Variable Annuities
What withdrawal penalty exists and at a what age for variable annuities?
If withdrawals are made before age 59½, a 10% penalty is applied to the earnings.
What are the two phases of variable annuities?
The accumulation phase (growth phase) The annuity phase
The accumulation phase (growth phase)
The first phase of a variable annuity wherein the units in the separate account increase in value.
Guaranteed Minimum Withdrawal Benefits (GMWBs)
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.
Life with Period Certain Payout Option
To guarantee that a minimum number of payments are made even if the annuitant dies. 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 Annuity Suitability
Variable annuities are meant to bring supplemental income into the household at a time in one's life when the income is needed. Therefore, supplemental income for retirement, not preservation of capital, should be the catalyst to consider a VA.
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.
Many contract owners choose random withdrawals over the annuity option. If this choice is made what taxation applies?
last in, first out (LIFO) 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 The IRS requires that all earnings are withdrawn first and are taxed at ordinary income rates. After earnings are completely withdrawn, there is no additional taxation because the cost basis has already been taxed.
If separate account performance is greater than the AIR, then
monthly income is more than previous month's payment
immediate annuity purchasing
purchased with a lump sum, and the payout of benefits usually commences within 30 days.
single premium deferred annuity purchasing
purchased with a lump sum, but payment of benefits is delayed until a later date selected by the annuitant.
A significant risk associated with fixed annuities:
purchasing power risk. The fixed payment that the annuitant receives loses buying power over time as a result of inflation.
Life Income Payout 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.
Determining the value of annuity units and the annuitant's subsequent monthly income. (Based on separate account performance and AIR)
■ If separate account performance is greater than the AIR, the monthly income is more than the previous month's payment. ■ If separate account performance is equal to the AIR, the monthly income stays the same as the previous month's payment. ■ If separate account performance is less than the AIR, the monthly income is less than the previous month's payment.
Annuitization
-when the annuitant begins to take income from the account -the value of the accumulation units is converted into a fixed number of annuity units -the annuity units are then liquidated to provide monthly income guaranteed for life of the annuitant
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. Assume an annuity is nonqualified unless a question specifically states otherwise. When contributions are made with after-tax dollars, these already-taxed dollars are considered the investor's cost basis and are not taxed when withdrawn. The earnings in excess of the cost basis are taxed as ordinary income when withdrawn.
Annuity
An annuity is a life insurance company product designed to provide supplemental retirement income. The term annuity specifically refers to a stream of income payments guaranteed for life. This product is unique from other securities products that have been discussed because of the guarantee it offers. Life insurance companies offer two basic annuity products: fixed annuities and variable annuities. Both products require that the purchaser make deposits to the insurance company, either in a lump sum or over time, and then at some point begin to withdraw the funds. Although designed to provide monthly income for the life of the annuitant, withdrawals are frequently taken in lump sums or random withdrawals.
Variable Annuity 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 in an amount equal to the total of all the investments made plus any earnings that have accrued. If the separate account has lost money, the annuitant's beneficiary is guaranteed the return of the total invested money at a minimum. Upon the death of the annuitant, the beneficiary will be liable for the ordinary income taxes on the earnings received just as if the annuitant had surrendered the annuity during the accumulation period. Finally, there is no penalty for early withdrawal even if the beneficiary is younger than age 59½.
Variable Annuity
Insurance companies introduced the variable annuity as an opportunity to keep pace with inflation. For this potential advantage, the investor, rather than the insurance company, assumes the investment risk. Because the investor takes on this risk, the product is considered a security. It must be sold with a prospectus and may be sold only by individuals who are both insurance licensed and securities licensed.
Combination Annuity
Investors may purchase a combination annuity to receive the advantages of both the fixed and variable annuities. In a combination annuity, the investor contributes to both the general and separate accounts, which provides for guaranteed payments as well as inflation protection.
Assume the following: $100,000 = after-tax contributions (cost basis) + 50,000 = earnings $150,000 = total account value If the investor makes a random withdrawal of $60,000, what are the tax consequences?
LIFO applies. Therefore, ordinary income taxes will be applicable to the first $50,000. If the investor is under age 59½, an extra 10% early withdrawal tax applies to the $50,000 as well. The remaining $10,000 is part of the after-tax contributions totalling $100,000 and is therefore not taxed.
Accumulation unit and annuity unit variation
The value of both accumulation units and annuity units will vary based on the performance of the separate account. The number of accumulation units varies as additional investments purchase additional units. Once the contract is annuitized, the number of annuity units received is fixed.
Lifetime Withdrawal Benefit (LWB) or Lifetime Income
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. One such cost is that in many policies the amount the investment grows to is not accessible to the annuitant under any circumstances. Therefore, cashing out the annuity contract is simply not possible. Different issuers might apply different formulas to determine if any portion of the growth might be available to withdraw and this can add to the complexity of the contract. These riders would not be suitable for anyone who isn't planning for or anticipates a lengthy retirement. For those who can, the costs 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.
A contract owner's interest in the separate account is known as
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.
If separate account performance is less than the AIR, then
the monthly income is less than the previous month's payment.
If separate account performance is equal to the AIR, then
the monthly income stays the same as the previous month's payment
(Similarities to Mutual Funds) Separate Account
As described previously, 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, and the value of their investment rises and falls based on the performance of the securities in the pool. This is precisely how mutual funds perform: the separate account of a variable annuity is operated and regulated just like a mutual fund.
Variable Annuity Separate Account
As with a fixed annuity, the purchaser makes payments to the insurer. However, the premium payments for variable annuities are invested in the separate account 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. Although annuitants are guaranteed monthly income for life, the amount of monthly income received is dependent on the performance of the separate account. Monthly income either increases or decreases, as determined by the separate account's performance.
Variable Life Insurance Waiver of Premium
Different riders to a policy can account for a number of different conditions. One to be aware of is "waiver of premium," which states that 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.
Payout and Assumed Interest Rate (AIR)
If the contract is annuitized (the annuity has decided to receive fixed monthly distributions), the actuarial dept. of the insurance company determines the initial value for the units and the amount of the first month's annuity payment. From this an assumed interest rate (AIR) is established. The AIR is a conservative projection of the separate account's performance over the estimated life of the contract.
(Similarities to Mutual Funds) Management and Registration
If the investment manager of an insurance company is responsible for selecting the securities to be held within the separate account, then it is directly managed and must be registered as an open-end management company. If the portfolio management is passed on to another party, it must be registered as a UIT (unit investment trust). (Investment Company Act of 1940)
Fixed Annuity
In a 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 is not a security; an insurance license (but not a securities registration) is required to sell fixed annuities.
Variable Life Insurance
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. Cash value fluctuates with the performance of the separate account and is not guaranteed. Instead, what is provided is a minimum guaranteed death benefit, which may increase above the minimum guaranteed amount depending on the separate account performance but never fall below. Any policy benefit that is guaranteed, such as the minimum guaranteed death benefit, is funded by that portion of the premium invested in the insurance company's general account. Any portion of the premium above what is necessary to pay for the minimum death benefit is invested in the separate account. In this way, the death benefit will never be less than the minimum guaranteed death benefit even if the separate account performs poorly.
Monthly Income payout option taxation
When an investor chooses to annuitize and selects a monthly income payout option, each month's payment is considered partly a return of cost basis and partly earnings. Only the earnings portion is taxable.
periodic payment deferred annuity purchasing
allows investments over time. Payments of benefits on this type of annuity are always deferred until a later date selected by the annuitant.
What are the two distinct differences between mutual funds and variable annuities?
■ The earnings on dollars invested into a variable annuity accumulate tax deferred. (Mutual fund dividend/capital gains distributions are taxable. In variable annuities they increase the separate account units' value and the tax liability is postponed until withdrawals.) ■ Variable annuities offer the advantage of income guaranteed to some extent depending on how the contract is set up. (Mutual fund shareholders are not)
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. In other words, enticements to cash out a life insurance policy or an existing annuity (either of which might come with high surrender charges) is considered abusive and not a suitable recommendation. Refinancing a home or withdrawing equity from a home to fund a purchase could never be considered suitable. ■ Variable contracts are not suitable for anyone who might need the lump sum of cash invested in the VA at a later time for any reason. Anticipating buying a home, needing cash for your children's college education, or any other upcoming expense would need to be considered outside the variable annuity investment. ■ 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. ■ Variable annuity contracts are insurance company products that invest in a portfolio of securities via their separate account. If someone has a low risk tolerance or is wary of the stock market, a VA is not likely a very suitable 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. In other words, they are best considered supplements to retirement income one can already anticipate like pensions and IRA or 401(k) distributions.
At the time of annuitization, the annuitant is required to select an annuity payout option. The choices relevant to the S7 are:
■ life income (also called life only or straight life); ■ life with period certain; and ■ joint life with last survivor.