Annuities Table of Contents

Transcription

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

21 managed by professional investment advisers. These advisers are paid a fee based on a percentage of the assets they manage. Separate account investment returns are comprised of the same four elements that normally make up mutual fund returns: Dividends Interest Realized gains and losses and Unrealized gains or losses In the separate account, unlike a mutual fund, all earnings are automatically reinvested and credited to the account. The value of each variable subaccount is computed daily, and the contract owner's interest is equal to the number of accumulation units owned multiplied by the value of each unit. Similar to fixed annuities, a variable annuity may be purchased as a: Single Premium Deferred Annuity (SPDA) Flexible Premium Deferred Annuity (FPDA) and Single Premium Immediate Annuity (SPIA) Deferred Annuity Accumulation During the variable annuity s accumulation phase, the contract owner selects the variable subaccounts to which his or her premium is allocated and the amount or percentage allocated to each. The owner chooses the variable subaccounts and percentages at the time of application for the annuity. These selections may be changed by the owner at any time. The variable subaccounts offered generally include the following, although many other options may be offered: A money market subaccount in which allocated premiums are invested in shortterm money market instruments selected with the objective of achieving the maximum current income consistent with reasonable safety of principal and liquidity A stock subaccount in which allocated premiums are invested in common and preferred stock in order to achieve capital appreciation A bond subaccount in which allocated premiums are invested in investment grade bonds selected with the objective of achieving a high level of income over the long term consistent with reasonable safety of principal When the contract owner has selected the variable subaccount or subaccounts in which to allocate the annuity premium, the annuity s cash value fluctuates from day to day based on the performance of the accounts selected. One of the very important features of a variable annuity is the contract owner s ability to transfer funds between variable subaccounts and to change the allocation of premiums as desired. This enables an owner to modify his or her investments in order to reflect current market conditions, and changed objectives and risk tolerance. 21

22 For example, suppose Jim Whittaker has a flexible premium deferred variable annuity to which he contributes $1,000 each month. His allocation and account values are currently as follows: Subaccount Percentage of Premium Allocated to Subaccount Current Subaccount Value Stock subaccount 50% 12,000 Bond subaccount 30% 9,000 Money market subaccount 20% 4,000 Jim believes that stock prices are going to be taking a downturn and transfers his funds in the stock subaccount to the bond account. Simultaneously, Jim changes the allocation of future premiums so that 50% of premiums are allocated to the bond account and 50% to the money market account. Insurers normally restrict the number of no-cost fund transfers a contract owner can make in his or her contract in one year and may charge a nominal fee for subaccount transfer exceeding 12 in a year. The value of a variable annuity is determined by multiplying the number of accumulation units by the value of each unit. When a contract owner pays premiums on a variable annuity, the insurer typically deducts any sales charges and allocates the net amount of the premium in the variable subaccounts selected by the owner. The number of accumulation units purchased by the allocation of premium will depend on the price per unit of that variable subaccount at the end of the business day. For example, suppose that George Wilson purchases a $30,000 single premium deferred variable annuity and allocates 50% to the stock subaccount and 50% to the bond subaccount. The number of accumulation units George owns is determined as follows: Subaccount Premium Allocation Value Per Unit = Number of Accumulation Units Stock $15,000 $7.30 = 2,054.8 units Bond $15,000 $5.70 = 2,631.6 units At any future date, George's annuity value is equal to the value of one accumulation unit at that time multiplied by the number of units he owns. For example, one year later, George's annuity is worth: Subaccount Unit Value x Units Owned = Accumulation Value Stock $7.00 x 2,054.8 units = $14, Bond $6.50 x 2,631.6 units = $17, Total = $31, Because the stock subaccount unit value declined, the value of George's stock subaccount similarly declined, from $15,000 to $14, However, since the unit value of the bond subaccount increased the value of George's bond account also increased from $15,000 to $17, Taxation of these earnings is, of course, deferred until those earnings are actually distributed to George or his beneficiary. 22

23 Managing Cash Value Volatility The decision to purchase a variable annuity contract is normally motivated, at least in part, by the buyer s desire to participate in possibly greater cash value growth by investing in the contract s variable subaccounts. What may keep some prospects from purchasing a variable annuity, however, is cash value volatility; simply stated, the ups and downs of the stock market may keep otherwise suitable buyers from investing. There are several tools that can enable the contract owner to enjoy the potential cash value growth possible with an investment in securities while minimizing the cash value volatility that is also characteristic of equity investment. The tools available in a variable annuity that can assist the owner in variable subaccount management include: Diversification Dollar cost averaging Asset allocation Interest sweep Automatic asset re-balancing Variable subaccount transfer While recognizing that not all insurers will offer all of these tools, let s examine each of them and their operation in the variable annuity contract. Diversification Diversification refers to the inclusion of a number of different investment vehicles in a portfolio in order to increase returns or reduce risk exposure. The variable annuity contract owner may diversify by including several different investment vehicles in a portfolio. By diversifying, the owner may increase the portfolio s return or decrease its risk exposure. Variable subaccounts are diversified, of course, in much the way that mutual funds are diversified. However, the owner may provide further diversification by selecting multiple subaccounts in which to invest. Insofar as the variable subaccounts are negatively correlated, i.e. one tends to go up when another goes does, the diversifiable risk to which the variable annuity contract is subject is reduced. By reducing the risk to which the cash value is exposed, the separate account s volatility is reduced. Asset Allocation Asset allocation involves dividing one s portfolio into various asset classes in order to preserve capital by protecting against negative developments while still taking advantage of positive developments. Although asset allocation is similar to diversification insofar as its objective is to reduce risk and preserve capital, asset allocation and diversification are not identical. The focus of diversification is on investing in various vehicles within an asset class; asset allocation s focus is on investment in various asset classes. In the process of asset allocation, the contract owner divides his or her investment among asset classes such as U.S. stocks, U.S. bonds, foreign securities and so forth. This is designed to produce a mix of assets that is suitable for the contract owner in view of his or her risk tolerance and investment objectives. Although the terms conservative, moderate and aggressive change depending upon who is using them, asset allocations for these different contract owners could approximate those shown below: 23

24 Variable Subaccount Conservative Moderate Aggressive Common stock 15% 30% 40% Bonds 45% 40% 30% International 5% 15% 25% Money market 35% 15% 5% Total 100% 100% 100% As the contract owner s risk tolerance moves from low risk to high risk, the allocation of assets also moves from conservative with an emphasis on fixed-income securities to aggressive, with a correspondingly higher allocation to common stock and international subaccounts. Automatic Subaccount Re-balancing Successfully employing asset allocation requires that the allocation remain in place for an extended period; that generally means for at least 7 to 10 years, provided the owner s objectives and risk tolerance have not changed during that period. The cash value management tool known as automatic subaccount re-balancing maintains that allocation. This tool automatically reallocates the assets among subaccounts periodically in order to maintain the owner s preselected percentage allocation among the variable subaccounts. Although not usually available on a monthly basis, this re-balancing can be scheduled quarterly, semi annually or annually and is normally provided without additional charge. Fund Transfer We have already noted that variable products enable contract owners to change their subaccount allocation without the need to recognize income for tax purposes. This facility to re-allocate funds from one variable subaccount to another allows the contract owner to actively manage his or her asset allocation and reduce subaccount volatility. Dollar Cost Averaging Dollar cost averaging is a well-known and workable strategy. When employed within a variable annuity contract, it enables a contract owner to average the cost of shares over the purchase period by systematically transferring fixed dollar amounts from one subaccount to another subaccount. Dollar cost averaging enables an investor to obtain an average cost for shares purchased that is below the average price for the shares in a fluctuating market. In a typical situation, a contract owner could use funds invested in the money market account to purchase shares in the stock account, and each month the insurer would automatically transfer a set amount from the money market account to the stock account. Usually, insurers require that a minimum amount be transferred and that the contract have a minimum cash value in order to establish dollar cost averaging. However, dollar cost averaging inside the contract is frequently provided at no charge. Although dollar cost averaging may usually be used to transfer funds from one variable subaccount to another, insurers do not normally permit the owner to transfer funds from the contract s fixed account under the dollar cost averaging option. 24

25 Interest Sweep Although insurers do not normally allow dollar cost averaging transfers from a fixed account, the contract owner may direct the insurer to periodically transfer any interest earned in the fixed account to one or more variable subaccounts under the interest sweep option. Normally the contract owner will select the variable subaccounts into which he or she wants the interest swept and indicate the percentage to be transferred into each of the selected subaccounts. In most cases, a contract owner may have the interest sweep take place monthly, quarterly, semi-annually or annually. It should be clear that the benefit of the interest sweep option is similar to the benefit of dollar cost averaging. In both cases, the contract owner takes a fairly fixed amount of funds the interest credited to the fixed account or a selected amount to be transferred and uses it to purchase units of the variable subaccounts. Just as in dollar cost averaging, the interest swept into the variable subaccounts will purchase fewer units when the value is higher and more when the value is lower. Because of that phenomenon, the average per-share cost is lower than the average per-share price in a fluctuating market; furthermore, the overall contract value is less likely to be significantly affected by large swings in market performance. Although the insurer usually requires a minimum value in the fixed account for it to implement the interest sweep option, there is usually no cost for it. As we can see, variable annuity contracts offer owners several tools with which to manage the policy s cash value during its accumulation phase. These tools include: Diversification Dollar cost averaging Asset allocation Interest sweep Automatic asset re-balancing Variable subaccount transfer Variable Annuity Payout Phase Identical to a fixed annuity, the variable annuity contract s payout phase begins when either of the following occur: A single premium immediate annuity is purchased or A single or periodic premium deferred annuity is annuitized at the annuity starting date Depending on the annuity settlement option selected by the contract owner, a variable annuity payout guarantees a periodic income payment to the annuitant at specific intervals for a specified period of time. As we noted earlier in our discussion of annuitization options, the income may be paid for life or for a lesser period. Unlike the periodic payments under a fixed annuity, the amount of each variable annuity periodic payment is not guaranteed. Instead, variable payouts may fluctuate up and down based on actual investment experience. (Some variable annuities offer contract owners a choice of fixed periodic payments or variable periodic payments while others offer variable accumulation but only fixed payouts.) Insurers are not uniform in the amount of control granted to annuitants after annuitization. While some insurers permit the annuitant to direct how the annuity value is invested and permit variable 25

26 subaccount transfers during annuitization, others do not. In the case of those other insurers, the value of the annuity is usually invested by the insurer in a variable subaccount comprised principally of stocks. At the annuity starting date, the accumulation units are converted to annuity units, and the amount of each payout received by the annuitant is based on the value of the annuity unit. After annuitization commences, the number of annuity units remains fixed; however, the value of each annuity unit varies based on the performance of the separate account. If the insurer offers a fixed payout, the value of each annuity unit in the case of a fixed payout remains level, and each periodic income payment would be the same. Three steps are required to calculate the number of annuity units at the variable annuity s annuity starting date. They are as follows: Determine the current contract value by multiplying the total number of accumulation units by the value per unit Determine the first monthly payment by multiplying the current contract value, in thousands, by the guaranteed annuity rate Determine the number of annuity units by dividing the first monthly payment by the current annuity unit value For example, suppose that Bill Jones purchased a single premium deferred variable annuity for which he paid $50,000 ten years ago. Bill is about to retire, and he and his wife have selected the joint and survivor life income option. Bill has 11,000 accumulation units in his annuity, and each accumulation unit is valued at $12. The guaranteed annuity rate stated in the contract for the payout Bill has selected is $8.10 per month for each $1,000 of cash value. The current value of an annuity unit is $5.44. We can calculate the number of annuity units that will be used to determine each monthly periodic payment to Bill and his wife. In step 1 we can determine the value of Bill s variable annuity contract by multiplying his 11,000 accumulation units by the value of one accumulation unit. Since each accumulation unit has a value of $12, the total cash value is $132,000. (11,000 x $12 = $132,000) In step 2, we can determine the amount of Bill s first periodic payment by multiplying the value of the annuity contract in thousands by the monthly annuity rate per $1,000. The result is $1, ($132 x $8.10 = $1,069.20) In step 3, we determine the number of annuity units (that will not change) by dividing the first monthly periodic payment by the value of one annuity unit. Since the first monthly periodic payment is $1, and the value of an annuity unit is $5.44, Bill has annuity units. ($1, $5.44 = ) Bill Jones and his wife will receive the value of annuity units as long as either lives. If the annuity unit value declines to $5 next month, they will receive $ ( units x $5). If it increases to $5.75 in the month after that, they will receive $1, ( units x $5.75). 26

27 Features and Benefits There are various features of a variable annuity that provide substantial benefits for a contract owner. During the accumulation phase of the variable annuity, those features and benefits are: Variable Annuity Features mean Benefits for the Contract Owner Control of premium allocation means The contract owner can select from a variety of variable subaccounts in order to achieve a potentially high return consistent with the level of risk the owner is willing to assume Tax-deferred growth means Tax on the deferred annuity earnings is deferred until the funds are distributed, resulting in a potentially larger accumulation Automatic reinvestment means All earnings are automatically reinvested, compounding any tax-deferred growth Flexibility means Deferred annuities can be purchased with a single premium or through a series of flexible premiums. Funds can be re-allocated from one variable subaccount to another as needed The features and corresponding owner benefits continue in the payout phase as shown below: Variable Annuity Features mean Benefits for the Annuitant Wide selection of payout arrangements means The payout can be tailored to meet the annuitant's needs Lifetime income means The annuitant can t outlive his or her income Potential hedge against inflation means The annuitant s income will tend to grow as inflation reduces its purchasing power Suitability There is no single investment that is appropriate for every investor; the same is true of a variable annuity. Purchase of a variable annuity should be considered by individuals who are willing to assume: 27

28 The responsibility for determining how the annuity premiums will be allocated among the available investment alternatives and Increased risk in return for potentially higher annuity gains When recommending the purchase of a securities product, such as a variable annuity to a customer, NASD rules require that an agent or registered representative must have reasonable grounds to believe that the purchase is suitable for the customer. Those reasonable grounds must be based on the customer's: Age Financial situation Other securities holdings Needs Tax status Objectives The amount of risk that the contract owner assumes usually depends on the variable subaccounts that he or she has selected. A variable annuity will usually offer a money market investment option that is very conservative and which offers a combination of high safety of principal and liquidity as the primary investment objective. Although such an investment option would offer smaller potential rewards than would other investment options, it may satisfy the contract owner s need for safety of principal. In contrast, variable subaccounts that invest in stocks offer potentially greater rewards, but involve the risk of a loss of principal. (See the Appendix for a review of bond ratings and basic characteristics of securities.) The contract owner is given the opportunity to balance risk and reward consistent with his or her risk tolerance and investment objectives by allocating the annuity premium among several variable subaccounts. In addition to these general principles relating to the suitability requirement, the NASD has published two important Notices to Members that bear directly on variable annuity suitability. In Notice to Members 96-86, the NASD provides guidelines with respect to the specific factors that could be considered by the agent or registered representative under the NASD suitability rule when he or she is recommending that the customer purchase a variable product. Those factors include the customer s: Life insurance needs Expressed preference for a non-insurance product Understanding of the variable product s complexity Appreciation of the extent of variable product charges Need for liquidity and short-term investment Need for retirement income and Investment sophistication & ability to monitor separate account performance Regardless of whether the product being recommended is a variable annuity or variable life insurance, the customer s life insurance needs should first be assessed. That life insurance need assessment will assist the registered representative in determining the suitability of variable life insurance, variable annuities or other, non-insurance product. Sometimes a customer will state that he or she is not interested in an insurance product of any sort. Even if the customer is misinformed about the product, his or her expressed desire for a non-insurance product should be followed, despite a variable product s being more appropriate to the customer s particular situation and goals. (In such a case, appropriate file documentation should be done.) 28

29 A somewhat greater level of financial sophistication may be required in the customer for an appropriate sale. The suitable variable product customer should be capable of dealing with the additional complexity of insurance products, able to monitor the variable subaccounts chosen and understand how to obtain information concerning their performance. Since insurance product charges are generally higher and more numerous than charges associated with other investment products, the sales and other charges that the customer can expect to incur in a variable product must be fully disclosed before any variable product sale is made. Since variable annuities are not liquid investments, they are not appropriate investments for temporary funds or for funds that will be needed in the few years following the purchase of the annuity. Because of that illiquidity, the registered representative should ensure that the customer has allocated other liquid funds for those financial needs that lie in the immediate future. A variable annuity may be an unsuitable sale if the customer has insufficient liquidity to meet shortterm needs. The suitable variable annuity customer should have a need to accumulate funds for retirement and be taking full advantage of other available retirement vehicles that may offer more significant tax benefits, such as individual retirement accounts, 401(k) plans and 403(b) plans. A customer that is not currently taking advantage of these more favorable tax-benefited plans that are available to him or her may be an unsuitable candidate for a variable annuity contract. The greater complexity of variable products makes the customer s investment sophistication an even more important consideration. The customer should understand the concept and variability of the variable subaccounts and feel comfortable with the steps required to monitor their performance. If the customer does not understand the operation of variable subaccounts or is unable to easily monitor their performance, a variable product may be unsuitable. In NASD Notice to Members the NASD offers guidance with respect to sales conduct in the sale of variable annuities. The Notice provides guidelines concerning: Customer information Product information Liquidity & withdrawal penalty disclosure Variable annuities in tax-qualified accounts and Variable annuity replacement Information needs to flow from the customer and to the customer in the suitable variable annuity sale. The registered representative must make reasonable efforts to obtain comprehensive customer information on which to base a suitable recommendation. Also, the registered representative must discuss all relevant facts with the customer that bear on the appropriateness of the variable annuity for the customer, including liquidity issues, costs, risks and tax treatment. Every variable annuity sale should be accompanied by a current prospectus, and the registered representative should have thorough product knowledge of the specifications of the recommended variable annuity. To the extent that surrender charges and tax penalties diminish the value of any withdrawal from an annuity, they reduce the product s liquidity. This lack of liquidity generally makes variable annuities unsuitable for customers with short-term objectives. For that reason, the registered representative should identify the customer s investment objectives and be sure that the customer understands the effects of surrender charges and any tax penalties for premature withdrawals. 29

30 When a variable annuity is recommended for use in a tax-qualified account, such as an IRA or a 401(k) plan, the registered representative must disclose to the customer that the tax-deferral feature of the variable annuity is unnecessary. A variable annuity should be recommended in a tax-qualified account only when non-tax-deferral benefits provided by the annuity support the recommendation. The registered representative should determine the suitability of any proposed variable annuity replacement based upon whether or not the provisions, limitations, cost structure and enhancements of the new contract will benefit the customer. (See Decisional Factors in Variable Annuity Suitability in the Appendix.) Compliance Requirements In order to be able to sell variable annuities an agent or registered representative must have the following licenses: A life insurance license with the state (and state variable contracts license, if applicable) An NASD Series 6 or Series 7 registration A state securities license Furthermore, because variable annuities are securities, their sale is subject to strict compliance requirements. The SEC, NASD and state securities and insurance regulators each have jurisdiction over their offer and sale. Here are some of the more important compliance requirements relating to the sale of variable annuities: A variable annuity prospectus a document that provides the information an investor should know in order to make an informed decision must be provided either prior to, or at the time of, any sale or sales presentation involving a variable annuity. Advertising or sales literature can be used in selling, presenting or soliciting interviews to sell variable annuities only after having been approved. Projecting the future value of a variable annuity or estimating the future performance of its variable subaccounts is illegal. Statements concerning a variable annuity that are inconsistent with the prospectus may not be made. All sales charges must be fully disclosed. 30

31 Combining Fixed and Variable Annuities Although fixed annuities offer guaranteed interest rates and annuity payouts and may be appropriate for risk-averse individuals, they have a significant shortcoming. Specifically, they may be unable to keep pace with inflation. For an individual relying on periodic payments from an annuity to supplement retirement income and who might live for 20 years or more after retirement, the erosion caused by inflation is a significant risk. While variable annuities offer the potential for payments to keep pace with inflation, they, too, have disadvantages. In the case of a variable annuity, there is a risk that periodic payments from it will decline. As a result, the retiree who expected his or her variable annuity to provide a greater return than a fixed annuity may be sorely disappointed. A possible solution to this Hobson s choice may involve the purchase of two annuity contracts. For example: A contract owner could split the annuity premium between a fixed and variable annuity during their accumulation phase. The premium split would depend on the individual's risk profile. If the investor was willing to assume moderate risk he or she might split the annuity premium 50/50. With half of the premium in a fixed annuity providing its comforting guarantees, the other half could then be invested in variable subaccounts that carry greater risk in return for potentially greater rewards. A similar arrangement could be made during annuitization. A conservative investor might wish to place 70% of the amount available into a fixed annuity and obtain a guaranteed, fixed income for life. The remaining portion could be allocated to a variable annuity in order to provide annuity payments that vary in amount and may keep pace with inflation. Depending on the insurer s contract, the owner may be able to make these fixed and variable allocations in a single contract. Summary Variable annuities offer investors an opportunity to invest in various portfolios within the taxfavored environment of an annuity. This enables the contract owner to enjoy the benefits of taxdeferral that are provided by an annuity product while participating in the potential growth of the securities market. At the time the owner applies for the variable annuity, he or she selects an asset allocation based on objectives and risk tolerance. That asset allocation may be changed at any time by the owner to reflect changed objectives or risk tolerance or for any other reason. Although the contract owner s investment in variable subaccounts exposes the investor to the risks and rewards normally associated with investing in the underlying portfolios, variable annuities offer their owners certain tools to manage variable product cash value volatility. Those tools include automatic asset re-balancing, interest sweep, dollar cost averaging, asset allocation and fund transfer. Although the use of these tools does not guarantee a profit or avoidance of a loss, they help contract owners to maximize earnings and minimize loss. The benefits of variable annuities are not restricted solely to the accumulation phase; contract owners can enjoy additional benefits through variable annuitization. A significant concern to many retirees is the potential loss of their income s purchasing power resulting from inflation. Variable payouts permit annuitants to overcome the loss of purchasing power by basing periodic annuity income changes on the performance of variable annuity units. 31

32 Enhanced suitability and compliance issues come into play with respect to the recommendation or sale of a variable annuity. In addition to the suitability requirements that apply to the recommendation of any investment, the NASD has provided guidelines for the appropriate recommendation of a variable annuity. Agents must be authorized to sell both life insurance products and investments in order to sell variable annuities. In addition to a life insurance license, agents must have a Series 6 or Series 7 registration and a state securities license. Variable annuities have many of the features that pertain generally to annuities but also have the characteristics of investment products. The important characteristics of a variable annuity may be summarized as follows: Variable periodic payments that may keep up with inflation Variable growth rate based on performance of variable subaccounts chosen Single or flexible premium products are available Periodic payments may be made immediately or deferred A broad selection of periodic payment arrangements are available Annuitant bears investment risk to the extent of variable subaccount allocation Premiums are invested in the insurer s separate account The variable annuity product is regulated by state insurance laws and the SEC Life insurance and securities licenses are needed to be able to sell the variable annuity product 32

33 Chapter Four Types of Fixed Annuity Contracts Important Lesson Points The important points addressed in this lesson are: Traditional declared-rate annuities are fixed annuities on which the issuing insurer, from time to time, establishes a crediting interest rate applicable to a single contract year Bonus rate annuities are fixed annuities on which the insurer credits a first-year interest rate that exceeds its simultaneously declared renewal interest rate; the difference in the rates is the bonus interest Multi-year guarantee annuities are fixed annuities that offer contract owners a declared rate product on which a stated interest rate is credited for a more-thanone-year period Interest-indexed annuities are fixed annuities that credit interest based on an interest index, such as the 10 Year Treasury Note Index Equity-indexed annuities are fixed annuities on which interest is credited based on the change in the level of an equity index, such as the S&P 500 Index Introduction To this point in our annuity discussion, we have talked about fixed annuities, examined the characteristics of annuities in general and then considered variable annuities. The assumption might be that fixed annuities are all alike. Few statements, however, could be further from the truth. Although fixed annuities all share certain common characteristics, they may differ markedly in other areas. The most important area in which fixed annuities may differ from one another is in how interest is credited to the annuity contract s cash value. In this chapter, we will look at variations on the fixed annuity theme and examine the important differences in the methods used to credit interest to them. The fixed annuities that will be considered include: Traditional declared-rate annuities Bonus annuities Multi-year guarantee annuities Interest indexed annuities and Equity indexed annuities Let s begin our consideration of these fixed annuity variations by looking at the declared-rate fixed annuity, the standard setter. 33

34 Traditional Declared-Rate Annuities A traditional declared-rate annuity is, by far, the simplest of annuity designs. Periodically, the insurer establishes both a first-year and renewal interest rate; depending on the volatility of interest rates in the economy, the insurer may establish a new interest rate each month often that rate is declared by the board of directors at its monthly meetings or may simply maintain the existing interest crediting rate from month to month. This is often referred to as the current rate to differentiate it from the guaranteed rate. The first-year interest rate applies to new annuity contracts, and the renewal rate applies to contracts beginning their second or later contract year. Although the interest crediting rate that applies to new contracts may be the same rate applied to contracts that are renewing at the same time, such is not always the case. Often, in recognition of the need to attract new business, an insurer will offer a first-year interest crediting rate that is somewhat higher than its interestcrediting rate offered to renewing contracts. In addition to the current rate that is declared by the insurer from time to time, every fixed annuity has a guaranteed interest-crediting rate. It is this rate that the insurer guarantees it will credit, at the minimum, regardless of prevailing interest rates in the economy or the insurer s return on its invested assets. This guaranteed interest-crediting rate may be 3 4 percent, depending on the contract. As we will see when we consider other types of fixed annuities equity indexed annuities in particular some annuities traditionally guarantee lower interestcrediting rates. In addition, traditional declared-rate annuities sometimes have a bailout rate; a bailout rate is an interest rate below which a contract owner may surrender his or her contract without surrender charges. Bonus Annuities A bonus annuity is a deferred annuity on which the first-year interest-crediting rate is greater than the current rate that the insurer anticipates it will credit in subsequent years. The difference in these rates is the bonus. The bonus offered by insurers selling bonus annuities may range anywhere from 1.5 percent to as high as 5 percent. Although some insurers may inflate the bonus that they credit and then credit below-market interest rates in renewal years in order to recover the bonus, this barelyethical approach is certainly not the norm. However, before recommending a bonus annuity to a customer, the financial practitioner will be well advised to review the renewal interest-crediting rate history of the insurer. Bonus annuities can facilitate the movement of funds from other savings and investment vehicles. This bonus, credited in the first year, may motivate a customer to transfer funds to the annuity that he or she might be otherwise reluctant to transfer because of: Surrender charges Stock and bond losses Transaction costs CD penalties Mutual fund losses Tax liability In certain bonus annuities, there may be strings attached to obtaining the higher first-year interest rate. For example, the contract owner may be able to receive the higher interest-crediting rate only if he or she makes no withdrawals from the contract, other than earnings, for a specified time period. Other bonus annuities may credit the higher first-year rate only if the contract is annuitized. Still other bonus annuities may require that the contract be maintained for a prolonged period in order to receive the bonus. 34

35 These conditions don t necessarily mean that the contract is an undesirable one or one that is unsuitable for a customer. They are, however, factors that should be considered before making a recommendation. Multi-Year Guarantee Annuities A multi-year guarantee annuity is a fixed annuity on which the current interest rate is guaranteed for a period greater than one year. Although some multi-year guarantee annuities offer a twoyear rate period, these contracts generally offer current interest rates for periods of three to ten years. They are designed specifically to appeal to those individuals that might be interested in certificates of deposit. Multi-year guarantee annuities normally provide contract owners with limited liquidity. Typically, the contract imposes surrender charges for surrenders at any time before the conclusion of the current guaranteed rate period. At the end of the rate period, a thirty-day period window applies during which the contract may be surrendered without the imposition of surrender charges. At the conclusion of the thirty-day window, the contract is renewed for another multiyear period equal to the previous period unless the owner has surrendered the contract or elected a different renewal period. During the multi-year guarantee period, surrender charges do not apply when: Withdrawals are taken not exceeding credited interest The contract owner elects periodic income payments or Death benefits are paid following the death of the contract owner In the case of certain multi-year guarantee annuities, the insurer will combine a feature of bonus annuities with multi-year guarantee annuities by crediting additional interest in the first year of the multi-year period. In a sense, multi-year guarantee period annuities resemble long term bonds and generally have at least one of their characteristics market value adjustment. As we know, bonds are affected by prevailing interest rates in the economy and may sell for a premium, i.e. for more than their face amount, or at a discount, i.e. for less than their face amount depending on the bond s nominal interest rate compared to prevailing interest rates. For example, my $1,000 5% bond will pay me $50 each year. If the prevailing interest rates in the economy will allow an investor to invest $1,000 and receive $80 in interest each year, i.e. 8 percent, there probably won t be many investors willing to pay me the full $1,000 for my bond. Instead, I would probably be able to sell the bond for $625 or slightly more than that, depending on how far the bond was from maturing for its face amount. This reduction in value is a market value adjustment. In contrast, the prevailing interest rates in the economy may decline dramatically, and an investor may only be able to obtain 3 percent interest in an alternative investment. In such a case, my 5% bond is very attractive and may command a price of up to $1,666, depending on when it is scheduled to mature. This increase in value is also a market value adjustment. Multi-year annuities have similar market value adjustments that apply to them if the contract owner surrenders the contract before the end of its term. This market value adjustment applies in addition to any applicable surrender charge or premature distribution tax penalty. If the 35

36 prevailing interest rates in the economy have increased, the market value adjustment is almost certain to be a negative one, and the applicable surrender charge on top of that market value adjustment could result in an expensive surrender. Alternatively, if the interest rates in the economy have declined, the market value adjustment is likely to be positive and will offset, to some extent, the applicable surrender charge. Unfortunately, the bulk of surrenders are done in response to the contract owner s desire to chase higher interest rates. For that reason, the market value adjustment is most likely to be negative. Interest Indexed Annuities Annuities whose renewal interest rates depend on a declaration by the insurer contain a certain trust me element. In other words, the contract owner is being asked to trust that the insurer will continue to credit competitive interest rates in renewal years. While many insurance companies offer consistently competitive interest-crediting rates, the owner is still being asked to rely on the actions of the insurer over which he or she has no control. Since the insurer is not required to declare a current interest rate that is in excess of its very low guaranteed rate, there is no assurance that it will. Furthermore, a contract owner that is dissatisfied with the insurer s interest-crediting rate and chooses to surrender his or her contract may be required to pay a surrender charge. Using interest rates that depend upon an index that is outside of the insurer s control effectively removes this reliance on the actions of the insurer. An early index used to determine annuity rates is the interest index, hence the name interest indexed annuity. Although several indexes are available for use in pegging the interest-crediting rates in an interest indexed annuity, the most common index used is the 10 Year U.S. Treasury Note Index. Although an interest index is used as the basis for interest crediting in an interest indexed annuity, an insurer need not design its product to credit an interest rate exactly that of the Index. Instead, an insurer may agree to credit interest that is 2 percent less than the index. Alternatively, the insurer may impose a cap on the rate of interest credited. For example, it may agree to credit the same interest as the index, up to 8 percent. In which case, any index interest rate greater than 8 percent would not be reflected in the interest credited to the annuity contract. Interest indexed annuities were introduced early in the decade of the 1990s and may still be marketed by certain insurers. As a marketing concept, however, these annuities were generally unsuccessful and failed to grab the imagination of consumers. Despite the inability of insurers to interest the investing public in the product, it, nonetheless, served a valuable purpose: it became the model for a new and much more attractive type of indexed annuity the equity indexed annuity. Equity Indexed Annuities There are some customers for whom the prospect of the possible loss of cash value is sufficient to keep them from a variable annuity contract and yet they are uninterested in declared-rate interest crediting. Despite their aversion to the possible loss of cash value in a variable contract, they may have a desire to participate in the gains possible in a variable contract. For these customers, an equity indexed annuity contract may be the answer. We will spend significantly more time on this type of fixed annuity for two reasons: 1. The equity indexed annuity has gained considerable buyer acceptance and 36

37 2. The interest-crediting methods are fairly complicated and require additional discussion An equity indexed product is one whose cash values are based on the performance of a selected equity index, such as the S&P 500 Index. If the equity index on which the cash value is based increases the contract s cash value will increase. Unlike variable annuity contracts, however, equity indexed annuity contract cash values are guaranteed as to principal and are also guaranteed a modest level of interest. As a result of that product design, the cash value of an equity indexed annuity contract may participate in some of the growth of the stock market but will be shielded from its decline. Determining Cash Value Just as the variable annuity contract is essentially identical to the declared-rate annuity product except as to how its cash value is determined, the equity indexed annuity product is also differentiated principally by the determinants of cash value. Since the equity indexed annuity contract s method of determining cash value requires that we add several new terms to the annuity lexicon, let s turn our attention to those terms first. The important terms that are used to describe the operation of equity indexed annuity cash value are: Daily interest account Contribution window Bucket Equity index account Tranche Index term period Equity index An equity indexed annuity contract s daily interest account is an account in which the contract owner s premiums are accumulated when paid. It is convenient to characterize this account as a staging area in which the funds are placed before being moved to the equity index account. While the premiums remain in the daily interest account, they receive interest at a rate declared by the insurer. Typically, the interest rate credited to funds in the daily interest account is consistent with the interest rate paid on funds on the insurer s declared-rate annuity contracts. In any case, the rate paid will not be less than the rate guaranteed in the contract. Funds may remain in the daily interest account for any period of time 30 days, 90 days, etc. depending on the equity indexed annuity contract s design. At the end of the contract s contribution window, all of the funds being held in the daily interest account the premiums credited along with any interest paid are moved into the equity index account. An equity indexed annuity contract s contribution window is the period during which premiums must remain in the daily interest account before being credited to the equity index account. At the point at which the premiums and interest in the daily interest account are transferred into the equity index account, i.e. at the close of the contribution window, the funds are conceptually placed in a bucket and are moved to the equity index account in a single tranche. A tranche is a portion or discrete amount and refers to the bucket of funds that is transferred from the daily interest account to the equity index account in a single tranche. The funds that constitute this bucket continue to be identified as part of the bucket throughout the initial period in which they are in the equity index account. Funds that have been transferred from the daily interest account into the equity index account immediately begin to have their growth defined by the equity index that is selected by the insurer. 37

38 So, the equity index account is that account in which the growth, if any, of credited funds is determined by changes in an equity index. We have taken for granted that equity index is a term understood by everyone. In the event that it isn t, let s define it. An equity index is a measure of performance of certain stocks that are included in a particular portfolio in relation to a base value set for that portfolio at an earlier time. There are many equity indexes that may be familiar: Standard & Poor s S&P 500 Index Nasdaq Index NYSE Index Value Line Composite Index AMEX Index Wilshire 5000 Index The S&P 500 Index is just one of several major common stock indexes published by Standard & Poor s Corporation and is often the preferred equity index for use in equity indexed products. It is a broad-based index consisting of 500 stocks that are included in the industrials, transportation, utilities and financials index. Similarly, the NYSE, AMEX and Nasdaq Indexes are indexes of stocks listed on the New York Stock Exchange, the American Stock Exchange and those securities traded on the Nasdaq overthe-counter system. The Value Line Composite Index is a stock index published by Value Line; it reflects the percentage changes in share price of about 1,700 stocks traded on the NYSE, AMEX and OTC market. The Wilshire 5000 Index, published by Wilshire Associates, Inc., is reported daily in the Wall Street Journal and represents the total dollar value, in billions, of 5,000 actively traded stocks. Any of these indexes may be selected as the equity index used in an equity indexed product. When the bucket of funds is moved from the daily interest account to the equity index account, the index term period begins. The index term period may be of any length and depends on the equity indexed annuity contract s design. Regardless of how long or short the index term period is, the index term period is the period of time over which equity index benefits are calculated. We noted that contribution windows and index term periods may be of almost any length decided upon when the equity indexed annuity product is designed, there are certain durations that are more popular in one type of product than another. In equity indexed annuity products, contribution windows the maximum period of time that funds remain in the daily interest account are often one month. However, three-month contribution windows may also be used. At the end of each index term period, all of the buckets contained in the equity index account are rolled over into a new index term period and any crediting interest, determined by the change in the equity index, is added. At the time that the funds in the buckets are rolled over into the new index term period, the premiums that have been accumulating in the daily interest account are also transferred into the equity index account as the first bucket in that index term period. Index Call Options & Participation Rate The mechanics of premium payment, crediting to the daily interest account and subsequent crediting to the equity index account are fairly straightforward. Once credited to the equity index account, interest is credited to the premiums based on several factors. Before we examine those factors, however, we need to take some time out to consider how insurers make certain that they will have sufficient resources to pay the interest promised. The most important element in 38

39 gaining that certainty is a financial vehicle known as an index call option. By purchasing an index call option, an insurer insures itself against the probability that it will be required to credit interest in excess of the guaranteed interest. When the funds are rolled into the equity index account, the insurer determines its index call option budget that is, how much money it has available to purchase the index call options that ensure it will be able to credit any excess interest promised. To determine its index call option budget, the insurer deducts certain amounts for: The funds that the insurer needs to invest in bonds and bond-like investments in order to be sure it will have sufficient funds to credit the guaranteed interest Administrative and sales expenses Profits When the insurer has deducted these amounts, the funds remaining constitute its index call option budget. If the insurer s index call option budget is large, it may be able to purchase index call options that will permit it to guarantee that the equity indexed annuity contract will receive 100 percent of the increase in the underlying equity index. More likely, however, the index call option budget will only permit the purchase of sufficient index call options to ensure 70 percent or 80 percent of the equity index increase. If the index call option budget permits the purchase of index call options that will guarantee 100 percent of the equity index change, the contract will have a 100 percent participation rate. And, an equity indexed annuity contract with such a participation rate will credit interest on the equity index account equal to the change in the index. An equity indexed annuity contract s participation rate is the percentage of the change in the underlying index that is credited to the contract. So, in a contract with a 100 percent participation rate, if the index increased by 20 percent, the contract would enjoy a 20 percent interest crediting. If the insurer s index call option budget only permits a 70 percent participation rate, that same 20 percent increase in the index would translate into a 14 percent interest crediting. (20% x 70% = 14%) The largest deduction from the funds transferred into the equity index account to determine the index call option budget is the amount of funds that must be invested in bonds and bond-like vehicles to ensure the crediting of the interest guaranteed under the contract. So, the higher the interest rate guaranteed by the contract, the more funds must be invested. But, the more money that must be invested to ensure payment of the guaranteed interest, the less money available to purchase index call options and that will generally reduce the contract s participation rate. As a result of this dynamic between the guaranteed interest rate and the participation rate, equity indexed annuity contracts tend to have lower interest rate guarantees than declared-rate annuity contracts in order to increase the index call option budget and, therefore, the contract s participation rate. Despite the somewhat lower guaranteed interest rate in equity indexed annuity contracts, the guarantee nonetheless assures the contract owner that even if the change in the external index is negative, some interest will be credited. Interest Crediting Methods Now that we have considered the underlying concepts that play a role in the actual interest credited to an equity indexed annuity contract, let s turn our attention to the methods that are used 39

40 to determine the raw interest crediting rates to which the contract s participation rate is applied. There are three methods that are generally employed to determine the raw interest crediting rates on equity indexed products, such as equity indexed annuity. Those raw interest rate crediting methods are known as: Total interest rate methods Annual interest rate methods and Combination indexing methods Although we will briefly describe these methods, we need to bear in mind that most flexible premium equity indexed annuity contracts use a total interest rate method known as point-topoint. Total Interest Rate Methods Each of these interest rate methods has several sub-categories. Total interest rate methods are generally categorized into the following: Long-term point-to-point Long-term point-to-point with average end and Look back methods In the long-term point-to-point method, the equity index at the time the equity indexed annuity funds are transferred from the daily interest account to the equity index account is compared with the equity index at the end of the index term period. Any increase in the index is divided by the beginning equity index to arrive at the percentage increase. The percentage increase is multiplied by the participation rate, and the result is the interest rate applied to the funds in the equity index account. Although this is the simplest equity index form, its principal disadvantage is that it relies on the index level on a single day. The second type of total interest rate methods that we noted long-term point-to-point with average end overcomes that reliance on a single day s equity index by substituting an average of the equity index closing levels for the index closing level on the last day of the index term period. For example, the S&P 500 index numbers for the last 30 days of the index term period could be used in place of the S&P 500 index on the last day. The 30-day average is less likely to be affected by a single bad day in the market than the index on a single day. The final total interest rate method we will consider is known as the look back method and, in reality, is comprised of three different methods that employ the same concept of looking back over the index term period. The three methods are the: High water look back method Low water look back method Annual highest day look back method The high water look back method uses the same starting point for the index, i.e. the beginning of the index term period, but may have a different ending point. In the high water look back method, the index level on each anniversary during the index term period is noted, and the highest anniversary index level during the index term period becomes the ending point even if it is the first anniversary and the index term period is five years or more. The calculation, once the beginning and ending points are determined, is identical: the percentage increase is determined 40

41 and multiplied by the participation rate; the result is the interest rate applied to the funds in the equity index account. The low water look back method is just the opposite of the high water look back method. In the low water look back method, the ending date of the calculation is the end of index term period. The beginning date, however, is the lowest index level at the beginning of the index term period or on the anniversaries. When the beginning date is selected based on that criterion, its index level is compared with the index on the ending date, and the regular calculation is made. The final look back method the annual highest day look back method uses the index level at the beginning of the index term period for the starting point. Each day of the year, the index level is noted, and the index level on the highest day is the index level chosen for that year. At the end of the index term period, the index levels for the highest day in each year during the term index period are averaged. The average becomes the ending point for the raw interest rate calculation. The total interest rate method that is generally used to determine the raw interest rate in an equity indexed annuity contract is the simplest form. It takes two equity index readings: one at the beginning of the index term period and a second at the end of the index term period. The percentage increase in the index rates is determined, and that is the raw interest rate applied. For example, suppose that Barbara Quick purchased an equity indexed annuity contract that: Uses a total interest rate method Has a one year index term period and Provides for a participation rate of 90 percent Let s further assume that the amount of premium and interest transferred from the daily interest account to the equity index account at the close of the contribution window is $5,000. The equity index at the time of transfer is 900; one year later, the equity index stands at 1,000. To calculate the interest credited to the $5,000 transferred to the equity index account, the 1,000 end value must be subtracted from the 900 beginning value to calculate the index growth of 100 points. The 100 point growth is then divided by the beginning index level of 900 to calculate the percentage growth of percent; this is the raw interest rate. The participation rate of 90 percent is applied to the raw interest rate to determine the actual rate of 10 percent. (11.11% x.9 = 10%) The actual crediting rate on the equity index account is 10 percent. When applied to the $5,000 in the equity index account, the insurer is required to credit interest of $500. ($5,000 x.10 = $500) Annual Interest Rate Methods Now that we have looked at the total interest rate methods of calculating equity index raw interest rates, let s consider the second general approach that we noted: annual interest rate methods. An important difference between these two approaches is the frequency of interest rate calculations. Total interest rate methods of calculating raw interest crediting rates derive a single interest rate for the entire index term period, regardless of its length. Annual interest rate methods may produce several different interest rates if the index term period covers more than a single year. The annual interest rate methods that we will describe are the: Annual reset point-to-point method Calendar year point-to-point method 41

42 and Averaging annual reset method The annual reset point-to-point method of calculating the raw interest in an equity indexed product is often referred to as the ratchet method. Under this method, each contract year has a beginning point and ending point for which an interest rate is calculated. At the end of the index term period which may include several contract years the interest rates for each of the contract years in the index term period are added together to produce an interest rate for the entire period. This composite raw interest rate is multiplied by the contract s participation rate to yield an effective interest crediting rate for the entire multi-year index term period. In this ratchet method, the index level at the end of the first year becomes the starting point for the second year; the ending index level for the second year becomes the starting index level for the third year, and so on. A variation of the ratchet method calls for the crediting of interest at the end of each of the contract years in the index term period. The result is a compounding of the interest on an annual basis that will generally increase the total interest credited to the contract. The compounding variation may be accompanied, however, by a lower participation rate that will tend to minimize the difference between the versions. In the annual reset point-to-point method that we just examined, the years in the index term period are contract years. In the next method to be considered, the years in the index term period are calendar years. The calendar year point-to-point method of calculating raw interest requires that calculations be made for partial periods, unless the contract has an issue date of January 1 st. For example, suppose that the index term period in a particular equity indexed product is five years and the contract uses a calendar year point-to-point method to determine interest. If the contract was purchased on September 1 st and has a 30-day contribution window during which funds are accumulated in the daily interest account, the index term period would begin on October 1 st. Since the contract calculates raw interest on a calendar year basis, i.e. from January 1 st to December 31 st, the period from October 1 st to December 31 st is a partial year for which a special interest rate calculation is required. The January 1 st to December 31 st calculation, however, is identical to the calculation examined in the ratchet method. A partial calculation is also required, of course, for the partial calendar year during which the index term period ends. The final annual interest rate method that we will consider is known as the averaging annual reset method. This method returns to the contract year rather than calendar year basis. In this method, the index level at the start of the contract year is the starting point for the raw interest calculation. The ending point, however, is not the index level at the close of the contract year. Instead, the ending point is an average of the index levels during the year. The index levels may be averaged for each trading day, each month or each quarter, and that average becomes the ending point in the raw interest calculation for that contract year. The starting point in a subsequent contract year is the index level at the beginning of that year. At the end of the index term period the annual raw interest rates are aggregated, multiplied by the participation rate and then applied to the contract s cash value. Combination Indexing Methods The last broad indexing methods that we will consider are combination indexing methods. In these combination methods, insurers have used some of the features of total interest rate methods and some of the features of annual interest rate methods. The two sub-categories of combination indexing methods that we will examine are the: Multi-year reset method 42

43 and Average end multi-year reset method The multi-year reset method and the annual reset point-to-point method are identical except in one respect: the multi-year reset method uses calculation periods that are at least two years long, while the annual reset method uses calculation periods that are only a single year in length. The index level when the calculation period begins is the starting point; the ending point is the index level at the conclusion of the calculation period. The ending point of the first multi-year calculation period becomes the starting point in the second multi-year calculation period, and so on. At the end of the index term period, the interest rates for the multi-year calculation periods are added together, multiplied by the participation rate and applied to the funds in the equity index account. The average end multi-year reset method is essentially the same as the multi-year reset method just considered except that the ending point in each calculation period is the average index level over the final 30 or 60 days in that period. At the conclusion of the index term period, the raw interest rates calculated for each of the calculation periods are aggregated, multiplied by the participation rate and applied to the funds in the equity index account. We have considered the principal methods that are employed by insurers to determine the raw interest crediting rate in their equity indexed products. The participation rate that is applicable to the particular equity indexed product may and often does reduce the actual rate that is applied to the funds in the equity index account. There is, however, an additional interest-limiting method that some insurers employ: an interest rate cap. Interest Rate Cap An interest rate cap is a limit on the interest rate that will be credited to the funds in the equity index account. The cap may apply to each year in a multi-year index term period, or it may apply to the overall index term period. A contract s actual interest rate may be subject to both a cap and a participation rate, each further limiting the interest that is eventually applied to the cash value. The various interest crediting methods, participation rates and rate caps make the evaluation of a particular equity indexed annuity contract a fairly complicated matter. Clearly, the conclusion that a certain contract is more competitive than another based solely on its interest crediting method is as inappropriate as reaching that conclusion based entirely on its participation rate or its rate cap. All of the elements must be considered together to make any kind of reasonable comparison of products. Furthermore, some equity index designs may produce better results in bull markets than other designs; other designs may perform more competitively in bear markets. Summary Traditional declared-rate annuities, offering the simplest annuity design, generally provide the standard against which other annuities are considered. These annuities credit interest on a singleyear basis during the first and renewal years at interest rate levels that are often, but not necessarily, identical. Bonus annuities are similar to traditional declared-rate annuities except that the issuing insurer credits a higher interest rate in the first year of the contract than in years following the first year. Multi-year guarantee annuities are declared-rate fixed annuities on which the issuing insurer establishes an interest rate that applies for more than a single year and may be applicable for up to 10 years. At the conclusion of the multi-year period, the contract owner has a window usually of 30 days during which the contract may be surrendered without incurring surrender charges. 43

44 Each of these declared-rate annuities requires that the contract owner rely on the issuing insurer s willingness to declare consistently competitive interest-crediting rates in the future. Unless the annuity contract design includes a bailout provision, the contract owner s only alternative to accepting a non-competitive interest-crediting level may be to surrender the contract and incur surrender charges. An alternative to declared-rate annuities, however, is an annuity whose interest-crediting level is based on an external index that is outside the insurer s control. Two such indexes have been employed: an interest index and an equity index. An interest indexed annuity, with interest levels based on an interest bellwether such as the 10 Year Treasury Note Index, was introduced early in the decade of the 1990s but met with little consumer acceptance. The lack of buyer interest in interest indexed annuities may have been due, in part, to substantial gains being experienced in the stock market during this period and the desire on the part of investors to participate in those gains. Despite the generally disappointing showing turned in by the interest indexed annuity design, it served an important function in pointing the way to a design that would enjoy far greater consumer acceptance: the equity indexed annuity. An equity indexed annuity contract is an annuity contract that has the general characteristics of a declared-rate annuity but differs with respect to the determination of its cash value. Equity indexed annuity contracts permit contract owners to participate in some of the growth of the stock market while avoiding any loss of principal. Equity indexed annuity cash value growth is based on the change in the equity index selected by the insurer. A number of broad-based equity indexes are available, including the S&P 500 index, the NYSE index, the AMEX index, the Nasdaq index, the Value Line composite index and the Wilshire 5000 index. Insurers may use any one of a number of interest crediting methods; a comparison of contracts, however, requires that the interest crediting methods, participation rate and caps be considered rather than just a single element. 44

45 Chapter Five Annuity Taxation Important Lesson Points The important points addressed in this lesson are: Although annuities offer non-tax benefits, their tax treatment is central to their popularity Non-qualified annuity premiums are non-deductible A non-qualified annuity s tax-deferral feature is generally available only when the annuity is owned by a natural person or by a trust for the benefit of a natural person; deferral is generally denied to corporate owners Withdrawals from a non-qualified annuity are considered a distribution of taxable earnings to the extent there are earnings on the contract Withdrawals or surrenders from a non-qualified annuity before age 59½ are subject to a 10 percent tax penalty Annuity payments are comprised of a tax-free return of basis and taxable earnings Non-qualified annuity death benefits are income taxable to the beneficiary to the extent of any gain on the contract The value of a non-qualified annuity at the owner s death is included in his or her federal gross estate Introduction Annuities have owner benefits that are not associated with annuity tax treatment. Principal among those benefits is the annuity s ability to guarantee an income that the annuitant cannot outlive, no matter how long that life turns out to be. Despite those non-tax benefits of annuities, however, it is the tax treatment of annuities that often creates the greatest amount of customer interest. In this chapter, we will consider the tax treatment afforded annuities during the contract owner s lifetime and upon his or her death and will examine both its favorable and its lessfavorable aspects.

46 Income Tax Treatment Non-qualified annuities are annuities that are not associated with a tax-advantaged plan, such as a tax sheltered annuity or individual retirement account. When annuities are used in taxadvantaged plans, the tax rules governing those plans take precedence over the annuity tax rules and, therefore, apply. As a result of the application of plan rules, the premiums paid for an annuity in a tax-advantaged plan may or may not be tax-deductible. Having offered this caveat, let s consider how non-qualified annuities are treated for tax purposes. Premiums Premiums that are paid for a non-qualified annuity contract are non-deductible, regardless of the type of annuity purchased. As noted above, premiums paid for an annuity may be tax-deductible if the annuity is purchased within a tax-advantaged plan such as a tax sheltered annuity or IRA. However, when annuity premiums are deductible in such a case, it is because of its inclusion in the plan rather than the product s character as an annuity. Cash Values Tax-deferral of the interest or earnings credited to an annuity s cash value is an important tax benefit offered by annuity contracts. At one time, annuities offered tax-deferred cash value growth regardless of the nature of the annuity owner. Since February 28, 1986, that has not been the case. Ownership by Non-natural Persons Generally Before February 28, 1986, many corporations routinely employed deferred annuities to fund their obligations under certain non-qualified deferred compensation plans for employees. The advantage in so doing was that the income earned on the contract was deferred until distributed. When distributed, the corporation would pay the tax on the earnings but would receive an offsetting tax deduction when the deferred compensation payment was made to the employee. To the extent that contributions are made after February 28, 1986 to a deferred annuity contract owned by an entity that is not a natural person, the contract is not treated for tax purposes as an annuity contract. In other words, in such a case any income earned under the contract owned by a corporation receives the same income tax treatment it would receive if it had been interest earned in a savings account. Tax-deferral under deferred annuities for corporations is all but gone. For deferred annuity contracts owned by corporations, the income on the contract is treated as ordinary income received or accrued by the corporate owner. According to 72(u) of the Internal Revenue Code, income on the contract is the excess of: (1) the sum of the net surrender value of the contract at the end of the taxable year and any amounts distributed under the contract during the taxable year and any prior taxable year over (2) the sum of the net premiums (amount of premiums paid under the contract reduced by any policyholder dividends) under the contract for the taxable year

47 and prior taxable years and any amounts includable in gross income for prior taxable years under this requirement. Internal Revenue Code 72(u) (u) Treatment of annuity contracts not held by natural persons (1) In general If any annuity contract is held by a person who is not a natural person - (A) such contract shall not be treated as an annuity contract for purposes of this subtitle (other than subchapter L), and (B) the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the owner during such taxable year. For purposes of this paragraph, holding by a trust or other entity as an agent for a natural person shall not be taken into account. (2) Income on the contract (A) In general For purposes of paragraph (1), the term ''income on the contract'' means, with respect to any taxable year of the policyholder, the excess of - (i) the sum of the net surrender value of the contract as of the close of the taxable year plus all distributions under the contract received during the taxable year or any prior taxable year, reduced by (ii) the sum of the amount of net premiums under the contract for the taxable year and prior taxable years and amounts includible in gross income for prior taxable years with respect to such contract under this subsection. Where necessary to prevent the avoidance of this subsection, the Secretary may substitute ''fair market value of the contract'' for ''net surrender value of the contract'' each place it appears in the preceding sentence. Ownership by Natural Persons and Certain Trusts Despite the loss of tax-deferral for corporate owners of deferred annuity contracts, tax-deferral of interest and earnings continues to be an important element in deferred annuity purchases by natural persons. Since deferred annuity earnings are not currently taxed to the owners of the contracts, the earnings that might have otherwise been used to pay the taxes due can remain within the contract and earn further interest. The accumulated value difference between a currently-taxable account and a tax-deferred account depends, of course, on the contribution amount, the assumed interest rate and the tax rate. However, we can get some feeling for the difference with a hypothetical comparison. Suppose, for example, that an individual contributes $5,000 at the beginning of each year to two accounts: one of the accounts is currently taxable, and the other is tax-deferred. If each of the accounts

48 provides a 10 percent annual return and the investor pays income taxes in a 25 percent marginal tax bracket, the difference in the accounts at various durations is as shown below: End Of Year Tax-Deferred Account Value Currently-Taxable Account Value * Difference 1 $ 5,500 $ 5,375 $ ,578 31,220 2, ,656 76,041 11, , ,386 34, , ,763 82, , , , , , , ,490, , , ,434,259 1,221,504 1,212,755 * Amounts shown assume taxes due on earnings in a 25% marginal tax bracket are deducted from the account balance each year. It is clear that the difference in the accumulated amount in a tax-deferred account compared to a currently-taxable account is considerable. It might be argued, however, that since the earnings in the tax-deferred account will be subject to taxation when distributed the difference will be consumed by taxes. Assuming that the individual s tax bracket does not change, we can see that there is still a substantial difference, even after the taxes are paid. If the tax-deferred account is distributed at the end of 20 years and taxes are paid in a 25 percent tax bracket, the individual will have $261,259 in the tax-deferred account after tax, compared with $232,763 in the currently-taxable account. The difference, of course, is $28,496. By the end of 30 years that after-tax difference has grown to $160,266; after 40 years, it is $654,190. The purpose behind the illustration is only to show the value of tax-deferral. Neither account may credit a consistent 10 percent interest, and tax laws may change, resulting in higher or lower taxes when the tax-deferred account is distributed. Interest credited to deferred annuities owned by certain non-natural persons may also be taxdeferred. The rule that causes a deferred annuity not to be treated as an annuity contract when owned by a non-natural person does not apply in the following cases: When the contract is acquired by the decedent s estate by reason of the decedent s death When the contract is held under a qualified pension, profit sharing or stock bonus plan, as a tax sheltered annuity or under an IRA When the contract is purchased by an employer upon the termination of a retirement plan and held until all amounts are distributed to the employee or beneficiary When the contract is an immediate annuity or When the contract is a qualified funding asset

49 A qualified funding asset is an annuity that is purchased and held to fund periodic payments for damages on account of personal injury or sickness. In addition to these exceptions to the rule concerning non-natural persons as owners of annuities, an annuity contract that is held by a trust or other entity as agent for a natural person is considered owned by a natural person for tax purposes. This important tax-deferral is not affected by the contract owner s changing of the allocation of assets within the contract. As a result, the contract owner may transfer cash value from one variable subaccount to another for any reason without being required to recognize any income. This facility to change asset allocation without tax consequences is important since it enables a contract owner to respond to changes in the market or to changes in his or her own risk tolerance without resulting in a tax event. Surrenders and Withdrawals Although annuity contracts owned by natural persons enjoy deferred taxation, the earnings are not tax free. When the contract s cash value is distributed, either by surrender of the contract or by withdrawal, any earnings are subject to taxation. When a deferred annuity contract is surrendered, the cash value in excess of the investment in the contract is taxable as ordinary income. The investment in the contract is normally equal to the premium cost for the annuity; however, certain adjustments may need to be made to the gross premium cost to arrive at the annuity s premium cost. The extra premiums paid for supplementary benefits must be excluded from the total gross premium to determine the premium cost. Any loan taken from the annuity contract that was included in income should be added to the investment in the contract. Likewise, when a withdrawal is taken from an annuity contract, the amount of the withdrawal is taxable as ordinary income to the extent it does not exceed the earnings on the contract. This is known as last in, first out (LIFO) tax treatment. For example, suppose that George Williams, a contract owner, had a cost basis in the contract of $50,000 and a cash value of $70,000; the difference, of course, would be the contract s earnings. If George took a withdrawal of $25,000, the first $20,000 taken from the contract would be considered earnings and fully taxable as ordinary income; the remaining $5,000 would be considered a tax-free return of basis. Premature Withdrawals and Surrenders Annuities receive favorable tax treatment a prime example of which is tax-deferral to encourage savings for retirement. In order to help assure that annuities are used for this purpose and not for short-term investment purposes, the tax code prescribes a tax penalty for premature distributions. The tax penalty for premature distributions is equal to 10 percent of the withdrawal or surrender that is includible in the recipient s income. The tax penalty applies to any payment received to the extent the payment is includible in income; however, the tax penalty does not apply to any of the following: Payments made on or after the individual becomes age 59½

50 Payments attributable to the individual s becoming disabled Payments allocable to investment in the contract before August 14, 1982 Payments made on or after the contract owner s death Payments made under an immediate annuity contract Payments made from an employer-purchased annuity upon the termination of a qualified plan and Payments that are part of a series of substantially equal periodic payments made for the life or life expectancy of the individual or the joint lives or joint life expectancies of the individual and his or her designated beneficiary Let s return to our earlier example of the $25,000 withdrawal taken by George Williams from his deferred annuity. We noted that $20,000 of the withdrawal would be considered taxable earnings, and the remaining $5,000 is a tax-free return of basis. If George is younger than age 59½ and the withdrawal does not meet one of the exceptions just listed, he will be liable for the income tax on the $20,000 taxable withdrawal plus 10 percent of the $20,000 taxable withdrawal. In other words, George would be liable for the income tax on $20,000 of income in his tax bracket plus a tax penalty of $2,000. Annuity Payments During Lifetime Payments received after the annuity starting date are known as amounts received as an annuity and are generally taxed under the annuity rules. Under the annuity rules, the purchaser s investment in the contract is received in equal tax-free amounts over the payment period, and the balance of the payment is taxable income. As a result, each payment received until the entire investment in the contract is recovered is comprised of a: Tax-free return of investment and Taxable income Although the basic rule with respect to annuity taxation applies to both fixed and variable annuities, the method of arriving at the portion of each payment that is tax-free as a return of the investment in the contract is somewhat different for them. Fixed Annuities In the case of annuity payments received under a fixed annuity, determination of the tax-free portion involves the calculation of an exclusion ratio. The exclusion ratio is then applied to each periodic income payment until the entire investment in the contract is recovered tax free. Periodic income payments received after the entire investment in the contract is recovered are fully taxable. A fixed annuity s exclusion ratio is the ratio that the total investment in the contract bears to the total expected return. The exclusion ratio is generally expressed as a percentage and is derived by dividing the investment in the contract by the expected return. For example, if the investment in the contract is $200,000 and the expected return is $300,000, the exclusion ratio would be $200,000 $300,000 =.667 = 66.7%. If the monthly income under this contract were $2,000, the amount that would be deemed a return of the investment in the contract and, therefore, tax

51 free is $2,000 x 66.7% = $1,334. The balance of $666 each month would be considered taxable earnings. Of course, if the recipient received only the $2,000 monthly income and had no other income, his or her total annual taxable income would be $666 x 12 = $7,992. Determining the expected return under an annuity contract is equally simple. We noted earlier that payments received as an annuity may be made under a: Temporary annuity or Life annuity If annuity payments are made under a temporary annuity, i.e. a fixed period or fixed amount annuity, the expected return is simply the sum of the guaranteed payments. If payments are for a fixed number of years, the expected return is the guaranteed amount receivable each year multiplied by the fixed number of years. For example, suppose the contract owner made a premium payment of $200,000 and arranged for income payments under a fixed period annuity for 10 years. Under the insurer s fixed period annuity, the contract owner would receive $3,000 each month for 120 months. His or her expected return would be, of course, $3,000 multiplied by the 120 months over which the contract owner will receive it, or $360,000. To determine the amount of each monthly income payment that is tax-free, we need only divide the $200,000 investment in the contract by the $360,000 expected return. By doing that, we determine that 55.6 percent of each $3,000 monthly payment is received tax free as a return of the contract owner s investment in the contract. ($3,000 x 55.6% = $1,668) Determining the exclusion ratio under an annuity contract involving life contingencies, i.e. a life annuity, is somewhat more complicated but still not difficult. The determination of the investment in the contract is done in the same fashion; calculating the expected return requires that a life expectancy table be consulted. The two tables that may be consulted to determine the expected return multiple for a single life annuity are Table I or Table V. Table I is a genderbased life expectancy table and is to be used if the investment in the contract does not include an investment after June 30, Table V is a unisex life expectancy table and is to be used if the investment in the contract includes an investment after June 30, A portion of Table V is reproduced below. Table V Ordinary Life Annuities One Life Expected Return Multiples (excerpt) Age Multiple Age Multiple Age Multiple

52 If our contract owner that had purchased the 10-year temporary annuity in our previous example had chosen, instead, to purchase a straight life annuity with his $200,000 and he was age 65, he might expect to receive about $2,000 per month for life. To determine his expected return, we would need to consult Table V (above), and we would find that his expected return multiple was (The expected return multiple approximates the individual s life expectancy.) The expected return multiple must be multiplied by the sum of one year s payments to determine the expected return. Since we know that the contract owner will receive $2,000 each month, his annual income will be $24,000. By multiplying the annual income by the expected return multiple, we can see that the total expected return under the contract is $480,000. Calculating his exclusion ratio requires only that we divide the $200,000 investment in the contract by the $480,000 expected return. The exclusion ratio thus calculated is 41.7%. ($200,000 $480,000 =.417) By multiplying the $2,000 monthly periodic payment by the exclusion ratio, we see that the tax-free portion of each monthly payment is $834. Therefore, $10,008 is excludable each year. Variable Annuities Determining the excludable portion of annuity payments received under a variable annuity is somewhat simpler. Although both fixed and variable annuities are subject to the same basic rule, the excludable portion of the payment is not determined through the calculation of an exclusion ratio since the expected return under a variable annuity is unknown. (Remember, variable annuity payments will go up or down depending on the investment performance of the portfolio supporting the annuity units.) Since the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. So, the excludable portion is calculated by dividing the investment in the contract by the number of years over which the annuity will be paid. If the contract owner that had purchased the fixed life annuity had used his $200,000 to purchase a variable annuity, we would determine the amount of income that was tax free each year by dividing the $200,000 by the 20.0 year expected return multiple. The result would be $200, = $10,000 excludable each year just about the same amount determined for the fixed annuity. Annuitant s Death After Annuity Starting Date If the annuitant purchased a temporary annuity or a life annuity with a period certain or refund guarantee and dies leaving a benefit payable to a beneficiary, the beneficiary will receive the payments tax free until the investment in the contract has been fully recovered. Payments received after that are fully taxable as ordinary income. Contract Owner s Death Before Annuity Starting Date If the contract owner of a deferred annuity dies before the annuity starting date, i.e. during the accumulation period, the beneficiary will generally receive the greater of the cash value or the total premiums paid. Any gain under the contract is taxable as ordinary income to the beneficiary. The death benefit under an annuity contract does not qualify for tax exemption as

53 life insurance proceeds payable by reason of the insured s death. The gain that is income taxable to the beneficiary is measured by subtracting the total gross premiums paid for the contract from the death benefit received under the contract. If the beneficiary elects, within 60 days following the contract owner s death, to apply the death benefit under a life income or installment option, he or she can avoid being taxed on the gain in the year of death. In such a case, the periodic payments will be taxable to the beneficiary under the regular annuity rules; the contract s exclusion ratio will be based on the decedent s investment in the contract and the beneficiary s expected return. Estate Tax Treatment The estate tax treatment given annuities depends on whether death occurred before or after the annuity starting date. If death occurred before the annuity starting date, i.e. during the accumulation period, the entire value of the annuity contract is includible in the decedent s federal gross estate. If death occurred after the annuity starting date, the commuted value of any remaining payments under the contract is included in the decedent s federal gross estate. Therefore, if the decedent had selected a straight life annuity no value would be included in his or her federal gross estate because no benefits are payable to a beneficiary under a straight life annuity. However, if the decedent elected a period certain and died before the end of the selected period, the commuted value of those remaining payments due the beneficiary is included in the decedent s estate. Summary Non-qualified annuities unquestionably provide important owner benefits that are not associated with the product s tax treatment. Despite those non-tax benefits, however, the tax treatment of non-qualified annuities remains central to the product s consumer popularity. Although non-qualified annuity premiums are non-deductible, the contract offers owners the opportunity to defer recognition of contract gains until distributed. As a result of this tax treatment, earnings that might have been needed to pay current income taxes on those earnings may remain in the account producing additional earnings. A sometimes forgotten, but important, feature is the contract owner s ability to re-allocate his or her cash value in the contract to other variable subaccounts, as needed. This facility enables the contract owner to respond to changes in the market and in his or her own risk tolerance. Unlike withdrawals from a life insurance policy s cash value, which are considered to be a withdrawal of basis before any earnings are withdrawn, withdrawals from a non-qualified annuity are considered to be earnings first. Only after all earnings are withdrawn from the annuity contract is the investment in the contract withdrawn. Non-qualified annuity tax benefits are provided to encourage taxpayers to save for their retirement. Accordingly, there is a penalty for distribution of annuity funds before the owner s age 59½. Unless the premature distribution meets a particular exemption, it is subject to a 10 percent tax penalty to the extent the distribution must be included in the contract owner s taxable income.

54 Non-qualified annuity tax benefits don t end with tax deferral. Periodic income payments received from a non-qualified annuity are deemed to be comprised of a tax-free return of basis along with taxable earnings. As a result of that favorable tax treatment, a portion of each annuity payment is tax-free until the entire investment in the contract has been recovered. The tax benefits of non-qualified annuities apply principally during the contract owner s lifetime. The tax treatment at death is somewhat less favorable. Non-qualified annuity death benefits are income taxable to the beneficiary to the extent of any gain on the contract. Unlike the treatment given to many other assets, annuities do not receive a step-up in basis at the death of the owner. Furthermore, the value of a non-qualified annuity at the owner s death is included in his or her federal gross estate.

55 Glossary Accumulation period Annuitant Annuity Annuity contract owner Annuity starting date Asset allocation Automatic asset rebalancing Bonus annuity Cash refund annuity 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. 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 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. The annuity 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 annuity starting date is the date on which periodic income payments are scheduled to begin. Asset allocation involves dividing one s portfolio into various asset classes in order to preserve capital by protecting against negative developments while still taking advantage of positive developments. Automatic asset re-balancing is a variable annuity feature that can normally be implemented by the contract owner without cost. Periodically, it re-balances the variable annuity portfolio by reallocating the funds so that the cash value allocation is returned to its pre-determined percentages among the variable sub-accounts. Funds in the fixed account are not usually considered in this re-balancing. A bonus annuity is a deferred annuity on which the first-year interestcrediting rate is greater than the current rate that the insurer anticipates it will credit in subsequent years. The difference in these rates is the bonus. 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.

56 Cash value management tools Contribution window Daily interest account Declared-rate annuity Deferred annuity Diversification Dollar cost averaging Equity index Equity index account Equity indexed annuity The automatic fund-reallocation options that may be offered by insurers selling variable annuities to aid contract owners in managing cash value include: asset allocation, automatic asset re-balancing, interest sweep and dollar cost averaging. An equity indexed annuity s contribution window is the period during which premiums must remain in the daily interest account before being credited to the equity index account. An equity indexed annuity s daily interest account is an account in which the owner s premiums are accumulated when paid. It is convenient to characterize this account as a staging area in which the funds are placed before being moved to the equity index account. While the premiums remain in the daily interest account, they receive interest at a rate declared by the insurer. A declared-rate annuity contract is an annuity contract on which the crediting interest rate is declared from time to time by the issuing insurer. A deferred annuity is an annuity under which a period longer than one payment interval must elapse before the first benefit payment is due. Diversification refers to the inclusion of a number of different investment vehicles in a portfolio in order to increase returns or reduce risk exposure. The basic principle behind the dollar cost averaging concept is that the investor will invest the same amount at regular intervals, irrespective of the price of the purchased securities. Because the same amount is regularly invested, it will purchase a greater number of shares of the security when its price is lower and a fewer number of shares when its price is higher. Because of this dynamic, in a market in which the share price is fluctuating, the investor will always have an average per-share cost that is less than the average per-share price over the purchase period. An equity index is a measure of performance of certain stocks that are included in a particular portfolio in relation to a base value set for that portfolio at an earlier time. The equity index account in an equity indexed product is that account in which the growth, if any, of credited funds is determined by changes in an equity index. An equity indexed annuity is one whose cash values are based on the performance of a selected equity index, such as the S&P 500 Index. If the equity index on which the cash value is based increases the contract s cash value will increase.

57 Exclusion ratio Fixed account A fixed annuity s exclusion ratio is the ratio that the total investment in the contract bears to the total expected return. The exclusion ratio is generally expressed as a percentage and is derived by dividing the investment in the contract by the expected return. It is used to determine the portion of each fixed annuity income payment that is received tax free as a return of cost basis. The fixed account is an investment option in a variable annuity contract that offers owners two important guarantees: The principal invested in the fixed account is guaranteed and A minimum level of interest crediting is guaranteed by the fixed account Fixed amount annuity Fixed 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. 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 Fixed period annuity Flexible premium annuity Guaranteed interest crediting rate 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. 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. A fixed annuity s guaranteed interest crediting rate is that interest rate that the insurer guarantees it will credit to the contract s cash value at a minimum. The insurer must credit interest to the contract s cash value at least equal to its guaranteed interest crediting rate, even though it may be earning less than that amount on its invested assets.

58 Immediate annuity Index call option Index call option budget 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. An index call option is a financial product by virtue of which insurers may hedge against the risk that it will be required to credit excess interest in an equity indexed product. By purchasing an index call option, an insurer insures itself against the probability that it will be required to credit interest in excess of the guaranteed interest. An insurer s index call option budget is the amount of money it has available to purchase the index call options that ensure it will be able to credit any excess interest promised on its equity indexed products. To determine its index call option budget, the insurer deducts from the amount credited to the equity index account certain amounts for: The funds that the insurer needs to invest in bonds and bond-like investments in order to be sure it will have sufficient funds to credit the guaranteed interest Administrative and sales expenses Profits Index term period Installment refund annuity The index term period is the period of time over which equity index benefits are calculated. 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. Interest crediting method The interest crediting method in any equity indexed product is that process by which the amount of interest in excess of the guaranteed interest is determined. The raw interest rate crediting methods normally employed are: Total interest rate methods Annual interest rate methods and Combination indexing methods Interest indexed annuity An interest indexed annuity is one whose cash values are based on the performance of a selected interest index, such as the 10 Year Treasury Note Index.

59 Interest rate cap Interest sweep Joint and survivor annuity LIFO Mortality & expense risk charge (M&E) Multi-year guarantee annuity Non-qualified annuity Participation rate An interest rate cap in an equity indexed product is a limit on the interest rate that will be credited to the funds in the equity index account. The cap may apply to each year in a multi-year index term period, or it may apply to the overall index term period. An equity indexed annuity contract s actual interest rate may be subject to both a cap and a participation rate, each further limiting the interest that is eventually applied to the cash value. Under the interest sweep feature, interest earned in the variable annuity contract s fixed account is swept periodically into one or more of the owner s chosen variable sub-accounts. Interest sweep is usually available monthly, quarterly, semi-annually or annually, and the contract owner needs to indicate the date on which the insurer is to begin making interest sweeps, the frequency of the sweeps and the percentage of the interest swept into each chosen variable subaccount. A joint and survivor annuity is a life annuity under which an income continues until the last of the two covered individuals dies. Under LIFO tax treatment an acronym for last in, first out any gain on the annuity contract is deemed to be distributed before any cost basis is received. The mortality and expense risk charge usually identified as M&E risk charge is designed to cover the insurer s mortality and expense risk. In an annuity contract, the insurer assumes the risk that the group of lives it has insured under its policies will survive longer than expected; this risk is the mortality risk part of the M&E risk charges. Additionally, the insurer assumes the risk that its cost of issuing and administering the variable annuity contracts will exceed its estimates; this is the expense risk part of the M&E risk charges. Insurers typically charge a current M&E risk charge but guarantee that the M&E risk charge will not exceed a guaranteed maximum. A multi-year guarantee annuity is a fixed annuity on which the current interest rate is guaranteed for a period greater than one year. Although some multi-year guarantee annuities offer a two-year rate period, these contracts generally offer current interest rates for periods of three to ten years. Non-qualified annuities are annuities purchased outside of any taxadvantaged plan such as a tax-sheltered annuity or individual retirement account. An equity indexed annuity s participation rate is the percentage of the change in the underlying index that is credited to the contract s cash value.

60 Period certain Qualified funding asset S&P 500 index Separate account Single premium annuity Straight life annuity Suitability Surrender charge Temporary annuity 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. A qualified funding asset is an annuity that is purchased and held to fund periodic payments for damages on account of personal injury or sickness. The S&P 500 Index is one of several major common stock indexes published by Standard & Poor s Corporation and is often the preferred equity index for use in equity indexed products. It is a broad-based index consisting of 500 stocks that are included in the industrials, transportation, utilities and financials index. A variable annuity issuer normally establishes a separate account comprised of a number of variable subaccounts. The separate account is so named because it is separate from the insurer s general asset account. Variable subaccounts are generally differentiated by objective, risk level and underlying portfolio. Single premium annuity contracts are annuities in which only one premium is envisioned. Generally no further premiums are either expected or permitted. 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. When recommending the purchase of a securities product, such as a variable annuity to a customer, NASD rules require that an agent or registered representative must have reasonable grounds to believe that the purchase is suitable for the customer. 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. 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.

61 Total interest rate methods Total interest rate methods of determining excess interest in an equity indexed annuity contract are generally categorized into the following: Long-term point-to-point Long-term point-to-point with average end and Look back methods Tranche Used in connection with an equity indexed product, a tranche is a portion or discrete amount and refers to the bucket of funds that is transferred from the daily interest account to the equity index account in a single tranche.

62 Bond Ratings Moody s S&P Definition Aaa AAA High-grade investment bonds. The highest rating assigned, denoting extremely strong capacity to pay principal and interest. Often called gilt edge securities. Aa AA Hi-grade investment bonds. High quality by all standards, but rated lower primarily because the margins of protection are not quite as strong. A A Medium-grade investment bonds. Many favorable investment attributes, but elements may be present which suggest susceptibility to adverse economic changes. Baa BBB Medium-grade investment bonds. Adequate capacity to pay principal and interest but possibly lacking certain protective elements against adverse economic conditions. Ba BB Speculative issues. Only moderate protection of principal and interest in varied economic times. (This is one of the ratings carried by junk bonds.) B B Speculative issues. Generally lacking desirable characteristics of investment bonds. Assurance of principal and interest may be small; this is another junk bond rating. Caa CCC Default. Poor-quality issues that may be in default or in danger of default. Ca CC Default. Highly speculative issues, often in default or possessing other market shortcomings. C Default. These issues may be regarded as extremely poor in investment quality. C D Default. Rating given to income bonds on which no interest is paid. Default. Issues actually in default, with principal or interest in arrears.

63 BASIC CHARACTERISTICS OF SECURITIES Investment Risk of Principal Loss Return Liquidity Tax Treatment + Comparable Variable Subaccount* Cash & Equivalents Passbook savings Low Low High Ordinary income Not applicable CDs Low Low Moderate Ordinary income Not applicable Money market accounts Low Low High Ordinary income Money market/cash management Treasury bills Low Moderate Moderate State & local tax exempt Debt Investments Corporate bonds Investment grade Low Moderate Low Ordinary income & capital gains Corporate bond High yield High High High Ordinary income & capital gains High yield corporate bond Government securities T-Notes Low Low Moderate State & local tax exempt Government bond T-Bonds Low Moderate Low State & local tax exempt Agency securities Low Moderate High Ordinary income Municipal bonds Low Moderate Low Federal tax exempt/possibly state & local tax exempt Not applicable Equity Investments Blue Chip Stock Moderate High High Ordinary income & capital gains Equity income Growth Stock High High High Ordinary income & capital gains Growth Small Cap Stock High High High Ordinary income & capital gains Small cap International Stock High High High Ordinary income & capital gains International equity *Names shown are the common names generally given to these subaccounts. Particular variable products may choose different names. + Tax treatment shown refers to the tax treatment afforded when not associated with a variable product.

64 Decisional Factors in Variable Annuity Suitability Does customer have sufficient available short-term liquidity? Yes No Does customer have investment goals that are consistent with the long-term nature of an annuity? Yes No Is the customer in a sufficiently high income tax bracket to benefit from tax deferral? Yes No Is the customer likely to be in a lower income tax bracket at the time that annuity funds are withdrawn? Yes No Is the customer s tolerance for risk consistent with his or her subaccount choice? Yes No Does the customer have sufficient life insurance to meet his or her family needs? Yes No Is the customer making full use of corporate and personal retirement plan opportunities? Yes No Is the customer capable of dealing with the additional complexities of the variable annuity monitoring variable subaccounts, obtaining subaccount value information, etc.? Yes No Does the customer understand the various additional fees and charges associated with the variable annuity? Yes No What special variable annuity suitability issues involve this customer? Note: If the answer to any of the above questions is No, the probability of a suitability claim is increased.

65 References Students may wish to consult the following sources for additional study of annuities and their taxation as well as for further information concerning methods of determining cash value in equity indexed products: Brostoff, S. Survey: Most Annuity Buyers Mid-Income National Underwriter Life & Health/Financial Services Edition, September 1, DeSimone, M. Who s Buying Non-Qualified Annuities? National Underwriter Life & Health/Financial Services Edition, June 4, DiBiase, C. Survey Finds Some Surprises In Equity-Indexed Demographics National Underwriter Life & Health/Financial Services Edition, January 3, Graves, E.E., ed McGill s Life Insurance. Bryn Mawr: The American College. Heinz, A Taxation of Financial Products. Chicago: Dearborn. Horwitz, E.J The Sales & Marketing Guide to Equity Index Annuities. Cincinnati: National Underwriter. Miner, D.A., ed, et al Tax Facts 1. Cincinnati: National Underwriter. Mitchel, J. Finances of the Affluent: Special Analysis of the Survey of Consumer Finances Journal of Financial Service Professionals, September Tromblay, D Variable Contracts. Chicago: Dearborn.