Ch 12 Series 7: Variable Annuities

taxation of annuities

-all contributions to annuities are made with after-tax dollars, unless the annuity is part of an employer-sponsored (qualified) retirement plan or held in an IRA. -when contributions are made with after-tax dollars, those already-taxed dollars are considered the investor's cost basis and aren't taxed when withdrawn. -the earnings in excess of the cost basis are taxed as ordinary income when withdrawn.

2 distinct phases of the variable annuity

1.accumulation phase=its growth phase. 2.annuity phase=payout phase.

2 basic annuity types life insurance companies offer

1.fixed annuities 2.variable annuities

accumulation units/ annuity units

a contract owner's interest in the separate account is known as either accumulation units or annuity units, depending on the contract phase. -both accumulation units and annuity units vary in value based on the separate account's performance. -the number of accumulation units varies as additional investments purchase additional units. however, once the contract is annualized, the number of annuity units received is fixed. —>accumulation phase=accumulation units. annuity phase=annuity units.

periodic payment deferred annuity

allows investments over time. payments of benefits on this type of annuity are always deferred until a later date selected by the annuitant.

annuitization

at some point, the annuitant will begin to take income from the account. this is known as the annuitization of the contract. -technically, the value of the accumulation units is converted into a fixed number of annuity units. -these annuity units are then liquidated to provide monthly income guaranteed for the life of the annuitant.

is a fixed annuity a security?

because the insurer is at risk, this product isn't a security; an insurance license is required to sell fixed annuities.

fixed vs variable annuity: how are payments made?

both fixed annuities payments and variable annuity payments are made with after-tax dollars.

fixed vs variable annuity: administrative expenses

both have fixed administrative expenses

what isn't guaranteed in variable life insurance?

cash value, which fluctuates with the performance of the separate account.

taxation of monthly income payout option (annuitization)

each month's payout is considered partly a return of cost basis and partly earnings. only the earnings portion is taxable.

fixed vs variable annuity: who assumes investment risk?

fixed anniuty: insurer assumes investment risk. variable annuity: annuitant assumes investment risk.

fixed vs variable annuity: monthly payment fluctuation

fixed annuities: monthly payment never falls below guaranteed minimum. variable annuities: monthly payments may fluctuate up or down.

fixed vs variable annuity: rate of return

fixed annuity: guaranteed rate of return. variable annuity: return depends on separate account performance

fixed vs variable annuity: where are payments invested?

fixed annuity: payments are invested in the general account. variable annuity: payments are invested in the separate account.

which annuity payout option will give the largest monthly payment?

generally, the life income payout option will give the largest monthly payment, because all calculations are based on the payments ceasing upon the annuitant's death.

joint life with last survivor payout option

guarantees payments over two lives. it is often used for husbands and wives. if the husband were to die first, his spouse would continue to receive payments for as long as she lives. if the wife were to die first, her spouse would receive payments for as long as he lives.

life income payout

if an annuitant selects the life income (life-only annuity) option, the insurance company will pay the annuitant for life. when the annuitant dies, there are no continuing payments to a beneficiary. generally, this option will give the annuitant the largest monthly payment because all calculations are based on the payments ceasing upon the annuitant's death.

combination annuity

investors may purchase a combination annuity to receive the advantages of both the fixed and variable annuities. the investor contributes to both the general and separate accounts, which provides for guaranteed payments as well as inflation protection.

ways to pay for an annuity

payments to the insurance company may be made either with a single lump-sum, investment or periodically on a monthly, quarterly, or annual basis. 1. single premium deferred annuity=purchased with a lump sum, but payment of benefits is delayed until a later date selected by the annuitant. 2. periodic payment deferred annuity=allows investments over time. payments of benefits on this type of annuity are always deferred until a later date selected by the annuitant. 3.immediate annuity=purchased with a lump sum, and the payout of benefits usually commences within 30 days.

are variable annuities considered securities? why? what regulations does this entail?

the investor, rather than the insurance company, assumes the investment risk. therefore variable annuities are considered securities. this means the variable annuity must be sold with a prospectus and may be sold only by individuals who are both insurance licensed and securities licensed.

purchasing power risk

the major risk associated with fixed annuities. the fixed payment that the annuitant receives loses buying power over tie as a result of inflation.

immediate deferred annuity?

there is no such thing as an immediate deferred annuity. deferred annuities have delayed payouts.

Guaranteed Minimum Withdrawal Benefits (GMWBs) benefit in a variable annuity contract

this benefit guarantees a regular periodic payment (monthly, quarterly, or annually) but only until the insurance company has paid back the annuitant an amount equal to the principal account value, or until the end of the contract term. therefore it should be noted that a "lifetime" of periodic payments is not guaranteed.

annuities' early withdrawal penalty

withdrawals before age 59.5 are subject to the 10% early withdrawal penalty and ordinary income tax on the earnings portion of the withdrawal.

taxation of random withdrawals payout option

-if an investor chooses random wtihdrawals over the annuity option, LIFO (last-in, first-out) taxation applies. -the IRS requires that all earnings are withdrawn first and are taxed at ordinary income rates. -after earnings are completely withdrawn, there is no additional taxation because the cost basis has already been taxed.

separate account

as with fixed annuity, the purchaser makes payments to the insurer. however, the premium payments for variable annuities are invested in the separate accounts of the insurer.this account is separated from the general funds of the insurer because it is invested differently. investments include common stock, bonds, and mutual funds, with the objective of achieving growth that will match or exceed the rate of inflation. the amount of monthly income received is dependent on the performance of the separate account.

fixed annuity

investors pay premiums to the insurance company that are invested in the company's general account. the insurance company is then obligated to pay a guaranteed amount of payout (typically monthly) to the annuitant based on how much was paid in. the insurer guarantees a rate of return and as such bears the investment risk. because the insurer is at risk, this product isn't a security; an insurance license is required to sell fixed annuities.

Lifetime Withdrawal Benefit (LWB) or Lifetime Income benefit in a variable annuity contract

-this benefit generally comes in the form of a rider that an annuitant can attach to the annuity contract. -with this rider, the insurance company guarantees a regular periodic payment for the lifetime of the annuitant even if the account balance goes to zero. -such riders come at a cost, i.e. the amount the investment grows to isn't accessible to the annuitant under any circumstances, which means that cashing out the annuity contract isn't possible

life with period certain payout option

-to guarantee that a minimum number of payments are made even if the annuitant dies, the life with period certain option may be chosen. -the contract will specifically allow the choice of a period of 10 or 20 years, for example. the annuitant is guaranteed monthly income for life with this option, but if death occurs within the period certain, a named beneficiary receives payments for the remainder of the period.

variable life insurance summary

-variable life insurance is a form of permanent life insurance that provides protection for the beneficiary in the event of the policy holders' death. -variable life insurance contracts invest the premiums paid in both the insurance company's general account as well as their separate account. -investment in the separate account gives the insured some investment choices such as common stock, bonds, or money market instruments, which in turn enables the insured to assume some investment risk in order to achieve some inflation protection for their death benefit. -a minimum guaranteed death benefit is provided. this may increase above the minimum guaranteed amount, depending on the separate account performance. however it will never fall below. -any portion of the premium above what is necessary to pay for the minimum death benefit is invested in the separate account. this makes it so that the death benefit will never be less than the minimum guaranteed death benefit even if the separate account performs poorly.

where are the premiums paid in variable life insurance invested?

in both the insurance company's general account as well as their separate account.

fixed vs variable annuity: how long is income guaranteed?

income is guaranteed for life for both fixed and variable annuities

who can sell variable annuities?

people who are both insurance licensed and securities licensed.

immediate annuity

purchased with a lump sum, and the payout of benefits usually commences within 30 days.

who determines the initial value of the annuity units if annuitization is chosen?

the actuarial department of the insurance company determines the initial value for the annuity units and the amount of the first month's annuity payment

an investor has contributed $100,000 to a variable annuity. the annuity is now worth $150,000. what is the investor's cost basis, and what amount is taxable upon withdrawal?

the cost basis = the amount of the contributions, or $100,000. the taxable amount at withdrawal will be the earnings of $50,000.

suitability of Lifetime Withdrawal Benefit (LWB)/ Lifetime Income contracts

these riders aren't suitable for anyone who isn't planning for or anticipating a lengthy retirement. for those who can, the cost of such a rider might be palatable to gain the peace of mind that comes with knowing that the income stream is guaranteed for as long as one lives.

variable annuity

-a contract with a life insurance company, with many similarities to a mutual fund. -they have deferred-growth and lifetime payout options, which make them popular with investors. -unlike a qualified retirement account, an annuity doesn't restrict the amount of funds that may be invested, and the funds invested aren't tax deductible. -an opportunity to keep pace with inflation (unlike a fixed annuity) -the investor, rather than the insurance company, assumes the investment risk. therefore variable annuities are considered securities. -this means the variable annuity must be sold with a prospectus and may be sold only by individuals who are both insurance licensed and securities licensed.

death benefit provision

-if an annuitant dies during the accumulation period, most contracts call for a death benefit to be paid to the variable annuitant's beneficiary. -this = the total of all the investments made + any earnings that have accrued. -if the separate account has lost money, the annuitant's beneficiary is at least guarantee the return of the total invested money at a minimum. -the beneficiary will be liable for the ordinary income taxes on the earnings received. there is no penalty for withdrawal if the beneficiary is younger than 59.5 years old.

annuities: qualified or not qualified?

assume an annuity is nonqualified unless a question specifically states otherwise.

suitability of a variable annuity

-supplemental income for retirement, not preservation of capital, should be the catalyst to consider a VA. general rules of thumb regarding the suitability of variable annuities: -variable contracts are considered most suitable for someone who can fund the contract with cash. enticements to cash out a life insurance policy or an existing annuity is considered abusive and not a suitable recommendation. no one should EVER recommend refinancing a home to fund a purchase. -variable contracts aren't suitable for anyone who might need the lump sum of cash invested in the VA at a later time for any reason. -because earnings in a VA are tax deferred (not taxed until withdrawn) there is no reason to place a VA in a tax-favored account like an IRA -If someone has a low risk tolerance or is wary of the stock market, a VA isn't probably a good recommendation for that individual. -maximum contributions to all other retirement savings vehicles available to an individual should be made before a VA is considered a suitable recommendation. i.e. they are considered supplements to retirement income one can already anticipate, like pensions, IRA, or 401(k) distributions

waiver of premium

-the premium will be forgiven or waived under conditions relating to an insured becoming totally disabled. -under a qualified plan, contributions used to purchase waiver of premium benefits are taxable to the plan participant and must be included in gross income in the year in which they were paid.

rules applied to see if the annuitant's monthly income will increase, decrease, or stay the same:

1.if separate account performance is greater than the AIR, the monthly income is more than the previous month's payment 2.if separate account performance is equal to the AIR, the monthly income stays the same as the previous month's payment 3.if separate account performance is less than the AIR, the monthly income is less than the previous month's payment

how can an investor withdraw funds from the separate account with a variable annuity?

1.investor can withdraw the funds randomly 2.investor can withdraw the funds in a lump sum 3.investor can annuitize the contract (receive monthly income)

annuity payout options

1.life income (also called life only or straight life) 2.life with period certain 3.joint life with last survivor

similarities of variable annuities to mutual funds

1.separate account: the separate account of the variable annuity consists of the purchasers' funds pooled together and invested in a diversified portfolio of stocks,bonds, and mutual funds. investors own a proportionate share of these securities. 2.management and registration: if the investment manager of an insurance company is responsible for selecting the securities to be held within the separate account, the separate account is directly managed and must be registered under the Investment Company Act of 1940 as an open-end management investment company. however, if the investment manager of the insurance company passes the portfolio management responsibility to another party, the separate account is indirectly managed and must be registered as a unit investment trust under the Act of 1940.

major differences between mutual funds and variable annuities

1.the earnings on dollars invested into a variable annuity accumulate tax deferred. mutual funds periodically distribute dividends and capital gains, and all of these distributions are taxable upon receipt or reinvestment. such distributions are never paid directly to the owners of annuities; instead, they increase the value of units in the separate account. tax liability is postponed until withdrawals take place. this tax-deferred growth has made annuities popular products for retirement accumulation. 2.variable annuities offer the advantage of income guaranteed to some extent depending on how the contract is set up. mutual fund shareholders are offered no guarantees on the income provided.

annuity

a life insurance company product designed to provide supplemental retirement income. a store of income payments guaranteed for life.

example of a random withdrawals payout option taxation: an investor has contributed $100,000 in after-tax contributions to the variable annuity. that variable annuity has $50,000 worth of earnings. now the total account value is $150,000. if the investor makes a random withdrawal of $60,000, what are the tax consequences?

because LIFO applies, those earnings that accumulated tax deferred are now fully taxable. the investor has to pay ordinary income taxes on the $50,000, and then the remaining $10,000 is a return of the cost basis and isn't taxed. if the investor is under age 59.5, an extra 10% early withdrawal tax applies.

assumed interest rate

determined when the actuarial department of the insurance company determines the initial value for the annuity units and the amount of the first month's annuity payment. the AIR is a conservative projection of the performance of the separate account over the estimated life of the contract. it is only relevant during the annuity phase of the contract.

fixed vs variable annuity: what is the portfolio based on?

fixed annuity: portfolio of fixed-income securities/real estate. variable annuity: portfolio of equity, debt, or mutual funds.

fixed vs variable annuity: regulations

fixed annuity: subject to insurance regulation. variable annuities: subject to registration with the state insurance commission and the securities exchange commission (SEC)

fixed vs variable annuity: purchasing power risk?

fixed annuity: there is purchasing power risk. variable annuity: typically protects against purchasing power risk.

single premium deferred annuity

purchased with a lump sum, but payment of benefits is delayed until a later date selected by the annuitant.