Annuities Table of Contents

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1 Annuities 1

2 Annuities Table of Contents Chapter One Introduction to Annuities and Annuity Buyers Important Lesson Points Introduction Demographics of Non-Qualified Annuity Purchasers The Annuity Concept Annuities in Operation Summary Chapter Two Characteristics of Annuities Important Lesson Points Introduction Premiums Single Premium Annuities Fixed Premium Annuities Flexible Premium Annuities Annuity Expenses Surrender Charges M&E Charges and Investment Advisory Fees Lives Covered by the Annuity Multiple Life Annuities When Payout Begins Deferred Annuity Immediate Annuity Cash Value Accumulation Fixed Annuities Variable Annuities Death Benefits Annuitization Methods Temporary Annuity Life Annuity Summary Chapter Three Variable Annuities Important Lesson Points Introduction Deferred Annuity Accumulation Managing Cash Value Volatility Diversification Asset Allocation Automatic Sub-account Re-balancing Fund Transfer Dollar Cost Averaging Interest Sweep Variable Annuity Payout Phase Features and Benefits Suitability Compliance Requirements Combining Fixed and Variable Annuities Summary 2

3 Chapter Four Types of Fixed Annuities Important Lesson Points Introduction Traditional Declared-Rate Annuities Bonus Annuities Multi-Year Guarantee Annuities Interest Indexed Annuities Equity Indexed Annuities Determining Cash Value Index Call Options and Participation Rate Interest Crediting Methods Total Interest Rate Methods Annual Interest Rate Methods Combination Indexing Methods Interest Rate Cap Summary Chapter Five Annuity Taxation Important Lesson Points Introduction Income Tax Treatment Premiums Cash Values Ownership by Non-Natural Persons Generally Ownership by Natural Persons and Certain Trusts Surrenders and Withdrawals Premature Withdrawals and Surrenders Annuity Payments During Lifetime Fixed Annuities Variable Annuities Annuitant s Death After Annuity Starting Date Contract Owner s Death Before Annuity Starting Date Estate Tax Treatment Summary Glossary Appendix 3

4 Chapter One Introduction to Annuities and Annuity Buyers Important Lesson Points The important points addressed in this lesson are: Annuities offer contract owners substantial tax benefits, including tax deferral of earnings and partially tax-free income benefits Annuities may be classified as fixed or variable, deferred or immediate, or qualified or non-qualified Although non-qualified annuity buyers may come from all economic strata, the majority of annuities are purchased by middle income individuals Non-qualified annuity buyers purchase annuities for a number of reasons, principal of them are as a retirement income supplement, a safe-haven investment, a survivor income or to provide a financial safety net in the event of illness Annuities were initially vehicles designed solely to systematically liquidate a principal sum over a lifetime Modern annuities are purchased more frequently for their accumulation advantages than for their distribution characteristics Introduction Annuities offer their owners the opportunity to systematically liquidate a principal sum or save money for a long-term objective. For many annuity buyers, that objective is to provide income during retirement. As we will see in our examination of annuities, they provide owners with a number of advantages; principal among them is their tax treatment. By purchasing and investing in an annuity, a contract owner can avoid current income taxation of earnings. By avoiding current income taxation, earnings that might have been used to pay current income taxes can be invested to produce additional income. Annuities tax advantages aren t limited to tax deferral, however; annuities offer additional tax advantages. For example, an investor purchasing a variable annuity can change his or her investment allocation in the contract s variable subaccounts whenever desired. Typically, such changes are made in order to implement new objectives or to modify the level of risk assumed. From a tax point of view, the important issue is that the contract owner can make these changes without being required to recognize income as would be required if, for example, the investor liquidated his or her stock portfolio in order to purchase bonds. In addition to these tax benefits, a contract owner that elects to annuitize his annuity contract, i.e. to take a periodic income from it, will find that part of each periodic income payment may be tax free as a return of his or her investment in the annuity contract. It will become apparent as we continue to examine annuities that they may be distinguished from one another in a number of ways. Annuity contracts may be: 4

5 Fixed or variable Deferred or immediate Single premium or flexible premium and Qualified or non-qualified Although we will briefly discuss qualified annuities, this course s principal focus will be on nonqualified annuities, i.e. annuities purchased outside of any tax-advantaged plan such as a taxsheltered annuity or individual retirement account. Demographics of Non-Qualified Annuity Purchasers Who buys non-qualified annuity contracts? Since annuity contracts offer some interesting tax benefits, we might expect that individuals with substantial incomes and assets would be the predominant buyers. That belief, at one time, was shared by certain members of Congress, who professed an interest in reducing some of the annuity s tax advantages. Although it might be reasonable to conclude that annuities are a vehicle only for the rich, that conclusion would be incorrect. Following the announced intention by Congress a decade or more ago to review the tax benefits afforded annuity owners, periodic surveys began to be commissioned in order to determine who purchases them. Over the time that these surveys have been done, the answer to that question has not varied substantially. Somewhat surprisingly, perhaps, the market for non-qualified annuities is comprised principally of middle-income purchasers, although affluent investors also buy them. The income and asset distribution of families in America shown below indicates that approximately 92 percent have earned incomes of less than $100,000; it is that group that constitutes the bulk of non-qualified annuity buyers. Income Household Income & Assets Percentage Distribution Distribution by Number of Households (millions) Under $75, $75,000 99, $100, , $200,000 and over Financial Asset Level Under $250, $250, , $500, , $1 4.9 million $5 million and over

6 In addition, studies indicate that almost one-half of these non-qualified annuity buyers are or were retired business owners, corporate officers or professionals, while fewer than 20 percent were blue collar or service employees. With respect to the ages of non-qualified annuity owners, studies indicate that a substantial percentage 30 percent by some estimates are age 72 and older. There are certain buying differences that were observed between individuals that owned declared-rate annuities and those that owned variable annuities or equity-indexed annuities. The first fixed annuity contract was purchased by individuals younger than age 50 in about 41 percent of contract owners. However, buyers of variable annuity contracts tended to buy at a somewhat earlier age. Fifty-three percent of annuity owners bought their first variable annuity before they were age 50. Buyers of equity indexed annuity contracts were also about 7 years younger than declared-rate annuity buyers. Despite the obvious tax benefits that would appear attractive to wealthier investors, some advisers believe that the affluent generally avoid investing in annuities. That opinion isn t supported by the demographic findings. Although slightly less than 6 percent of households overall own an annuity, about three times that percentage of individuals earning $200,000 or more own them. As might be expected, the percentage of annuity ownership and the median annuity value tend to increase as household income and net worth increase. 1 The Federal Reserve Board s Survey of Consumer Finances, published in January 2000, categorizes annuity ownership by income and asset levels as shown in the chart below. Income Household Income & Assets Percentage Distribution Of Annuity Ownership Median Value Of Annuity Owned All families 5.7 $ 30,000 Under $75, ,000 $75,000 99, ,000 $100, , ,000 $200,000 and over ,000 Financial Asset Level Under $250, $ 18,000 $250, , ,000 $500, , ,000 $1 4.9 million ,000 $5 million and over ,000 It also appears that, irrespective of the income and asset category of the annuity purchaser, the funds invested in the annuity were the result of individual earnings rather than an inheritance. 1 James O. Mitchel, Finances of the Affluent: Special Analysis of the Survey of Consumer Finances, Journal of Financial Service Professionals, September,

7 Why Buyers Purchased Non-Qualified Annuities The available studies have provided some insight into the demographics of a non-qualified annuity buyer. Let s consider why they purchased their annuities. Four reasons are offered for most non-qualified annuity purchases. Those reasons are: 1. For a supplemental retirement income 2. To provide funds, if needed, to purchase care following the onset of a serious illness 3. To provide a safe investment haven in the event other investments perform poorly 4. For an income to a survivor, e.g. a widow or widower A Gallup survey, reported in a June 4, 2001 National Underwriter article, 2 underscores these purchase motivations. According to the National Underwriter article, eight in ten annuity owners interviewed identified three principal motivators leading to their non-qualified annuity purchase: To use the annuity income as a financial cushion if the owner or spouse lived beyond their life expectancy To avoid being dependent on children and To ensure a retirement income It is interesting to note that, while retirement income was an important motivator for many nonqualified annuity buyers, few annuity owners used the annuity funds. Instead, 90 percent of the annuity buyers responding still owned the first annuity they had bought, and only thirty percent of annuity owners had withdrawn funds from the annuities they owned. Many annuity owners fear depleting their funds and becoming dependent. For that reason, many people beyond retirement age try to live entirely on their investment income or interest from their savings and avoid invading principal. The Annuity Concept The term annuity hearkens back to a Greek word, annus, which means year and connotes an annual income payment. As initially conceived, an annuity is simply a product that, through annual payments, systematically liquidates a principal sum over a lifetime. In its traditional meaning, an annuity offers a benefit that can t be found in any other financial vehicle; that benefit is an income that cannot be outlived, no matter how long-lived the individual is. Think of how important that might be. Suppose that you were age 65 and had a sum of money with which to live the remainder of your life $300,000, for example and could not obtain additional funds under any circumstances. You could invest your principal in a money market account and live off the interest that was earned. At 4 percent, your annual income would be about $12,000; however, since you did not invade the principal, you would never run out of money. Unfortunately, the income you received wouldn t provide much in the way of luxuries and probably not very many necessities either. Since that approach doesn t provide sufficient income for you, you decide to look up your life expectancy in the actuarial tables and find that at age 65, your life expectancy is approximately 2 Marcella DeSimone, Who s Buying Non-Qualified Annuities? National Underwriter, June 4,

8 21 years. By doing a few calculations, you determine that you can increase your annual income to $20,000 by withdrawing an increasing amount of principal each year. At that rate, and assuming you continue to earn 4 percent on the balance, the principal will last for exactly 21 years. Because $20,000 isn t sufficient to maintain your lifestyle, you decide to try to increase your earnings on the principal, knowing that by placing your funds in investments that can produce a higher income you will be risking the loss of the principal. However, if you can increase your earnings on the principal, you can take annual withdrawals of $25,850 each year and not exhaust the principal until the end of 21 years. Based on that reasoning, you decide to move your principal out of the money market account and invest it in high yield bonds, also known as junk bonds. But, what risks have you taken? The risk that immediately comes to mind is that the junk bonds may lose their value if interest rates increase, and since these high yield bonds have a low rating the issuer may be unable to meet the interest and principal payments at some time in the future. The more significant risk, however, relates to your lifespan. If you live longer than the actuarial table says you are likely to, your income will cease entirely. The additional risk that you have assumed is the risk of outliving your money. The alternative, of course, is to purchase an annuity. At age 65, the monthly income that you can purchase per $1,000 of principal ranges from about $7 to $10, depending upon the insurer from which it is purchased. 3 In other words, your $300,000 of principal can be applied to purchase a single premium immediate annuity that pays you an annual life income between $25,200 and $36,000. And, even if you live longer than the 21 years that the actuarial table considers your life expectancy, your income will continue. Furthermore, if you used a variable annuity, your income could increase over time to make up for the erosion of your purchasing power due to inflation. Although this example illustrates the traditional use of an annuity as a vehicle to systematically liquidate a principal sum it doesn t go far enough. In today s economy, annuities are used frequently as a vehicle in which to accumulate the fund that will be used to provide a retirement income. Let turn our attention now to how modern annuities work. Annuities in Operation Earlier in this Chapter it was noted that annuities can be categorized in a number of ways, including as a deferred or immediate annuity. In the example posed just above, the investor would have placed his $300,000 in an immediate annuity, since he was interested in having his income begin right away. Many people, however, prefer to make regular premium payments to their annuity and build up the fund over time. That kind of annuity is called a flexible premium deferred annuity (FPDA) and is the kind of annuity that we will be spending most of our time discussing. In an FPDA, the contract owner makes premium payments to an insurance company. The insurance company credits the premium payment to the cash value of the owner s contract. Depending on how the cash value is invested, the annuity contract will be either a fixed annuity or a variable annuity. For now, our assumption is that the annuity is a fixed annuity to which the insurer credits interest annually. There are three parties to an annuity contract. Those parties to the contract are the: 3 E.E. Graves, ed. McGill s Life Insurance, p

9 Contract owner Annuitant and Insurer The contract owner is the person that owns the contract, pays the premiums and has certain rights, including the right to name a beneficiary to receive any survivor benefits. The annuitant is the person whose life governs the duration of life annuity periodic payments. In the majority of cases, the contract owner is also the annuitant; however, the contract owner and annuitant need not be the same person. The period before the annuity starting date and during which the contract owner is paying premiums on the annuity contract is known, appropriately, as the accumulation period. In an FPDA, the contract owner may make premium payments as regularly or irregularly as desired and, within certain limits, in any amount chosen. Usually insurers require that any payment made meet a certain minimum amount, such as $25; similarly, an insurer may limit the amount of any individual premium paid to no more than $250,000. The minimum premium requirement is imposed to enable the insurer to avoid costly premium administration involving small amounts. The maximum premium limitation may be imposed to ensure that the insurer is able to make a timely investment of the premium payments. During the accumulation period, the contract owner may take withdrawals from the annuity. However, a surrender charge may be applied if the withdrawal is taken during the surrender period. Premium payments cease on the annuity starting date. That is the date on which periodic income payments are scheduled to begin. Periodic income payments continue throughout the annuitization period or payout period. Summary The annuity contract that initially provided only for the systematic liquidation of a principal sum over a lifetime has become a highly competitive financial vehicle for the accumulation of funds as well as for their distribution. Offering buyers significant tax benefits, annuities may be classified as fixed or variable annuities, deferred or immediate annuities, qualified or nonqualified annuities, and as single premium or flexible premium annuities. Although non-qualified annuity buyers may come from all economic strata, the vast majority of annuities are owned by middle income individuals with annual incomes of less than $100,000. These individuals purchase their annuities principally for four reasons: to provide supplemental retirement income, to provide a financial safety net in the event of a catastrophic illness, to be a safe haven in the event that other investments perform poorly, and to provide a survivor income. 9

10 Chapter Two Characteristics of Annuities Important Lesson Points The important points addressed in this lesson are: Annuities may be funded by single premiums, fixed level premiums or flexible premiums Insurers generally impose a fee on annuity contract owners for expenses of new business acquisition, record maintenance, accounting and reporting Variable annuity contracts typically have higher fees than fixed annuities, generally reflecting their more complex nature Surrender charges may be imposed for annuity withdrawals or surrenders during the early contract years known as the surrender charge period Annuities may cover a single life or multiple lives The most popular multiple-life annuity is a joint and survivor annuity, often covering spouses In a fixed annuity the insurer bears the risk of principal loss; in a variable annuity, the contract owner generally bears that risk Insurers credit fixed annuities with interest periodically; variable annuity cash values are based on the performance of the variable subaccounts to which the premium is allocated Periodic annuity income payments may be made under temporary annuities or life annuities Introduction Annuities, as noted earlier, come in a variety of types: fixed, variable, deferred, immediate, nonqualified and so on. Despite that variability, there are certain common characteristics of virtually all annuities. In this chapter we will look at these common characteristics. Premiums Premiums paid for annuity contracts may be of three types: 1. Single premiums 2. Fixed level premiums 3. Flexible premiums 10

11 Single Premium Annuities Single premium annuity contracts are annuities in which only one premium is envisioned. Generally no further premiums are either expected or permitted. Often, single premium annuity contracts are funded by money received from an employer s qualified plan a pension or profit sharing plan or as a result of a severance package received from a terminating employer. Sometimes, of course, single premium annuity premiums come from inheritances or an individual s certificate of deposit. Single premium annuities may be either single premium immediate annuities (SPIA) or single premium deferred annuities (SPDA). Level Premium Annuities Annuities are sometimes funded through fixed level premiums. Under this approach, the contract owner pays a regular premium at fixed intervals, i.e. monthly, quarterly, semi-annually or annually, much as he or she would pay a whole life insurance premium. Normally, the contract owner does not have the option of paying more or less than the billed premium. Fixed level premiums characterize traditional retirement annuity contracts. While fixed level premiums provide a certain compulsion to accumulate funds through a forced savings approach, this premium-paying method has largely given way to flexible premiums. Flexible Premium Annuities The most popular method of funding an annuity is through flexible premiums. In a flexible premium annuity, the insurer sends regular premium notices on the chosen frequency to the contract owner who may remit the billed premium, more or less than the billed premium, or no premium at all. (There are, typically, certain minimum and maximum premiums permitted by the insurer.) Under the flexible premium approach, the contract owner may pay a premium when his or her cash flow permits and pay no premium when it doesn t. This popular premium-paying method has supplanted, for the most part, the less-flexible fixed level premium approach. Whether the annuity premiums are paid on a fixed, level basis or on a flexible basis, annuities on which ongoing premiums are paid may only be deferred annuities; single premium annuities, however, may be either deferred annuities or immediate annuities. Annuity Expenses Annuity expenses differ, to some extent, depending upon whether the annuity contract is a fixed annuity or a variable annuity. Regardless of whether the contract is a fixed annuity or a variable annuity, however, the insurer may impose a level sales charge, taken from each premium before being credited to the contract s cash value. Sales charges generally enable the insurer to recover its expenses of acquiring the new business and, in the case of annuities, are principally commission and other distribution expenses. In addition to sales charges, the insurer may levy a charge for record maintenance, accounting and reporting. Surrender Charges It is possible that a contract owner may elect to withdraw funds from a fixed or variable annuity contract or surrender it entirely before the insurer has been able to fully recover its sales charges. In such a case, the insurer generally charges the contract owner a withdrawal or surrender charge. Surrender charges apply only during the surrender charge period and usually (although not always) reduce over the period. Although insurers are generally able to impose surrender charges 11

12 at any level, typical surrender charges for a flexible premium deferred annuity are levied as a percentage of the amount withdrawn as shown below: Contract Year and later Surrender Charge 7% 6% 5% 4% 3% 2% 1% 0% M&E Charges and Investment Advisory Fees While sales and record keeping expenses may apply to either fixed or variable annuity contracts, there are certain expenses that are normally found only in variable annuity contracts due to their generally greater complexity. These additional variable annuity expenses include: Mortality and expense risk charges (M&E) and Investment advisory fees Let s consider the M&E charges first. Insurers selling variable annuities face two mortality risks. Those risks are that: Annuitants will live longer than anticipated based on mortality statistics and The death benefit guaranteed in the contract will exceed the value of the annuity at the time of the contract owner s death In addition to these two mortality risks, the insurer also faces an expense risk: that it will be more costly to administer and distribute the variable annuity contracts than it assumed. Both of these risks are charged for in the insurer s M&E charges. M&E charges are deducted from the separate account. Investment advisory fees charged provide the payment for investment advisory services provided to the funds that comprise the separate account. The investment advisory fees are charged at the fund level, rather than at the separate account level and are generally higher for funds that are more complex and lower for funds that are simpler. Accordingly, investment advisory fees are higher for higher for international funds or for stock funds (.7% - 2% annually) than for money market funds (.3% -.6%). Lives Covered by the Annuity Up to this point in our examination of annuities, discussion has centered on an annuitant and a contract owner. Based on that, it might be reasonable to conclude that an annuity may cover only one individual. That is not the case. Multiple Life Annuities Although annuities involving only a single life predominate, annuities covering two lives are also popular. There are two types of annuities covering two lives: a joint life annuity and a joint and survivor annuity. While there need exist no familial relationship between the two individuals that are included under an annuity that covers two lives, the most common arrangement is one that covers a husband and wife. 12

13 A joint and survivor annuity is a life annuity under which an income continues until the last of the two covered individuals dies. As we will discuss more fully when we examine annuitization methods, the income provided under the joint and survivor annuity may or may not decline following the first death. Although the arrangement for continuing income after the first of the two annuitants dies may be anything agreed to by the annuitants and the insurer, the most common income arrangements provide the following percentage of income to the survivor: 100% 75% 66 2/3% 50% The two reasons that generally cause annuitants to select a reduced income benefit after the first death are: 1. Living expenses may be expected to reduce when one of the annuitants dies and 2. The income provided under the joint and survivor annuity while both are alive will be higher if the survivor income is lower Married participants in qualified retirement plans are required to take a benefit from them that is a qualified joint and survivor annuity under which the participant s spouse would receive an income benefit of at least 50 percent of the benefit payable while both are alive. The spouse may, of course, waive that right. The second type of multi-life annuity is known as a joint life annuity. Under this arrangement, all income benefits cease upon the first of the two annuitants to die. Although such an income arrangement may have application in certain unusual circumstances, it is not nearly as popular as a joint and survivor annuity. When Payout Begins We noted that annuities may be classified as deferred annuities or immediate annuities. The difference between the two may be obvious, but it is reasonable to spend a few minutes discussing the differences. Deferred Annuity A deferred annuity is an annuity under which periodic income payments are deferred to, i.e. delayed until, some date in the future. That future date, i.e. when periodic income payments are scheduled to begin, is known as the annuity starting date. The period between the time that the annuity is purchased and the annuity starting date is the accumulation period. A deferred annuity is an annuity under which a period longer than one payment interval must elapse before the first benefit payment is due. As a practical matter, however, a period of several years often separates the annuity-purchase date and its annuity starting date. A deferred annuity may be funded by a single premium or by periodic premiums. In a typical situation, a 40 year-old non-qualified annuity buyer might decide to pay monthly premiums of $250 for an FPDA. When the contract owner reaches age 65, he or she might reasonably expect to have an accumulated value in the annuity of about $140,000, depending on the interest rate paid over the years of the accumulation period. 13

14 Immediate Annuity Unlike a deferred annuity, an immediate annuity is one in which the first periodic income payment is due one income payment interval after the date that the annuity was purchased. For example, if the immediate annuity provides for annual periodic payments, the first income payment would be due one year after the immediate annuity was purchased. If the annuity provides for monthly periodic income payments, the first payment would be due one month following the date that the immediate annuity was purchased. Immediate annuities are only funded by single premiums. Annuity Type First Periodic Payment Premium Options Immediate annuity Deferred annuity One income payment interval following purchase More than one income payment interval following purchase Single premium only Single premium or periodic premiums Cash Value Accumulation The words fixed and variable have been mentioned several times in the discussion thus far. It is time that some definitions are attached to these labels. Fixed Annuities A fixed annuity is one under which the insurer, rather than the contract owner, bears the risk of loss of principal. The insurer guarantees the contract owner that: Principal will not be lost, regardless of the insurer s investment performance and Interest at least equal to a stated minimum rate will be credited Although insurers guarantee to credit interest at a rate at least equal to a stated minimum in a fixed annuity, they may and usually do credit interest at a higher rate, known as the current rate. The insurer may credit interest in a fixed annuity in excess of the guaranteed rate based on: The interest declaration made by the insurer s Board of Directors or The performance of a particular index If the fixed annuity credits an interest rate based on the insurer s declaration, it is known as a declared-rate fixed annuity. If the fixed annuity credits an interest rate based on a particular index, such as an equity index or interest index, it is known as an equity indexed annuity or an interest indexed annuity, respectively. We will examine both of these approaches to crediting current interest in a later chapter. Variable Annuities 14

15 Unlike a fixed annuity, in which the insurer bears the investment risk, contract owners of variable annuities bear the risk of loss of principal to the extent that the variable annuity premiums are allocated (by the contract owner) to the insurer s separate account. To the extent that the variable annuity premiums are allocated to the separate account, the accumulated value of the variable annuity depends upon the performance of the variable subaccounts to which the premiums are allocated. In a variable annuity, the contract owner may allocate his or her premiums to the: Separate account or Fixed account The insurer s separate account is generally comprised of several variable subaccounts that are usually differentiated from each other by objective and risk level. Although any insurer s separate account may have many variable subaccounts, a separate account will usually offer the variable annuity contract owner the opportunity to allocate premiums to a: Common stock portfolio Bond portfolio or Money market fund In addition to allocating variable annuity premiums to the separate account, the contract owner may choose to allocate some or all of his or her premiums to the variable annuity contract s fixed account. The fixed account is similar to a fixed annuity to the extent that the insurer guarantees both the principal and a minimum rate of interest. The accumulated value of a variable annuity at any time is equal to the value of the separate account and the value of the fixed account. Some variable annuity contracts provide for the allocation of premiums to the separate account only during the accumulation period; other variable annuity contracts permit both variable accumulation and variable payout. Variable Annuity Premium Allocation to Fixed and Separate Account Contract Owner Separate Account Fixed Account Stock Variable Subaccount Bond Variable Subaccount Money Market Variable Subaccount 15

16 Death Benefits Death benefits payable in an annuity contract depend on whether the contract owner/annuitant dies before or after the annuity starting date. If death occurs after the annuity starting date, any benefit payable to a beneficiary will depend on the type of annuity selected as well as on the presence of any refund or guarantee period, as discussed in the next section entitled Annuitization Methods. Basic annuity death benefits payable if death occurs before the annuity starting date are equal to the greater of the premiums paid or the cash value. In the case of a fixed annuity, the contract s cash value will always be equal to or greater than the total of the premiums paid, since the owner is guaranteed against loss of principal and the insurer regularly credits interest. In a variable annuity, because the value of the cash value may go up or down depending on the performance of the variable subaccounts to which the premium is allocated, the guarantee that the death benefit will never be less than the premiums paid is an important one. We will discuss variable annuity death benefits in greater depth in the next chapter when we examine variable annuities. At that time, we will look at some of the competitive innovations in the product s death benefit, including a periodic step-up. Annuitization Methods When the contract owner purchases an immediate annuity or the deferred annuity contract reaches the annuity starting date, the owner must decide on the annuitization method, i.e. how the periodic income is to be paid out. There are two basic methods of annuitization, depending on whether or not life contingencies are involved: Temporary Annuity Temporary annuity or Life annuity A temporary annuity is an annuity in which no life contingencies are involved. In other words, the payout is not affected by whether or not the annuitant dies. There are two types of temporary annuities: 1. Fixed amount annuity and 2. Fixed period annuity A fixed amount annuity is a temporary annuity under which a principal sum plus interest is liquidated and each payment is a specified, level amount. When the principal and interest have been liquidated, the payments cease whether or not the annuitant is alive. If the annuitant dies before the entire principal and interest have been liquidated, the balance is paid to the annuitant s beneficiary. A fixed period annuity is a temporary annuity under which level income payments are made for a specified period. At the conclusion of the specified period, income payments cease, whether or not the annuitant is alive. If the annuitant should die before the end of the period, income payments continue to the annuitant s beneficiary until the period ends. 16

17 Life Annuity We noted that a temporary annuity is an annuity that does not involve life contingencies. A life annuity, by definition, is an annuity involving life contingencies. The annuitant is the measuring life in a life annuity. Although the annuitant need not also be the contract owner, in the vast majority of cases, they are the same person. In the basic life annuity generally known as a straight life annuity periodic income payments are made for the annuitant s entire life, whether the remaining lifetime is measured in months or decades. However, if the annuitant receives at least one periodic payment and then dies, no further payments are due. For example, assume that a 65 year-old man purchases an immediate straight life annuity for $1 million and elects to receive monthly periodic payments. His monthly payments are likely to be between $8,000 and $10,000 monthly. If he should die after receiving only one $8,000 income payment, no other payments would be made to anyone else, and his annuity premium would become a part of the insurer s general assets. Annuitants sometimes object to the loss of their annuity premium if they should die after receiving only a single periodic payment. An annuitant that wants to receive periodic life annuity payments but also wants to be sure that a guaranteed minimum is paid out has two choices: 1. A period certain or 2. A refund annuity Under either approach, the insurer guarantees that an income will continue for the annuitant s entire life, no matter how long that life is. It also guarantees, however, that a certain minimum amount will be paid. Under a life annuity with a period certain, the insurer promises to pay an income for the life of the annuitant, but if the annuitant should die before a particular period the period certain ends, payments will continue to a beneficiary for the balance of that period. For example, suppose an annuitant owns a life annuity with a 10 year period certain. If the annuitant lives for 30 or 40 years, payments will continue until he or she dies. If the annuitant were to die at the end of 8 or 9 years after beginning to receive income payments, however, the payments would continue for the remainder of that 10 year certain period to the annuitant s beneficiary. A period certain may be for as short as 5 years or as long as 25 or 30 years. The longer that the period certain is, the lower the periodic life income is. A refund annuity is somewhat similar to a period certain insofar as it guarantees that a certain minimum amount will be paid, regardless of when the annuitant dies. There are two types of refund annuity: 1. A cash refund annuity and 2. An installment refund annuity In a cash refund annuity, the insurer guarantees that if the sum of the periodic income payments received by the annuitant does not at least equal the amount of the annuity purchase price at the time of the annuitant s death, the difference will be paid in a lump sum to the annuitant s beneficiary. For example, if the annuitant had paid $100,000 for an immediate cash refund annuity and died after receiving a total of $25,000 in periodic payments, a payment of $75,000 would be made to his or her beneficiary. 17

18 In an installment refund annuity, the insurer guarantees that if the sum of the periodic income payments received by the annuity does not at least equal the amount of the annuity purchase price at the time of the annuitant s death, income payments will continue to a beneficiary until the difference is paid. For example, suppose that the annuitant paid $100,000 for his or her installment refund annuity and was receiving a monthly periodic payment of $1,000. If the annuitant died after receiving 75 payments, the beneficiary would receive the $1,000 monthly payments for an additional 25 months. Although the actual amount of monthly life annuity benefits payable per $1,000 of premium is affected by the prevailing interest rate, the following monthly life income amounts purchased by a $100,000 premium for the different types of annuities will offer some insight into their relative cost to the annuitant. Type of Life Annuity Monthly Income Male Age 75 Straight life annuity $1,282 Life annuity with 10-year period certain $1,094 Refund annuity $1,155 Although this discussion of life annuity guarantees has been couched in terms of single-annuitant contracts, the concepts and the guarantees apply equally to joint and survivor annuities. In other words, the two annuitants under a joint and survivor annuity may opt for a straight life annuity under which payments cease upon the second death, or they may elect a period certain or a refund annuity. Summary A contract owner may choose to fund his or her annuity contract whether a fixed or variable annuity on the basis of a single premium, fixed level premiums or flexible premiums. Although fixed level premium annuities provide greater benefit guarantees, contract owners have generally preferred the convenience and lack of compulsory payments offered by flexible premium annuity contracts. Annuity contracts generally require the contract owner to pay fees to enable the insurer to recover its costs to acquire the business, i.e. principally sales and distribution expenses, as well as fees for record maintenance, accounting and reporting. Variable annuities, in addition to these fees that generally apply to all types of annuities, impose additional fees reflecting the increased costs associated with administering this more complex product. Insurers normally impose surrender charges in the early years of the contract in order to enable them to recover the balance of any new business acquisition costs in the event of early termination or withdrawal. Annuity contracts may be written to cover a single life or multiple lives. The most popular multiple-life annuity is a joint and survivor annuity. Although joint annuitants need not be related, the most popular joint and survivor annuity is one covering spouses. A joint and survivor annuity provides an income benefit until the last of the two annuitants dies. Qualified retirement plans require that a married participant take his or her retirement benefit in a joint and survivor annuity unless the participant s spouse agrees to forgo this guaranteed survivor income. 18

19 The principal difference between a fixed annuity and a variable annuity relate to the different means by which the cash value grows. In a fixed annuity the issuing insurer periodically credits the cash value with interest based on a declared rate or on the performance of a specified index. In a variable annuity, cash value growth depends upon the performance of the variable subaccounts to which the annuity premium is allocated. That difference in cash value growth leads to an important difference with respect to risk: in a fixed annuity, the insurer bears the risk of principal loss; in a variable annuity, the contract owner bears that risk. On and after the annuity starting date, income benefits are payable. Annuity income benefits may be paid under a temporary annuity either a fixed period annuity or fixed amount annuity or a life annuity. If paid under a life annuity, the contract may or may not provide for benefits to be paid to a survivor depending on the contract owner s election. 19

20 Chapter Three Variable Annuities Important Lesson Points The important points addressed in this lesson are: Variable annuities combine the characteristics and risks of traditional investment products with the features of an annuity The variable annuity contract owner selects an asset allocation at the time of application and may change it when needed Variable annuity contracts give owners the opportunity to manage the volatility of cash value through various no-cost options such as automatic subaccount rebalancing Variable payouts enable annuitants to overcome the purchasing power erosion of their income caused by inflation Variable annuity suitability for a customer, in addition to meeting traditional suitability criteria, must meet special suitability requirements related to variable products In addition to a life insurance license, an agent must have a Series 6 or Series 7 registration and a state securities license in order to sell variable annuities Introduction An investor can attempt to meet his or her financial objectives through the purchase of a variety of investments. Investments that may be used to meet objectives include stocks, bonds, money market instruments and mutual funds. Variable annuities combine many of the characteristics and risks of these investments with the features of an annuity. We examined the characteristics of annuities in chapter two. Generally, except for the guaranteed interest rate found in fixed annuities, a variable annuity has similar characteristics. Instead of receiving interest however other than with respect to funds placed in a Fixed Account the cash value of a variable annuity depends on the investment performance of the variable subaccounts to which the contract owner has allocated premiums. Fixed annuities are supported by the insurer s general account that is generally invested in bonds and other fixed income securities. Variable annuities are invested in the insurer s separate account, an account that is segregated from the insurer s general account and comprised of several variable subaccounts differentiated by objective, risk level and underlying portfolio. Accordingly, the return enjoyed by a variable annuity will fluctuate based on the performance of the variable subaccounts in which the owner has invested premiums. Since separate accounts are not governed by state insurance law requirements for secure, fixed income securities, a separate account can be funded with common stocks and other more-volatile securities similar to a mutual fund. Also similar to mutual funds, separate accounts are 20

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