a specified term, such as the first 5 or 7 years. The insurance company reserves the right to change the _________________ at the expiration of each term, but the company usually guarantees the then-current rate for the subsequent term.

participation rate

Fixed Annuity Contract Design

· Premiums are quoted in $100 of annual premium or per $10 of monthly income · Minimum guaranteed rate of interest · Most come with secondary higher guaranteed rate (for first several years) · Cash withdrawals make reduce secondary rate · Bailout provision- if at the end of that secondary period, the interest rate drops too far, many policies have bailout provision which says you can withdraw your fund with no additional surrender chargers · Cash option (withdrawing or partially surrendering) allows an annuitant at the start of the liquidation period to withdrawal the funds in cash rather than as an annuity. If you take a lump sum instead

At the end of each term or participation period, the value of the annuity is the greatest of the following three amounts:

• the contract value based on the minimum interest rate guarantees • the accumulated value derived by applying the participation rate to the increase in the index on the applicable anniversary. This amount is subject to any cap on the maximum crediting rate and to any floor on the minimum crediting rate. • the premiums paid through the end of the term, minus any withdrawals

Terminating an indexed annuity before the end of a specified term usually results in loss of the index-crediting option. The termination is usually the greater of the following two amounts:

• the guaranteed-interest contract value • the aggregate purchase amount minus adjustments for any partial withdrawals previously taken

uses of annuities

1. Those seeking to accumulate an estate or hedge against adverse financial developments (savings tool) 2. Those seeking guaranteed income, especially during retirement 3. Charitable Gift Annuities a. Contributing to religious, education, or other charitable organizations b. Providing life income for annuitant(s) c. Minimize taxes d. Charitably inclined client donates cash or other assets to charity/ Charity pays annuity income for life of annuitant to donor or other beneficiary. Client is entitled to an immediate tax deduction for irrevocable gift to charity based on value of gift and IRS annuity tables that determine the present value of an annuity based on age and federal interest rate, like exclusion ratio 4. People who buy annuities generally expect to live a long life, but there's a special class of annuities called Impaired Risk Annuities- increased annuity payments (or reduced premiums) reflect annuitant's reduced life. The sicker you are, the better it pays. These use underwriting. 5. Structured Settlement a. If you buy a lottery ticket and you take the payments over your lifetime, you're participating in a structured settlement b. Wrongful death claim, bodily injury claim c. Provides financial security, management of benefits, guaranteed payout, and benefits that can be matched to need (court order)

(T/F) For a client in poor health, the underwriter might offer an impaired risk annuity that requires a higher premium for the same benefits.

False. When a client's life expectancy is reduced, the insurer is most likely to provide annuity payments for a shorter period of time. Consequently, the premium to provide a given level of benefits is lower than the premium charged to an annuitant with a normal life expectancy.

a type of refund annuity that provides a certain number of annuity payments whether the annuitant lives or dies, and payments continue for the whole of the annuitant's life if he or she lives beyond the guaranteed period

life annuity certain

A 50 percent refund annuity contract

guarantees a minimum return of one-half of the purchase price, a compromise between a straight life annuity and a 100 percent refund annuity. Under the 50 percent refund annuity contract, if the annuitant dies before receiving benefits equal to half of the cost of the annuity, monthly installments continue until the combined payments to both the annuitant and a designated beneficiary equal half of the cost of the annuity.

an annuity that considers the annuitant's reduced life expectancy in the underwriting process and increases the annuity payments (or lowers the premium) accordingly

impaired risk annuity

A client with a reduced life expectancy is likely to qualify for an

impaired risk annuity. Because the applicant's health is considered in the underwriting process, annuity payments are increased (or the premium lowered) in relation to the shorter life expectancy.

an annuity for which the interest earned is linked to changes in some type of securities index, such as the Standard & Poor's 500 Index (S&P 500)

indexed annuity

a type of refund annuity that promises that if the annuitant dies before receiving monthly payments equal to the purchase price of the annuity, the payments will continue to a contingent beneficiary or beneficiaries until the full cost has been recovered

installment refund annuity

All other things being equal, an annuity with a period certain is always more expensive per dollar of income than a straight life annuity because

it is not based solely on life contingencies. Some of the payments are a certainty; the only cost-reducing factor is the compound interest earned on the unliquidated portion of the purchase price. Therefore, the longer the term of the period certain (the period of guaranteed payments), the more costly this type of refund annuity is or the lower the yield on the purchase price.

an annuity with benefit payments that continue until the last death among specified lives

joint and last survivor annuity

a joint-and-last-survivor annuity with periodic benefit payments that drop to one-half the former amount following the first death among the annuitants

joint and one half annuity

an annuity with benefit payments that continue only until the first death among specified lives

joint annuity (joint life annuity)

The seldom-issued __________________ annuity provides that the income ceases at the first death among the lives covered

joint or joint-life

This annuity contract is very useful, and widely marketed, especially for husband and wife couples

joint-and-last-survivor annuity

an annuity whose benefit payments continue for the duration of a designated life

life annuity (whole life annuity)

This annuity pays a guaranteed minimum number of monthly payments, regardless whether the annuitant lives or dies, and payments continue for the whole of the annuitant's life if he or she lives beyond the guaranteed period.

life annuity certain

lifetime financial support that is composed of periodic payments instead of, or in addition to, a single lump-sum payment awarded by a court to an injured party or throughout the minority of dependent heirs. These annuity contracts are specifically tailored to meet financial needs of the claimants who are the injured or wronged parties. The periodic payments of income are received tax free by the claimant during his or her life and by the claimant's beneficiaries thereafter for the balance of any guarantee period.

structured settlements

a contract that provides for the payment of an annuity only for a limited period. Benefits cease at the earlier of death or the end of a specified period.

temporary life annuity

Life insurance companies cope with problems of adjusting annuity prices for anticipated future increases in life expectancy in three ways:

• computing annuity premiums on the basis of mortality tables that reflect annuitants' lower mortality. This current approach has replaced an earlier technique of using age setbacks. • using a low-interest assumption in the premium formula. Intensified competition among insurance companies and between insurance companies and investment media, however, has caused companies to adopt interest assumptions closer to the level of their actual investment earnings. • calculating the premiums and/or benefits on a participating basis, which enables the insurance company to use conservative assumptions.

key features of FIAs

• participation rate formula. This formula defines the potential return of the annuity, based on increases in the value of a stock index. • term period. Most contracts anticipate a series of terms of uniform length; however, some contracts reserve the insurer's right to modify the term period available for continuation at the expiration of any existing term. • participation rate. The participation rate is used in the participation rate formula to determine the amount of the index gain that can be applied (if any) to produce more than the guaranteed yield. Higher participation rates may be available from some insurers if the purchaser accepts a lower guaranteed interest rate. • cap on the crediting rate. Some contracts cap the crediting rate that is applied to the accumulated value of the contract, preventing full formula participation in times of very rapid index increases. • minimum crediting rate. Most contracts specify a floor of 0 percent as the minimum extra interest crediting rate applicable to the accumulated value. This prevents the application of a negative percentage in the formula to reflect plunges in the index value, and it ensures that the fixed-interest-rate guarantee is the worst possible outcome. • no SEC regulation. Equity-indexed annuities currently are regarded as fixed annuities and may be sold by agents who are not licensed to sell variable products. • minimum guarantees. The minimum guarantees under equity-indexed annuities are lower than those for traditional fixed-interest annuities, and the rates actually guaranteed apply to less than the full amount paid as a premium. The specified interest rate applied each year to the contract value is set forth in the contract and remains fixed unless a negotiated change is later agreed to by both the contract owner and the insurance company

The market for annuities comprises two broad categories of individuals:

• those who have already accumulated an estate, either through inheritance or by their own personal efforts • those who are seeking to accumulate an estate