Chapter 2 -- Annuity Products

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Peregrine Knight
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1 Chapter 2 -- Annuity Products Multiple Choice Identify the choice that best completes the statement or answers the question. When you have answered all of the questions, click the Check Your Work button to review the correct responses. When you finish,use the Back button on your browser to return to the study text.. 1. The current rate of interest paid on a traditional fixed annuity is: a. tied to current market rates b. whatever rate the annuity company chooses to pay c. guaranteed at the time the contract is established d. whatever rate of interest the company can earn on the investments in the general account 2. When the current rate of interest is set using a tiered rate method, the contractholder will earn different rates of interest depending on: a. the total amount invested in the contract b. whether the contract is eventually annuitized or not c. when the premiums are paid into the contract d. none of the above 3. Client A invests $50,000 in a fixed annuity contract and earns a current rate of 4% this year, while Client B invests $100,000 in the same contract and earns 4.25%. Which interest crediting method does this contract use? a. new money method b. portfolio method c. sliding scale method d. tiered-rate method 4. Which interest crediting method is based on when premiums are paid into the contract? a. pocket of money method b. tiered rate method c. sliding scale method d. portfolio method 5. Contracts with a bailout rate will: a. automatically terminate the contract if interest rates fall below the initial rate b. allow contractholder to surrender the contract without surrender charges if the current rate falls below the bailout rate c. tie current interest rates tied to market rates d. guarantee the principal in the event of the annuity company s insolvency 6. The value of a variable contract s annuity units will be adjusted based on: a. changes in the stock market b. minimum interest rates guaranteed by the annuity company c. the investment results in the selected separate account d. none of the above 7. The assumed interest rate (AIR) in a variable annuity: a. serves the same function as the minimum guaranteed rate in a fixed annuity b. is the minimum amount the investments in the separate account must earn before the

The current rate of interest paid on a traditional fixed annuity is: a. tied to current market rates b. whatever rate the annuity company chooses to pay c.

2 contract will pay income payments to the annuitant c. is compared to the investment returns in the separate account to determine if this month s income payment will be higher or lower than last month s d. is the rate of interest state regulators apply to determine a variable annuity s reserve requirement 8. An equity indexed annuity that is simply based on the value of the index at maturity relative to the value of the index at inception uses the a. point-to-point indexing method b. high-water indexing method c. ratchet indexing method d. annual reset indexing method 9. The annual reset indexing method is sometimes called the: a. high-water method b. ratchet method c. point-to-point method d. average value method 10. An investor is comparing the purchase of an equity indexed annuity (EIA) based on the S&P 500 with purchase Spiders, an exchange traded fund (ETF) that holds a stock portfolio that mirrors the S&P 500 index. Which of the following is true? a. the total return to the investor will be higher in the EIA than the ETF b. the EIA s return includes dividend income, the ETF does not c. the investor can avoid market downturns in the ETF, but not the EIA d. none of the above are true 11. The S&P 500 increased by 12% this year. Which of the following annual reset contracts will credit the investor with the greatest increase in a EIA based on that index? a. Contract A with a 90% participation rate and 8% interest rate cap b. Contract B with a 80% participation rate and 10% index cap c. Contract C with a 3% yield spread and 15% index cap d. Contract D with a 2% yield spread and 10% interest rate cap 12. Which of the following annuity contracts impose the fewest costs on contractholders? a. immediate fixed annuities b. deferred fixed annuities c. immediate variable annuities d. deferred variable annuities 13. Which of the following are properly analyzed as a cost of investing in an equity indexed annuity? a. participation rates b. floors c. ratchets d. all of the above 14. Which of the following is costs in a deferred fixed annuity is the least transparent (not clearly disclosed) to contractholders? a. surrender charges b. interest rate spread c. contract charges d. market value adjustments 15. A market value adjustment affects fixed deferred annuity holders who: a. annuitize their contracts b. surrender their contracts c. take penalty-free withdrawals

is the rate of interest state regulators apply to determine a variable annuity s reserve requirement 8.

3 d. all none of the above

4 Chapter 2 -- Annuity Products Answer Section MULTIPLE CHOICE -- page references to Safeguarding2web.pdf 1. ANS: B page 2 The current rate of interst is typically set by the company on an annual basis. Presumably it is tied to current market conditions, but in reality it is whatever rate the company chooses. All contracts will have a guaranteed minimum rate -- and the contract will earn the higher of the two. 2. ANS: B page 2 Tiered-interest rate contracts will credit the account with two rates of interest -- one is applied to the contract s cash value, and a higher rate to the annuity value. If the contract is annuitized, the annuity payments will be based on the annuity value (i.e., the higher rate); if the contract is surrendered or funds are withdrawn, the contractholder will only receive the cash value (based on the lower rate). 3. ANS: C page 2 Annuities using a sliding scale method will credit higher rates of interest to contracts with higher principal balances. 4. ANS: A page 2 The pocket of money, or new money, method credit interest based on the timing of the premium payments. For example, premiums contributed to the account in 2006 may earn 3.75%, premiums paid in 2007 earn 3.80%, while 2008 premiums earn 3.60% 5. ANS: B page 2 A bailout rate allows contractholders to surrender their contracts if current rates fall below the bailout rate. In that case, the company will waive any surrender charges. 6. ANS: C page 3 Annuity unit values are tied to the investment results in the separate account(s) selected by the contractholder. 7. ANS: C page 3 The AIR is a benchmark rate of return used to determine variations in variable annuity payments. If the investments in the separate account equal the AIR, this month s annuity payment will equal last month s. If the separate account s investment results beat the AIR, the annuitant s monthly payment will increase. If the investment fail to meet the AIR, the monthly payment will shrink. There are no required reserves in an variable annuity, nor are there any guaranteed minimum rates of return. 8. ANS: A page 4 The point-to-point indexing method simply compares the index s values at the beginning and end of the contract. Any variation in the index between those two dates are irrelevant. 9. ANS: B page 4

All contracts will have a guaranteed minimum rate -- and the contract will earn the higher of the two. 2.

5 The annual reset method will review the value of the index on state dates (usually the contract s anniversary date). If the value of the index has increased since the last review, that higher value will be credited to the contract. If the value is lower, the decline will be ignored (i.e., the contract will retain the previous higher value). In this way the contract value can only ratchet up -- and for that reason, this method is called the ratcheting method. 10. ANS: D page 4 All of the statements are incorrect: total return for the ETF includes dividend income (return on EIAs reflect price changes only), and so ETFs will have a higher rate of return. EIAs shelter the investor from bear markets, EFTs do not. 11. ANS: D page 4 Contract A limits the gain to 90% of the 12% increase, or 10.8%, and that is subject to an overall cap of 8% -- or 8% this year Contract B limits the raise in the index to no more than 10% per year, and then only credits 80% of that amount -- or 8% year Contract C limits growth in the index to no more than 15%, since this year s growth is less than that maximum, the contract will credit the actual 12%, less the 3% yield spread, or 9% this year Contract D reduces the index s 12% gain by the 2% yield spread, or 10% -- and that is subject to an overall cap of no more than 10%, so the contract will credit 10% this year 12. ANS: A page 5 The only cost factor for immediate fixed annuities is factored into the annuity payout tables. The other types of contracts impose a number of other fees and charges. 13. ANS: A page 5 The mechanisms that reduce the amount of an index s growth that are credited to an EIA -- such as participation rates, yield spreads, and caps -- impose a cost on the contractholders. 14. ANS: B page 5 The interest rate spread is the difference between the interest credited to the contract and the interest earned by the annuity company s general assets. The company s interest income is rarely disclosed to contractholders. 15. ANS: B page 5 A market value adjustment will affect fixed contractholders who surrender their contracts or who take large partial withdrawals. In these cases, the company will adjust the cash value (surrender value) of the contract based on the current interest rates at the time of surrender. If current interest rates are higher than some stated rate in the contract, the cash value will be reduced. If current rates are lower, the cash value will be increased.

In this way the contract value can only ratchet up -- and for that reason, this method is called the ratcheting method. 10.

With any annuity, there are two distinct time periods involved: the accumulation period and the payout or annuity period:

With any annuity, there are two distinct time periods involved: the accumulation period and the payout or annuity period: A n annuity is simply a stream of periodic payments. Start with a lump sum of money, pay it out in equal installments over a period of time until the original fund is exhausted, and you have created an