ANNUITY SUITABILITY AND DISCLOSURE

Transcription

1 ANNUITY SUITABILITY AND DISCLOSURE Researched and Written by: Edward J. Barrett CFP, ChFC, CLU, CEBS, RPA, CRPS, CRPC 1

2 Disclaimer This course is designed as an educational program for financial professionals. EJB Financial Press is not engaged in rendering legal or other professional advice and the reader should consult legal counsel as appropriate. We have tried to provide you with the most accurate and useful information possible. However, one thing is certain and that is change. The content of this publication may be affected by changes in law and in industry practice, and as a result, information contained in this publication may become outdated. This material should in no way be used as an original source of authority on legal and/or tax matters. Laws and regulations cited in this publication have been edited and summarized for the sake of clarity. Names used in this publication are fictional and have no relationship to any person living or dead. This presentation is for educational purposes only. The information contained within this presentation is for internal use only and is not intended for you to discuss or share with clients or prospects. Financial professionals are reminded that they cannot provide clients with tax advice and should have clients consult their tax advisor before making tax-related investment decisions. EJB Financial Press, Inc Congress St. New Port Richey, FL (800) This book is manufactured in the United States of America 2014 EJB Financial Press Inc., Printed in U.S.A. All rights reserved 2

3 About The Author Edward J. Barrett CFP, ChFC, CLU, CEBS, RPA, CRPS, CRPC, began his career in the financial and insurance services back in 1978 with IDS Financial Services, becoming a leading financial Advisor and top district sales manager in Boston, Massachusetts. In 1986, Mr. Barrett joined Merrill Lynch in Boston as an estate and business-planning specialist working with over 400 Financial Advisors and their clients throughout the New England region assisting in the sale of insurance products. In 1992, after leaving Merrill Lynch and moving to Florida, Mr. Barrett founded The Barrett Companies Inc., Broker Educational Sales & Training Inc., Wealth Preservation Planning Associates and The Life Settlement Advisory Group Inc. Mr. Barrett is a qualifying member of the Million Dollar Round Table, Qualifying Member Court of the Table and Top of the Table producer. He holds the Certified Financial Planner designation CFP, Chartered Financial Consultant (ChFC), Chartered Life Underwriter (CLU), Certified Employee Benefit Specialist (CEBS), Retirement Planning Associate (RPA), Chartered Retirement Planning Counselor (CRPC) and the Chartered Retirement Plans Specialist (CRPS). EJB Financial Press EJB Financial Press, Inc. ( was founded in 2004, by Mr. Barrett to provide advanced educational and training manuals approved for correspondence continuing education credits for insurance agents, financial advisors, accountants and attorneys throughout the country. Broker Educational Sales & Training Inc. Broker Educational Sales & Training Inc. (BEST) is a nationally approved provider of continuing education and advanced training programs to the mutual fund, insurance and financial services industry. For more information visit our website at: Or call us at

4 Preface On March 28, 2010, the National Association of Insurance Commissioners (NAIC), the voluntary organization of insurance regulators from the 50 states, the District of Columbia and the five U.S. Territories, adopted and published its 2010 Suitability in Annuity Transactions Model Regulation. This Model Regulation was adopted to set standards and procedures for suitable annuity recommendations and to require insurers to establish a system to supervise recommendations so that the insurance needs and financial objectives of consumers are appropriately addressed. In addition, the Model Regulation, specifically Section 7A, requires the producer to have adequate product specific training, including compliance with the insurer s standards for product training, prior to soliciting an annuity. Also, in Section 7B it requires a one-time, minimum four credit hour general annuity training course offered by an insurancedepartment approved education provider and approved by an insurance department in accordance with applicable insurance education training laws or regulations. For this mandated course, the provider may not train in sales or marketing techniques or product specific information. Minnesota had become the 31st State to adopt the 2010 NAIC Suitability in Annuity Transactions Model Regulation (#275). MN HF 791 Second Engrossment was filed on May 14, 2013 by the Minnesota Secretary of State after the time for Governor Dayton to sign or veto the legislation had expired. Having elected to do neither, the legislation was enacted under the laws of the Session as Chapter 54, and becomes effective on June 1, Under Chapter 72A.203 of the Minnesota Statutes Annotated, it provides standards and procedures for recommendations to consumers that result in transactions involving annuity products so that the insurance needs and financial objectives of consumers at the time of the transactions are appropriately addressed. Note: All states must come into compliance with The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Public Law Number , 111th Cong., 2d sess. (July 21, 2010) which requires all states to meet the requirements of the 2010 NAIC Model Regulation by June 16, As of July 9, 2013, Alaska, California, Colorado, Connecticut, Florida, Hawaii, Idaho, Iowa, Illinois, Kansas, Maryland, Michigan, Minnesota, Mississippi, New Jersey, New York, North Dakota, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Texas, Utah, Washington, West Virginia, Wisconsin, and the District of Columbia have adopted the 2010 NAIC Model Regulations and training requirements. To receive continuing education credit for this course you must complete either a paper exam or an online exam with a total of 40 questions and receive a passing grade of 70% or higher. For assistance you can call or go online at: 4

5 TABLE OF CONTENTS About The Author... 3 Preface... 4 CHAPTER 1 HISTORY AND CLASSIFICATION OF ANNUITIES Overview Learning Objective History of Annuities Annuities in the United States Annuity Sales Annuity Buyers Primary Uses of Annuities Classification of Annuities Purchase Option Single Premium Periodic (Flexible) Premium Payments Date Income Payments Begin Deferred Annuities Immediate Annuities Investment Options Income Payout Options Straight (Single) Life Income Option Cash Refund Installment Refund Option Life with Period Certain Option Joint and Full Survivor Option Period Certain Review Questions CHAPTER 2 FIXED ANNUITIES Overview Learning Objective The Fixed Annuity Market Types of Fixed Annuities Crediting Rates of Interest Non-forfeiture Interest Rate Current Rate of Interest Portfolio Rate New Money Rate Calculating the Rate Trends Interest Rate Projections Bonus Annuities Two-Tiered Annuities Fixed Annuity Fees and Expenses Disadvantages of Fixed Annuities Review Questions

6 CHAPTER 3 VARIABLE ANNUITIES Overview Learning Objectives VA Product Features Separate Accounts Variable Investment Options Accumulation Units VA Charges and Fees Mortality and Expense (M&E) Charge Management (Fund Expense) Fees Contract (Account) Maintenance Fees VA Sales Charges Premium Tax Investment Features Dollar Cost Averaging Fund Transfers Asset Rebalancing Guaranteed Minimum Death Benefit Enhanced Death Benefits Guaranteed Living Benefit (GLB) Riders VA Licensing and Regulation Delivery of a Prospectus Financial Industry Regulatory Authority (FINRA) FINRA Rule FINRA Rule FINRA Rule FINRA Rule 2090: Know Your Customer SEC Approves Consolidated FINRA Rules Effective Date Review Questions CHAPTER 4 INDEX ANNUITIES Overview Learning Objective Index Annuity Defined IA Basic Terms and Provisions Market Index Index Period Participation Rate Cap Rate Spreads or Margins No-Loss Provision Minimum Guaranteed Interest Rate and Account Value Liquidity Surrender Charges Two-Tiered Annuities Other Charges and Fees

7 Interest Calculation Exclusion of Dividends Primary Interest Crediting Strategies Point-to-Point High Water Mark (Look Back) Annual Reset (Ratchet) Averaging Combination Methods Index Annuity Waivers and Riders Types of Riders IAs with Bonuses Profile of an IA Buyer Review Questions CHAPTER 5 ANNUITY CONTRACT STRUCTURE Overview Learning Objective Importance of Annuity Contract Structure Simple Structuring Is Best Complex Structures Annuity Contract Forms Parties to the Annuity Contract The Owner Rights of the Owner Changing the Annuitant Duration of Ownership Purchaser, Others as Owner Taxation of Owner Death of Owner: Required Distribution Spousal Exception The Annuitant A Natural Person Role of the Annuitant Naming Joint Annuitants/Co-Annuitants Taxation of Annuitant Death of Annuitant The Beneficiary Death Benefit Whose Death Triggers the Death Benefit? Changing the Beneficiary Designated Beneficiary Spouse or Children as Beneficiaries Non-Natural Person as Beneficiary Multiple Beneficiaries Taxation of Beneficiary Death of Beneficiary Insurance Company

8 Collecting and Investing the Premium Paying the Guaranteed Death Benefit Paying the Guaranteed Income Option Review Questions CHAPTER 6 ANNUITY TAX LAWS Overview Learning Objective IRC 72: The Annuity Tax Laws Types of Premiums IRC 72(a) IRC 72(b): Exclusion Ratio Rule IRC 72(c)(4): Annuity Starting Date IRC 72(e): Lifetime Distributions IRC 72(e)(4)(A): Loans and Assignments IRC 72(e)(4)(c): Gift of the Annuity Contract IRC 72(e)(5)(E) Gain in the Contract IRC 72(e)(11)(A)(ii) Aggregation Rules IRC 72(t)(1): Additional 10% Penalty Tax on Early Distribution IRC 72(q)(1): Premature Distribution 10% Penalty Tax IRC 72(s): Death Distribution Rules At Death of the Holder IRC 72(u): Non-Natural Person Rule IRC 72(u)(4): Defines an Immediate Annuity IRC Section 165: Claiming a Loss IRC Section 7702B(e)(1) IRC 1035: Tax-Free Exchanges IRC 1035 Requirements Partial IRC 1035 Exchanges Revenue Ruling IRS Revenue Procedure The New IRC Section 1035(a)(4) PLR Inherited Annuity 1035 Exchange Partial Annuitization of NQ Annuity Contracts IRS Revenue Procedure IRC 2039: Estate Tax Inclusion Annuities inside Qualified Plans Congressional Mandate Annuities in an IRA Advantages of Annuities inside a Qualified Retirement Plan RMD Rule Requirements on Variable Annuity Contracts Actuarial Present Value Defined RMD Calculation under the New Rules Safe Harbor Rules Example: Calculating RMD under New Rules New Proposed Treasury Regulation Longevity Contracts IRC 691(c) Income in Respect of a Decedent (IRD) Calculating the IRD Deduction:

9 Disclaimers With Regards to Tax and Legal Issues Review Questions CHAPTER 7 UNFAIR MARKETING AND TRADE PRACTICES Overview Learning Objective The NAICs Unfair Trade Practices Act Misrepresentation Twisting Churning Fraud Altering Applications Premium Theft False or Misleading Advertising Defamation Boycott, Coercion, Intimidation Discrimination Rebating Minnesota s Unfair Claims Practices Act The NAIC Model Life Insurance Replacement Regulation Purpose Application Duties of Insurance Producers Duties of Insurers That Use Agents Duties of Replacing Insurers That Use Agents Duties of Existing Insurer Minnesota Replacement Statute The NAIC Model Regulation on the Use of Senior Specific Certifications and Professional Designations Minnesota Prohibited Use of Senior Specific Certification and Professional Designations Annuity Disclosure Model Regulation Fixed and Index Annuities Variable Annuities Recordkeeping Minnesota NAIC Suitability of Annuity Model Regulation Background NAIC Suitability in Annuity Transactions Model Regulation Determining Suitability Systems of Supervision and Training FINRA Compliance Dodd-Frank Wall Street Reform Act Review Questions CHAPTER 8 MINNESOTA SUITABILITY OF ANNUITY LAWS Overview Learning Objective

10 Background Minnesota HF Minnesota Suitability of Annuity Chapter 72A Section 1: M.S. 72A.203 Exemptions Section 2: M.S. 72A.2031 Definitions: Section 3: M.S. 72A 2031 Duties of Insurers and Insurance Producers Section 4: M.S. 72A.2033 Insurance Producer Training Section 5: 72A.2034 Penalties Section 6: 72A.2035 Record Keeping Section 7: 72A 2036 Relationship to Other Laws: Enforcement Section 8: Effective Date Indicators of Short-Term Memory or Judgment Loss Financial Professionals Role in Capacity Assessment Indicators of Lack of Capacity-Warning Bells and Red Flags Communication with Client Keep Records of Initial Capacity Assessment Review Questions Chapter Review Answers Confidential Feedback

11 CHAPTER 1 HISTORY AND CLASSIFICATION OF ANNUITIES Overview Annuities are flexible in that there are a number of classifications (options) available to the purchaser (contract holder/owner) that will enable him or her to structure and design the product to best suit his or her needs. In this chapter, we will examine the various classifications of annuities, such as the purchase option, date income payments begin, investment options and the income payout options. Learning Objective Upon completion of this chapter, you will have an understanding of the following: The history of annuities; Sales of Annuities in the United States; How annuities are classified; The phases of an annuity: Accumulation and Distribution (Payout); How to identify the annuity buyer, and Primary uses of an annuity. History of Annuities As mentioned above, annuities can actually trace their origins back to Roman times. Back then, dealers sold contracts called annua, or annual stipends yearly payouts for life. Roman citizens would make a one-time payment to the annua, in exchange for lifetime payments made once a year. Annuity comes from the Latin word annuus, meaning yearly. During the 17 th century, annuities were used as fundraising vehicles. In Europe, governments were constantly looking for revenue to pay for massive, on-going battles with neighboring countries. The governments would then create a tontine, promising to pay for an extended period of time if citizens would purchase shares today. The United Kingdom, locked in many wars with France, started one of the first group annuity contracts called the State of Tontine of Participants in these early government annuities would purchase a share of the Tontine for 100 from the UK 11

12 Government. In return, the owner of the share received an annuity during the lifetime of their nominated person (often a child). As each nominee died, the annuity for the remaining proprietors gradually became larger and larger. This growth and division of wealth would continue until there were no nominees left. Proprietors could assign their annuities to other parties by deed or will, or they passed on at death to the next of kin. Annuities in the United States Annuities made their first mark in America during the 18th century. In 1759, a company in Pennsylvania was formed to benefit Presbyterian ministers and their families. Ministers would contribute to the fund, in exchange for lifetime payments. It wasn t until 1912 that Americans could buy annuities outside of a group. The Pennsylvania Company for Insurance on Lives and Granting Annuities was the very first American company to offer annuities to the general public. Annuities constituted a small share of the U.S. insurance market until the 1930s, when two developments contributed to their growth. First, concerns about the stability of the financial system drove investors to products offered by insurance companies, which were perceived to be stable institutions that could make the payouts that annuities promised. Flexible payment deferred annuities, which permit investors to save and accumulate assets as well as draw down principal, grew rapidly in this period. Second, the group annuity market for corporate pension plans began to develop in the 1930s. The entire country was experiencing a new emphasis saving for a rainy day. The New Deal Program introduced by President Franklin D. Roosevelt (FDR) unveiled several programs that encouraged individuals to save for their own retirement. Annuities benefited from this new-found savings enthusiasm. By today s standard, the first modern-day annuities were quite simple. These contracts guaranteed a return of principal, and offered a fixed rate of return from the insurance company during the accumulation period (Fixed Annuity). When it was time to withdraw from the annuity, you could choose a fixed income for life, or payments over a set number of years. There were few bells and whistles to choose from. What was always proved to be attractive about annuities was their tax-deferred status because they were issued by insurance companies. That all changed beginning in 1952, when the first variable annuity was created by the College Retirement Equities Fund (CREF) to supplement a fixed-dollar annuity in financing retirement pensions for teachers. Variable annuities credited interest based on the performance of separate accounts inside the annuity. Variable annuity owners could choose what type of accounts they wanted to use, and often received modest guarantees from the issuer, in exchange for greater risks they (the owner) assumed. This type of annuity was then made available to any individual, when the Variable Life Insurance Company (VALIC) in 1960, began to market its own nonqualified variable annuity. It was the variable annuity that boosted the popularity of annuities. Then in 1994, Keyport 12

13 Life Insurance Company introduced a new type of a fixed annuity called an index annuity. And the rest is history. Annuity Sales Total annuity sales reached $61.9 billion during the fourth quarter of 2013 resulting in an increase of 17 percent the largest quarterly percentage increase in 11 years, according to LIMRA s Secure Retirement Institute (SRI). For the entire year 2013, total annuity sales increased 5 percent to $230.1 billion (see Table 1.1). Table 1.1 Total U. S. Individual Annuity Sales and Assets ($ billions) YEAR SALES ASSETS 2000 $190.0 $1, , , , , , , , , , , , , N/A Source: Morningstar Inc. and LIMRA International, Windsor, Conn (Estimate from a survey of 60 insurers that account for 95 percent of Total U.S. annuity sales, February, 2014). Annuity Buyers In another survey conducted by LIMRA, more than three-quarters of recent annuity buyers are satisfied with their purchase of an annuity. LIMRA published this finding in a summary of results from a survey of 1,200 consumers age 40 or over who purchased a retail deferred annuity within the past three years. The study was conducted in the third quarter of Nearly 9 in 10 buyers of traditional fixed annuities are happy with their purchase, new research reveals. The survey reveals that 86% of traditional fixed annuity buyers are satisfied with their deferred annuity purchase. Likewise, most buyers are variable annuities (75%) and indexed annuities (83%) are also satisfied with the purchases, the survey reveals. 13

14 LIMRA observes that, of those who are satisfied, two-thirds of the VA households (61% for indexed and half for traditional fixed) own two or more annuities. The study also discloses that five of six deferred annuity buyers would recommend an annuity to their friends or family. Primary Uses of Annuities The top reason consumers give for buying an annuity is to supplement their Social Security or pension income. The second most popular reason is to accumulate assets for retirement; this is especially true for individuals under age 60 (see Table 1.2). Table 1.2 Intended Uses for Annuities Source: LIMRA Study, the Deferred Annuity Buyer Attitudes and Behaviors 2012 Receiving guaranteed lifetime income is also a concern, especially for buyers aged 60 and older, the survey says. Annuity buyers single most important financial objective is to have enough money to last their and/or their spouse s lifetime. Classification of Annuities Annuities can be structured according to a wide array of details and factors, such as: Purchase options Date income payments begin Investment options Income payout options 14

15 These different ways in which annuities can be structured provide individuals seeking annuities the flexibility to construct an annuity contract that will best meet their goals and objectives. Let s discuss each of these classifications in greater detail. Purchase Option An annuity begins with a sum of money, called principal. Annuity principal is created (or funded) in one of two ways; immediately with a single premium or over time with a series of flexible premiums. Single Premium A single premium annuity is basically just what the name implies; an annuity that is funded with a single, lump-sum premium, in which case the principal is created immediately. Usually, this lump sum is fairly large. Periodic (Flexible) Premium Payments But not everyone has a large lump sum with which to purchase an annuity. Annuities can be funded through a series of periodic (flexible) premiums payments that, over time, will amass an amount large enough to buy a significant annuity benefit. At one time, it was common for insurers to require that periodic annuity premiums be fixed, and level, much like insurance premiums. Today, it is more common to allow contract owner s flexibility as to allowing premiums of any size (within certain minimums and maximums, such as none less than $25 or more than $2,000,000) and at virtually any frequency. Date Income Payments Begin The annuity is the only investment vehicle that has two phases based upon when the income payment begins. The phases are: Deferred (Accumulation Phase); or Immediate. (Pay-out/Distribution Phase) Deferred Annuities Deferred annuities are designed for long-term accumulation and can provide income payments at some specified future date. A deferred annuity can be funded with either periodic payments, commonly called flexible premium deferred annuities (FPDAs), or funded with a single premium, in which case they re called single premium deferred annuities, or SPDAs. While a deferred annuity has the potential of providing a 15

16 guaranteed lifetime income at some point in the future, the current emphasis in a deferred annuity is on accumulating funds rather than liquidating funds. An advantage that deferred annuities have over many other long-term savings vehicles is that there are no taxes (tax-deferral) paid on the accumulated earnings in an annuity until withdrawals are made. Immediate Annuities An immediate annuity is designed primarily to pay income benefit payments one period after purchase of the annuity. Since most immediate annuities make monthly payments, an immediate annuity would typically pay its first payment one month (30 days) from the purchase date. If, however, a client needs an annual income, the first payment will begin one year from the purchase date. Thus, an immediate annuity has a relatively short accumulation period. As you might guess immediate annuities can only be purchased with a single premium payment and are often called single-premium immediate annuities, or SPIAs. These types of annuities cannot simultaneously accept periodic funding payments by the owner and pay out income to the annuitant. The average age of a SPIA buyer is 73. The main difference between deferred and immediate annuities is when annuity payments begin. Every annuity has a scheduled maturity or annuitization date (usually age 90 or age 95), which is the point the accumulated annuity funds are converted to the payout mode and benefit payments to the annuitant are to begin. According to LIMRA SRI, total sales of annuities in 2013 were $230.1 billion (see Table 1.3). Deferred annuities totaled $216 billion and immediate annuities totaled $14.1 billion, (which includes $5.8 billion of structured settlements). Table 1.3 Annuity Industry Total Sales Deferred vs. Immediate Annuities, ($ billions) YEAR DEFERRED IMMEDIATE TOTAL 2000 $ $ 8.8 $

17 Source: Morningstar Inc. and LIMRA SRI, February 2014 Includes Structured Settlements reporting sales of $5.8 billion A once-snubbed annuity product the income annuity appears to be gaining a foothold in the broad annuity marketplace and in the practices of advisors who serve the boomer and retirement income markets. According to LIMRA, SPIA sales were up 30 percent in the fourth quarter of 2013 to reach a record $2.6 billion. SPIA sales totaled $8.3 billion for 2013, which is 8 percent higher than in 2012 and another record (see Table 1.4). Table 1.4 Total Sales of Immediate Annuities ($ billions) YEAR VARIABLE FIXED TOTAL 2000 $ 0.6 $ 8.0 $ Source: Morningstar Inc. and LIMRA International, February Not including Structured Settlements 17

18 Investment Options An annuity can be classified by two types of investment options. They are: Fixed Annuity (FA) Variable Annuity (VA) The most popular type of annuity sold is the variable annuity (VA). VA sales increased 4 percent in the fourth quarter of 2013 reaching $36.3 billion. Total VA sales fell 1 percent in 2013 from the prior year and were $145.3 billion (see Table 1.5). Total fixed annuity sales improved 46 percent in the fourth quarter over the prior year to reach $25.6 billion a level they have not reached since the second quarter of Total fixed annuity sales rose 17 percent in 2013; totaling $84.8 billion (see Table 1.5). Table 1.5 Annuity Industry Total Sales Variable vs. Fixed ($ billions) YEAR VARIABLE FIXED TOTAL SALES 2000 $ $ 52.7 $ Source: Morningstar Inc. and LIMRA International, February,

19 Income Payout Options There are a several ways to annuitize an annuity. Of course, the option to receive a lumpsum is available. If the decision is made to annuitize, the options are: Straight life income, Cash refund, Installment refund, Life with period certain, Joint and survivor, and Period certain. Straight (Single) Life Income Option A straight life income option (often called a life annuity or single life annuity) pays the annuitant a guaranteed income for his or her lifetime. This is the purest form of life annuitization. The straight life income option pays out a higher amount of income than any other life with period certain or a joint and survivor option, but they might not be higher than other options (such as cash refund, installment refund, or pure period certain). At the annuitant death, no further payments are made to anyone. If the annuitant dies before the annuity fund (i.e., the principal) is depleted, the balance, in effect, is forfeited to the insurer. It is used to provide payments to other annuitants who live beyond the point where the income they receive equals their annuity principal. Cash Refund A cash refund option provides a guaranteed income to the annuitant for life and if the annuitant dies before the annuity fund (i.e., the principal) is depleted, a lump-sum cash payment of the remainder is made to the annuitant s beneficiary. Thus, the beneficiary receives an amount equal to the beginning annuity fund less the amount of income already paid to the deceased annuitant. Installment Refund Option Like the cash refund, the installment refund option guarantees that the total annuity fund will be paid to the annuitant or to his or her beneficiary. The difference is that under the installment option, the fund remaining at the annuitant s death is paid to the beneficiary in the form of continued annuity payments, not as a single lump sum. Life with Period Certain Option Also known as the life income with term certain option, this payout approach is designed to pay the annuitant an income for life, but guarantees a definite minimum period of payments. For an example, if an individual has a ten-year period certain annuity, and receives monthly payments for six years before dying, his or her beneficiary will receive the same payments for four more years. Of course, if the annuitant died after receiving 19

20 monthly annuity payments for ten or more years, his or her beneficiary would receive nothing from the annuity. Joint and Full Survivor Option The joint and full survivor option provides for payment of the annuity to two people. If either person dies, the same income payments continue to the survivor for life. When the surviving annuitant dies, no further payments are made to anyone. There are other joint arrangements offered by many companies: Joint and Two-Thirds Survivor. This is the same as the above arrangement, except that the survivor s income is reduced to two-thirds of the original joint income. Joint and One-Half Survivor. This is the same as the above arrangement except that the survivor s income is reduced to one-half of the original joint income. Period Certain The period certain option is not based on life contingency; instead it guarantees benefit payments for a certain period of time, such as 5, 10, 15, or 20 years, whether or not the annuitant is living. At the end of the specified term, payments cease. Table 1.6 Comparison of Monthly Settlement Options Income Payment Options Male Estimated Monthly Income Annual Payout Female Estimated Monthly Income Annual Payout Straight Life Annuity $ % $ % Life Annuity with Period Certain of 120 Monthly Payments $ % $ % Life Annuity with Period Certain of 240 Monthly Payments $ % $ % Income Payment Options Estimated Monthly Income Annual Payout Rate Joint and Survivor Life Annuity 100%* No Payments to Beneficiaries $ % Guaranteed Income for 5-Year Period Certain Only $ % *Assumptions: Male age 65; Female age 65; Annuitize $100,000. Source: 1/31/

21 Chapter 1 Review Questions 1. Annuity comes from the Latin word annuus which means: ( ) A. Yearly ( ) B. Monthly ( ) C. Quarterly ( ) D. Biannually 2. In 1952, the first variable annuity was created by: ( ) A. The Romans ( ) B. College Retirement Equities Fund (CREF) ( ) C. Presbyterian ministers ( ) D. Variable Annuity Life Insurance Company 3. Which of the following is not used to calculate fixed annuitization? ( ) A. Age of the annuitant ( ) B. Assumed (Anticipated) Interest Rate (AIR) ( ) C. Payout option chosen ( ) D. Sex of the annuitant 4. Which type of annuity will begin to make annuity payments one month after the purchase payment? ( ) A. Deferred annuity ( ) B. Period certain annuity ( ) C. Immediate annuity ( ) D. Temporary annuity 5. Which of the following income payout options pays the annuitant the highest guaranteed income for his or her lifetime? ( ) A. Refund Life ( ) B. Life with installments ( ) C. Joint life ( ) D. Straight life income 21

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23 CHAPTER 2 FIXED ANNUITIES Overview A fixed annuity is an investment vehicle offered by an insurance company that guarantees to pay a stated rate of interest for a specified period of time. The investor (contract owner) has the choice to accumulate the interest on a tax-deferred basis or take it as income. With a fixed annuity, the insurer, not the insured, accepts the investment risk. In this chapter, we will review the fixed annuity market, the various types of fixed annuities, and their advantages and disadvantages. Learning Objective Upon completion of this chapter, you will have an understanding of the following: The fixed annuity market; The various types of fixed annuities; How interest rates are credited to a fixed annuity; Fixed annuity fees and expenses, and The disadvantages of fixed annuities. The Fixed Annuity Market Premiums made to a fixed annuity are invested in the insurance companies general account. The company then invests the premiums it receives in a manner that will allow it to credit the rates it has stated it will pay. The interest rate chosen by the insurance company during the first year is meant to be competitive with rates currently offered on other financial vehicles. Of course, one of the major features of a fixed annuity is safety. Safety of principal and also safety in that the rate of return is certain. According to LIMRA and IRI/Beacon Research, 2013 fourth quarter total fixed annuity sales increased 45 percent over the prior year to reach $25.6 billion a level they have not reached since the second quarter of Total fixed annuity sales rose 17 percent in 2013, totaling $84.8 billion (see Table 2.1). 23

24 Types of Fixed Annuities The basic types of deferred fixed annuities can be broken down into the following categories. They are: Book value deferred annuity products earn a fixed rate for a guaranteed period. The surrender value is based on the annuity s purchase value plus a credited interest, net of any charges. Book value products are the predominant fixed annuity type sold in banks. Market value adjusted annuities are similar to book value deferred annuities but the surrender value is subject to a market value adjustment based on interest rate changes. Index annuities guarantee that a certain rate of interest will be credited to premiums paid but also provide additional credited amount based on the performance of a specified market index (such as the S&P 500 ). Table 2.1 Fixed Annuity Sales and Net Assets ($ billions) YEAR TOTAL SALES NET ASSETS 2000 $ 52.7 $ N/A Source: Morningstar Inc. and LIMRA International, February

25 Types of immediate (fixed income) annuities: Structured settlement annuities are used to provide ongoing payments to an injured party in a lawsuit. Single premium immediate annuities (SPIAs) are usually purchased with a lump sum and payments begin immediately (usually within 30 days) or within one year after the annuity is purchased. As reported by LIMRA International, traditional book value and market value adjusted (MVA) annuity sales were hit hard by the decline in interest rate spreads in 2011 and However, during the fourth quarter of 2013, book value sales increased 46 percent to $6.6 billion from $4.5 billion during the same period in Full year 2013 book value sales were $22.4 billion (see Table 2.2). Market value-adjusted products more than doubled during the fourth quarter to $1.9 billion from $1.0 billion in In addition to the substantial growth experienced by fixed-rate deferred annuities, indexed annuities grew by 40 percent in the fourth quarter of Table 2.2 Fixed Annuity Sales 2013 ($ billions) TYPE SALES Fixed-rate deferred $20.2 Book value 15.9 Market value adjusted 4.3 Indexed 26.8 Fixed deferred 47.0 Deferred income 1.48 Fixed immediate 5.7 Structured settlements 3.9 Total 58.0 Crediting Rates of Interest Typically, a fixed annuity contract will offer two interest rates: a guaranteed rate and a current rate. The guaranteed rate is the minimum rate that will be credited to funds in the annuity contract regardless of how low the current rate sinks or how poorly the issuing insurance company fares with its investment returns. A typical guaranteed interest rate is between 1.5% and 3%. 25

26 Non-forfeiture Interest Rate In 2003, the National Association of Insurance Commissioners (NAIC) adopted a new annuity Standard Non-forfeiture Law (SNFL) that ties the minimum interest rate that must be paid by fixed annuities to current yields. Prior to this, the state-mandated minimum interest rate was 3% in most states. During times of extremely low interest rates, this made profitably crediting an interest rate above 3% difficult and sometimes impossible. As a result, many companies had no choice but to pull specific products or interest rate guarantee periods from the market. With the new law, the rate floats between 1% and 3%. The standard does not become effective until adopted by individual states, but almost all states now have enacted one of two types of relief either in the form of a 1.5% minimum guaranteed interest rate, or a rate that moves with prevailing interest rates. Current Rate of Interest The current interest rate (excess rate) varies with the insurance company s returns on its investment program. Some annuity contracts revise the current rate on a monthly basis; others change the current interest rate only one time each year. As mentioned earlier, today s low credited interest rates in fixed annuities has caused a major decline in sales. Rates for 2012 however, are even lower than a year ago. According to the Fisher Index (see Table 2.3 below and on the following page), the Index tracks average fixed annuity rates over one-year periods and CD type of annuities. For Example: As of February 7, 2012, the average first year fixed rate for a fixed annuity on the high norm was 2.84% and the low norm was 0.89%. That s for nearly 590 products issued by almost 75 carriers. But a similar pattern holds for five-year CD rates and treasury bonds, with interest rates in both products lower than a year ago. So fixed annuity rates are tracking with trends in the overall environment. As of March 8, 2013, fixed annuity rates continued to remain below 3 percent. The highest-paying five-year fixed annuity was crediting 1.60 percent at the beginning of March 2013, according to the Fisher Annuity Index. 26

27 Report Date: Table 2.3 Interest Rate Trends on Fixed Annuities 1 st Year Interest Rate Trends On Traditional Fixed Annuities Normal Annuity Range # of # Of Lowest Low Average High Highest Companies Annuities Rate Norm Rate Norm Rate Std. Deviation 04/08/ % 0.76% 2.53% 4.30% 12.20% 2.08% 04/01/ % 0.77% 2.53% 4.29% 12.20% 2.08% 03/11/ % 0.77% 2.55% 4.33% 12.20% 2.09% 10/08/ % 0.79% 2.52% 4.24% 12.20% 2.09% 04/09/ % 0.95% 2.87% 4.79% 12.20% 2.15% Average Rates for CD Type or Multi-Year Guarantee (MYG) Annuities Note: Averages and number of annuities count each band/tier as a separate annuity for this summary. Years # of Companies # of Annuities /08/ % 1.46% 1.52% 1.65% 1.60% 1.78% 2.06% 2.27% 2.18% 04/01/ % 1.46% 1.52% 1.63% 1.60% 1.76% 2.08% 2.29% 2.20% 03/11/ % 1.46% 1.52% 1.63% 1.60% 1.75% 2.06% 2.28% 2.19% 10/8/ % 1.13% 1.49% 1.39% 1.62% 1.54% 1.72% 1.99% 2.15% 2.09% 04/09/ % 1.08% 1.61% 1.55% 1.75% 1.85% 1.98% 2.30% 2.46% 2.49% Source: Fisher Annuity Index, Coit Rd #102 Dallas, Texas Once the interest rate on an annuity contract has been set, there remains at least one other item to understand regarding the method in which the interest will be credited to the funds placed in the annuity. This item is the method of interest rate crediting that the insurance company will apply to the specific annuity contract. Generally, there are two methods of crediting interest: Portfolio (average) Rate Method, and New Money Rate Method. 27

28 Portfolio Rate The portfolio (average) rate method credits policyholders with a composite of interest that reflects the company s earnings on its entire portfolio of investments during the year of crediting. During periods of rising interest rates, the interest credited to the new contribution received during the year will be heavily influenced by the interest earned on investments attributable to old contributions those received and invested 5, 10, 15 or more years earlier. The interest credited will therefore be stabilized. To illustrate this method under both a rising and declining interest trend, see Illustration 2.4. Under the steadily increasing trend, the contribution made in year 1 earns 3.0%, all funds in the account (new or old) in year 2 earn 4.0%, and all funds in the account during year 3 earn 5.0%. Illustration 2.4 Illustrative Comparison of Increasing and Decreasing Portfolio Rates Increasing Rates Year Year 1 Year 2 Year 3 One 3% 4% 5% Two 4% 5% Three 5% Decreasing Rates Year Year 1 Year 2 Year 3 One 5% 4% 3% Two 4% 3% Three 3% New Money Rate Under the new money rate (sometime referred to as the banding approach, or investment year method of crediting interest), the contributions made by all contract holders in any given period are banded together and credited with a rate of interest consistent with the actual yield that such funds obtained during the period. Thus, even though a company s average return on all money may be only 5% in a given period, the contributions made by all participants during the current period may be credited with the 5.0% if the company was able to make new investments that, on average, returned in excess 5.0% interest. Moreover, the interest rate credited on those contributions should continue to earn 5.0% until the monies are reinvested. After reinvestment, the interest on these contributions will change and the rate credited to contributions banded in the following period could be higher or lower. Under a trend of increasing interest, and assuming monies are reinvested every year, an investment in year 1 earns 5.0% (the new money rate for that year) and then earns 5.25% 28

29 in the second year and 5.50% in the third year (see Illustration 2.5 on the following page). An investment in year 2 earns 6.0% (the new money rate for that year) and then earns 6.00% in the second year and 6.25% in the third year. Finally, an investment in year 3 earns 7.0%. Illustration 2.5 Illustrative Comparison of Increasing and Decreasing Portfolio Rates Increasing Rates Year Year 1 Year 2 Year 3 One 5.00% 5.25% 5.50% Two 6.00% 6.25% Three 7.00% Decreasing Rates Year Year 1 Year 2 Year 3 One 5.00% 4.50% 4.50% Two 4.00% 4.00% Three 3.00% Note: The higher rates were used for the new money rate illustration. That is because the portfolio rate includes the return on investments made in earlier years at lower rates. The illustrations points out three things. First and most important, it is deceptive to compare the current interest rate between two companies using different approaches. Second, the new money rate method is advantageous to the participant when interest rates are increasing. Third, in a declining interest rate period, the portfolio method has merit. Another consideration in analyzing the products of tax-deferred annuity companies that use the new money approach is how funds are treated when a participant makes a partial withdrawal of funds. There are three approaches that are used: LIFO, FIFO and HIFO. Last In, First Out (LIFO) means that the sum withdrawn will be taken from the most recent contribution band. First In, First Out (FIFO) means that the sum withdrawn will be taken from the earliest contribution band. Highest In, First Out (HIFO) means that the sum withdrawn will be taken from the band that is being credited with the highest interest rate. Keep in mind that, although interest rates are very important, they are but one of several items to be considered when selecting a fixed annuity. Calculating the Rate Whether the portfolio rate or the new money rate method is used, there are several approaches used to arrive at the actual numerical rate to be credited. A common approach 29

30 is to credit a rate (or rates, in the case of the new money rate method) that reflects the company s earnings on its entire portfolio of investments during the year in question. Another approach would be to use an expected rate of return on the accumulations. Trends In valuing the rate of interest credited (rate of return) on their investments, a number of insurance companies have moved from the calendar year to a quarterly approach. Some have even adopted techniques for valuing the return on a daily basis. The objective of such a move is twofold: The insurance company can move quickly if it believes the spread between the rate of return actually being earned on its investment and the rate credited to the contract is moving in a direction disadvantageous to its best interests, and Competitive position in the marketplace can be maintained, especially when interest rates increase sharply. Interest Rate Projections Most companies sales literature will show projections for the guaranteed interest rate, however, these types of data provide little, if any, information to help select an annuity. Since projected values are hypothetical, their use as an instrument of prediction is significantly flawed. Only when a company has established a trend of consistently high historical current interest rates do projections of future accumulations become significant. Bonus Annuities Some insurance companies declare a bonus rate of interest that will be paid on top of a current or base rate offered on an annuity contract. This bonus is designed to attract new business to the insurance company. The bonus amount offered by many insurance companies can range from one percent to five percent of the original single premium payment. For example, if an applicant purchases an annuity with a single premium of $100,000, and the extra credit sign-up bonus is 5 percent, the account value will be $105,000. Some insurers may credit the bonus with the initial premium payment and or may credit the premium payments made within the first year of the annuity contract. Under some annuity contracts, the insurer will take back all bonus payments made to the annuity holder within the prior year or some other specified date, if the annuity holder makes a withdrawal, if a death benefit is paid to the annuity holder s beneficiaries upon the annuitant s death, or in other circumstances. Though this feature is attractive, there might be some hidden costs. Some companies charge extra fees and/or extend surrender periods. Some contracts may impose higher mortality and expense (M&E) charges, while others may impose a separate fee specifically to pay for the bonus feature. As the insurance producer, it is your responsibility to understand these costs and fully disclose to the purchaser of an annuity. 30

31 Two-Tiered Annuities A two-tiered annuity is basically a dual-fund, dual-interest rate contract. The two funds are the accumulation account and the surrender value. There is a permanent increasing surrender charge. The interest rate offered is a relatively high interest rate, but only if the owner holds the contract for a certain number of years and then must annuitize the contract. If the annuity is surrendered at any point prior to the contract period, the interest credited to the contract is recalculated from the contract s inception using a lower tier of interest rates. The higher tier of rates is designed to reward annuitization and to make the product more attractive than competing annuities, the lower tier of rates generally makes the contract very unattractive compared to other alternatives. And the interest penalty applies under some contracts even if the annuity is surrendered due to the death of the owner. This type of fixed annuity contract has come under scrutiny by state insurance departments in how they are marketed and sold especially to seniors. Fixed Annuity Fees and Expenses Fixed annuity fees and expenses generally cover the insurance company's administrative expenses, the cost of offering the annuitization guarantee and profits to the insurance company and sales agent. This may be called the Mortality and Expense (M&E) charge. A fixed annuity does not have separate account management (as a variable annuity). Instead, they are claims on the general fund of the insurance company. As such, they don t have expense ratios. But they do have other expenses such as: Contract Charge: The rate quoted is the rate paid. Some fixed annuities may assess an annual contract fee, typically around $30 to $50. In addition, fixed annuities will have the following charges: Interest Spread: Just like other investments fixed annuities have fees and expenses. Most fees and expenses of a fixed annuity are factored into the stated annual percentage rate (APR) the investor is quoted, this is known as the interest spread. Surrender Charge: Most fixed annuity contracts impose a contract surrender charge on partial and full surrenders from the contract for a period of time after the annuity is purchased. This surrender charge is intended to discourage annuity holders from surrendering the contract and to allow the insurance company to recover its costs if the contract does not remain in force over a specific period of time. 31