Welcome... Introduction to the Annuity... Development... How an Annuity Operates?... Investment Options... Which Annuity is Best?...

Transcription

1 This should be used as an outline for internet use. The internet courses do not have page numbers. Welcome Introduction to the Annuity Mortality tables The insurer, contract owner, The annuitant, the beneficiary Development Reinsurance Network How an Annuity Operates? Investment Options Immediate Fixed Annuities Immediate Variable Annuities Deferred Annuities Accumulation Annuities Which Annuity is Best? Review Questions Variations of the Annuity

2 Single-Pay Deferred Fixed Annuity Accumulation Annuity Straight-Life Annuity Lifetime w/period Certain Annuity Refund Annuity Two-Tier Annuity Joint-and-Survivor Annuities Pre-Retirement Survivor Annuity Wrap-Around Annuity CD-like Annuity Split Annuities Reverse Annuity Mortgage (RAM) Private Annuity Qualified Annuities Tax-sheltered Annuities (TSAs) Accumulation & Payout Period Non-Qualified Annuities Review Questions Annuitization Seven-Pay Life Insurance Exclusion Ratio

3 Bailout Provisions Review Questions Rating Systems Introduction to A.M. Best Rating System A.M. Best's Rating Modifiers A.M. Best's Ratings "Not Assigned" Classification Standard & Poor's Corp. rating System Moody's Rating System Duff & Phelp's rating System Weiss Research, Inc. Rating System State Ratings Review Questions Advantages of the Annuity Safety Record FDIC, BIF, Pass-through Insurance The Uniform Gifts to Minors Act Reserve Requirements Financial Clout Rating Services Performance Professional Manager / Investment Team

4 Commission Charges Withdrawal Options Guaranteed Death Benefit Avoidance of Probate Review Questions Disadvantages of the Annuity IRS Tax Penalty Surrender Charges Mortality & Expense fees Contract Maintenance Charge Review Questions Annuities verses other Investments Annuities verses the IRA IRA Tax Rules IRA-Substitute Policies Annuities verses Mutual Funds Potential sources of income tax SEC College Tuition Review Questions Variable or Fixed Rate Features of the Fixed Rate

5 Guarantees Free Bailout Options Adding to the annuity contract Provides a secure future Annuitization Investment Features of the Variable Rate Aggressive Growth Growth Growth and Income International Stocks Balanced or Total Return Corporate Bonds Government Bonds High-Yield bonds Global and International Bonds Sector or "Specialty" Portfolios DCA SWP Review Questions Agent Ethics Defining Ethics Why Be Ethical?

6 Ethics in Action Due Diligence Review Questions Glossary of Terms

7 Before an agent can sell these products, a basic understanding must be had. There are so many products on the market today for policyowners to invest in that we must know what the best products are so we can pass this on to our clients. What is an Annuity? An annuity is an investment that is made through an insurance company. Annuities do not have anything to do with life insurance or any other type of insurance coverage, even though the insurance companies offer them. Annuities are sold (marketed) by a variety of means, from an insurance agent to a bank to a brokerage firm. An annuity contract could be defined as a life insurance policy without the mortality charges because there is no "net amount at risk." Life insurance companies rate prospective policyholders with what is called mortality tables. These are a base for calculating cost per thousand dollars of a life insurance policy. Each year people grow older, so the chances of dying become larger. The first table used by insurance companies was the American Experience Table. It was based on statistics gathered between 1843 and During that time, out of 1000 men age 35, statistically 8.95 died during that year. The second table the insurance companies utilized was the Commissioners' 1941 Standard Ordinary Table based on death statistics between 1930 and During this period of time the death rate for men at age 35 was 4.59 per thousand. In 1966, the insurance companies were required to use the Commissioners' 1958 Standard Ordinary Table based on death statistics between 1950 and Obviously this would be an outdated table, but this was the last required table to be used. On this table, the rate per thousand dropped to Every year Americans tend to live longer because of many reasons, one of them being the advance of medical technology.

8 Choosing an insurance company that uses the most current mortality tables will insure that your clients are receiving the cheapest premium rates. Insurance companies are not required to go back to old policyholders when new mortality tables come which would reduce their premiums. They will continue year after year to charge at the old mortality table. An annuity is allowed to grow within a contract without current taxation. It also includes the charges for expenses. Life insurance, the investment aspect, is also allowed to do this. The major difference between the two is the mortality charges. There are three different types of annuities. They are: 1. Immediate annuities, either variable or fixed rate 2. Deferred annuities, either variable or fixed rate 3. Accumulation annuities, either variable or fixed With the fixed annuity there is a set rate of return. The variable annuity lets the investor choose from a series of portfolios that can be aggressive or conservative. Thus the rate of return can fluctuate. The insurance company gives the policyholder certain assurances when they invest in the annuity. The four parties to an annuity contract are: the insurer, the contract owner, the annuitant and the beneficiary. There are always four parties, although one person may fulfill more than one role. The insurer: No matter who sold the annuity, the contract agreement is always between the policyholder and the insurance company. The insurance company is the insurer. The annuity contract contains assurances and the terms of agreement. It also stipulates what can and cannot be done. These would include additional investing, withdrawals, cancellations, penalties, and of course, the guarantees. An agent will need to understand each annuity contract sold by the different insurance companies. Products differ and the need to understand those differences is important for the agent as well as the policyholder. The contract owner: The policyowner is the contract owner. It is their money; they decide among the different options offered. An agent needs to be aware of the options offered so as to give a wellrounded view of what is available. The policyholder has the right and the ability to add more money (if this is allowed by the insurer or the

9 annuity contract selected), terminate the annuity, and withdraw a portion or all the money and to change beneficiaries or the annuitant. The changing of beneficiaries and/or annuitants requires an approval from the insurer along with the required papers to be filled out. The contract owner can be an individual, a couple, a trust or a corporation. The one requirement is that the owner must be an adult. A minor can be named as long as there is a guardian or custodian listed. The contract owner (policyholder) controls the investment. They can decide to gift or will a partial amount of the entire sum to anyone or any entity at any time. The annuitant: The person named by the contract owner as the annuitant can be anyone currently living and only one person can be named. It does have to be a person though, not a living trust, corporation or partnership. The annuitant is similar to the insured of a life insurance policy. If the annuitant is not also the policyowner, they have no say in the contract, cannot make withdrawals, change names or terminate the contract. The annuity will remain in force until the contract owner makes a change or the annuitant dies. Like an insurance policy, when you purchase it on someone else, which is the insured, the annuitant must also sign the annuity contract. Some annuity applications do not require the annuitant's signature. In selecting an annuitant, there is normally an age requirement imposed by the insurance company. While most companies require the annuitant to be under the age of 75, that age does vary among companies. Most companies allow the contract owner to change the annuitant at any time with a stipulation that the new annuitant has been alive when the contract was first written. Changing the annuitant is not as easy as changing a beneficiary. The insurance company must approve of the change first. If the new annuitant is young, the change may be made quite easily. If the new annuitant is older, mortality risks come in to play and the change may not be as easy. In any case, a contract owner who wants to change annuitants must follow the procedures the insurance company indicates. The beneficiary: Simply stated, the beneficiary is waiting for the death of the annuitant. This is the only way the beneficiary can prosper. Like the annuitant, (if not also the policyholder) the beneficiary has no say or control in the management of the policy. Whereas the annuitant must be a person, not an organization. The

10 beneficiaries can be trusts, corporations or partnerships as the beneficiaries, as well as friends, children, relatives or spouses. The annuity contract can name multiple beneficiaries. For instance, Alan, the annuity contract owner, could specify that his wife receives 50 percent of the proceeds. The Humane Society might receive 30 percent and the remaining 20 percent could go to Microsoft Inc. One owner must be "primary" and the other "contingent" unless the insurer will permit co-ownership. Many companies no longer permit co-ownerships as they used to. This is because of so many legal problems - especially in divorces. Companies do not want to get dragged into such things. The same is also true for annuitants. While it is still possible to find insurers that allow co-annuitants, most prefer a single annuitant due to legal problems. Most applications do not even show a line for co-annuitants, but insurers may still allow it if asked to do so. The annuity contract can have two contract owners, such as a husband and wife. Then the annuitant can be either the husband or wife or both. This would protect the couple's assets in case one of them died. This is one area where total understanding of how the annuity works is crucial. If any other beneficiary was listed, for instance, a child or charity, the surviving spouse would not receive the money. The contract owners need to have this well thought out so the annuity will meet the goals intended. Beneficiary designations may be set up with a primary beneficiary (the spouse) and a contingent beneficiary - the children. A single person can thus hold multiple titles. Alan could name himself as the annuitant and beneficiary as well as being the contract owner. If Alan elected to name himself as the contract owner and the annuitant, and then a loved one or entity as the beneficiary, he would still have complete control of the annuity. Upon Alan's death, the proceeds would pass on to the intended beneficiaries or heirs. Alan would also retain the capability of changing the beneficiaries if he elected to. It must be noted that while Alan would have the right to name himself as the annuitant and the beneficiary, it would not make sense to do so in any way. One of the advantages of the annuity is avoiding probate. Naming himself as the annuitant and the beneficiary would nullify this advantage by reverting the money to the estate

11 which would pass through probate and all the expenses incurred or go to a contingent beneficiary. Annuity Development: The word annuity means "a payment of money." The insurance industry designed them to do just that. The annuity is simply a periodic fixed payment for life or for a specified period of time, made to the individual by the insurance company. One of the most notable industries to go into the insurance world is the banks and savings and loan institutions. In the early 1920's, the United States government began using annuities to fund government retirement accounts, as did the labor unions. Due to the requirements the government mandated, the insurance industry came up with two safety features: 1. A guaranteed minimum interest rate built into the annuity contract. 2. The reinsurance network. Backed by the insurance companies' reserves, a reserve system for annuities was first introduced during the 1920s. The legal reserve system required then and still requires now that insurance companies keep enough surplus cash on hand to cover all cash values and annuity values that may come due at any given time. It is these reserves that enable the minimum interest rate guarantees to exist. The reinsurance network was designed so that if there was a large run on the money in the insurance industry, no one company would be required to take the brunt of the loss. The insurance companies spread the risk out among all of the companies that are offering similar products. On October 19, 1987, the stock market crashed and since that day it has been known as "Black Monday." Annuities were primarily unaffected by this event. When the Great Depression hit the country in the 1920's, over 9,000 banks failed. Stocks and bonds were not worth anything. The exception to the utter economic disaster the country experienced was insurance companies. They had enough cash on hand to pay their policyholders. This was required by the government as already mentioned. The companies continued to pay their guaranteed minimum interest rates

12 that had been established years earlier. After the depression hit, new laws were passed by congress requiring many of the other financial industries to provide some of the same safety features on their products that insurance companies were already required to have. Variable annuities were first introduced in the US in the early 1950s. One of the best-known variable annuities is the College Retirement and Equities Fund (CREF). At the end of 1991 it was estimated that over $200 billion was invested in variable annuities and there were well over eight billion contract owners. From 1973 to 1978 the most popular annuity products carried a permanent seven percent surrender charge. The only way to avoid this charge was to annuitize. Then, as time went on, a few companies began to offer bailout options and limited surrender penalties. Bailouts allowed the client to withdraw their money without penalty charges if the interest rate on their annuity fell below the initial rate. Once this bailout option hit the market, a new generation of products developed. In the 1980s The New York Stock Exchange member firms began aggressively marketing bailout annuities. As interest rates hit all-time highs, insurance companies quickly had to become superb asset managers rather than just good risk managers. The early 1980s saw the introduction of indices and two-tiered annuities. The index rate annuity is a fixed annuity whose renewal rate fluctuates during the surrender charge period based upon some independent market indicators. It might be Treasury Bills or any variety of bond indices. This type of indexing is designed to protect the consumer in a low interest rate environment. These products do not tend to have bailout options since they are designed to accurately reflect the changing financial climate. Two-tiered annuities were designed to reward the policyholder who decides not to surrender their annuity by offering a higher first tier interest rate. If the policyholder surrendered or transferred to another carrier, a lower interest rate was retroactively applied; this was the second tier. The two-tier has a second and permanent surrender charge in the form of the lower interest rate. The annuity may have a substantial charge for withdrawals; a charge that may never disappear. This may make it look as if the company is paying competitive rates, but if the policyholder elects to

13 withdraw, they may be credited with an extremely low interest rate. The interest rate is only realized if annuitization is utilized through the initial insurer. This, then, locks the policyholder into the same company for life. When a person is comparing two-tier rates with other annuities and/or companies can be misleading unless this is considered -- comparisons. Two companies that suffered setbacks that we can learn from are Baldwin United and Charter Oil. Baldwin United experienced a setback in the 1980s when interest rates fueled uncontrolled growth. This resulted in significant setbacks in the insurance industry. Baldwin United's internal investments and questionable accounting procedures eventually resulted in their block of annuity business being sold to Metropolitan Life. Charter Oil suffered from the over supply of oil and gas that crippled the entire industry. This resulted in Charter Oil selling their annuity block to Metropolitan Life also. One very important point to make note of: in both cases, the contract owners did not lose any of their investment. Policyholders continued to earn tax-deferred interest in the seven to eight percent range. Not all industries can say the same thing. The two problem companies previously mentioned and the passage of TEFRA (The Tax Equity and Fiscal Responsibility Act of 1982), caused annuity sales to drop. During this time, new annuity products emerged. Surrender periods reduced, bailout provisions improved and a move towards multiple year guarantees developed. Many of these new annuities were designed to compete with Certificates of Deposit (CDs). Once an individual decides to invest in an annuity, the agent gives the person an application. The application asks for basic information such as name, address, social security number, etc. The social security number is, of

14 course, asked for income tax purposes if a distribution is ever made. The application also asks for information on the chosen annuitant. The birth date of the annuitant is a requirement so that the insurer can see that they are within the age limitations. The application also covers investment options, the type of money (whether it is a roll-over from another source, a retirement plan or a regular investment) and the signature of the contract owner and the annuitant. After all the information is completed and signed, the agent submits the application to the insurance company with funds accompanying it. A contract will be sent or delivered to the policyholder. The annuity contract will include a cover sheet that summarizes parts of the application and will point out what type of return or what type of investment portfolio has been chosen. As already discussed, the contract owner has the power to add money, change beneficiaries and/or annuitants, make withdrawals or cancel the entire contract. Investment Options: As stated in the introduction there is two different types of annuities and options within those types. To recap, there are: Immediate Annuities, Deferred Annuities and Accumulation Annuities. Within these two, there are the options of either a variable or fixed period/amount. We will first be discussing Immediate Annuities and the options within. Immediate Fixed Annuities: The immediate annuity is just as it sounds; checks are issued by the insurance company to the policyholder immediately upon investment. Immediate annuities are designed for people who rely on receiving a specific amount of money. One of the first decisions to be made once the policyholder has chosen the annuity, as an investment option is to choose whether it is to be fixed or variable. The second decision involves how long of a payout period the policyholder wants. The periodic check issued under the fixed annuity to the annuitant will be a fixed amount for the duration of the payout period. The duration of the payout period may be determined by stipulating to the insurance company the period of time during which the policyholder wishes to receive the checks. The period of time, which is chosen by the policyholder, could be, for example, five, ten or 20 years.

15 This depends upon the amount of money invested, prevailing levels of interest rates and the period of time the policyholder selects. If Alan invested $80,000 and wanted $1,000 a month for five years, not adding in interest, Alan would be taking out a total of $60,000. Alan could not, of course, choose to take out $2,000 a month for five years. This is because the funds, the base invested amount, would not be there even if the interest rates were sky high. The insurance company will determine how many months they would be able to pay the amount requested by the policyholder in the time period also requested. Immediate annuity checks can be sent out monthly, quarterly or annually. The amount of each check will not fluctuate; the specific dollar amount of the check, of course, would depend upon the initial investment made. A chief consideration for the policyholder is the amount of return (%) being offered on the annuity. When considering which company to suggest to clients, an agent should factor in how much money the company is offering to give the policyholders each month. Telling the policyholders of all the choices available will allow them to make the most informed choice. If Alan was told that an insurance company would give him $275 each month for five years with an initial $10,000 investment he would want to then shop around. Of course, an agent would want to shop around for the policyholder so the commission may not be lost. One difference between companies is the rate of return that each company is willing to offer. However, the rate of return should never be the primary concern. Company stability is much more important. From the aspect of policyholder service, it pays to shop around before an agent recommends certain companies. Both the agent and the policyholder will want the best possible service. Companies are often very competitive even in the service area. A policyholder may be concerned that the money invested, and then paid out during the payout period, may run out before they die. It is possible to select payment for life, although they may be a lesser monthly dollar amount. This is called a Life Annuity payout option. It also may be referred to as a Straight Life Annuity. Under the Life Annuity payout option, the insurance company keeps all funds that remain when the annuitant dies. Nothing more would go to a beneficiary. The policyholder,

16 the annuitant, would be taking the risk. All Life Annuities share a common characteristic: The insurer (the insurance company) is betting that one or both of the annuitants will die prematurely. The contract owner, investor, hopes to live for another 100 years. So the policyholder can either win by living longer, or lose by dying earlier than the company estimates. Of course, winning or losing doesn't count for much when you're pushing up daisies. For example, if Alan were to invest in a life annuity he would be betting that he would outlive the amount invested or at the least break even. If a few months down the road after the life annuity was taken out, Alan were to die, his beneficiaries would not see any of the money invested in the annuity. The insurance company would then take control of the money. If though, Alan lived 100 years after the annuity contract was taken out, he would come out on top. The alternative to this is the Refund Annuity. This may also be referred to as Lifetime with Period Certain Annuity. The policyholder can request that the insurance company make payments for life, but to continue those payments for a stipulated period of time if the policyholder should die prematurely. The policyholder could, for example, insist the insurance company make payments for life with a minimum of at least ten, 15, or 20 years or until the beneficiaries receive back at least the entire invested amount that was originally put into the annuity contract. If Alan did not want to take a chance with his hard earned money, he may opt for a refund annuity. Alan could then stipulate that if he were to die prematurely, the balance of the annuity funds would continue to be paid to his beneficiaries. There is also the Joint-and-Survivor Annuities. With this type of annuity the insurance company can guarantee payments for the lives of two people. These are used most frequently by married couples. As with Immediate Fixed Annuities, Joint-and-Survivor Annuities can also be issued with minimum guarantee periods or the refund-certain variety. Immediate Variable Annuities: Any policyholder depending on a fixed annuity income can expect to have an ever decreasing standard of living because the economy is always

17 experiencing inflation. The variable annuity was designed to overcome the decrease in purchasing power of the fixed annuity. The basic idea behind the variable annuity is to invest the capital sum of the annuity into an investment portfolio of stocks and/or mutual funds and anticipating that inflation will cause the stocks to appreciate. That appreciation will provide increasing income to the annuitant. Though this sounds very good, annuitants have not found the variable annuities attractive as investments. The most obvious reason is that there is a measure of risk. A policyholder does not have a guarantee that way the stock market will go. There is no promise made that the annuity will increase in value as inflation increases. Another drawback of the variable annuity is that it does not satisfy the annuitants demand for a consistent monthly income that most people who annuitize (this will be discussed in chapter four) are wanting. Because of the risks involved, many are not willing to gamble their future standard of living. A variable rate option, whether it is an immediate or deferred annuity, does not guarantee any returns. The insurance company that the variable annuity is purchased from does not tell the policyholder how to invest their money. The company does not share in the profits, nor does it share in the losses. The same thing is true if the policyholder was to buy a stock, bond or mutual fund. If the investment goes up 25 percent in one year, the policyholder receives the entire gain. On the other hand, if the investment goes down 25 percent, no one comes to the rescue. The investor may know the risks involved in a variable rate, and still want it for its flexibility. In the New Century Family Money Book by Jonathan D. Pond, he suggests that a policyholder "divide the deferred or immediate-pay annuity purchases between fixed and variable annuities. The net result will be the holding of balanced annuities." Lipper Analytical Service of Denver that monitors mutual fund and variable annuity performance, stated that a review of fixed income mutual funds and equity mutual funds show that they have under-performed when compared to similar group in variable annuities. Almost every major mutual fund complex is now in the variable annuity business. If Alan and Cathy opted for the immediate variable annuity because they wanted their income to keep up with inflation, they are betting that the invested capital will also grow so that their income will grow and keep up

18 with inflation. This, again, is a gamble. There are no assurances that the stock market will keep up with inflation, nor do mutual funds give this sort of assurance. Deferred Annuities: A deferred annuity is normally used as a way to accumulate a retirement savings. A policyholder purchases it, and then watches their money grow. Only a few deferred annuities allow the policyholder the option of taking a lump-sum when they retire rather than forcing them to annuitize. Even though a deferred annuity is essentially a tax deferred saving plan, it does not mean tax free. Eventually the policyholder will pay taxes on the money withdrawn for retirement. The policyholder also receives no tax deduction on the amount of money that is initially invested to establish the annuity. An Individual Retirement Account (IRA) will let the policyholder deduct the contributions made to the account, although restrictions do apply. There are two types of deferred annuities: 1. Single-premium Annuities 2. Flexible-payment Annuities Simply speaking, the single premium annuity is purchased with one lump sum. The flexible payment annuity lets the policyholder purchase it with installments over a set period of years. If the policyholder chooses they can receive the interest income from the annuity either through sporadic or scheduled withdrawals, if the deferred annuity plan will let them do so. Deferred annuities can be constructed so that the policyholder can request a portion of the income be given to them annually while the rest is reinvested, much like a Certificate of Deposit (CD). In most cases, though, the policyholder has the principal (the amount initially invested) and any earned interest reinvested automatically. The policyholder could, however, choose to terminate the investment or simply withdraw a portion of the principal. This is subject to applicable fees, if any apply. These would be stipulated in the contract.

19 As with the immediate annuities, a deferred annuity has the option of choosing either a fixed or variable interest rate. Investors who purchase CDs do so because they want the interest income or because they plan on rolling over the CD into another CD or investment. The deferred annuities can be constructed to do the same things, accomplishing the same goals. The owner of the annuity can request that a certain amount be sent to them annually or reinvested so a larger amount of money is earning interest; a concept known as compound interest, which is interest earning interest. The deferred annuity can offer a great deal of flexibility. Besides automatically reinvesting, the contract owner has the ability to terminate the annuity or withdraw part of the principal, subject to possible costs. Deferred annuity contracts are not as efficient as single premium life insurance policies in accomplishing the transfer of wealth on to a beneficiary. The annuity contract, while deferring taxation on earnings within the contract until future use, never escapes that pent-up income tax liability. Accumulation Annuity The Accumulation Annuity is a type of annuity that is similar to the deferred annuity. Whereas the deferred annuity can either is started by putting one lump sum in or making payments to the annuity to build up the principal. The Accumulation Annuity is strictly offered so that one can make systematic payments to the annuity for a period of time. Then, at some later date, the policyholder can annuitize (shift from accumulation to a monthly payout) when they are ready to retire. Which annuity is best? The type of annuity that is chosen by the policyholder should depend on the following four factors: Time Horizon Other Owned Investments Goals & Objectives Risk Level Time Horizon is when the policyholder plans on using the investment proceeds. The longer the policyholder is willing to live with an investment,

20 the more they should concentrate on equity building products. Though not an insurance product, it has been proven that stocks have outperformed bonds in every decade. Other Investments should be considered when looking at annuity investing. If the policyholders have no other investments, a variable annuity may be too risky for them and their future income levels. On the other hand, they may feel they can invest well enough to better their income. One thing to keep in mind is that things can change in the marketplace -- suddenly. Diversification has always been a fundamental in successful investing. If the policyholders' investments are tied up in debt instruments, they should look at equity options within a variable annuity. Goals and Objectives would include how much the policyholder wants for retirement, sending a child or children through college or just to buy a house in a few years. Whatever the policyholder's goal may be, it is important to turn these into dollar objectives - something that can be attained. We can all dream, but once a goal is set, it may be easier for one to plan and meet that goal. Once this has been established, and the policyholder knows their existing holdings, then comes the step of calculating how to attain that figure (goal). Risk Level is what the policyholders accept in certain investments. This level can go up or down depending on the investment chosen. A policyholder needs to be comfortable with the risk levels of the investments they choose. This means they need to be aware of them to begin with. Review Questions 1) An annuity contract could be defined as a life insurance policy without the mortality charges. True False 2) There are always four parties to annuity contract. True False 3) "Black Monday" was when the stock market crashed in the year of:

21 a) 1985 b) 1986 c) 1987 d) 1988

22 The oldest type of annuity is the Single-Pay Deferred Fixed Annuity. The contract owner pays the insurance company the intended investment Generally the insurance companies require that it be no less than $5,000. The owner could add to the initial amount that was invested anytime prior to annuitization. The insurance company guarantees that when the annuitant reaches an age of their choice, he or she will receive a fixed dollar amounts for as long as the person lives. The oldest type of annuity is the Single-Pay Deferred Fixed Annuity. The contract owner pays the insurance company the intended investment. Generally the insurance companies require that it be no less than $5,000. The owner could add to the initial amount that was invested anytime prior to annuitization. The insurance company guarantees that when the annuitant reaches an age of their choice, he or she will receive a fixed dollar amounts for as long as the person lives. The Accumulation Annuity is similar to the deferred annuity. Whereas the deferred annuity can either is started by putting one lump sum in or making payments to the annuity to build up the principal. The Accumulation Annuity is strictly funded by systematic payments to the annuity for a period of time. Then, at some later date, the policyholder can annuitize (shift from accumulation to a monthly payout) when they are ready to retire. We have already briefly gone over some variations of the annuity in the first chapter, but for a review let's recap what those were. A Life Annuity, also referred to as a Straight Life Annuity, is used when a policyholder wants to maintain a lifetime income. If, however, the annuitant dies prematurely, the insurance company retains all funds remaining.

23 Lifetime with Period Certain Annuity or Life and Installments Certain Annuities is used for those who choose to receive income for life with a guaranteed payment period even if they die prematurely. A typical choice may be a "life or ten years certain." The key word here is certain. The "certain" period of time is usually either ten or twenty years, this can be any number of years depending on the annuity contract. This type of contract states that should the annuitant die prior to the stated "certain" time period, payments would then continue to the beneficiary until that specified number of years has been met. On the other hand, the annuitant may receive payments longer than the "certain" period stated, depending on how long their life extends. That is where the "life" part comes in. The Lifetime with Period Certain Annuity, also referred to as a Refund Annuity, can be used when the policyholder wants to avoid the risk of a Straight Life annuity. The policyholder can request that the insurance company make payments for life, but to continue those payments for a stipulated period of time, 10, 15, or 20 years, if the policyholder should die prematurely. The annuity could also be constructed to pay the beneficiaries until they receive back at least the entire invested amount that was originally put into the annuity contract. A Refund Annuity may pay out less in monthly installments than would a Straight Life Annuity. Even so, an individual may not want a Straight Life Annuity because the beneficiaries could loose the funds remaining if the policyowner died prematurely. An agent, may want to point out that annuities are not designed for beneficiaries. They may want to provide for their dependents separately (through life insurance, for instance), and consider the Immediate Straight Life which gives them a larger monthly check. Two variants of the "period certain" options are: 1. Cash Refund Annuity 2. Installment Refund Annuity Both the Cash Refund and the Installment Refund Annuity options guarantee enough payments to the policyholder or the beneficiary to match the full and original investment. The Cash Refund pays the beneficiary in a lump sum. The Installment Refund does exactly as the name implies, making installment payments. These contracts can reduce the size of the

24 policyholder's monthly income. This is because the Cash Refund option means that any money left over in the annuity would go to the beneficiary if the annuitant dies prior to a complete liquidation. Two-tiered annuities allow the policyholder to be either rewarded or penalized depending on the avenue they select. They are rewarded if they stay with one company by receiving a higher interest rate. If the policyholder surrenders or transfers to another carrier, they are penalized with a lower interest rate that is retroactively applied. This is the second tier. The two-tier has a second and permanent surrender charge in the form of the lower interest rate. The annuity may have a substantial charge for withdrawals; a charge that may never disappear. It is important to understand that the insurer may seem to be paying competitive rates, but if the policyholder elects to withdraw, they may be credited with an extremely low interest rate. The first-tier interest rate is only realized if annuitization is utilized through the initial insurer. This, then, locks the policyholder into the same company for life. Comparing two-tier rates with other annuity plans can be very misleading. Joint-and-Survivor Annuities allow the insurance company to guarantee payments for the lives of two people. Married couples use these most frequently. As with Immediate Fixed Annuities, Joint-and-Survivor Annuities can also be issued with minimum guarantee periods or the refundcertain variety. The joint-and-survivor annuity provides payments to a surviving spouse. This may be a wiser choice for a married couple instead of something like the straight life annuity because a straight life annuity is setting aside less money to cover the spouse, though it is providing a higher monthly payment. It has been argued that the higher monthly payment the straight life annuity provides could go towards premium on a life insurance policy. The other side of the coin is that the couple could run out of money and let the life insurance policy lapse. The life insurance proceeds, once one of the spouses dies, would have to be managed effectively so that they would have enough to live on for the rest of their own life. If the surviving spouse is older and their health is failing when death occurs to the other, how would they manage the funds then? One important bit of advice for any agent dealing with the retirement savings or life savings of a couple: Choose an A+ company (A.M. BEST rating. This will be discussed in chapter five along with other rating systems). It doesn't matter how good the annuity contract

25 is if the company selected fails. Some professionals suggest using an insurance company that has been rated highly by two or three different rating services. The Retirement Equity Act of 1984 gives spouses of employees more protection. Under this bill, the normal way for a married person's pension to be paid out is through the use of a joint-and-survivor annuity. This means that the spouse will not be left without a pension income when the breadwinner dies. The employer's responsibility to pay benefits over a longer period of time means that the initial benefit checks will be smaller. The employer is not allowed, however, to reduce the joint-and-survivor annuity below 50 percent of the benefit for the worker's life alone. The normal provisions must also include a Preretirement Survivor Annuity. This is similar to the joint-and-survivor annuity in that the survivor is guaranteed the income of the pension even if the vested employee dies before retiring. Vesting is when an employee benefit plan participant has the rights of ownership to the employer contributions made on their behalf, plus earnings on those contributions. The Wrap-Around Annuity, also referred to as a Switch-Fund Annuity, is the joining of a life insurance company and a mutual fund organization that manages several mutual funds with different goals and different investment policies. The insurance company provides the annuity contract and the mutual fund company provides the investments. This type of annuity allows the policyholder the freedom to specify which of the mutual funds to invest in. In 1982, the IRS issued a tax restrictive ruling on Wrap-Around Annuities. The IRS may refer to the Wrap-Around Annuity as an "Investment Annuity." The Investment Annuity and the Wrap-Around Annuity are both

26 terms for arrangements under which an insurance company agrees to provide an annuity funded by investment assets placed by or for the policyholder with a financial custodian with assets placed in a specifically identified investment (mutual fund). It is normally held in a segregated account of the insurer. The IRS has ruled that, under such arrangements, sufficient control over the investment assets is retained by the policyholder so that income on the assets prior to the annuity starting date is currently taxable to the policyholder rather than to the insurance company, with the exception of certain contracts grandfathered under Rev. Rule and Rev. Rule , the underlying investments of the segregated asset accounts of variable contracts must meet diversification requirements set forth in the regulations. (IRS Sec. 817 {h}) CD-like Annuities are a hybrid of the Single Premium Deferred Annuities (SPDA). However, the CD-like Annuities give the policyholder the liquidity and rate of return most often seen with traditional Certificates of Deposit that are marketed by the banks. Unlike CDs, these annuities have all the advantages of the SPDAs that include tax-deferred growth, guarantees of principal and the opportunity to convert the account value to a guaranteed income for life or specified period of time. Whereas SPDAs are designed to be used as tax-deferred investments for the long-term, CD-like Annuities are geared for the short term. They normally offer longer guaranteed interest periods as well. Some CD-like Annuities may allow additional deposits, depending on the contract, and allow partial penalty-free withdrawals from the account during a specified option period. The additional deposits and the withdrawal options are often referred to as "windows of opportunity." The most common CD-like Annuities run for periods of one, three or five years. The window of opportunity generally lasts for 30 days after each guaranteed interest period. Certainly, the largest selling point of the CD-like Annuity is the taxdeferred growth with liquidity coming after a relatively short period of time. A definite advantage of the CD-like Annuity is the ability after the term of the annuity is up, to take the money out, principal and interest, without any insurance company penalty, cost or fee. The partial or complete withdrawal can be sent to the policyholder or to another insurer. If the policyholder uses a 1035 tax-free exchange, the policyholder will not incur any tax events. A 1035 Exchange enables a policyholder to move their money from one

27 company to another without tax consequences. Not all investments allow this change from one investment to another with tax implications. Such a move is known as a 1035 Exchange by the IRS. It is known as a tax-free exchange since the policyholder does not pay any taxes. The policyholder would pay taxes only if they started to make partial withdrawals or completely withdrew their money. This transfer is tax-free because the policyholder cannot touch the money being transferred. The money must go directly to the new company or annuity. The actual tax-free exchange is quite easy. Once the policyholder has chosen the new company or annuity, a new application is filled out along with a separate form identified as the 1035 exchange request. The forms are sent along with the existing contract. The new insurance company will take care of the rest. If the policyowner cannot find the existing contract, another form can be filled out to turn in with the application. The policyholder can make the 1035 exchange at any time, although they would be subject to any penalties incurred by the current insurance company holding the contract. The penalties incurred depend on the specifics of the contract. Normally, though, if the policyholder has stayed with the current insurance company for a certain number of years, there will be no penalty. Penalty schedules can range from five to ten years, with some annuities having penalties that never leave. Though there may be penalties imposed by the insurance companies, they are not limited by the number of 1035 Exchanges per year. If the policyholder does not reinvest in an annuity and deposits it in some other type of investment, the policyholder could then incur a tax event. They would be subject to a ten percent IRS penalty if the policyholder were not 59 ½ or disabled or dead. This potential of a ten percent penalty can be avoided under the provisions of the 1035 exchange. The policyholder is, of course, going to want the highest interest rate possible. They will stay with the same company if the new rates offered are still competitive with other companies. Split Annuities are contracts that are divided into two parts. One part is distributed while the other remains intact earning interest. While the annuity can have either a fixed or variable rate, the fixed rate can make the guarantee

28 of complete restoration within a set period of time. A Split Annuity is for anyone who needs current income, needs a tax break, and wants the guarantee at the end of a specific period of time. The amount received each month will change with the securities investments that the policyholder selected. It is possible to choose a fixed rate annuity if a person desires a specific amount payable. The chief difference between a split annuity and an immediate annuity is that the split annuity is designed to restore principal. The immediate annuity only capitalizes on the short-term performance. Split annuities can be used as long-term investments, whereas immediate annuities vary from a few years to a lifetime. Split annuities can offer the policyholder guarantees in terms of performance that the immediate annuity cannot unless a fixed rate option is used. In choosing a variable or fixed rate, one should consider the market and the policyowner's goals. The variable rate cannot offer any guarantees like the fixed rate ones. However, the potential for return is greater on the variable rate options. As with all annuities, the distribution amount is flexible prior to annuitization. If the policyholder does not need as much income, the contract can be changed. The same is true if the policyholder decides they need more income. They would then be weighing down the split annuity more heavily for income as opposed to growth. Remember, the policyholders only become locked in for the portion they annuitize. Reverse Annuity Mortgages (RAM) is similar to the reverse mortgage. The difference is that with a Reverse Annuity Mortgage the policyholder is guaranteed a home and an income for life. Consequently, the income generated is almost always smaller than that from a reverse mortgage. Consider the Reverse Annuity Mortgage as an income supplement, not an income generator. A Reverse Annuity Mortgage works like this: The policyholder first takes out a mortgage. With the mortgage proceeds, they purchase an annuity from the insurance company of their choice.

29 The insurance company would then subtract the interest due on the mortgage, send it to the lending institution and send the policyholders the net amount back. When the policyowner dies, the home is sold and the mortgage principal is repaid and any remaining proceeds go the their estate. The amount of the annuity payments depends upon several things; including interest rates, the property value, the policyholder's age and martial status. Because the insurance company is taking on the mortality risks, they want to insure a profit for themselves. This means that the annuity payment is going to be smaller that a straight reverse mortgage payment over a fixed term. The tax requirements on a Reverse Annuity Mortgage can have a very negative impact. The guidelines for determining the amount of the monthly annuity that must be declared as taxable income is prescribed by the Internal Revenue Service (IRS). This means they are very complicated. Simply speaking, if the interest rates are high, the policyholder's taxable income may be larger than was actually received. In other words, the policyholders could be taxed on income they never received. A Private Annuity, also referred to as a Family Annuity, is another option for a couple interested in the Reverse Annuity Mortgage options. The policyholder would sell their home to a private party, like their children, and in turn receive an annuity income for life. The policyholder would execute a separate agreement that would guarantee the policyholder a lifetime tenancy in their home. As with any annuity, one must consider the tax ramifications and the estate planning choices it offers. The Private Annuity removes the home, considered an asset, from their estate. Assuming the policyowners would spend the income from the annuity; the transfer would have the effect of lowering the total value of the estate. The IRS has published tables for valuing Private Annuities since there is certainly not the same assurance that the private annuities will be paid. A loss under a private annuity is disallowed for federal income tax purposes where the other party is spouse, brother, sister, ancestor or lineal descendant. Various fiduciary relationships between the parties also can result in automatic disallowance of any loss.