STUDY chapter 6) Annuities - Structure, Design, Funding, Premiums, Payments

Multiple Life Annuities; *Joint and Survivor Option* -A joint and survivor annuity payout option pays annuity benefits to two annuitants. -If either of the two annuitants dies, payments will be made to the surviving annuitant for life. Payments stop upon the death of the surviving annuitant. -With the joint and full survivor option, the same income payment is paid to the surviving annuitant. -The monthly payout will be higher with a single-life annuity than a joint and survivor annuity, because the expected payment period is longer.

*There are variations of this option, which pay the surviving annuitant less than what was received when both annuitants were alive which include*: ~Joint and 2/3 survivor annuity - the survivor receives 2/3 of the original annuity payments upon the death of the first annuitant ~Joint and 1/2 survivor annuity - the survivor receives 1/2 of the original annuity payments upon the death of the first annuitant ~Example: Linda and Tom are married and have a joint and 1/2 life annuity. While Tom and Linda are alive, their household receives $3,000 in monthly annuity payments. If Tom dies before Linda, Linda would begin receiving $1,500 in monthly annuity payments.

*Single Premium Deferred Annuity (SPDA)*; Funding Method -A deferred annuity purchased with a single premium.

-A lump sum payment is made to the insurer, and the payments to the annuitant are deferred until a specified time. -The monies deposited grow tax-deferred until annuitization. (Annuitization: The point at which funds accumulated in an annuity are converted into periodic income payments beginning the annuity phase.)

Funding method; *Periodic Payments*

-An annuity where both the premium amount and frequency of premium payments are flexible is called a *flexible premium deferred annuity (FPDA).* -Flexible premium annuities are appropriate for individuals who have fluctuating incomes, or who are unable to pay for an annuity in one lump sum. -The major drawback of flexible premium annuities is the inability to determine the actual amount of the annuity benefit.-Because the amount of each premium payment to be paid and the total amount that will be paid into the annuity is a flexible amount that depends on future premium payments, there is no way to determine the exact amount of the annuity benefit that will be received until the final premium payment is received.

*Date Income Payments Begin*

-Annuities can be broadly categorized into two types, based on when the annuity phase (payout period) begins: Immediate and Deferred. -Once the payout period begins, the annuity no longer accepts funding payments.

Funding method; *Periodic Payments* *Level=Fixed(Premiums)*

-Annuities funded by periodic premiums may have: Level premiums or Flexible premiums. -Annuities may also be funded by periodic premiums paid over time. Premiums may be paid: Monthly, Quarterly, Semi-annually, or Annually Under a level premium arrangement, a fixed premium amount is paid in installments over time until the annuity income begins. -A flexible premium arrangement is similar to a level premium annuity, except that the owner of the annuity can elect to pay varying amounts for each premium payment. -The amount of each premium payment must fall within a certain minimum and maximum amount.

Funding Method; *Single Premium*

-Annuities may be funded with a single lump sum premium. -This immediately creates a principal sum. -Annuities funded with a single premium are either: +Single Premium Immediate Annuity (SPIA) + Single Premium Deferred Annuity (SPDA)

Date Income Payments Begin; *Immediate Annuities* ((Immediate Annuities = Don't Have Accumulation Period)) Example: David, who is retired, inherited some money from his grandfather. He used the money to purchase a single payment immediate annuity on February 1st specifying monthly payments. His payments began on March 1st.

-Annuity payments that begin immediately after the annuity is purchased are immediate annuities. Unlike deferred annuities, immediate annuities do not have an accumulation period. -This is because a single premium must be used for purchase, and the payout period must begin within one year. -This type of annuity is called a *premium immediate annuity (SPIA)* because a single premium is used to purchase the immediate annuity, and the payment period begins one payment period from the date the annuity was purchased.

*Factors that Determine the Amount of Each Annuity Payment*

-Based on the payout option chosen, the benefits may be guaranteed, but these guarantees have the effect of lowering each annuity payment. -The more frequent the annuity payments, the lower the payment amount. -The insurer's operating expenses, though small, lower the annuity payment amount. -The assumed interest rate is the growth rate insurers estimate that the annuity's cash value will earn during the annuity phase.

*Funding Method.*

-Funds that build up during the accumulation period of an annuity are termed principal. -There are two ways to fund the principal sum: +Single premium (lump sum payment) or +A series of periodic payments paid over time.

Pure Life Payout; *Straight Life Income Option (Life Annuity)* -The straight life option has the fewest guarantees in place, but provides the largest periodic income payment. -Fewer guarantees also mean a greater risk that the full value of the annuity may not be paid out. The straight life option is a win-lose scenario. Example: The good news - a win - if an annuitant is alive after depleting the annuity funds, the insurer will have to pay annuity payments out-of-pocket. Example: The bad news - you lose - if an annuitant dies after receiving only one or two annuity payments, the insurer keeps the remaining balance of the annuity.

-If no guarantee is desired, the life annuity payout option is straight life, also referred to as life only or pure life. The annuitant receives annuity payments for their entire life. Upon the annuitant's death, the annuity payments stop. The insurer retains any balance on the annuity. -The balance of the annuity forfeited to the insurer is then used to pay benefits to annuitants who live longer than expected. - A *straight life income option* pays principal and interest from an annuity fund for as long as the annuitant is alive.

Determining Annuity Premiums; *Loading Costs*

-Loading Costs: The amount of a premium payment must include a portion of the insurer's operating expenses. -These operating costs that the annuity owner must contribute to via premium payments are considered loading expenses and are factored into the amount of premium payments.

Annuity Certain (Period Certain Option); *Fixed Amount Installment* -Annuity Certain = Doesn't Guarantee Life Income -Annuity certain payout option which pays the annuitant a stipulated amount periodically. -With the fixed amount installment, a stipulated amount is paid to the annuitant periodically. -The contract owner decides how much each payment will be, and the insurer determines how long payments will last based on the value of the annuity and assumed interest rate.

-Payments stop when the funds are depleted. -Example: Mark has a 15-year fixed period installment annuity certain. Mark will receive payments for 15 years. Even if he is still alive after the 15 years, the payments stop. Lets say Mark has a fixed amount installment annuity certain that is valued at $100,000. Mark decides to receive the payment amount of $10,000 a year. Mark would receive paymetns for 10 years until the funds are depleted. Even if he is still alive after 10 years, the payments stop.

*Payout Options* You will notice some of the life insurance settlement options are the same as annuity payout options.

-Similar to settlement options for life insurance policies, annuity payout options are the ways to pay out funds from an annuity. Once selected, the payout option cannot be changed after payments begin. -Aside from one lump sum distribution, there are six annuity payout options: Straight life, Cash refund, Installment refund, Life with period certain, Joint and survivor,& Annuity certain.

Life with Guaranteed Minimum Payouts; *Installment Refund Option* ((Remaining funds paid to beneficiary in *installments*))

-Similar to the cash refund option, the installment refund option pays the annuitant income for life. -The difference: upon the annuitant's death the beneficiary will receive the balance of annuity funds, equal to the remaining funds in the annuity, *paid in installments.* -Example: If Tom's $100,000 installment refund annuity pays him $1,200 monthly annuity payments, then upon Tom's death, Linda will receive $1,200 monthly annuity payments until the balance of principal is disbursed.

Date Income Payments Begin; *Bail-Out Provision* Bail-Out Provision = No surrender charges

-Some deferred annuities offer a bail-out provision, which allows the annuity owner to surrender the annuity without surrender charges on conditions stated in the contract. -A common example is if interest rates drop a specified amount within a specified time period.

Determining Annuity Premiums; *Annuitant's Age*

-The Annuitant's Age: The age at which an annuitant will start receiving lifetime income payments determines the amount of an annuitant's premium payment. -Example: Bonnie and Clyde are both 45 years old. Clyde (an annuitant), who will begin receiving monthly lifetime income payments of $400 upon attaining 65 years of age, will pay a lower premium than Bonnie (also an annuitant), who will begin receiving the $400 monthly income payments upon attaining 60 years of age.

Determining Annuity Premiums; *Annuitant's Sex* -Example: Mark and Mary are both 45 when they start their annuity accumulation phases. They both expect to begin receiving income payments at age 65. Because Mary's life expectancy is longer than Mark's - she (statistically) will receive payments for a longer period of time. Her longer life expectancy results in a higher premium.

-The Annuitant's Sex: Statistically, men do not live as long as women. Because of this fact, women will typically have to pay higher premiums than men of the same age, because women are likely to live longer, and, therefore, will require more income payments.

Determining Annuity Premiums; *Assumed Interest Rate*

-The Assumed Interest Rate: When determining premium amounts, insurers estimate an assumed interest rate that would apply to the future investment of the premiums.

*Factors that Determine the Amount of Each Annuity Payment* -Older = Larger Benefit

-The interest rate has the potential to increase annuity payments. +Fixed annuities (annuities with a fixed interest rate) pay fixed annuity payments, and +Variable annuities pay variable annuity payments. -The older the annuitant, the more likely the annuitant is to die, so the higher the annuity payment.

Life with Guaranteed Minimum Payouts; *Life with Period Certain Option/or life income with term certain option* Example: Matthew (the annuitant) has an $80,000 life with 10-year period certain annuity. The annuity pays monthly payments to Matthew (the annuitant) for 6 years until Matthew's death. Since there are 4 years remaining in the 10-year period certain, Matthew's beneficiary, Barbie, receives payments (in the same amount as Matthew received) for 4 years. At the end of 4 years, payments stop.

-The life annuity with period certain or life income with term certain option provides the annuitant with guaranteed income for life and further guarantees annuity payments for a minimum number of years, such as 10 or 20. -If the annuitant dies within the period certain, the beneficiary will receive annuity payments for the remainder of the period. -Any balance in the annuity fund after the period certain ends, is retained by the insurer. -If the annuitant lives beyond the period certain, the beneficiary would not receive anything. -While the life with period certain annuity guarantees life income to the annuitant, it does not guarantee the full value of the annuity will be paid out.It guarantees that annuity payments will be paid for at least a certain number of years.

Date Income Payments Begin; *Surrender and Withdrawal Charges* Example: Rick purchases an annuity contract with a $30,000 purchase payment. The contract has a schedule of surrender charges beginning with 8% in the first year and declining by 1% each year thereafter. Rick is allowed to withdraw 10% of the contract value each year - free of surrender charges. In the first year, Rick decides to withdraw $10,000, or one-third of his contract value of $30,000 (assuming that his contract value has not changed because of investment performance). In this case, Rick could withdraw $3,000 (10% of contract value) free of surrender charges, but he would pay a surrender charge of 8%, or $560, on the other $7,000 withdrawn. In addition to the surrender charge, there is a 10% tax penalty for surrendering a deferred annuity before the age of 59 ½, as well as ordinary income tax that must be paid on the interest earned. Fortunately, Rick is 62 years old and will not incur the early withdrawal tax penalty.

-When a contract owner partially or entirely surrenders a deferred annuity prior to annuitization, the insurer will impose a surrender charge. The purpose of the charge is to account for lost investment value the insurer relied upon. -The surrender charge is greatest during the early contract years and in many cases decreases to zero after a certain number of years, such as in the 10th or 15th year. -Some annuities have a free withdrawal feature that allows the contract owner to withdraw a certain amount each year (typically 10%) without incurring a surrender charge.

Life with Guaranteed Minimum Payouts; *Cash Refund Option/refund life annuity option* Example: Greg (the annuitant) received $33,025 from a $50,000 cash refund annuity while alive. When he died, Cindy - his wife and the beneficiary - received $16,975 (the balance in the annuity) in a lump sum payment. Cindy will have to pay income tax on the interest portion of the annuity payment.

-With the cash refund option the annuitant will receive income for life, and upon the annuitant's death, the beneficiary will receive the remaining balance of annuity funds. -Because the refund life annuity option provides the most guarantee, each annuity payment will be smaller than that provided by the life annuity with period certain or straight life. - Keep in mind the beneficiary would have to pay income tax on the interest portion of the annuity payments, just as the annuitant would.

Annuities

A contract which protects against the risk or living longer than expected. Annuities provide a guaranteed life income to protect against the risk of depleting retirement funds.

Funding Method; *Single Premium Immediate Annuity (SPIA)* -An immediate annuity which is purchased with a single premium.

A lump sum payment is made with the insurer, and payments to the annuitant start immediately.

Annuity Certain = Doesn't Guarantee Life Income

Annuity Certain = Doesn't Guarantee Life Income

All of the following are true of the life with period certain annuity payout option, EXCEPT: Select one: a. The annuitant is provided with guaranteed income for life. b. Payments are guaranteed for a minimum number of years. c. Any balance in the annuity fund after the period certain ends is refunded to a beneficiary. d. The life with period certain option does not guarantee the full value of the annuity will be paid out.

Any balance in the annuity fund after the period certain ends, is retained by the insurer. The correct answer is: Any balance in the annuity fund after the period certain ends is refunded to a beneficiary.

Collin buys a fixed deferred annuity. Upon annuitization, he chooses the life annuity with period certain payout option. Collin will receive $3,000 each month with a 15-year certain period. If Collin dies after seven years, how much will his beneficiary receive? Select one: a. $0 b. $252,000 c. $288,000 d. $540,000

Collin's beneficiary will receive eight years worth of $3,000 monthly annuity payments. This works out to $288,000 (15 _ 7 = 8 years remaining in the period certain. $3,000 _ 12 months per year = $36,000. $36,000 _ 8 = $288,000). The correct answer is: $288,000

Determining Annuity Premiums; *Income Amount and Payment Guarantee* -The Income Amount and Payment Guarantee: How much lifetime income payments will be and the amount of any payment guarantees, such as a 10-year period certain, also impact the amount of premiums. (Period Certain:Duration of time that annuity payments are guaranteed to be paid. Typically 5, 10, or 15 years.)

Example: Robert has decided that he wants to have enough money to maintain his current lifestyle when he retires. So, he purchases an annuity and has a higher than normal premium payment - because he wants his lifetime income payments to be greater. Example: John wants to guarantee his income for 10 years after he retires, so his annuity premiums are also higher than average - because of the 10-year guarantee. -High annuity premium amounts result from high-income payments and long payment guarantee periods.

*Factors that Determine the Amount of Each Annuity Payment* -Male = Larger Benefit -Longer Anticipated Lifespan = Smaller Benefit Shorter Anticipated Lifespan = Larger Benefit -This is the reverse logic of life insurance: the longer the annuitant is expected to live, the lower the annuity payment. Because women are expected to live longer than men, the annuity payment will be lower.

Example: Robert, a 75 year-old man, and Ella, his 75 year-old wife, both purchase $100,000 immediate annuities. The monthly payments that Robert receives are higher than Ella's because he is not expected to live as long as Ella. Mortality tables state that women live longer than men. -Example: Robert has twin 50 year-old sons. They also purchase immediate annuities and the monthly payments that they receive are lower than Robert's payments - because of the number of years that the payouts will be made, based on their ages, is longer than their dad's.

Exclusion Ratio

Informs contract owners what portion of each annuity payment is taxable.

*Life with Guaranteed Minimum Payouts*

Many consumers do not like the idea of losing all or most of their investment in their annuity, if they were to die after receiving a few payments. Insurance companies offer alternatives to the pure life payout that provide guaranteed minimum payouts.

Which of the following is not true about the impact of the annuitant's sex on the premium payments? Select one: a. Men live more dangerously so their premiums are higher. b. Women live longer than men, so their premiums are higher. c. Both of the above. d. Neither of the above.

Men's premiums are typically lower than women's because their life expectancy is shorter. The dangers of their lifestyle may impact life insurance premiums, but do not impact the annuity premiums. The correct answer is: Men live more dangerously so their premiums are higher.

*Factors that Determine the Amount of Each Annuity Payment*

The amount of each annuity payment is based on the following factors: Annuity cash accumulation; Payout guarantees, if any; Annuity payment frequency Loading; The assumed interest rate; The annuitant's age; The annuitant's sex; The more cash value available at the time of annuitization, the larger the annuity payment.

Annuity Certain (Period Certain Option); *Fixed Period Installment* -Annuity certain payout option which pays periodic annuity payments to the annuitant for a stipulated period of time.

The fixed period installment pays periodic annuity payments to the annuitant for a stipulated period of time. Based on the annuity value at annuitization and the assumed interest rate, the insurer calculates the amount of each annuity payment. Payments stop when the period ends.

*Annuity Certain (Period Certain Option)*

Unlike a life annuity, the annuity certain option does not guarantee a life income. Instead, it provides income for a fixed time period, such as 10 or 15 years. An annuity certain has a distinct beginning and end, so if income is needed for life, a *life annuity* is more suitable.

*Determining Annuity Premiums*

When determining annuity premiums, insurers consider five important factors: The annuitant's age, The annuitant's sex, Assumed interest rate, Income amount and payment guarantee, and Loading costs.

Date Income Payments Begin; *Deferred Annuities* Example: David's brother Doug (who is employed full time) also inherited money from their grandfather. Doug opted for a single premium deferred annuity (SPDA). He chose to invest the money immediately, but to defer the payments for 10 years - thus allowing it to earn tax-deferred interest. Example: Their sister Diane, has 5 children, and lots of unplanned expenses. Therefore, she chose to invest her inherited money in a FPDA (flexible premium deferred annuity). This allows her to build her annuity over time - and vary the (dollar) amount of her premiums for her periodic payments based on the availability of her funds.

~With a deferred annuity, the annuity period begins sometime in the future. ~Deferred annuities may be funded with: +A single premium (SPDA ~ single premium deferred annuity) or +Periodic premium payments (FPDA - flexible premium deferred annuity). ~Payments begin a specified number of years after purchase and can be no sooner than at *least one year* after purchase. ~Deferred annuities can be purchased with a single premium or with multiple premiums. -*During the accumulation period of a deferred annuity, the principal earns compound interest on a tax-deferred basis.* -The exclusion ratio informs contract owners what portion of each annuity payment is taxable. -Deferred annuities are frequently used to build retirement funds.

*Fixed versus Variable*

• Fixed Life Insurance policies earn a constant rate of interest thereby providing a guaranteed minimum of benefits. • Variable Life Insurance policies earn a fluctuating rate of interest and do not guarantee a certain cash value.