Chapter 12 Annuities
Tax-Sheltered Annuities A TSA is a pension plan for employees of nonprofit organizations as specified by the IRS, in accordance with section 501(c)(3) and 403(b) of the Internal Revenue Code. The tax deferment allowed is much like that allowed for contributions a corporate employer makes to a qualified pension or profit-sharing plan.
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Calculating guaranteed interest rates Premiums or payments made during the accumulation period earn a guaranteed return on a tax-deferred basis. There are two ways to calculate guaranteed interest paid on these contributions. The current purchase rate reflects the current interest rates based on current economic conditions. This rate is guaranteed at the beginning of each calendar year and could fluctuate from year to year. The guaranteed purchase rate is the minimum interest rate that is guaranteed for the life of the contract. This will be a fairly modest amount, such as 4-5%. This is the minimum return that will be paid even if the current annual rate falls below the guaranteed rate. Deferred annuities guarantee a minimum interest rate that contributions will earn. Because the guaranteed rate is often less than prevailing interest rates, the insurer will frequently credit excess interest on the contract. Excess interest calculations are based on how much the insurer has actually earned on its investments.
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Joint Life and Survivorship and Joint Life Annuities A joint and survivorship option provides benefits for the life of the annuitant and the life of a survivor. A stated monthly amount is paid to the annuitant, and upon the annuitant's death the same or a lesser amount (such as two-thirds or one-half) will be paid for the lifetime of the survivor. A joint life annuity differs from the joint and survivorship annuity option because it covers two or more annuitants and provides monthly income only until the first annuitant dies. After the first annuitant's death, all income benefits cease.
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Market value adjusted (MVA) annuities are individual deferred annuity contracts with underlying assets held in a different account. The values are guaranteed if held for a specific period of time, but the nonforfeiture values may fluctuate according to a market value adjustment formula if held for shorter periods. MVA annuities are also known as modified guaranteed annuities. This is a fixed contract, and the interest paid is dependent on the fixed rate and the actual rate of the underlying bonds which are in the General Account. The interest rate on MVA annuities is guaranteed (fixed) for a specific period of time. An adjustment is only made if the annuity is surrendered. If interest rates rise, surrender charges will be higher due to the adjustment. If interest rates are low, there will not be a surrender charge. The market value adjustment comes into play only if the annuity owner decides to surrender the annuity contract early. If the owner does decide to do this, a surrender charge and market value adjustment apply. If current interest rates are higher than the contract rate, the annuity owner will receive less. If the current rates are lower than the contract rate, the annuity owner will receive more. This increase or decrease is what is referred to as the "market value adjustment."
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Temporary Annuity Certain A temporary annuity provides annuity payments for a specified period of time (such as 5 or 10 years), or until death of the annuitant—whichever occurs first. It does not necessarily guarantee payment for life or for the specified period of time. It provides for one contingency or the other. The key concept is that the earlier event will terminate benefits.
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There are five factors used to determine annuity premiums. Annuitant's age The age at which an annuitant will begin to receive a lifetime income is important because it helps the company determine what premium to charge. An annuitant who will begin to receive $300 per month for life beginning at age 60 will pay a higher premium than an annuitant who will begin to receive $300 per month for life beginning at age 65. Annuitant's sex Because statistically women live longer than men, a woman will pay higher premiums because she is likely to require more income payments than a man her own age. Assumed interest rate Life insurance companies invest premiums and earn a rate of return on those investments. When determining premiums, companies estimate an assumed interest rate for those premium dollars. Income amount and payment guarantee The amount of the periodic income to be paid out also impacts the premium, as do any payment guarantees (such as a 10-year period certain). The higher the amount of periodic income and the longer the guarantee it must be paid, the higher the annuity premium will be. Loading for company expenses As with life policies, the annuity purchaser helps pay the company's operating expenses. The premiums charged must have an expense, or loading, factor added to them.
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Under an immediate annuity, the benefit payments begin within 12 months of purchase. Frequently, an immediate annuity is purchased with life insurance proceeds, an inheritance, or a settlement received for injuries. Under a deferred annuity, the benefit payments are postponed until a later date, such as a planned retirement age. The combination of premium method and commencement of benefits is often used to describe an annuity. Single premium annuities may be single premium immediate annuities. However, we also find single premium deferred annuities, under which a single premium is paid but benefits are deferred. All periodic premium annuities are periodic payment deferred annuities, but different deferral periods may be involved—benefits may begin immediately after the last premium payment, or be postponed until a later date.
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In some cases, surrender charges can be waived for an annuitant entering a long-term facility.
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A bail out provision allows the annuity owner to surrender the annuity without surrender charges if interest rates drop a specific amount within a specific time period.
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A retirement income annuity is an ordinary deferred annuity, but with an additional feature—a decreasing term life insurance rider that provides term life insurance with a face amount that decreases each year the policy is in force. The effect is that if the annuitant reaches retirement age, say 65, the decreasing term insurance death benefit expires and annuity payments begin providing retirement income. If, however, the annuitant dies before retirement, the decreasing term insurance death benefit is combined with the value of the annuity and then paid to the annuitant's beneficiary in any settlement option chosen.
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An annuity can only be surrendered during the accumulation period.
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Fixed annuity Interest Rate Guarantees There may be two levels of guaranteed interest: a current rate that is guaranteed at the beginning of each calendar year, and a minimum guaranteed rate that will be paid if the current rate falls below this level.
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Group Versus Individual Annuities Annuities can benefit groups as well as individuals. Retired employees receiving a stream of income from their former employer are getting an annuity benefit. Small employers often purchase group annuities for employees during their working years. Larger employers often operate their own annuity pool, using a trust fund to hold investment assets and dispense benefits.
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Guaranteed Minimum Payouts Many people were not happy knowing that most or all of their investment would be lost if they were to die after receiving just a few payments. This caused insurance companies to start offering some alternatives that provided a minimum guaranteed payout.
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Nonforfeiture Provisions An annuity contract owner who stops making premium payments during the accumulation period does not lose the value accumulated in the annuity up to that point. Instead, the contract holder will have nonforfeiture options or rights to the cash value accumulation in the annuity. Surrender The contract may be surrendered for its cash value in a lump sum payment. However, most companies will level some kind of surrender charge, which is higher in the early years of the contract and then scales downward as time goes on, called a "back-end load." The surrender charge discourages surrender of the annuity and it compensates the company for loss of investment value. In some cases, surrender charges can be waived for an annuitant entering a long-term facility.
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Refund Life Annuity A refund life annuity will pay the annuitant for life, but if the annuitant dies too soon after the annuity period begins, there will be a refund of any undistributed principal or cost of the annuity. This option assures that the full purchase price of the annuity will be paid out to someone. This refund may be in the form of continued monthly installments (installment refund) or paid in one lump sum (cash refund), whichever has been elected by the annuitant.
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If a nonqualified annuity is surrendered or withdrawn during the accumulation period, the cash withdrawals are made on a last in, first out basis (LIFO). In other words, the first monies withdrawn from the nonqualified annuity are considered to be from the interest earned on the principal, and they are taxed accordingly.
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If the policy is surrendered for a lump sum prior to the age 59½, a 10% tax penalty will apply, in addition to the surrender charge.
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A flexible premium annuity is like the level premium annuity in that annuity premiums are made over time, usually years, until annuity benefits are scheduled to begin. The difference is that with a flexible premium annuity, the purchaser has the option to vary the amount of each premium payment, as long as it falls between a minimum and maximum amount—for example, between $200 and $10,000. There is, however, a disadvantage to a flexible premium annuity. The actual amount of the annuity benefit cannot be determined in advance because there's no way to determine in advance the amount of each premium that will be paid or how much will be paid in total for the annuity. The purchaser of a flexible premium annuity, therefore, must wait until the final premium payment has been made to determine the exact amount of the annuity benefit. Benefits can be projected on the basis of assumptions about premium payments.
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An equity-indexed annuity (EIA) is a fixed annuity (meaning the principal and interest are both guaranteed) with an equity-linked rate of return. Excess interest earnings (above the interest rate guarantees) are calculated using an indexing method that is linked both to the stock market as well as the insurance company's overall investment performance. EIAs are not currently classified as securities and do not require a securities license to sell. Interest earned is tied to an equity index such as the S&P 500, adjusted yearly to reflect any index increases. The advantage of an equity-indexed annuity is that it has a guaranteed minimum interest rate and can never decrease in value. It also gives the annuitant the opportunity to beat the rate of inflation.
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Annuity benefit payments are a combination of principal and interest. Accordingly, they are taxed in a manner consistent with other types of income: the portion of the benefit payments that represents a return of principal (i.e., the contributions made by the annuitant) is not taxed; the portion representing interest earned on the declining principal is taxed. The result, over the benefit payment period, is a tax-free return of the annuitant's investment and the taxing of the balance. An exclusion ratio is applied to each benefit payment the annuitant receives: The ratio is applied to the benefit payments, allowing the annuitant to exclude from income a like percentage. Deferred annuities accumulate interest earnings on a tax-deferred basis. While no taxes are imposed on the annuity during the accumulation phase, taxes are imposed when the contract begins to pay its benefits. To discourage the use of deferred annuities as short-term investments, the Internal Revenue Code imposes a penalty as well as taxes on early withdrawals and loans from annuities. Partial withdrawals are treated first as earnings income (and are thus taxable as ordinary income); only after all earnings have been taxed are withdrawals considered a return of principal. Furthermore, a 10% penalty tax is imposed on withdrawals from a deferred annuity before age 59½.
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Life Annuity Certain An annuity certain is an option that does not guarantee a lifetime income to the annuitant. It provides an income for a guaranteed period (or for a fixed amount) regardless of whether the annuitant is alive or not. The guaranteed period could be 5, 10, 15, or 20 years. If the annuitant outlives the guaranteed period, the annuity payments cease. If the annuitant dies during the guaranteed period, the payments continue to a survivor until the guaranteed period of time ends. The life annuity with period certain provides a life annuity with an extra guarantee for a certain period of time. This guarantees a lifetime income, but if death occurs within the period certain, annuity payments will be continued to a survivor for the balance of the period certain (which may be specified as 5, 10, 15, or 20 years, or some other period).
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Life Annuity—No Refund A life only (straight life) option provides for payment of annuity benefits for the life of the annuitant with no further payment following the death of the annuitant. This option will pay the highest amount of monthly income to the annuitant because it is based only on life expectancy, but it creates a risk that the annuitant may die early and forfeit much of the value of the annuity to the insurance company.
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The annuity period is the "taking out" time. This is the period following the accumulation of the annuitant's payments (principal and interest) during which annuity benefits are received. During the annuitization period, the insurance company controls the funds in the annuity and disburses them according to the contract terms.
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