SUITABILITY IN ANNUITY TRANSACTIONS (2014 EDITION)

Transcription

1 SUITABILITY IN ANNUITY TRANSACTIONS (2014 EDITION) Researched and Written by: Edward J. Barrett CFP, ChFC, CLU, CEBS, RPA, CRPS, CRPC

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by changes in law and in industry practice, and as a result, information contained in this publication may become outdated.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

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

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

6 CHAPTER 3 VARIABLE ANNUITIES Overview VA Defined The VA Market VA Product Features Separate Accounts Investment Options Accumulation Units VA Charges and Fees Mortality and Expense (M&E) Charge Management (Fund Expense) Fees Contract (Account) Maintenance Fees Summary of Above Fees Surrender Fees VA Sales Charges Premium Tax Investment Features Dollar Cost Averaging Fund Transfers Asset Allocation Asset Rebalancing Guaranteed Minimum Death Benefit Enhanced Death Benefits Contract Anniversary, Or Ratchet Initial Purchase Payment with Interest or Rising Floor Enhanced Earnings Benefits Guaranteed Living Benefit (GLB) Riders Guaranteed Minimum Income Benefit (GMIB) GMIB Features and Benefits GMIB Caveats GMIB Client Suitability GMIB Costs Guaranteed Minimum Account Balance (GMAB) GMAB Example GMAB Caveats GMAB Client Suitability GMAB Costs Guaranteed Minimum Withdrawal Benefit (GMWB) GMWB Example GMWB Caveats GMWB Client Suitability GMWB Costs Guaranteed Minimum Withdrawal Benefit for Lifetime GMWBL Features and Benefits GMWBL Client Suitability

7 GMWBL Costs Treatment of Withdrawals Recent Innovations and Trends of GLBs Outlook for Variable Annuities Variable Annuitization: Calculating Variable Annuity Income Payouts Annuity Units Assumed Interest Rate (AIR) Review Questions CHAPTER 4 INDEX ANNUITIES Overview IA Defined IA Market Profile of an IA Buyer IA Basic Terms and Provisions Index Period Participation Rate Cap Rate Spreads or Margins No-Loss Provision Guaranteed Minimum Account Value Liquidity Fees and Expenses Surrender Charges Interest Calculation Exclusion of Dividends Crediting Interest Interest Crediting Methods Point-to-Point High Water Mark (Term High Point) Annual Reset (Ratchet) Index Averaging Other Interest Crediting Methods Multiple (Blended) Indices Monthly Cap (Monthly Point-to-Point) Binary, Non-Negative (Trigger) Annual Reset Bond-Linked Interest with Base Hurdle Annual Fixed Rate with Equity Component Rainbow IA Waivers and Riders Types of Waivers Types of Riders IAs with Bonuses Regulation of IAs Review Questions

8 CHAPTER 5 ANNUITY TAX LAWS Overview Annuity Defined for Tax Purposes? Premiums IRC 72: Tax-Deferral IRC 72(a) IRC 72(b): Exclusion Ratio Rule IRC 72(c)(4): Annuity Starting Date IRC 72(e): Lifetime Distributions IRC 72(e)(4)(A): Loans and Assignments IRC 72(e)(4)(c): Gift of the Annuity Contract IRC 72(e)(5)(E) Gain in the Contract IRC 72(e)(11)(A)(ii) Aggregation Rules IRC 72(t)(1): Additional 10% Penalty Tax on Early Distribution IRC 72(q)(1): Premature Distribution 10% Penalty Tax IRC 72(s): Death Distribution Rules at Death of the Holder IRC 72(u): Non-Natural Person Rule IRC 72(u)(4): Defines an Immediate Annuity IRC Section 165: Claiming a Loss IRC Section 7702B(e)(1) IRC 1035: Tax-Free Exchanges IRC 1035 Requirements Partial IRC 1035 Exchanges Revenue Ruling IRS Revenue Procedure PLR Inherited Annuity 1035 Exchange The New IRC Section 1035(a)(4) Partial Annuitization of NQ Annuity Contracts IRC 2039: Estate Tax Inclusion IRC 691(c) Income in Respect of a Decedent (IRD) Calculating the IRD Deduction: Disclaimers With Regards to Tax and Legal Issues Review Questions CHAPTER 6 PARTIES TO THE CONTRACT Overview The Owner Rights of the Owner Changing the Annuitant Duration of Ownership Purchaser, Others as Owner Taxation of Owner Death of Owner: Required Distribution Spousal Exception The Annuitant A Natural Person

9 Role of the Annuitant Naming Joint Annuitants/Co-Annuitants Taxation of Annuitant Death of Annuitant The Beneficiary Death Benefit Whose Death Triggers the Death Benefit Changing the Beneficiary Designated Beneficiary Spouse or Children as Beneficiaries Non-Natural Person as Beneficiary Multiple Beneficiaries Taxation of Beneficiary Death of Beneficiary Insurance Company Collecting and Investing the Premium Paying the Guaranteed Death Benefit Paying the Guaranteed Income Option Review Questions CHAPTER 7 CONTRACT STRUCTURE Overview Types of Contracts Remedies for Improper Structure Review Questions CHAPTER 8 SUITABILITY OF ANNUITIES Overview NAIC Suitability Model Senior Protection in Annuity Transactions Model Regulation NAIC Suitability in Annuity Transactions Model Regulation Determining Suitability Systems of Supervision and Training FINRA Compliance VA Regulation under the Federal Securities Laws Securities Act of Securities Act of Investment Company Act of Regulation of Fees and Charges FINRA Regulation of VA FINRA Rule FINRA Rule FINRA Rule FINRA Rule 2090: Know Your Customer SEC Approves Consolidated FINRA Rules Effective Date Benefits of Maintaining Suitability Standards Avoid Market Conduct Trouble

10 Increased Client Satisfaction A WIN-WIN-WIN Solution Review Questions CHAPTER 9 ANNUITIES INSIDE QUALIFIED RETIREMENT PLANS Overview Background Congressional Mandate Annuities in an IRA Advantages of Annuities inside a Qualified Retirement Plan RMD Rule Requirements on Variable Annuity Contracts Actuarial Present Value Defined RMD Calculation under the New Rules Safe Harbor Rules Example: Calculating RMD Under New Rules New Proposed Treasury Regulation Longevity Contracts Review Questions CHAPTER 10 UNFAIR MARKETING PRACTICES Overview Misrepresentation Fraud Altering Applications Premium Theft False or Misleading Advertising Defamation Boycott, Coercion, Intimidation Twisting Churning Discrimination Rebating Use of Senior Specific Certifications and Designations Annuity Disclosure Model Regulation Fixed and Index Annuities Variable Annuities Recordkeeping Review Questions Chapter Review Answers Confidential Feedback

11 CHAPTER 1 ANNUITY BASICS Overview Did you know that annuities have been in use for more than 2,000 years and date back to the Roman Empire? Today, the appeal of the annuities is broad. Some annuities are extremely safe and conservative; others range from moderate-risk to quite risky, offering the potential of higher returns. In this chapter, we will review how an annuity is defined, the history of the annuity, and discuss the outlook for annuities sold in America. We will also review the various classifications of the annuity, the purchase options, the date annuity benefit payments begin, the investment options, and the various payout options. Annuity Defined In general terms, an annuity is a mathematical concept that is quite simple in its most basic application. Start with a lump sum of money, pay it out in equal installments over a period of time until the original fund is exhausted, and you have an annuity. Expressed differently, an annuity is simply a vehicle for liquidating a sum of money. But of course, in practice, the concept is a lot more complex. An important factor missing from above is interest. The sum of money that has not yet been paid out is earning interest, and that interest is also passed on to the income recipient (the annuitant ). Anyone can provide an annuity as long as they can calculate the payment based upon three factors: A sum of money Length of payout period, and An assumed interest rate However, there is one important element absent from this simple definition of an annuity, and it is the one distinguishing factor that separates insurance companies from all other financial institutions. While anyone can set up an annuity and pay income for a stated period of time, only an insurance company can do so and guarantee income for the life of the annuitant. The insurance companies, with their unique experience with mortality tables, are able to provide an extra factor into the standard annuity calculation, a survivorship factor. The 11

12 survivorship factor provides insurers with the means to guarantee annuity payments for life, regardless of how long that life lasts. Don t get confused between an annuity and a life insurance contract. Annuities are not life insurance contracts. Even though it can be said that an annuity is a mirror image of a life insurance contract they look alike but are actually exact opposites. Life insurance is concerned with how soon one will die; life annuities are concerned with how long one will live. History of Annuities As mentioned above, annuities can actually trace their origins back to Roman times. Back then, dealers sold contracts called annua, or annual stipends yearly payouts for life. Roman citizens would make a one-time payment to the annua, in exchange for lifetime payments made once a year. Annuity comes from the Latin word annuus, meaning yearly. During the 17 th century, annuities were used as fundraising vehicles. In Europe, governments were constantly looking for revenue to pay for massive, on-going battles with neighboring countries. The governments would then create a tontine, promising to pay for an extended period of time if citizens would purchase shares today. The United Kingdom, locked in many wars with France, started one of the first group annuity contracts called the State of Tontine of Participants in these early government annuities would purchase a share of the Tontine for 100 from the UK Government. In return, the owner of the share received an annuity during the lifetime of their nominated person (often a child). As each nominee died, the annuity for the remaining proprietors gradually became larger and larger. This growth and division of wealth would continue until there were no nominees left. Proprietors could assign their annuities to other parties by deed or will, or they passed on at death to the next of kin. Annuities in the United States Annuities made their first mark in America during the 18th century. In 1759, a company in Pennsylvania was formed to benefit Presbyterian ministers and their families. Ministers would contribute to the fund, in exchange for lifetime payments. It wasn t until 1912 that Americans could buy annuities outside of a group. The Pennsylvania Company for Insurance on Lives and Granting Annuities was the very first American company to offer annuities to the general public. Annuities constituted a small share of the U.S. insurance market until the 1930s, when two developments contributed to their growth. First, concerns about the stability of the financial system drove investors to products offered by insurance companies, which were perceived to be stable institutions that could make the payouts that annuities promised. 12

13 Flexible payment deferred annuities, which permit investors to save and accumulate assets as well as draw down principal, grew rapidly in this period. Second, the group annuity market for corporate pension plans began to develop in the 1930s. The entire country was experiencing a new emphasis saving for a rainy day. The New Deal Program introduced by President Franklin D. Roosevelt (FDR) unveiled several programs that encouraged individuals to save for their own retirement. Annuities benefited from this new-found savings enthusiasm. By today s standard, the first modern-day annuities were quite simple. These contracts guaranteed a return of principal, and offered a fixed rate of return from the insurance company during the accumulation period (Fixed Annuity). When it was time to withdraw from the annuity, you could choose a fixed income for life, or payments over a set number of years. There were few bells and whistles to choose from. What was always proved to be attractive about annuities was their tax-deferred status because they were issued by insurance companies. That all changed beginning in 1952, when the first variable annuity was created by the College Retirement Equities Fund (CREF) to supplement a fixed-dollar annuity in financing retirement pensions for teachers. Variable annuities credited interest based on the performance of separate accounts inside the annuity. Variable annuity owners could choose what type of accounts they wanted to use, and often received modest guarantees from the issuer, in exchange for greater risks they (the owner) assumed. This type of annuity was then made available to any individual, when the Variable Life Insurance Company (VALIC) in 1960, began to market its own nonqualified variable annuity. It was the variable annuity that boosted the popularity of annuities. Then in 1994, Keyport Life Insurance Company introduced a new type of a fixed annuity called an index annuity. And the rest is history. Annuity Sales Total annuity sales reached $61.9 billion during the fourth quarter of 2013 resulting in an increase of 17 percent the largest quarterly percentage increase in 11 years, according to LIMRA s Secure Retirement Institute (SRI). For the entire year 2013, total annuity sales increased 5 percent to $230.1 billion (see Table 1.1 on the following page). 13

14 Table 1.1 Total U. S. Individual Annuity Sales and Assets ($ billions) YEAR SALES ASSETS 2000 $190.0 $1, , , , , , , , , , , , , N/A Source: Morningstar Inc. and LIMRA International, Windsor, Conn (Estimate from a survey of 60 insurers that account for 95 percent of Total U.S. annuity sales, February, 2014). Annuity Buyers In another survey conducted by LIMRA, more than three-quarters of recent annuity buyers are satisfied with their purchase of an annuity. LIMRA, published this finding in a summary of results from a survey of 1,200 consumers age 40 or over who purchased a retail deferred annuity within the past three years. The study was conducted in the third quarter of Nearly 9 in 10 buyers of traditional fixed annuities are happy with their purchase, new research reveals. The survey reveals that 86% of traditional fixed annuity buyers are satisfied with their deferred annuity purchase. Likewise, most buyers are variable annuities (75%) and indexed annuities (83%) are also satisfied with the purchases, the survey reveals. LIMRA observes that of those who are satisfied, two-thirds of the VA households (61% for indexed and half for traditional fixed) own two or more annuities. The study also discloses that five of six deferred annuity buyers would recommend an annuity to their friends or family. 14

15 Primary Uses of Annuities The top reason consumers give for buying an annuity is to supplement their Social Security or pension income. The second most popular reason is to accumulate assets for retirement; this is especially true for individuals under age 60 (see Table 1.2). Table 1.2 Intended Uses for Annuities Source LIMRA Study, the Deferred Annuity Buyer Attitudes and Behaviors 2012 Receiving guaranteed lifetime income is also a concern, especially for buyers aged 60 and older, the survey says. Annuity buyers single most important financial objective is to have enough money to last their and /or their spouse s lifetime. Classification of Annuities Annuities are flexible in that there are a number of classifications (options) available to the purchaser (contract holder/owner) that will enable him or her to structure and design the product to best suit his or her needs. They are: Purchase options Date income payments begin Investment options Income payout options Let s discuss each of these classifications in greater detail 15

16 Purchase Option An annuity begins with a sum of money, called principal. Annuity principal is created (or funded) in one of two ways; immediately with a single premium or over time with a series of flexible premiums. Single Premium A single premium annuity is basically just what the name implies; an annuity that is funded with a single, lump-sum premium, in which case the principal is created immediately. Usually, this lump sum is fairly large. Periodic (Flexible) Premium Payments But not everyone has a large lump sum with which to purchase an annuity. Annuities can be funded through a series of periodic (flexible) premiums payments that, over time, will amass an amount large enough to buy a significant annuity benefit. At one time, it was common for insurers to require that periodic annuity premiums be fixed, and level, much like insurance premiums. Today, it is more common to allow contract owner s flexibility as to allowing premiums of any size (within certain minimums and maximums, such as none less than $25 or more than $2,000,000) and at virtually any frequency. Date Income Payments Begin The annuity is the only investment vehicle that has two phases based upon when the income payment begins. The phases are: Deferred (Accumulation Phase); or Immediate. (Pay-out/Distribution Phase) The main difference between deferred and immediate annuities is when annuity payments begin. Every annuity has a scheduled maturity or annuitization date (usually age 90 or age 95), which is the point the accumulated annuity funds are converted to the payout mode and benefit payments to the annuitant are to begin. According to LIMRA SRI, total sales of annuities in 2013 were $230.1 billion (see Table 2.1). Deferred annuities totaled $216 billion and immediate annuities totaled $14.1 billion, (which includes $5.8 billion of structured settlements). 16

17 Table 1.3 Annuity Industry Total Sales Deferred vs. Immediate Annuities ($ billions) YEAR DEFERRED IMMEDIATE TOTAL 2000 $ $ 8.8 $ Deferred Annuities Source: Morningstar Inc. and LIMRA SRI, February, Includes Structured Settlements reporting sales of $5.8 billion Deferred annuities are designed for long-term accumulation and can provide income payments at some specified future date. A deferred annuity can be funded with either periodic payments, commonly called flexible premium deferred annuities (FPDAs), or funded with a single premium, in which case they re called single premium deferred annuities, or SPDAs. While a deferred annuity has the potential of providing a guaranteed lifetime income at some point in the future, the current emphasis in a deferred annuity is on accumulating funds rather than liquidating funds. An advantage that deferred annuities have over many other long-term savings vehicles is that there are no taxes (tax-deferral) paid on the accumulated earnings in an annuity until withdrawals are made. 17

18 Immediate Annuities An immediate annuity is designed primarily to pay income benefit payments one period after purchase of the annuity. Since most immediate annuities make monthly payments, an immediate annuity would typically pay its first payment one month (30 days) from the purchase date. If, however, a client needs an annual income, the first payment will begin one year from the purchase date. Thus, an immediate annuity has a relatively short accumulation period. As you might guess immediate annuities can only be purchased with a single premium payment and are often called single-premium immediate annuities, or SPIAs. These types of annuities cannot simultaneously accept periodic funding payments by the owner and pay out income to the annuitant. The average age of a SPIA buyer is 73. A once-snubbed annuity product the income annuity appears to be gaining a foothold in the broad annuity marketplace and in the practices of advisors who serve the boomer and retirement income markets. According to LIMRA, SPIA sales were up 30 percent in the fourth quarter of 2013 to reach a record $2.6 billion. SPIA sales totaled $8.3 billion for 2013, which is 8 percent higher than in 2012 and another record (see Table 1.4). Table 1.4 Total Sales of Immediate Annuities ($ billions) YEAR VARIABLE FIXED TOTAL 2000 $ 0.6 $ 8.0 $ Source: Morningstar Inc. and LIMRA International, February Not including Structured Settlements 18

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

20 Income Payout Options Another way to classify an annuity is the payout option chosen. Once an annuity matures and its accumulated fund is converted to an income stream, a payout schedule is established (see Table 1.6). There are a number of annuity payout options available: Straight life income, Cash refund, Installment refund, Life with period certain, Joint and survivor, and Period certain. Straight (Single) Life Income Option A straight life income option (often called a life annuity or single life annuity) pays the annuitant a guaranteed income for his or her lifetime. This is the purest form of life annuitization. The straight life income option pays out a higher amount of income than any other life with period certain or a joint and survivor option, but they might not be higher than other options (such as cash refund, installment refund, or pure period certain). At the annuitant death, no further payments are made to anyone. If the annuitant dies before the annuity fund (i.e., the principal) is depleted, the balance, in effect, is forfeited to the insurer. It is used to provide payments to other annuitants who live beyond the point where the income they receive equals their annuity principal. Cash Refund A cash refund option provides a guaranteed income to the annuitant for life and if the annuitant dies before the annuity fund (i.e., the principal) is depleted, a lump-sum cash payment of the remainder is made to the annuitant s beneficiary. Thus, the beneficiary receives an amount equal to the beginning annuity fund less the amount of income already paid to the deceased annuitant. Installment Refund Option Like the cash refund, the installment refund option guarantees that the total annuity fund will be paid to the annuitant or to his or her beneficiary. The difference is that under the installment option, the fund remaining at the annuitant s death is paid to the beneficiary in the form of continued annuity payments, not as a single lump sum. Life with Period Certain Option Also known as the life income with term certain option, this payout approach is designed to pay the annuitant an income for life, but guarantees a definite minimum period of payments. For an example, if an individual has a ten-year period certain annuity, and receives monthly payments for six years before dying, his or her beneficiary will receive 20

21 the same payments for four more years. Of course, if the annuitant died after receiving monthly annuity payments for ten or more years, his or her beneficiary would receive nothing from the annuity. Joint and Full Survivor Option The joint and full survivor option provides for payment of the annuity to two people. If either person dies, the same income payments continue to the survivor for life. When the surviving annuitant dies, no further payments are made to anyone. There are other joint arrangements offered by many companies: Joint and Two-Thirds Survivor. This is the same as the above arrangement, except that the survivor s income is reduced to two-thirds of the original joint income. Joint and One-Half Survivor. This is the same as the above arrangement except that the survivor s income is reduced to one-half of the original joint income. Period Certain The period certain option is not based on life contingency; instead it guarantees benefit payments for a certain period of time, such as 5, 10, 15, or 20 years, whether or not the annuitant is living. At the end of the specified term, payments cease. Income Payment Options Table 1.6 Comparison of Monthly Settlement Options Male Estimated Monthly Income Cash Flow Female Estimated Monthly Income Cash Flow Single life income no payments to beneficiaries $ % $ % Single life w/10 years certain $ % $ % Single life w/20 years certain $ % $ % Single Life w/installment Refund $ % $ % 21