Annuities Basic INTRODUCTION TO ANNUITIES. Like life insurance, annuities are also insurance products that rely on mortality

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1 Annuities Basic LESSON 1 INTRODUCTION TO ANNUITIES What is an Annuity? Like life insurance, annuities are also insurance products that rely on mortality and investment experience to protect against the loss of income. They differ, however, in one key respect: life insurance is designed for the protection of the individual s family or estate after his/her death, but annuities are designed for the protection against living a long life and outliving one s income. The main focus of an annuity is not on how soon one will die but on how long one will live. Annuities have the basic function of systematically liquidating specific sums of money over a specified period of time. An annuity is a contract between an individual and an insurance company under which the individual makes a lump-sum payment or series of payments to the insurance company. In return, the company will provide periodic payments or an income over a certain period of time, life expectancy, or both. The individual benefits in that he/she does not have to pay income taxes on any interest or earnings until he/she starts receiving annuity payments or begins to make withdrawals.

2 An annuity can be "deferred" as a means of accumulating income while deferring taxes, or it can be "immediate," meaning it pays the annuitant income at fixed or variable interest rates as long as he/she is living. Note: Life insurance starts at the death of the insurer, while annuity ends with the death of the annuitant. The Annuity Contract Parties Involved in an Annuity Contract An annuity contract is issued to the owner by the insurance company. The owner then nominates an annuitant, which is normally him/herself. The annuitant s expected life span is used to set the amounts for the future annuity income payments. In an annuity contract, the annuitant is provided with a series of periodic payments that begin on a specified date; for example, a specific age or a contingent date. These payments will continue for the duration of the annuitant s life or for some fixed period. In some cases, an annuity guarantees the lifetime income of the annuitant. This agreed upon payment schedule will continue until the death of the annuitant, regardless of whether he/she dies one month or 50 years after purchasing the annuity. Generally, the beneficiary receives the death benefit if the owner or annuitant dies before the beginning of the income payments.

3 NOTE: Only a life insurance company can issue a life annuity contract. The Owner The owner is the individual who buys an annuity by paying a sum of money, a premium or purchase payment, to an insurer that is an insurance company. The owner has the authority to make decisions about his/her annuity contract, such as how much money to invest and how to allocate the money, if the contract is variable. The owner also names the beneficiary and annuitant. Finally, the owner determines how and when the annuitant will receive income. An owner can own the annuity in his/her name or jointly with another person. If the annuity is jointly owned, the decisions that are made about the annuity may require the consent of all the owners, and there might be some tax consequences. The Annuitant Typically, the annuitant and the owner are the same person. It is the annuitant s life expectancy that is used by the insurance company as the basis for setting the dollar amounts for the future annuity income payments. Annuitants do not make the decisions regarding the annuity contract, but if they are the owners of it, they do participate.

4 The Insurance Company The insurance Company has the right to issue the variable annuity contract. When an owner makes a payment for purchasing the annuity, the insurance company provides regular contract information, and assures that the money is invested according to the owner s wishes. The insurance company also seals the variable annuity s guaranteed death benefit and fixed life time income option. The Beneficiary In case of sudden or premature death of the owner or annuitant, prior to the beginning of the income payments, the beneficiary will receive the benefit payments. A beneficiary can be one or more persons, a trust, or a charity. Nominating a beneficiary in the annuity contract is important, but it is often ignored by some contract applicants and owners. In case there is no nomination of a beneficiary in the contract, the money that is present in the annuity could end up going to the person s estate or being subject to probate. In such a case, the matter is taken to the court, which determines the distribution of the annuitant s assets. A person can change the beneficiaries of his/her annuities on the contract, but it is important to keep their information up-to-date.

5 Annuities Premium Payment Methods Single Premium Annuity This kind of annuity is purchased by making a single lump-sum payment at the contract s inception. A single premium annuity does not allow the owner to make additional deposits into the account. Periodic Premium Annuity This type of annuity consists of a series of periodic premium payments that spread over a period of time. These premiums can be level/fixed or flexible. NOTE: In Flexible Payment Annuities, a certain initial premium may be required, but then the annuitant is allowed to make additional deposits at different times, subject to contract minimums. Annuities vs. Retirement Plans When compared to traditional retirement plans, annuities tend to provide better benefits, amongst which is a higher yield than what can be found in most savings plans. Annuity earnings grow on a tax-deferred basis until the annuitant chooses to withdraw. In addition, annuities have a unique flexibility that allows the annuitant to customize the features of the annuity on his/her own terms. All of these aspects are utilized by the annuitant to accumulate funds for retirement, create and distribute income for retirement, or both.

6 Qualified Retirement Plans, such as 401(k)s, Keogh Plans, IRAs, and Simplified Employee Pension Plans (SEPs), typically place a cap on annual contribution limits, and may even restrict who can contribute to the plan. Where annuities provide flexibility in planning (namely in allowing a choice between variable and fixed), qualified retirement plans operate within a pre-determined format. But like annuities, money in qualified retirement plans cannot be accessed (without a penalty tax), until the plan owner has reached a specified age or contingency date. Periods of Time Annuity contracts have two important periods associated with them. Accumulation Period The time period in which an annuitant has to make premium payments to an insurance company; in other words, the annuity is accumulating value. Annuity Period The period in which an insurance company pays the monthly payments to the annuitant. This period is also referred as the time of Annuitization. In the accumulation period, interest earnings on the premium contributions grow and accumulate on a tax-deferred basis. There will be no tax applied to the interest portion of the annuity account until the annuitant begins to receive benefit payments.

7 Types of Annuities Categorization on the basis of payments of benefits Annuitants can choose among two different types of annuities, depending upon their investment goals and income needs. These two types are: Immediate Annuity: This type of annuity is designed to make payments to the annuitant right after his/her premium is made. Premium payment is made in one lump sum, the contract is annuitized immediately, and payments to the annuitant begin after one period (such as a month, three months, six months, or a year). These payments are paid from the assets that annuitant has already invested, or may have already accumulated. Deferred Annuity: This type of annuity allows the annuitant to delay the start of his/her income payments for a time period of his/her own choice. Premium payments may be made in a lump sum or in installments, and the payments to the annuitant do not begin for more than a year after the first premium payment is made. Often, deferred annuities start when the annuitant reaches a certain age, such as retirement age. This type of annuity is primarily designed to accumulate assets for the long-term investment goals of an annuitant, such as retirement.

8 Categorization of Annuities on the Basis of the Investment of the Premiums Insurance companies offer both fixed and variable insurance products: Fixed Annuity Purchasers of fixed annuities are guaranteed certain minimum payments. The premium that an annuitant invests in a fixed annuity becomes a part of the issuing company s general investment account. The annuitant is accredited a fixed interest rate that normally does not vary over the duration of his/her contract. Fixed annuities guarantee a stream of fixed payments over the lifetime of the annuity, and limit the annuitant s investment risk as well. Variable Annuity The annuity is called variable because the amount payable to the annuitant varies depending on the market value of the assets underlying the contracts. The premium that an annuitant invests in a variable annuity is separated into a general account and a separate account, also commonly referred to as a variable account. The assets present in the separate account are different from the general account of the issuing company. The general account offers a guaranteed return on investments. The separate account assets are used to purchase securities, including bonds and stocks, and the fluctuation in the value of this separate account is based upon the performance of these investments. The annuitant can decide how much of the premium they want allocated in each of the accounts and thus, can determine the amount of

9 investment risk they are willing to take on. Therefore, payments from variable annuities depend on the performance of the securities in the annuity portfolio, and have a possibility for greater return than fixed annuities. Note: With a fixed contract, the insurance company assumes the investment risk; with a variable contract the purchaser assumes the investment risk and retains any accompanying reward. Settlement/Payout Options When either a fixed or variable annuity is annuitized, the contract holder may choose from several payment options: Life Annuity A life or straight life annuity option provides guaranteed periodic income payments (monthly, quarterly, semiannually or annually) over the annuitant s remaining life. This type of annuity pays the largest amount of income per dollar of principal and cannot be outlived. However, when the annuitant dies, the payments terminate. The beneficiaries of the annuitant do not receive any value from the contract, even if the annuitant dies before significant payments are made. If there is any principle remaining that has not been paid out at the annuitant s death, it is given up.

10 Period Certain A period certain option will guarantee annuity payments for a specified period of time, such as 5 or 10 years. If the annuitant dies during the specified period, these payments will be continued to the annuitant s named beneficiaries until that period expires. Life Annuity with a Period Certain A life annuity with a period certain gives the annuitant periodic payments over the annuitant's remaining life, for a specified period of time. However, if the annuitant dies during the period certain, the payments continue to the beneficiary for the remainder of the period certain. This option may be suitable for those who do not feel comfortable with the straight life annuity. It guarantees payments during the period certain and also provides for life-long income. The available period certain is usually available for 5, 10, 15 or 20 years. If the life of the annuitant passes the period certain, his/her policy then reverts to a Life Annuity with no refund or beneficiary. Because of this extra guarantee of payment, the payments on this option are lower than for straight life. NOTE: The period certain can be almost any number of years, as long as it is less than the annuitant's expected remaining life. A common choice is a life annuity with 20 years certain. If the annuitant lives more than 20 years, he/she is guaranteed payments over his/her remaining life. However, if the annuitant dies

11 in less than 20 years (such as after five years), payments to the beneficiary continue for the remainder of the 20 years (such as for fifteen years). Joint and Last Survivor Life Annuity The joint and last survivor annuity is a common choice for a husband and wife. Payments continue for as long as either of the two annuitants is alive. If one of the annuitants dies, the periodic payments continue, often with a reduction in the amount, for the remaining life of the second annuitant. There will be no further payments paid out after the death of second annuitant. Since the payments continue as long as either annuitant is alive, the initial payments are less than for a straight life annuity. Unit Refund Life Annuity With a unit refund life annuity, the insurer guarantees payment of a certain minimum number of units. This option is only available with variable annuities. The guaranteed number of annuity units is calculated at the start of the payout period as the value in the account divided by the value of an annuity unit at that time. Thus, if the value of an account is $250,000, and the value of an annuity unit is $25.00, the number of annuity units is 10,000. If the annuitant dies before the units are paid out, the beneficiary receives the remaining units. Fixed Amount The annuitant may choose to receive payments in a fixed amount. Payments are made in the fixed amount until the account is exhausted. For a fixed annuity, the

12 amount is fixed in dollars; for a variable annuity, the amount is fixed in units. If the annuitant dies before the fixed amount is paid, the beneficiary receives the remaining payments. However, the annuitant may live beyond the expected time and exhaust the payments. Combined or Balanced Annuity A combined annuity is a combination of a fixed and variable annuity. For the combined annuity, the fixed annuity portion is paid out in a fixed number of dollars and the variable annuity portion is paid out in a fixed number of annuity units. Life Annuity Refund This is a variation of the guaranteed minimum annuity. If the annuitant dies before the amount he/she paid into the annuity is depleted, the beneficiary would receive a lump-sum payment equivalent to the principal sum of the annuity. Installment Refund This type of annuity works the same as the life annuity. The only difference is that it pays the remainder amount to the beneficiary in monthly installments, instead of a lump sum, until the account has been expired. Annuity Benefits

13 Mortality Guarantee Fixed and variable annuities both have mortality guarantees. Mortality guarantees force the insurer to assume the risk that the annuitant will live beyond his/her life expectancy as calculated from mortality tables. With a mortality guarantee, even if an annuitant outlives his/her life expectancy, payments will continue for the rest of his/her life (or for the agreed-upon period, if a fixed period option was chosen). Expense Guarantee The expense guarantee restricts the insurer from passing on expense increases above expected limits to the annuitants during the payout period. Both fixed and variable annuities have expense guarantees. Death Benefit If the annuitant dies in the accumulation period, the beneficiary is entitled to the cash value of the contract. The cash value is the premiums paid, less expenses, plus earnings on the premiums. With some variable annuities, for an additional premium, the insurer may offer to pay a minimum death benefit equal to the premiums paid. The minimum would be paid if the investments in the separate account have suffered losses so that the cash value is below what was paid into the annuity. The death benefit applies to both fixed and variable annuities, but the minimum death benefit would only be used for a variable annuity.

14 Note: The Life Annuity option does not include a death benefit. Surrender Value Before annuity payments begin, the contract holder may surrender the contract and receive the cash value of the contract. Once annuity payments begin, the annuitant may not surrender his annuity. Other Benefits: The purpose of annuities is to offer a long-term investment product for retirement purposes where all interest, dividends and capital gains accumulate, tax-deferred. These benefits can supplement an individual s monthly retirement income at higher rates compared to other investments. Investment in an annuity has no limit. Although there are forms of retirement investments which have a contribution limit as regulated by the federal government, there is no contribution limit on annuities. However, some companies that have placed a limit on the amount an individual can add in annuity, but it is usually a very large amount. The annuitant does not have to pay any accrued interest or earnings until he/she withdraws money from the annuity.

15 Payouts can begin immediately after the opening of the annuity, or can be deferred until a later time when the annuitant may need an income, such as during retirement. If a person decides to take an income stream from his/her annuity, he/she can choose from a variety of annuity payout options, including payouts guaranteed for the duration of his/her life. Finally, annuities can be used to fund other qualified retirement plans. For example, individuals participating in IRAs and/or employer plans with maximum contribution amounts can utilize annuities as a way of deferring current income from taxes. Contribution limits for annuities can be much greater than the annual amount allowed by an IRA; and, as IRAs are already income-tax deferred, using annuities to fund them can provide the additional guarantee of income and death benefits, which are not offered in IRAs. Some Considerations While advising clients about the benefits that annuities can provide, insurance and financial professionals should also be aware of several important factors. Like bank CDs, annuities are not insured by the FDIC (Federal Deposit Insurance Corporation), meaning the government does not insure the annuitant s money as it does that of deposit investments in banks.

16 A key tool that financial professionals can use to assure potential clients of their company s stability in the insurance market is to share their company s rating. There are many services available to check the stability rating, including Standard & Poor's, Moody's, and A.M. Best. These independent rating services rate insurance companies based on financial strength and claim-paying ability. There are also cost considerations to early withdrawals that clients must be made aware of prior to entering into an annuity contract. Like IRAs and some other qualified retirement plans, annuities are subject to early-withdrawal penalties and fees. Normally there is a 10% early withdrawal penalty if an annuitant makes a withdrawal from the annuity before the age of 59½. Some insurance companies also assess a surrender charge if an annuitant withdraws money before a specified time. Additionally, annuities can be subject to administrative charges and fees.

17 Quiz 1 1 The annuitant is best defined as the (Lesson 1, Parties Involved in an Annuity Contract) A. Insuring company B. Agent representing the insuring company C. Owner of the contract D. Owner and beneficiary of the contract 2. Ramon wants to know what is fixed in a fixed annuity. Which answer is the most appropriate to give him? (Lesson 1, Types of Annuities) A. A fixed annuity ensures premiums are fixed in the general investment account. B. Fixed annuities guarantee a stream of fixed payouts. C. Investing in a fixed annuity fixes the investment risk exposure. D. Premium payments for a fixed annuity are fixed at a particular amount. 3. In a fixed annuity with a period certain option, what happens when the annuitant dies within the specified period? (Lesson 1, Settlement/Payout Options) A. Annuity payments remaining are forfeited B. Annuity units are awarded to the beneficiaries C. Beneficiaries receive the payments till the period ends D. Nominees receive payments of a reduced amount 4. The period when the annuitant makes payments to the insurance company is known as the period of (Lesson 1, Periods of Time) A. Accumulation B. Annuitization C. Payout D. Probate

18 5. Steve never incurred penalty charges during the term of his annuity. Which one of the following combinations represents the charges he did pay? (Lesson 1, Some Considerations) A. Administration charges and surrender charges B. Early withdrawal charges and front end load C. Front end load and administration charges D. Surrender charges and early withdrawal charges 6. Which of the following is NOT a feature of a fixed life annuity with period certain? (Lesson 1, Settlement/Payout Options) A. Beneficiaries receive payment if owner dies within period certain B. Higher payouts than simple life annuities C. Life long income guarantee D. Period certains of five to 20 years 7. Jim is 28, single and planning for retirement. He is a risk averse person. Which of the following combinations should he invest in now? (Lesson 1, Types of Annuities) A. Fixed life annuity B. Fixed period certain annuity C. Unit refund life annuity D. Variable life annuity 8 Which of the following best shows the difference between a fixed and variable annuity? Fixed Annuity Variable Annuity (1) Higher Risk Lower Risk (2) Lower Risk Higher Risk (3) Lower Return Higher Return (4) Higher Return Lower Return (Lesson 1, Types of Annuities) A. (1) B. (1) and (4) C. (3) D. (2) and (3)

19 9. Max has a unit refund life annuity. At the start of the payout period the value of the annuity account is $110,000. He has 2200 annuity units. Given that the last current rate was 4%, what is the value of an annuity unit? (Lesson 1, Settlement/Payout Options) A. $48 B. $50 C. $52 D. The value cannot be determined with the information given 10. Mr. Washington would like to gauge the performance of several annuity providers. Which of the following is likely to be the best source of information? (Lesson 1, Some Considerations) A. Agent advice B. Brochures C. Annuity contracts D. Moody's services

20 Quiz 1 - Answers 1. (D) The correct answer is D. The annuitant is the person who receives the benefits from an annuity. He is typically, but not always, also the owner of the contract. A and B are incorrect by definition. C is not the best answer because of the possibility that the owner and beneficiary of the annuity are different. 2. (B) The correct answer is B. A fixed annuity is one in which the insurance company guarantees a stream of fixed payments over the life of the annuity. A, B and C use the term 'fixed' incorrectly. 3. (C) The correct answer is C. The purpose of a period certain option is to guarantee that nominees receive the remaining annuity payments. A is incorrect by default, and will occur where a life annuity does not have a period certain option. B is incorrect, life annuities with units are only available for variable annuities. D is incorrect because the period certain option guarantees that beneficiaries will receive the full amounts. 4. (A) The correct answer is A. This is the period where the annuity fund increases in value (accumulates) because the annuitant makes payments into it. B and C are incorrect because they both refer to the opposite period (i.e. when the insurance company pays the annuitant). D is incorrect. It has nothing to do with payments made to the insurance company. It would refer to the period during which the annuity proceeds were being disputed in a court of law. 5. (C) The correct answer is C. The two penalty charges here are: surrender charges (penalty for withdrawal) and early withdrawal charges (usual penalty for withdrawals before reaching the age of 59 ½). Administration charges are fees taken by the insurance company to manage the provisions of the contract. Front end load is a standard sales charge that is added to the initial premium payment. C is the only combination that avoids any penalties. 6. (B) The correct answer is B. This type of annuity actually offers lower payouts as compared to simple life annuities. A, B and C are incorrect because these are features of this type of annuity. A, the beneficiaries will continue to receive payment for the remainder of the period certain. C is worth noting. It is because of this extra guarantee of life long payment that the payouts are lower than those of a straight life annuity. If the owner lives beyond the period certain in D, the annuity reverts to a straight life annuity.

21 7. (A) The correct answer is A". Given the options and the information available, Jim would be best suited to the option in "A". Since the annuity is fixed it offers a low risk advantage over the variable annuities in "C" and "D" (a unit refund life option is only applicable to variable annuities). Also, Jim cannot outlive a life annuity. A period certain annuity would guarantee payments to beneficiaries, but we are not given any information about Jim's desire to provide for anyone else. In general the fixed annuity guarantees him the highest payout that cannot be outlived, and offers him a low risk. 8. (D) AThe correct answer is D. Fixed annuities are lower risk (therefore lower return) as compared to higher risk (therefore higher return) variable annuities. A is incorrect because fixed annuities have a lower risk associated with them than variable annuities. B is incorrect because it reverses the actual situation. C is incorrect because it is not the most appropriate answer. While fixed annuities do have a lower return than variable annuities, choice C leaves out the risk concept. Consequently it is not as good an answer as D. 9. (B) The correct answer is "B". The value of one unit at the start of the payout period is calculated by dividing the account value by the number of units ($110,000/2,200 units = $50 per unit). "A" and "C" are the result of incorrect calculations involving the current rate. The last current rate is irrelevant to this calculation. "D" is incorrect because the information given is sufficient to get the correct answer "B'. 10. (D) The correct answer is D". Mr. Washington should rely most on the findings of rating services like Moody's. These independent firms assess the stability and performance of companies in the insurance market and publish ratings to disclose their analysis. Being third party professional information, this is the best source. "A" is incorrect because agent advice is first party information. Although they owe a duty of good faith, it is also possible that the agent lacks the information and ability to assess firm or industry wide performance. "B" is incorrect because brochures are made to advertise products to the public. They usually do not contain enough information for the reader to make a performance comparison. Brochures also portray the achievements of that company in the best possible light and may cloud the issues."c" is incorrect because the annuity contracts will only reveal the particulars of the agreement. They do not contain comparative performance information; they are not generally considered useful in such circumstances.

22 LESSON 2 FIXED ANNUITIES What is a Fixed Annuity? A fixed annuity is a guaranteed contract intended to curb the annuitant s investment risk. Interest, principal and benefit payment amounts are guaranteed by the insurance company and backed by funds invested in the annuitant s general account. The premium is invested securely by the insurance company, which in turn credits a stable interest rate that becomes a part of the insurance company s general investment account. Thus, the annuitant is credited a fixed interest rate that typically does not fluctuate over the duration of his/her annuity contract. With a fixed annuity, the investment risk is on the insurance company. Process of Investing in a Fixed Annuity An investor sends money (premiums) to an insurance company, either in one lump sum or in installments over a period of time. The insurance company invests the premiums in assets with fixed income rates, such as bonds. Earnings (or losses) on the investments come from interest and dividend payments, gains (net of losses) on sale of assets, and unrealized appreciation (or depreciation) in value of assets. Though the premium payments are not tax deductible, the earnings on the investments accumulate on a tax-deferred basis. Again, earnings are not taxable until withdrawn.

23 When the investor wants to receive payment on the investment, the investor annuitizes the contract, and the company starts paying the beneficiary a fixed periodic (such as monthly) amount. When the contract is annuitized, an actuary determines the periodic amount by calculating the annuitant s life expectancy from mortality tables and calculating a periodic payment that will exhaust the investment and earnings less an expense factor over that remaining life. Though the annuitant may live for a shorter or longer time than predicted, the insurance company guarantees the payment over the person s lifetime. The insurer also guarantees that the expense factor will remain the same over the payment period. Thus, with a fixed annuity, the insurer assumes the investment risk over both the premium payment and payout periods, assumes the mortality risk over the payout period, and guarantees the number of dollars the annuitant will receive and the expense factor over the payout period. The fixed annuity is regarded only as an insurance product, and, as such, is regulated by the insurance laws in the state in which it is sold. Fixed Annuities Tax Deferred Policies Fixed annuities are tax-deferred policies used for retirement planning of the annuitant. The annuitant has the choice of buying one of two types of annuity depending upon his/her needs. The available choices are:

24 Single Premium Annuity Enables the annuitant to make a single lump sum deposit (usually a minimum deposit of $5,000 is required) at the beginning of the contract only. If the annuitant wishes to make additional deposits, a second account must be purchased. Flexible Premium Policy Enables the annuitant to add to his/her annuity as often as he/she would like. With a fixed annuity, the annuitant s money goes to work for him/her immediately by beginning to earn tax-deferred interest on the premium payments that he/she makes. Fixed annuities offer guaranteed interest rates that are fixed by the insurance company for a set period of time, which may be one, two, three, five or even 10 or 15 years. This period of time depends on the selection of the annuity contract by the annuitant. After the initial interest guarantee period of the annuity ends, the annuitant will earn a renewal interest rate, normally set by the insurance company on an annual basis. This rate changes with the fluctuations in the market, but normally it is guaranteed to remain at or above 3%. Interest Rates on Fixed Annuities There are two levels of interest in fixed annuities.

25 Current Rate This reflects the current interest rates based on the current economic conditions of the market. This rate is guaranteed at the beginning of each calendar year, and there might be some fluctuation in it from year to year. Some annuities offer a guaranteed 3, 5 and 7 year current rate. Minimum Guaranteed Contract Rate This rate is guaranteed for the life of the annuity contract. This minimum return will be paid, even if the current annual rate falls below the guaranteed rate. Fixed Annuities Phases: Accumulation and Payout Fixed annuities have two phases, Accumulation Phase and Payout Phase. During the accumulation phase, an annuitant puts money into his/her annuity. After an accumulation period ends, the annuitant begins the payout phase. During the payout phase, the annuitant receives any purchase payments. In fixed annuities, the annuitant has the authority to determine the length of these two phases. The fixed annuity accumulation phase can have a length of months to years. The payout phase of the fixed annuity allows the annuitant to structure his/her payments in one of two ways: as a lump sum or as a series of payments over a period of years, depending upon one s needs.

26 Fixed Annuities Features Fixed Annuities Charges: Most of the fixed annuities offered in the market have no front-end loads or charges, but most have some kind of penalty for early withdrawals or surrenders. Surrender penalties and charges vary from policy to policy. Annuitants should consider the amount of liquidity he/she needs when deciding on an annuity. The longer the surrender fee period an annuitant selects, the higher his/her interest rate will be. Exclusive Offers: These days, most annuity companies or insurance companies allow their annuitants a certain amount of withdrawals without any surrender penalties or charges. Interest only and 10% free withdrawal are common offers, but some companies offer free withdrawals up to 15% of the principal and interest. Taxes: A person pays no taxes on the income and investment gains from his/her annuity until he/she withdraws the money. Offers by the Insurance Companies: Because fixed annuities offer guaranteed principal, some companies promise their annuitants a 100% payment of the original premium of the principal, even if the annuitants terminate their policies

27 early. Insurers are bound contractually and must provide benefits whether or not the annuity earns its assumed rate of return. Are Fixed Annuities Suitable for Your Client? Fixed annuities are suitable for a number of people with different needs, but are not a blanket answer for all clients. If a client is looking for immediate, unfettered access to his/her funds, fixed annuities would not be the best investment choice. If a client wants to participate in the equity market and is willing to assume some greater risks as well, fixed annuities are not the best investment instrument to achieve this goal. If a client is seeking an ideal retirement planning tool that affords tax benefits, flexibility and safety, then fixed annuities are the right investment vehicle. Fixed annuities play a significant role in almost every retirement plan. How effectively fixed annuities can play their part depends on a number of factors, including the annuitant s age, the amount of time that an annuitant has to accumulate assets, and others specific factors that can be jointly discussed between the annuitant and the insurance agent.

28 Benefits of a Fixed Annuity Tax Deference Tax deference is one of the greatest advantages that a fixed annuities product has over most bonds, bank certificates of deposit, and the majority of mutual funds. The interest earned on the annuity is tax deferred; therefore, the annuitant s funds grow at a faster rate than a taxable fund. This will continue as long as the funds are kept in the annuity. Once the funds are removed from the annuity, however, the earnings become taxable. Safety The safety and security of the annuitant s funds is another benefit of fixed annuities. Insurance companies guarantee the annuitant s principal and a minimum interest rate. Flexibility Flexibility is an appealing feature of fixed annuities for most investors. Fixed annuities offer different kinds of flexibility for the annuitant, including: Flexibility in paying premiums. Flexibility in how he/she wants to be paid. Flexibility in deciding about the future of the annuity after his/her death, and the beneficiaries of the annuity.

29 Unlike other financial instruments, a fixed annuity is able to provide the annuitant with a guaranteed income for the rest of his/her life. Ability to Avoid Probation This is a financial advantage that many fixed annuities offer to annuitants. Normally, at the death of an annuitant, the annuity death benefits will be paid to a beneficiary designated by the owner of the annuity, avoiding the financial and emotional stress caused by the probate process. Like most assets, the annuity is part of the annuitant s taxable estate. A person can consult his/her estate, probate and tax advisor for specific circumstances. Beneficiaries can choose to receive a lump sum payment, or a guaranteed monthly income.

30 Quiz 2 1. All of the following are true about the accumulation and payout phases of fixed annuity contracts EXCEPT (Lesson 2, Fixed Annuity Phases) A. The annuitant accepts the current rate B. The annuitant can vary the length of the accumulation phase C. The insurer calculates the expense factor D. The insurer can vary the length of the payout phase 2. In which of the following is the insurance company most likely to invest premiums from a fixed annuity? (Lesson 2, Process of Investing in a Fixed Annuity) A. Government Bonds B. Shares C. Real Estate D. Startups 3. Which of the following customers are best suited to a fixed annuity? (Lesson 2, Are Fixed Annuities Suitable for your Client?) A. Richard; young, risk averse and planning for retirement B. Brenda; young, risk averse and looking to make a quick profit C. Tyrone; aging, risk taking and planning for retirement D. Michaela; middle aged, risk taking and looking to provide for her beneficiaries 4. Normally, the annual renewal interest rate on a fixed annuity is set at (Lesson 2, Fixed Annuities - Tax Deferred Policies) A. A maximum of 3% B. A minimum of 3% C. A maximum of 5% D. A minimum of 5%

31 5. The fixed annuity market is facing a downturn due to better paying alternatives. Of the following announcements, which is most likely to reduce sales of new fixed annuities even further? (Lesson 2, Fixed Annuities - Tax Deferred Policies) A. A decision to increase in the surrender charges B. A decision to increase the interest rates payable C. A decision to improve the renewal rates offered D. A decision to invest in premiums in even less risky areas 6. Hamish has read up on annuities. He becomes suspicious while talking to an agent who is trying to sell him a fixed annuity contract. Which one of the agents statements is most likely to be the red flag? (Lesson 2, Process of Investing in a Fixed Annuity) A. "The annuity will allow you to name beneficiaries." B. "The company will be charging surrenders from this year onwards." C. "The contract is governed by the Securities Act." D. "The early withdrawal charge is 2%." 7. LMZ Insurance has signed a fixed annuity contract with C. Howard. Three years into the contract they change the interest rate on the annuity. When would Howard be able to challenge this decision? (Lesson 2, Fixed Annuities - Features) A. If the company has made the contract on five year rate basis B. If the contract is for more than $100,000 C. If the annuity is still in the accumulation period D. If Howard has recently lost a lot of money and is dependent on the annuity proceeds

32 8. Kim is a risk taking person. On the advice of his brother, he has decided to invest in a fixed annuity. Which of the following combinations is he most likely to choose? (Lesson 2, Benefits of a Fixed Annuity) (1) Annual renewal rate. (2) 3 year rate guarantee. (3) 10% free withdrawal. (4) 15% free withdrawal. A. (1) and (3) B. (1) and (4) C. (2) and (3) D. (2) and (4) 9. Which of the following customers are best suited to a fixed annuity? (Lesson 2, Are Fixed Annuities Suitable for your Client?) A. Richard; young, risk averse and planning for retirement B. Brenda; young, risk averse and looking to make a quick profit C. Tyrone; aging, risk taking and planning for retirement D. Michaela; middle aged, risk taking and looking to provide for her beneficiaries 10. All of the following are characteristics of the current rate EXCEPT? (Lesson 2, Interest Rates on Fixed Annuities) A. It can be set for periods of one to seven years B. It has a minimum percentage C. It can fluctuate annually D. It is unguaranteed

33 Quiz 2 - Answers 1. (D) The correct answer is "D". This is the only choice that is not true. The annuitant has the right to decide the length of the payout phase. He can choose for it to be periodic or a lump sum payment. "A," "B" and "C" are incorrect because they are true. The insurer periodically offers a current rate which is generally accepted by the annuitant ("A"). It is the right of the annuitant to decide on the length of the accumulation phase. It can vary from a one lump sum premium to periodic payments over many years ("B"). At the start of the payout phase the insurers actuary carries out various calculations; one of these is the expense factor ("C"). 2. (A) The correct answer is A. Bonds (specially government backed ones) offer a guaranteed interest to the investor. In a fixed annuity the insurance company bears the investment risk. To minimize this risk it will use the most secure investment vehicle. B is incorrect because shares prices fluctuate according to market sentiments; and dividends can vary in amount. C is incorrect because real estate prices are vulnerable to market fluctuation. The final choice, D, is incorrect because providing venture capital to startups is very risky. The business could thrive or fail. 3. (A) The correct answer is A. The people most suited to fixed annuities are those that are looking for a stable income stream (i.e. risk averse) for later on in life. B is incorrect because Brenda is looking to make a quick profit. Even though she satisfies the risk averse quality, annuities are long term investment vehicles are not able to generate quick profits. C and D are incorrect because both Tyrone and Michaela are willing to take risks with their investments. Tyrone would be better of looking at a variable annuity which gives him the option to earn higher returns. Michaela is looking to provide for her beneficiaries and should look at an insurance policy rather than an annuity. 4. (B) The correct answer is B. Normally the interest rate is guaranteed to remain at or above 3%. The other answers are incorrect by default. 5. (D) The correct answer is "D". This is the only announcement that would reduce the desire for new annuity buyers to purchase a fixed annuity. Investing in areas that are less risky than normal is likely to result in less interest paid to the owner. People would stick with their better paying alternatives. "A" would affect the current holders of annuities, and not have that much of an impact on prospective buyers. "D" is a better answer. "B" and "C" would do the opposite. "B" would attract newer buyers. "C" would also be seen as a bonus by newer buyers; but would please current owners.

34 6. (B) The correct answer is "C". A fixed annuity is seen as an insurance product only. Hence while it is subject to insurance laws, it does not fall within the scope of the Securities Act. Some annuities are affected by this act, but they must be variable annuities. This is the only suspect statement among the four given. "A," "B" and "D" are statements of policies and would not raise any suspicions. 7. (A) The correct answer is "A". Insurance companies can change the interest rate to reflect market conditions. They can do so as long as they do not go below the minimum rate. However, if they had guaranteed Howard a rate for five years, they are contractually obliged to maintain this rate. He would be able to challenge the decision in this case. "B," "C" and "D" are incorrect, they have nothing to do with the companies power to change the contract rate. 8. (B) The correct answer is "B". Since he is a risk taker who has invested in a low risk vehicle, it is likely that he will try to make the most of his money. By taking a annual renewal rate he would increase the risk as compared to a 3 year guarantee. Therefore (1) would be preferred to (2). When considering the withdrawals, he would take the one which offered him the higher percentage. This would enable him to take out more money and use it to invest in other areas. Therefore (4) would be preferred to (3). The best combination is "B". "A," "C" and "D" are incorrect because they do not give the best combination. 9. (A) The correct answer is A. The people most suited to fixed annuities are those that are looking for a stable income stream (i.e. risk averse) for later on in life. B is incorrect because Brenda is looking to make a quick profit. Even though she satisfies the risk averse quality, annuities are long term investment vehicles are not able to generate quick profits. C and D are incorrect because both Tyrone and Michaela are willing to take risks with their investments. Tyrone would be better of looking at a variable annuity which gives him the option to earn higher returns. Michaela is looking to provide for her beneficiaries and should look at an insurance policy rather than an annuity. 10. (D) The correct answer is D. Though the duration of the current rate may vary, it is always guaranteed. It may be guaranteed at the start of each year or guaranteed for a longer term. A is incorrect because though generally set and guaranteed annually, sometimes the current rate can be set for longer periods going up to seven years. B is incorrect because annuity interest rates are always subject to a minimum rate. C is incorrect because where current rates are set annually, the insurance company is likely to adjust them to reflect market conditions.

35 LESSON 3 VARIABLE ANNUITIES What is a Variable Annuity? A variable annuity is a cross between a fixed annuity and a mutual fund, having many characteristics of each. As with a fixed annuity, premium payment can be made in one lump sum or in installments, and payout may be immediate or deferred. However, while fixed annuity payments are placed in the insurance company s general account, variable annuity payments are placed in a separate account and are invested separately from the other investments of the insurance company. Because of the investment risk inherent in a variable annuity, it is regulated both by state insurance laws and by state and federal securities laws. A variable annuity is designed to give a long-term retirement option to an annuitant. It is generally not suitable for individuals who need their funds in less than ten years time. Separate Account A separate account is an account established and maintained by an insurance company for the purpose of segregating specific assets from the insurance company s general investments. All of the income and the realized and unrealized gains and losses on the assets held in the separate account must be

36 allocated to the account, and no other income, gains, or losses of the insurance company may be allocated to the account. The separate account is considered an investment company and must be registered under the Investment Company Act of Interests in separate accounts are defined as securities, and, thus, the offering of an interest in a separate account must be registered under the Securities Act of The investment advisor for the separate account must be registered under the Investment Advisors Act of 1940, and persons offering variable contracts for sale must be representatives registered under the Securities Exchange Act of Since states typically view variable contracts as insurance products, individuals offering variable contracts must usually also have an insurance license. Characteristics of Separate Accounts Insurance companies will usually have more than one separate account. Each separate account will have a different set of objectives and investment policies, which are set out in the prospectus describing the separate account. For example, just as for mutual funds, the separate account could specialize in a certain type of securities, such as common stock, bonds and preferred stock, government securities, Ginnie Mae, or money market instruments. It could also emphasize a specific goal such as capital growth (aggressive or conservative) or current income.

37 Variable contract purchasers can typically split their funds among several separate account options and switch among them as desired. This exchange privilege is similar to that offered between funds in fund families. The insurance company may limit the amount that can be placed in one account and may charge for switches between accounts over a certain number per year. The insurer must keep accurate records of each participant s proportionate investment in each separate account and credit him/her with his/her proportionate share of all income, gains, and losses. Separate accounts present the potential for greater yield, but are not guaranteed. Account values in separate accounts will vary with changes in the market conditions, and can lose money over time, if performance of the investments made is poor. Annuitants can choose how to allocate their premiums within the accounts. Thus, depending on how much money is allocated into a separate account, a certain amount of risk must be assumed by the annuitant. Underlying Investments Separate accounts may invest in securities such as stock directly by purchasing the securities or indirectly by purchasing mutual fund shares of a fund that invests in the security, as follows: With the direct method, the separate account is registered as an open-end investment company. The insurer uses the premiums to buy

38 securities and the contract owner has an undivided interest in the portfolio of securities. With the indirect method, the separate account is registered as a unit investment trust. The insurer places the premiums in the unit investment trust, which uses them to buy mutual fund shares. The mutual fund may be one managed by the insurer or may be independent. Valuation of a Variable Annuity Contract Investors paying into the separate account build up accumulation units, which are much like the shares of a mutual fund. The NASD defines an accumulation unit as an accounting measure used to determine a contract owner s interest in the separate account during the accumulation period of a deferred annuity contract. Accumulation units are priced after receipt of the customer s funds, as are shares in a mutual fund. The earnings in the separate account accumulate tax-deferred, in the same manner as earnings in a fixed annuity do. When the investor annuitizes the variable annuity, the actuary calculates a payment factor just as for a fixed annuity. However, rather than calculating a fixed dollar payment, the actuary converts the accumulation units to annuity units, and states the monthly payment to the individual in terms of the number of annuity units that will be paid. The insurer guarantees the payment of the proper