ANNUITIES AND PENSION PLANS

Transcription

1 CALIFORNIA ANNUITIES AND PENSION PLANS RETIREMENT PLANNING AND DISABILITY RETIREMENT Researched and written by Irina Kerr

2 1 INDEX Introduction 1 CHAPTER I MAJOR ASPECTS OF RETIREMENT PLANNING 2 Identifying Retirement Goals and Insurance Needs 2 Projected Annual Retirement Expenses 4 Inflation 5 Possible Income Sources 6 Social Security 6 Retirement Income and Social Security 9 Pension Plans and Pension Income Role in Secure Retirement 10 Insurance Products for Retirement 13 Personal Savings 16 Summary 17 Quiz 18 Answers 19 CHAPTER II GENERAL ASPECTS OF ANNUITIES 20 Overview 20 Definitions 22 Indexed Annuities 23 Purchase Options 23 Types of Annuities 24 Annuity Pay-Out Options 24 Market Value Adjusted (MVA) Annuities 26 Deferred Annuities 27 The Tax-Deferred Advantage 28 Summary 29 Quiz 30 Answers 30 CHAPTER III VARIABLE ANNUITIES 31 Overview 31 Definitions 31 What is a Variable Annuity 32 Advantages 34 Disadvantages 34 Long-Term Care Riders 35 Living Income Benefits 36 Extra Credit Sign-Up Bonuses/Bonus Credits 36 Waivers 37 Death Benefit Waiver 37 Nursing Home Waiver 38 Terminal Illness waiver 38 Disability Waiver 38 Variable Annuity Charges 39

3 2 Surrender charges 40 Options, other than cashing out 41 Variable Annuities and Investments 42 Subaccounts 42 Family of Funds 44 Investment options for Variable Annuities 45 Liquidity Options 47 Agents 48 Protection by State Guaranty Association 49 Summary 50 Quiz 52 Answers 53 CHAPTER IV EQUITY-INDEXED ANNUITIES 54 Overview 54 Some of the Contract Features 55 Indexing Methods 56 Conclusion 57 Summary 60 Quiz 61 Answers 62 CHAPTER V CHAPTER VI BASICS OF INVESTMENT OPTIONS AVAILABLE FOR VARIABLE ANNUITIES, IRAs, 401(K) AND SOME OTHER RETIREMENT PLANS Overview 63 Investment Risks 64 Different Classes of Assets 65 Definitions 66 Aggressive Growth Funds 68 Mutual Funds 69 Options to Earn Money in the Fund 69 Kinds of Mutual Funds 70 Funds Comparison 72 Fees and Sales Loads 72 Advantages of Mutual Funds 73 Disadvantages of Mutual Funds 73 Stocks 74 Types of Stocks 74 Bonds 76 The benefits bonds provide 77 Types of Bonds 78 Market Indicators 79 Asset Allocation 80 Dollar Cost Averaging 82 Summary 84 Quiz 86 Answers 87 RECOMMENDATIONS AND RESPONSIBILITIES OF AGENTS REGARDING SALES OF VARIABLE ANNUITIES 63 88

4 3 Customer information 88 Liquidity and Earnings Accrual 89 Investment in Tax Qualified Accounts 90 Summary 92 Quiz 93 Answers 93 CHAPTER VII INDIVIDUAL RETIREMENT ACCOUNTS 94 Overview 94 IRA Definitions 95 Types of IRAs 96 IRA Deduction Limitations 98 Spousal IRA 98 Roth IRA 99 Guidelines for Roth IRA Accounts 100 Advantages of Roth IRA 100 Roth IRA Contributions 101 Income Limitations 102 Other Differences of Roth IRA Contributions from 103 Regular IRA The Roth IRA Withdrawals 104 Accessing IRA Funds Before Retirement & Early 106 Withdrawals Penalties on Conversion from a Regular IRA to a 107 Roth IRA Income Acceleration 108 IRS Ordering Rules 108 Impact of Taxes and Tax Brackets 109 The Roth IRA Beneficiaries 109 Highlights of an IRA 110 Highlights of a Roth IRA 111 Summary 113 Quiz 114 Answers 115 CHAPTER VIII PENSION PLANS 118 Overview 118 Laws and regulations as related to retirement and 118 pensions Employer Based Pension Plans 121 Defined Contribution Plans 122 Factors Affecting the Design of Employee Benefit 123 Plans Death Benefits 124 Waiver and Spousal Consent Rules for Qualified 125 Pre-retirement Survivor and Qualified Joint and Survivor Annuities Minimum Distribution Rules 126

5 4 Money Purchase Pension Plans 128 Distributions and in-service withdrawals 130 Profit Sharing Plans 130 Withdrawals 131 A hardship withdrawal 132 Employee Stock Ownership Plans (ESOPs) 133 Savings Plans 135 Withdrawals 136 Distributions 136 Cash or Deferral Arrangements (CODAs) 137 Keogh Plan 137 Profit Sharing Keogh Plan 138 Money Purchase Keogh Plan 138 Defined Benefit Keogh 139 Simplified Employee Pension, SEP 139 SIMPLE plans 140 Contributions 141 Distributions 141 Pension Fund Money protection 142 Summary 143 Quiz 145 Answers 145 CHAPTER IX CASH OR DEFERRED PLANS UNDER SECTION 401(K) 147 Overview 147 Definitions 148 Eligibility 151 Objectives 152 Contributions 152 Distributions 153 Rollover 154 Administration 155 Fees and expenses 155 Common Investment options and related fees 157 Variable Annuities and 401(k) plans (k) Plan Investments and Asset Allocation 158 Summary 161 Quiz 163 Answers 164 CHAPTER X TAX TREATMENT OF DISTRIBUTIONS FROM PENSION PLANS AND ANNUITIES 166 Definitions 166 Rollovers and Simplified Method 168 Qualified domestic relations order (QDRO) 170 Variable Annuities 170 Periodic Distributions 172 Non-periodic Distributions 175 Loans Treated as Distributions 179

6 Lump-Sum Distributions 181 Summary 184 Quiz 186 Answers 187 CHAPTER XI DISABILITY RETIREMENT 188 Overview 188 Definitions 192 Social Security and Disability 193 Individual Disability Insurance 198 Disability Income Insurance 199 Group Disability Benefits 199 Options and Features of Disability Policies 200 Inflation 201 Business protection 202 Taxes and Disability retirement 203 Summary 205 Quiz 207 Answers 208 CHAPTER XII RETIREMENT PLANNING AND LIFE INSURANCE AGENT 210 Determining the Insurance Needs 210 Income and Outflow 212 Estate planning 213 An emergency fund 214 Gross Estimate of Insurance 214 Computation of Retirement Income 216 Retirement Distribution Options 217 Taxation of retirement Distributions 218 The Major retirement Threats and retirement Insurance Needs 219 Major Health Problems 219 Long-term care insurance 220 Summary 222 Quiz 224 Answers 225 Glossary Examination questions A Examination answers A Examination questions B Examination answers B 5

7 INTRODUCTORY NOTE Retirement and financial security are vital national issues, since the number of Americans 65 and older will more than double to nearly 70 million and nearly half of them will spend about 25 years or more in retirement. This book provides material on retirement planning, covering the major aspects of retirement planning, like identifying retirement goals and needs, evaluating income and expenses, estimating possible income sources. It also includes ample information on annuities, their general aspects and types, contributions and distributions, tax aspects and purchase options. The book covers variable annuities, highlighting their advantages and disadvantages, describing riders, waivers. It also describes basics of investment options available for variable annuities, charges and subaccounts. A separate chapter is dedicated to agents responsibilities regarding sales of variable annuities. It also has material on equity-index annuities, indexing methods included. The book also covers major retirement plans, such as IRA, Roth IRA, 401(k), Keogh plans and other qualified retirement plans. The material includes information on contributions, distributions and rollovers, as well as tax treatment. There is also material on disability retirement and social security treatment of disability claims. This book is not intended to be a formal primer on financial, tax or legal aspects. However, insurance agents must not only have a comprehensive understanding of the major issues of financial, legal and tax aspects of insurance products, but also to be able to explain the advantages to prospects with the highest degree of professionalism, integrity and ethics.

8 1 INTRODUCTION Retirement and financial security are very important national issues and the nation s response to today s social, demographic, and economic pressures will profoundly affect the quality of everyone s retirement. The number of Americans 65 and older will more than double to nearly 70 million, and nearby half will spend about 25 years or more in retirement. This will place tremendous financial burdens on all programs that serve the elderly, most notably Social Security. Thus, individual retirement savings and private pensions will become increasingly important in years to come as supplements to Social Security. The retirement planning process is a long-term vehicle and is a very important part of the entire financial planning process. Its primary purpose is to identify specific and a comfortable amount of net annual retirement income, to evaluate all available financial sources, and to design a long-term plan to reach the desirable standard of living during retirement years. Besides saving and investing for retirement, an individual should also consider the issues threatening the savings, namely the problems of taxation, inflation and the chance of outliving the income. Moreover, there are some considerations that should be taken into account. Such dramatic events as major health problems, long-term care needs, divorce, the death of a spouse, and disability might deplete the savings unless protected by insurance. The Insurance industry is one of the leading providers of retirement products, and has strong commitment to help Americans plan for their retirement. At present many insurance products are available on the market to provide for both insurance protection against financial losses and cash accumulation for retirement savings. Life insurance contracts, health insurance, annuities, and various pension plans are the tools to provide a financially secure retirement. The purpose of this book is to review retirement planning issues and the options that are available for retirement financial planning. The book is not intended to be a formal primer on financial, tax or legal aspects, since a financial plan for retirement purposes may require assistance of a certified financial planner, an accountant, a tax attorney and a lawyer in addition to an insurance agent. However, insurance agents have to understand the major issues of financial, legal, tax and insurance aspects of retirement planning to be able to advise prospective customers on a high professional level of all insurance products and other financial options available on the market for retirement planning purposes.

9 2 CHAPTER I MAJOR ASPECTS OF RETIREMENT PLANNING Retirement planning is a long-term vehicle, thus, strategy and tactics of retirement planning will depend on the age of the individual, his or her marital status and family considerations, retirement goals and financial resources to achieve the goals. Retirement planning is a comprehensive process for determining how much insurance coverage and money a prospect will need for retirement. Many life events affect financial security: marriage, purchasing a home, starting a family, and education needs. That is why the approach to retirement planning should be very individual. However, there are several basic principles that are applied in retirement planning. Before an insurance agent can suggest what can be done in every particular case, the insurance needs should be determined. Financial planning for retirement purposes is a dynamic process, which starts with identification of the prospects specific goals. Once the pertinent data is gathered, the goals are analyzed in terms of ways of achieving them. Identifying Retirement Goals and Insurance Needs Principal retiree s needs may be broken down into the following main issues: Income and Expenses Lifestyle Housing Health care Estate planning Emergency needs Income and Expenses The income side of a prospect is a very important part of general retirement planning. Here is a list of most important issues to be discussed with the prospect: What types of insurance does the prospect have? Is the prospect a participant of any pension plans, like 401(k), IRA, Roth IRA, Keogh, SEP, etc.? Has the participant undertaken any other savings strategies, like savings accounts, stocks, bonds, CDs, or other securities?

10 3 How much is the prospect planning to spend on housing, utilities, food, clothing, travel, hobbies, or any other items or activities? When is the prospect planning to retire? (at the age of 65, earlier, or later) Is the prospect planning to have a full- or part-time job after retirement? For how long does the prospect estimate the need of retirement income? Lifestyle and housing issues are very important in gross estimating of a prospect retirement needs. If a prospect is planning to move to a warmer climate or a smaller house, moving expenses should also be included into retirement income needs. Health care is another important issue to consider. Most retirees are eligible for Medicare A and B; some retirees enjoy medical benefits from their employers. But a need for long-term care or major health problems can deplete any retirement savings. Insurance protection against financial losses in the event of a serious illness is also a part of retirement planning process. Estate planning is another factor an insurance agent should consider while helping with the retirement planning strategies. Are there any dependents to take care of? Does the prospect want to use up all the money by the time he or she dies? The answers to these questions also determine the specific retirement needs. An emergency fund helps with all the unforeseen financial problems. These problems may be associated with living and overlap with financial needs associated with dying. The additional financial needs associated with living may be the following: Living longer than an individual expects Need for additional medical care, like assistance with daily activities Inflation Increase of cost of living Premature death can also cause financial problems: Cost of final illness or injury Final expenses Paying mortgage and other debts Providing continuing family income Funding children s education Providing current income and retirement income for the spouse The basic steps of retirement planning are the following: To identify all the specific needs of a prospect

11 4 To evaluate all income sources To estimate retirement needs in an annual income stream, adjusted for inflation To determine if there is a retirement gap, and what steps should be taken to ensure a secure retirement income. Projected Annual Retirement Expenses Though it is impossible to estimate all retirement expenses, there are some typical expenses that most individuals incur. The total projected expenses make an impact on financial retirement planning while computing a retirement gap. These expenses vary and may include the following: House payments (mortgage or rent) Utilities, home maintenance, property taxes Loan payments (car payments, bills, credit cards) Food and household supplies Clothing, cleaning, personal supplies Domestic help Entertainment, clubs Insurance premiums Medical/dental expenses not covered by insurance Travel Hobbies Gifts to family, friends Other This is an approximate list of possible expenses. A general rule of thumb is that on average retirement income equals to 75 percent of pre-retirement net income. However, there are many people who live quite comfortably on a lesser amount. Hence the current expenses can help to estimate the needed retirement income, adjusted for inflation and possible higher cost of living. In 1997 Consumer Expenditure Survey, the Department of Labor says that on average, people 65 and older spend about $25,275 a year.

12 5 Average Annual Expense Breakdown for People 65 and Older ($25,275 in total expenses) 5% 4% 5% 12% 18% 4% 9% 14% 29% food 14% housing 31% utilities 9% clothing 4% transportation 18% health care 12% entertainment 5% household furnishings 4% other 5% Source: U.S. Bureau of Labor Statistics. Consumer expenditure Survey Inflation is another important consideration in retirement planning. Due to the fact that people retire earlier and live longer, the impact of inflation can be very substantial. If we take a married couple with $25,000 current annual living expenses, the same living expenses may amount to $56,000 in 20 years, with the inflation rate of 4 percent. Impact of Inflation Based on 4% Inflation Based on 8% Inflation Cost of Living Cost of Living Today 10 Yrs 15 Yrs 20 Yrs Today 10 Yrs 15 Yrs 20 Yrs $25,000 $37,000 $45,000 $56,900 $25,000 $54,000 $79,250 $116,500 $30,000 $44,400 $54,000 $67,700 $30,000 $64,800 $95,100 $139,800 $50,000 $74,000 $90,000 $109,600 $50,000 $108,000 $158,500 $233,000 Both living expenses and inflation are important in retirement planning and understanding retirement needs, as it is planning for a period of time and not a point in time. Tax consequences and planning for the receipt and investment of the funds is another important factor to consider. The taxation of retirement distributions depends on the type of the pension plan or annuity. This book will discuss tax consequences for every type of pension plan and distributions.

13 6 The projected retirement income should be calculated in an annual stream of income to better understand the required amount necessary for comfortable and secure retirement. Having estimated the total projected expenses, and having adjusted them for inflation and possible higher cost of living, we received a part of information necessary for retirement planning. This dynamic approach to financial planning allows development of a plan where the needs and goals for retirement are its basic foundations. Now the question is what sources of income are available to a prospect at present. Possible Income Sources There is an abundance of insurance products, savings accounts, investment options and pension plans on the market today to satisfy people s needs for retirement financial planning. The wide range of options available may be narrowed to the following: Social Security Pension plans Insurance products Personal Savings Social Security Traditionally Social Security benefits are considered by a majority of people as the foundation of their retirement planning programs. The Social Security contributions deducted from paychecks serve as a government-enforced retirement savings plan. However, the Social Security system is under increasing strain. Improved health care and longer life spans have resulted in an increasing number of people drawing Social Security benefits. And as the baby boomers approach retirement, even greater demands will be placed on the system. In 1940, 4.0 active workers supported each person drawing Social Security benefits, only 3.2 workers support each Social Security pensioner at present. By 2030 it is projected there will be 2.0 active workers to support each Social Security pensioner. (Source: Social Security and Inflation Congress first legislated an increase in Social Security benefits in the 1950 Amendments and from that time beneficiaries have their payments recomputed. These annual increases in Social Security benefits are to offset the corrosive effects of inflation on fixed incomes. These increases are known as Cost of Living

14 7 Allowances (COLAs). October 18, 2000 Social Security Commissioner Kenneth S. Apfel announced an annual increase of 3.5 percent for the 45 million Americans who receive Social Security. The continued low inflation rate in the United States was nonetheless a bit higher in 1999 than at any time since The cost-of-living increase was 2.4 percent in 1999 and 1.3 percent in (Source: Amy Goldstein, Washington Post Social Security Pay to Rise 3.5% Jan. 1 ) However, the long-term future of Social Security is precarious. The trust fund for the benefits paid are expected to cover the program s expenses until Thus, long-term retirement planning should take into consideration that Social Security benefits are playing a more limited role when calculating retirement income. Moreover, some financial professionals suggest ignoring Social Security altogether when developing a retirement income plan Social Security Changes Tax Rate: Employee 7.65% 7.65% Self-Employed 15.30% 15.30% Maximum Earnings Taxable: Social Security (OASDI only) $76,200 $80,400 Medicare (HI only) N o L i Quarter of Coverage: $780 $ Year individual reaches 65 Under age 65 Maximum Social Security Benefit: $17,000/ yr. ($1,417/ mo.) $10,080/ yr. ($840/m o.) Worker $1,433/m o. $25,000/ yr. ($2,084/ mo.) $10,680/ yr. ($890/m o.) $1,536/m o. SSI Federal Payment Standard: Individual $512/mo. $530/mo. Couple $769/mo. $796/mo. SSI Resources Limits: Individual $2,000 $2,000

15 8 Couple $3,000 $3,000 Estimated Average Monthly Social Security Benefits: Before and After Before 3.5% COLA After 3.5% COLA All Retired Workers $ 816 $ 845 Aged Couple, Both Receiving Benefits $1,363 $1,410 Widowed Mother and Two Children $1,639 $1,696 Aged Widow(er) Alone $ 783 $ 811 Disabled Worker, Spouse and One or More Children $1,266 $1,310 All Disabled Workers $ 759 $ 786 (Source: Retirement Income and Social Security Retirees rely on a variety of income sources for retirement income. These sources mainly include earnings and public assistance. As the chart below shows, only 40 percent of retirees income came from Social Security, 18 percent was from employer pensions, 18 percent was from asset income, including savings, and 20 percent from earnings. Social Security, Pension and Asset Income are Major Income Sources for the Aged Social Security 40% Other 4% Pensions 18% Earnings 20% Assets 18% Source: Fast Facts and Figures About Social Security, 1998 MetLife Online gives a chart that shows the sources of income for retired people with incomes of $31,000 or more with the information from Social Security Administration for December The chart given below shows that Social Security and pensions provide only a fraction an individual may need for secure retirement. The percentage of Social Security is only 23 percent of the total retirement purposes.

16 9 Social Security Provides Only a Fraction for Retirement Purposes Social Security 23% Other 3% Earned Income 29% Pensions 21% Savings & Investments 24% Thus, it is clearly seen that Social Security benefits can be only a part of the total retirement financial planning. Pension Plans and Pension Income Role in Secure Retirement There are two basic types of pension plans: A defined benefit plan. A defined contribution plan A defined benefit plan is typically funded by the company. The length of service and salary are two major factors influencing the fundamentals of retirement benefits. The defined benefit is usually calculated using a formula based on a percentage of the final compensation multiplied by the number of years an individual works for his or her employer. On the other hand, the employer is required to fund a defined benefit plan adequately, so it will provide the promised benefits when an employee retires. The employer is the bearer of the investment risk, while benefits are guaranteed by the federal government. Employees do not have any input into money investments and allocations in the defined benefit plans. In a defined benefit plan, it is unlikely that an employee can gain access to his or her pension money before retirement. A defined contribution plan, which is also known as an individual account plan, is generally funded by a combination of employer and employee contributions. The employer pays a specified amount of money on an annual basis, which is then divided among the individual accounts of each participating employee. The sum of contribution and earnings on invested contributions over the years determine the retirement benefits. In this type of retirement plan the employees have a greater control over the investments and bear the investment

17 10 risk. This type of plan is also portable. When an employee leaves a job, he or she can take the benefits to another job. The amount the employer puts in varies, as it depends on the type of defined contribution plan. It is typically: Based on the discretion of the employer A fixed dollar amount A percentage of an employee s compensation There are a variety of defined contribution plans, which include: Profit-sharing plans, in which the employer contributes a portion of each year s profit to the plan. Employee stock ownership plans (ESOPs), in which the employer s contribution is made in the form of company stock 401(k) plans, in which each employee is entitled to elect to defer a portion of his or her income and place the money in an individual pension account. There are some 401(k) plans, where the employer also contributes to the employee s individual account. There are also defined contribution plans that allow an employee to allocate his or her funds among different kinds of investment options. This type of plan offers varying degrees of risk and reward. A younger participant may choose highyielding investments, like stocks, though it has a larger degree of market risk, while some more conservative individuals would rather prefer security and safety of a fixed-income investment. There is also an option to balance the allocation of funds between a predictable return and higher risk investments. If an individual is in a defined contribution plan, such as a profit-sharing, 401(k), or stock bonus plan, there are some options to have access to the pension money. All these plans are targeted on creating as asset allocation that meets and individual s savings objectives and matches his or her risk tolerance. Pension plans are also differentiated into qualified plans and non-qualified plans. Qualified plan is a retirement or pension plan that the IRS recognizes for preferential tax treatment and it meets the qualification requirements of the U.S. Department of Labor. Non-qualified plan is a retirement or pension plan that the IRS does not recognize for preferential tax treatment, such as the deferral of taxes, or it fails to meet the qualification requirements of the U.S. Department of Labor.

18 11 Tax deferral is to put off tax liability on investment earnings, usually until some time specified in the plan. Eligibility Each plan has its own rules regarding employee eligibility to participate and the formula used for determining benefits. According to federal law, the eligibility rules must allow for participation by a broad group of workers, and the benefits formula cannot discriminate in favor of highly compensated employees. Employees are generally eligible to participate in a company s pension if: They are 21 or older They have been employed for at least one year They work at least 1,000 hours a year for the sponsoring employer. However, employers may waive these requirements. Part-time employees are typically not eligible. To be fully vested means that an individual has a nonforfeitable right to all his or her pension benefits, even though payment of the benefits may not be made until some later date. Any of the employee s own contributions to the plan, such as through 401(k) deductions from the salary, are automatically his or hers. Each plan varies, but it often takes between five and seven years of service to become fully vested. If an individual leaves the company or retires after becoming fully vested, all of the pension benefit is still his or hers, but if it happens before becoming fully vested, an employee loses the unvested portion. However, even if the pension benefit is to be paid to a fully vested employee, this payment may be delayed until the employee reaches retirement age. There are also some other requirements, for example if an employee quits and the benefit is $3,500 or less, he or she can be forced to withdraw the pension benefit money. The account balance varies and in some cases the balance should exceed $5,000 for an employee who is quitting the job to be able to leave the money in the plan. The book will deal in detail with some of the most popular pension plans. Much of the growth in defined contribution plans has come from the growth of 401(k) plans, which are profit-sharing and stock bonus pension plans. Individual Retirement Accounts (IRAs) Individual Retirement Accounts (IRAs) also offer attractive retirement savings. Different types of IRAs are available on the market today: Traditional IRA Deductible IRA

19 12 Nondeductible IRA Roth IRA Traditional IRA. Individual Retirement Accounts came into existence as part of the Employee Retirement Income Security Act of 1974 (ERISA). They were made widely available as of Later on with tightened eligibility restrictions people with high or even middle incomes no longer qualified to make tax-deferred IRA contributions. At present, thanks to expanded eligibility and the introduction of a whole new type of IRA called the Roth IRA, Individual Retirement Accounts have once again became good tools in retirement planning process. Traditional IRAs are also known as Standard IRAs, Regular IRAs, or just as IRAs. The basic rules of eligibility are rather straightforward; anyone who is younger than age 70 ½ at the end of the year can make an annual IRA contribution of up to either $2,000 or his or her total compensation for that year, whichever is less. Nondeductible IRA. Taxpayers who exceed the income limits for the deductible IRA and the Roth IRA can contribute up to $2,000 to a nondeductible IRA. While contributions cannot be deducted from income for tax purposes, earnings are not taxed until they are withdrawn. Roth IRA. The Roth Individual Retirement Account was created under The Taxpayer Relief Act of It was named for its principal advocate, Delaware Senator William Roth. It offers investors one more alternative for building savings for retirement, since they are available to many taxpayers that do not qualify for deductible Traditional IRAs. Unlike the traditional IRA, contributions to the Roth IRA are not tax deductible. This is a disadvantage of Roth IRA, as all contributions to Roth IRA must be made with after-tax dollars. This is true regardless of the income level and whether or not an individual is an active participant in an employer-sponsored retirement plan. The tax benefit is realized when funds are withdrawn. A Roth IRA allows contributions after an individual reaches age 70 ½ as long as the individual or individual s spouse has earned income. One of the major advantages of Roth IRA is that withdrawals are not taxed if: An individual is 59 ½ or older when he or she can make the withdrawals The Roth IRA was set up and the first contribution made five or more years prior to the withdrawal date Insurance Products for Retirement Insurance industry is one of the main leaders in providing a wide range of insurance products not only as a tool against financial losses, but as a tool in retirement planning.

20 13 Life insurance products with cash accumulation feature play an important role in retirement financial planning. The consumer demand for more flexibility in terms of investment features, resulted in a new variety of life insurance products with various options for investment. The basic types of these relatively new insurance products are Universal Life, Variable Life, Universal Variable Life and Adjustable Life. There are also numerous combinations of life policies with a wide range of flexible features as related to investment and cash value accumulation, which also can be used a financial tools in retirement planning. Variable Life and Universal Variable Life provide for flexibility in cash value accumulation and allow wider possibilities to allocate assets and to meet specific objectives and risk tolerance. Partial withdrawals and preferred loans are also very attractive options of Universal Life and Variable Life contracts. As has already been said, retirement planning is a long-term project. According to the 2000 Retirement Confidence Survey (RCS) seventy percent say they have a savings or investing strategy for their retirement, and 41 percent have thought about insurance coverage for long-term care or nursing home needs. Major health problems or disability may interfere with the retirement planning. Life and health insurance products have a variety of options to protect policyowners against financial losses. An optional rider may be attached to the contract for a nominal charge to protect oneself and his or her family from financial losses in case of illness, disability or accident. One of the most commonly used types of additional benefits is a disability insurance benefit, known as waiver of premium. If the insured becomes totally disabled, the disability insurance benefit will pay the life insurance premiums. There is another type of disability benefit, which is known as a disability income benefit. It can be provided either as waiver of premium with disability income or may be attached as a separate benefit. If the insured with such an option in his or her contract becomes totally disabled the benefit will pay a monthly income to the insured. There is also a dismemberment benefit mostly known as accidental death and dismemberment benefits. Commonly known as double indemnity the benefit covers an additional death benefit in the event of the insured s death due to an accident. Of all the options offered in life insurance policies the accidental death rider is probably the most famous. It increases the face amount of the policy should the insured die due to an accident. The term double indemnity appeared since the increase is usually double the face amount, but it does not have to be. If

21 14 the insured loses one or more limbs, or sight of one or both eyes, or, in some cases, hearing, as the result of an accident injury the dismemberment, benefit pays the amount specified in the contract. There also appeared living benefits and long-term care in life insurance policies, which are either attached to the contract as benefits or as separate riders. An insured with a terminal disease and a need for a special medical care can use living benefits as a portion of the proceeds otherwise payable as a death benefit. These sorts of benefits are usually provided without charge since the payment of death claim is imminent. It is widely acknowledged that these benefits are a humane approach to life insurance proceeds, since the money are usually used to ease pain and suffering during the final period of life. A need for daily living assistance, long-term care, or a nursing home can deplete retirement savings. Though long-term care benefits are a feature of health insurance, they are also available as a separate rider to a life insurance policy. In this case an additional premium is charged and this type of benefit will not affect the policy s face cash value. Some policies have these benefits as part of an integrated plan. In this case an additional premium is not charged for long-term care benefits, as the funds for this purpose are borrowed from the life insurance benefits, thus reducing face value and cash value. There is also Term Insurance Rider. This type of rider allows an insured to have two policies almost for the price of one. One policy is a cash value type and the other one is a term policy that allows the policyholder to keep the face value high for income protection. When the insured has money enough the term policy can be converted to a cash value plan. There is another type of term insurance rider, which allows the policyholder who purchases cash value insurance to acquire term insurance for the spouse or children. It is known as a family rider, as purchasing term insurance for other family members allows the family as a whole to avoid paying an insurance company expenses like commissions, twice, which would occur if the term policy is purchased separate and apart from the cash value policy. Another advantage of Life insurance contracts is a death benefit. Premature death of the breadwinner of the family can seriously interfere with retirement planning, besides a possibility of leaving a family with a lesser income, unpaid debts and no funds for children s education. The combination of insurance protection against premature death with the cash value aspect of life insurance policy is an invaluable asset in retirement planning. Another insurance product on the market designed for retirement planning are annuities. Riders and death benefits are also available, similar to Life insurance contracts. Annuities are tax-deferred savings that are offered by life insurance

22 15 carriers. They provide a wide spectrum of risk tolerance for investors, from fixed interest to equity index with principle guarantee to full variable annuity products. The variable investment characteristics of Variable Life (VL) and Variable Universal Life (VUL) products are also shared by Variable Annuities (VA). The differences in these products depend on age, health, financial status, family needs, employment situation and benefits, other investments and an individual s personal risk tolerance. VAs are frequently available as qualified retirement plan options in employee benefit programs, which permit regular contributions into VA accounts. There are numerous choices how to pay for annuities, to invest the payments, and to receive proceeds of annuity contracts. Some of the greatest advantages of annuities are that annuity contract earnings are exempt from all taxation while they remain in the contract, and unlike many retirement accounts, there is no penalty for keeping money in an annuity contract past the age of 70 ½. Earnings on the contract do not influence Social Security entitlements and the annuity owner determines when the funds come out of the account and in what form. There are generally no limits on the amount of money an individual may pay into annuity contracts. Personal Savings Personal and family savings may include: Bank or credit union savings accounts United States government securities Certificates of deposit, mutual funds, corporate securities (stock and bonds) Commercial real estate Any other liquid assets. An insurance agent should remember that before fully defining the foundations for retirement planning, it is necessary: To inventory and analyze all assets of the client To project the retirement needs To offer available options for retirement planning on the basis of the individual's particular needs and possibilities Having estimated all the needs and current financial status of the client enables the insurance agent an opportunity to offer available products on the market that will best serve the client s particular needs for retirement planning. First of all it is necessary to compute the retirement gap, if any. Financial experts suggest that percent of the individual s current annual gross income is required for retirement. The total income the client expects to receive annually from all sources available currently should be added up to know how much the

23 16 client needs for each retirement year. To determine the amount a client needs to save, it is necessary to find out how many years are left before the client plans to retire and to estimate life expectancy using mortality tables. Having received the total additional savings needed at retirement, the insurance agent can offer the strategy of retirement savings by offering available products on the market. To do it in the best interests of the client an insurance agent should know all the aspects of various options for retirement planning. The book will deal in detail with various insurance products that can be offered to help people save for retirement purposes in next chapters.

24 17 SUMMARY Retirement planning is a comprehensive, dynamic and a long-term process for determining the insurance coverage and cash accumulation an individual needs to secure retirement years. Although the approach to retirement planning is very individual and depends on many particular circumstances of life, there are some basic principles applied in retirement planning. Before offering any available products that can help a client save for retirement purposes, an agent should help the client to estimate the gross current annual income and to identify goals and insurance for retirement. Identifying retirement goals and insurance needs helps the client to estimate gross annual income needed to satisfy these goals and needs for secure retirement. Such factors as life style and housing, health care and estate planning, an emergency fund and consequences of premature death or outliving estimated retirement years should be taken into consideration. The income side of a prospect is another very important part of general retirement planning. The current insurance a client has, participation in any pension plans or saving plans, the current savings and investment strategies should be taken into account to serve in the best of the client s interests. Impact of inflation and tax consequences are also important factors that determine retirement planning. The taxation of retirement distributions depends on the type of the pension plan or annuity. Traditionally Social Security benefits have been considered by a majority of people as the foundation of the retirement planning. However, in spite of the government efforts to ensure Social Security benefits for American people who will retire in years or later, it is evident that Social Security benefits are not enough for a comfortable life during retirement years, even with Cost-of-Living annual Adjustments (COLAs). Thus, Social Security benefits may be considered only a part of the total retirement planning strategy. There is a variety of insurance products with cash accumulation features, like Universal Life, Variable Life, Universal Variable Life, Adjustable Life, Annuities and a wide range of numerous combinations of flexible features that an agent can offer prospects for retirement purposes. Death benefit and optional riders help policyowners to protect themselves and their families against financial losses in case of premature death or serious health problems, besides accumulating cash for retirement purposes. There is also a wide range of pension plans available on the market today. Defined benefit and defined contribution plans, profit-sharing plans and employee

25 18 stock ownership plans together with IRAs and Roth IRAs provide for taxsheltered savings for retirement purposes. To professionally help an individual with retirement planning and to serve a client in his or her best interests, it is vitally important that an insurance agent knows all options and features of products for retirement planning purposes in detail. Retirement planning strategies should be based on particular possibilities and needs of the client. QUIZ QUESTIONS 1. What is the first step an agent should undertake for retirement planning? 2. What are the principal retiree s needs to be taken into consideration for retirement planning? 3. Name at least three of the possible retirement expenses. 4. Social Security benefits provide about 60 percent of necessary amount for retirement (True/False) 5. Name at least three insurance products that help saving for retirement purposes. 6. Name at least three optional riders that can be used to protect an individual and his or her retirement savings against serious health problems.

26 19 ANSWERS 1. The first step an agent should undertake for retirement planning is to estimate gross annual income of the client and to find out the current efforts of the client on retirement savings, financial strategies and current insurance protection. 2. The principal retiree s needs to be taken into consideration for retirement planning are lifestyle, housing, health care, estate planning and emergency needs. 3. House payments (mortgage or rent), home maintenance, utilities, property taxes, food and household supplies, loan payments (car payments, bills, credit cards), food and household supplies, clothing, cleaning, personal supplies, domestic help, entertainment, clubs, insurance premiums, medical/dental expenses not covered by insurance, travel, hobbies, gifts to family, friends 4. False. Social Security benefits provide about 40 percent of necessary amount for retirement. 5. There is a variety of insurance products with cash accumulation features, like Universal Life, Variable Life, Universal Variable Life, Adjustable Life, Annuities and a wide range of numerous combinations of flexible features that an agent can offer prospects for retirement purposes. There is also a wide range of pension plans available on the market today. Defined benefit and defined contribution plans, profit-sharing plans and employee stock ownership plans together with IRAs and Roth IRAs provide for tax-sheltered savings for retirement purposes. 6. Disability insurance, also known as waiver of premium Accidental death and dismemberment benefits, also known as double indemnity Long-term care Living benefits Term Insurance Rider Family rider

27 20 CHAPTER II GENERAL ASPECTS OF ANNUITIES Overview Annuities could be a great vehicle for the investment portfolio; they are widely used for retirement purposes and to complement life insurance. Annuities are taxdeferred savings that are offered by life insurance carriers. Individuals invest billions of dollars yearly into annuities. They provide a wide spectrum of risk tolerances for investors, from fixed interest to equity index with principle guarantee to full variable annuity products. In the most literal sense an annuity is a payment made yearly under a contract to provide an income. This term is also applied to any series of periodic payments made at regular, fixed intervals; the length of the interval is called the annuity period. In general, there are two main classes of annuities certain and contingent annuities. Under an annuity certain, the payments are to continue for a specified number of payments, and calculations are based on the assumption that each payment is certain to be made when it is due. With a contingent annuity, each payment is contingent on the continuance of a given status, as with a life annuity, under which each payment is contingent on the survival of one or more specified persons. A special case of the annuity certain is the perpetuity, which is an annuity that continues forever. One of the best-known examples of perpetuity is the interest payment on the British government bonds known as consoles. Since these obligations have no maturity date, it is intended that the interest payments will continue indefinitely. The contingent annuity used in life insurance and pension plans is based upon the risk-sharing principle. A life annuity is a subclass of annuities in general. The price of an annuity paying a certain specified sum for life is based upon the life expectancy of the annuitant at the time the annuity is to begin. In effect, the annuitant joins a large number of other individuals of the same age in establishing a fund. This fund is calculated on the basis of mortality tables for it to be sufficient to pay each person the life income agreed on in a contract. Some individuals will live longer than others and receive more in payments than they have put into the fund, whereas others will not live long enough to receive what they have put in. This is a risk-sharing principle, which allows purchasing an annuity that guarantees much higher payments than could be obtained if the same amount of money were invested at interest. This is the major advantage of annuity. The main disadvantage of such type of annuities is that the family or heirs will not get anything upon the death of the annuitant.

28 21 A group annuity differs from an individual annuity in that the annuity payments are based upon the assumed length of lives of members of a given group. The size of payments depends on several factors: The assumed interest rate The life expectancy of the individual or of the individuals making up the group The length of the period during which payments are guaranteed The length of time elapsing before the payments start The number of lives on which the payments are continued. An employer, who may pay all or part of the cost, sponsors the typical group life annuity. Under the usual arrangement, every employee receives annually a credit with the life insurance company for the annuity purchased to begin at age 65. The final pension received is calculated on the basis of the total sum of the individual annuities purchased throughout the worker s life. As a rule, an irrevocable claim to these annuity rights is gained only after the person has worked with the employer for a specified number of years or has reached a specified age. The problem of inflation has led to experimentation with variable annuities to protect annuitants against decreases in purchasing power. The major distinguishing characteristic of a variable annuity is that the payments vary according to underlying trends in the stock market. Funds paid in for the variable annuity are invested in common stock rather than in bonds, mortgages, or other fixed-interest investments as is typical for regular annuities. In simplified terms, if the stock market rises 10 percent in one year, the annuitant may expect payments to go up by approximately 10 percent in the following year. If the stock market drops 10 percent, the annuitant will suffer a 10 percent decrease in income. Thus, the annuitant s income is automatically adjusted for these changes each year, gaining or losing in accordance with the stock market fluctuation and the economy development. Some variable annuity plans are tied up directly to a cost-living index. In order to finance the increased benefits, the employer invests a portion of the funds in equities such as common stock and real estate. An assumption is made that there will be a sufficient gain to enable the employer to pay the increased cost of living, on the other hand, the employee is not expected to suffer reductions in annuity payments. The problem of adjusting retirement benefits to changes in the economy has been the concern in many countries. Some governments have pegged the price of government bonds to the cost-of-living index with the automatic increase in interest payments, if the cost of living rises, but with a guarantee that the interest will not drop below a specified amount. (Source: Encyclopaedia Britannica)