4 - HOUR ANNUITY TRAINING COURSE (2013 EDITION)

4 - HOUR ANNUITY TRAINING COURSE (2013 EDITION) Researched and Written by: Edward J. Barrett CFP, ChFC, CLU, CEBS, RPA, CRPS, CRPC

Disclaimer This course is designed as an educational program for financial professionals. EJB Financial Press is not engaged in rendering legal or other professional advice and the reader should consult legal counsel as appropriate. We have tried to provide you with the most accurate and useful information possible. However, one thing is certain and that is change. The content of this publication may be affected by changes in law and in industry practice, and as a result, information contained in this publication may become outdated. This material should in no way be used as an original source of authority on legal and/or tax matters. Any laws and regulations cited in this publication have been edited and summarized for the sake of clarity. Any names used in this publication are fictional and have no relationship to any person living or dead. This presentation is for educational purposes only. The information contained within this presentation is for internal use only and is not intended for you to discuss or share with clients or prospects. Financial professionals are reminded that they cannot provide clients with tax advice and should have clients consult their tax advisor before making tax-related investment decisions. EJB Financial Press, Inc. 7137 Congress St. New Port Richey, FL 34653 (800) 345-5669 www.ejbfinpress.com This book is manufactured in the United States of America 2013 EJB Financial Press Inc. Printed in U.S.A. All rights reserved 2

About The Author Edward J. Barrett CFP, ChFC, CLU, CEBS, RPA, CRPS, CRPC, began his career in the financial and insurance services back in 1978 with IDS Financial Services, becoming a leading financial advisor and top district sales manager in Boston, Massachusetts. In 1986, Mr. Barrett joined Merrill Lynch in Boston as an estate and business-planning specialist working with over 400 financial advisors and their clients throughout the New England region assisting in the sale of insurance products. In 1992, after leaving Merrill Lynch and moving to Florida, Mr. Barrett founded The Barrett Companies Inc., Broker Educational Sales & Training Inc., Wealth Preservation Planning Associates and The Life Settlement Advisory Group Inc. Mr. Barrett is a qualifying member of the Million Dollar Round Table, Qualifying Member Court of the Table and Top of the Table producer. He holds the Certified Financial Planner designation CFP, Chartered Financial Consultant (ChFC), Chartered Life Underwriter (CLU), Certified Employee Benefit Specialist (CEBS), Retirement Planning Associate (RPA), Chartered Retirement Planning Counselor (CRPC) and the Chartered Retirement Plans Specialist (CRPS). About EJB Financial Press EJB Financial Press, Inc. (www.ejbfinpress.com) was founded in 2004, by Mr. Barrett to provide advanced educational and training manuals approved for correspondence continuing education credits for insurance agents, financial advisors, accountants and attorneys throughout the country. About Broker Educational Sales & Training Inc. Broker Educational Sales & Training Inc. (BEST) is a nationally approved provider of continuing education and advanced training programs to the mutual fund, insurance and financial services industry. For more information visit our website at: www.bestonlinecourses.com. Or call us at 800-345-5669. 3

Preface On March 28, 2010, the National Association of Insurance Commissioners (NAIC), the voluntary organization of insurance regulators from the 50 states, the District of Columbia and the five U.S. Territories, adopted and published its 2010 Suitability in Annuity Transactions Model Regulation. This Model Regulation was adopted to set standards and procedures for suitable annuity recommendations and to require insurers to establish a system to supervise recommendations so that the insurance needs and financial objectives of consumers are appropriately addressed. In addition, the Model Regulation, specifically Section 7A, requires the producer to have adequate product specific training, including compliance with the insurer s standards for product training, prior to soliciting an annuity. Also, in Section 7B it requires a one-time, minimum four credit hour general annuity training course offered by an insurancedepartment approved education provider and approved by an insurance department in accordance with applicable insurance education training laws or regulations. For this mandated course, the provider may not train in sales or marketing techniques or product specific information. As of April 29, 2013, Alaska, California, Colorado, Connecticut, Hawaii, Idaho, Iowa, Illinois, Kansas, Maryland, Michigan, Mississippi, New Jersey, New York, North Dakota, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Texas, Utah, Washington, West Virginia, Wisconsin, and the District of Columbia have adopted the 2010 NAIC Model Regulations and training requirements. Note: All states must come into compliance with The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Public Law Number 111-203, 111th Cong., 2d sess. (July 21, 2010) which requires all states to meet the requirements of the 2010 NAIC Model Regulation by June 16, 2013 2013. To help you, the producer, meet the training requirement of Section 7B, this book: 4-Hour Annuity Training Course has been written and submitted to the various state s Department of Insurance for approval as a correspondence self-study course that meets the outline of minimum required topics set forth in Section 7B(3) of the Model Regulation. To receive continuing education credit for this course you must complete either a paper exam or an online exam with a total of 50 questions and receive a passing grade of 70% or higher. 4

TABLE OF CONTENTS About The Author... 3 Preface... 4 CHAPTER 1 ANNUITY BASICS... 11 Overview... 11 Annuity Defined... 11 History of Annuities... 12 Annuities in the United States... 12 Annuity Sales... 13 Annuity Buyers... 14 Primary Uses of Annuities... 15 Classification of Annuities... 15 Purchase Option... 16 Single Premium... 16 Periodic (Flexible) Premium Payments... 16 Date Income Payments Begin... 16 Deferred Annuities... 17 Immediate Annuities... 18 Investment Options... 19 Income Payout Options... 20 Straight (Single) Life Income Option... 20 Cash Refund... 20 Installment Refund Option... 20 Life with Period Certain Option... 20 Joint and Full Survivor Option... 21 Period Certain... 21 Review Questions... 22 CHAPTER 2 FIXED ANNUITIES... 23 Overview... 23 The Fixed Annuity Market... 23 Types of Fixed Annuities... 23 Crediting Rates of Interest... 25 Non-forfeiture Interest Rate... 25 Current Rate of Interest... 26 Portfolio Rate... 27 New Money Rate... 28 Calculating the Rate... 29 Trends... 30 Interest Rate Projections... 30 Bonus Annuities... 30 Two-Tiered Annuities... 31 Fixed Annuity Fees and Expenses... 31 Disadvantages of Fixed Annuities... 32 Fixed Annuitization: Calculating Fixed Annuity Payments... 32 Review Questions... 33 5

CHAPTER 3 VARIABLE ANNUITIES... 35 Overview... 35 VA Defined... 35 The VA Market... 35 VA Product Features... 37 Separate Accounts... 37 Investment Options... 37 Accumulation Units... 38 VA Charges and Fees... 40 Mortality and Expense (M&E) Charge... 40 Management (Fund Expense) Fees... 40 Contract (Account) Maintenance Fees... 41 Summary of Above Fees... 41 Surrender Fees... 42 VA Sales Charges... 43 Premium Tax... 44 Investment Features... 44 Dollar Cost Averaging... 45 Fund Transfers... 46 Asset Allocation... 46 Asset Rebalancing... 47 Guaranteed Minimum Death Benefit... 47 Enhanced Death Benefits... 47 Contract Anniversary, Or Ratchet... 48 Initial Purchase Payment with Interest or Rising Floor... 48 Enhanced Earnings Benefits... 48 Guaranteed Living Benefit (GLB) Riders... 49 Guaranteed Minimum Income Benefit (GMIB)... 50 GMIB Features and Benefits... 50 GMIB Costs... 51 Guaranteed Minimum Account Balance (GMAB)... 51 GMAB Costs... 51 Guaranteed Minimum Withdrawal Benefit (GMWB)... 51 GMWB Costs... 52 Guaranteed Minimum Withdrawal Benefit for Lifetime... 52 GMWBL Features and Benefits... 52 GMWBL Costs... 53 Treatment of Withdrawals... 53 Recent Innovations and Trends of GLBs... 54 Outlook for Variable Annuities... 54 Variable Annuitization: Calculating Variable Annuity Income Payouts... 55 Annuity Units... 56 Assumed Interest Rate (AIR)... 57 Review Questions... 59 CHAPTER 4 INDEX ANNUITIES... 61 Overview... 61 6

IA Defined... 61 IA Market... 61 Profile of an IA Buyer... 63 IA Basic Terms and Provisions... 63 Index Period... 63 Participation Rate... 63 Cap Rate... 64 Spreads or Margins... 64 No-Loss Provision... 65 Guaranteed Minimum Account Value... 65 Liquidity... 65 Fees and Expenses... 66 Surrender Charges... 66 Interest Calculation... 67 Exclusion of Dividends... 67 Crediting Interest... 67 Interest Crediting Methods... 68 Point-to-Point... 68 High Water Mark (Term High Point)... 70 Annual Reset (Ratchet)... 71 Index Averaging... 71 Other Interest Crediting Methods... 72 Multiple (Blended) Indices... 72 Monthly Cap (Monthly Point-to-Point)... 72 Binary, Non-Negative (Trigger) Annual Reset... 72 Bond-Linked Interest with Base... 73 Hurdle... 73 Annual Fixed Rate with Equity Component... 73 Rainbow Method... 74 IA Waivers and Riders... 75 Types of Waivers... 75 Types of Riders... 76 IAs with Bonuses... 76 Regulation of IAs... 77 Review Questions... 79 CHAPTER 5 PARTIES TO THE CONTRACT... 81 Overview... 81 The Owner... 81 Rights of the Owner... 81 Changing the Annuitant... 81 Duration of Ownership... 82 Purchaser, Others as Owner... 82 Taxation of Owner... 82 Death of Owner: Required Distribution... 83 Spousal Exception... 83 The Annuitant... 83 7

A Natural Person... 83 Role of the Annuitant... 84 Naming Joint Annuitants/Co-Annuitants... 84 Taxation of Annuitant... 84 Death of Annuitant... 84 The Beneficiary... 85 Death Benefit... 85 Whose Death Triggers the Death Benefit... 86 Changing the Beneficiary... 86 Designated Beneficiary... 86 Spouse or Children as Beneficiaries... 86 Non-Natural Person as Beneficiary... 86 Multiple Beneficiaries... 87 Taxation of Beneficiary... 87 Death of Beneficiary... 88 Insurance Company... 88 Collecting and Investing the Premium... 88 Paying the Guaranteed Death Benefit... 88 Paying the Guaranteed Income Option... 89 Review Questions... 90 CHAPTER 6 ANNUITIES INSIDE QUALIFIED RETIREMENT PLANS... 91 Overview... 91 Background... 91 Congressional Mandate... 91 Annuities in an IRA... 92 Advantages of Annuities inside a Qualified Retirement Plan... 93 RMD Rule Requirements on Variable Annuity Contracts... 94 Actuarial Present Value Defined... 95 RMD Calculation under the New Rules... 95 Safe Harbor Rules... 95 Example: Calculating RMD Under New Rules... 96 New Proposed Treasury Regulation Longevity Contracts... 97 Review Questions... 98 CHAPTER 7 SUITABILITY OF ANNUITIES... 99 Overview... 99 NAIC Suitability Model... 99 Senior Protection in Annuity Transactions Model Regulation... 99 2010 NAIC Suitability in Annuity Transactions Model Regulation... 100 Determining Suitability... 101 Systems of Supervision and Training... 102 FINRA Compliance... 103 FINRA Regulation of VA... 104 FINRA Rule 2821... 104 FINRA Rule 2330... 106 FINRA Rule 2111... 107 FINRA Rule 2090: Know Your Customer... 107 8

SEC Approves Consolidated FINRA Rules... 108 Effective Date... 108 Review Questions... 109 CHAPTER 8 UNFAIR MARKETING PRACTICES... 111 Overview... 111 Misrepresentation... 111 Fraud... 111 Altering Applications... 111 Premium Theft... 112 False or Misleading Advertising... 112 Defamation... 112 Boycott, Coercion, Intimidation... 112 Twisting... 113 Churning... 113 Discrimination... 113 Rebating... 113 Unsuitable Replacements... 114 Purpose... 114 Application... 114 Duties of Insurance Producers... 115 Duties of Insurers That Use Agents... 116 Duties of Replacing Insurers that Use Agents... 118 Duties of Existing Insurer... 119 Use of Senior Specific Certifications and Designations... 120 Annuity Disclosure Model Regulation... 121 Fixed and Index Annuities... 121 Variable Annuities... 122 Recordkeeping... 122 Review Questions... 124 Chapter Review Answers... 125 Confidential Feedback... 127 9

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

survivorship factor provides insurers with the means to guarantee annuity payments for life, regardless of how long that life lasts. Don t get confused between an annuity and a life insurance contract. Annuities are not life insurance contracts. Even though it can be said that an annuity is a mirror image of a life insurance contract they look alike but are actually exact opposites. Life insurance is concerned with how soon one will die; life annuities are concerned with how long one will live. History of Annuities As mentioned above, annuities can actually trace their origins back to Roman times. Back then, dealers sold contracts called annua, or annual stipends yearly payouts for life. Roman citizens would make a one-time payment to the annua, in exchange for lifetime payments made once a year. Annuity comes from the Latin word annuus, meaning yearly. During the 17 th century, annuities were used as fundraising vehicles. In Europe, governments were constantly looking for revenue to pay for massive, on-going battles with neighboring countries. The governments would then create a tontine, promising to pay for an extended period of time if citizens would purchase shares today. The United Kingdom, locked in many wars with France, started one of the first group annuity contracts called the State of Tontine of 1693. Participants in these early government annuities would purchase a share of the Tontine for 100 from the UK Government. In return, the owner of the share received an annuity during the lifetime of their nominated person (often a child). As each nominee died, the annuity for the remaining proprietors gradually became larger and larger. This growth and division of wealth would continue until there were no nominees left. Proprietors could assign their annuities to other parties by deed or will, or they passed on at death to the next of kin. Annuities in the United States Annuities made their first mark in America during the 18th century. In 1759, a company in Pennsylvania was formed to benefit Presbyterian ministers and their families. Ministers would contribute to the fund, in exchange for lifetime payments. It wasn t until 1912 that Americans could buy annuities outside of a group. The Pennsylvania Company for Insurance on Lives and Granting Annuities was the very first American company to offer annuities to the general public. Annuities constituted a small share of the U.S. insurance market until the 1930s, when two developments contributed to their growth. First, concerns about the stability of the financial system drove investors to products offered by insurance companies, which were perceived to be stable institutions that could make the payouts that annuities promised. 12

Flexible payment deferred annuities, which permit investors to save and accumulate assets as well as draw down principal, grew rapidly in this period. Second, the group annuity market for corporate pension plans began to develop in the 1930s. The entire country was experiencing a new emphasis saving for a rainy day. The New Deal Program introduced by President Franklin D. Roosevelt (FDR) unveiled several programs that encouraged individuals to save for their own retirement. Annuities benefited from this new-found savings enthusiasm. By today s standard, the first modern-day annuities were quite simple. These contracts guaranteed a return of principal, and offered a fixed rate of return from the insurance company during the accumulation period (Fixed Annuity). When it was time to withdraw from the annuity, you could choose a fixed income for life, or payments over a set number of years. There were few bells and whistles to choose from. What was always proved to be attractive about annuities was their tax-deferred status because they were issued by insurance companies. That all changed beginning in 1952, when the first variable annuity was created by the College Retirement Equities Fund (CREF) to supplement a fixed-dollar annuity in financing retirement pensions for teachers. Variable annuities credited interest based on the performance of separate accounts inside the annuity. Variable annuity owners could choose what type of accounts they wanted to use, and often received modest guarantees from the issuer, in exchange for greater risks they (the owner) assumed. This type of annuity was then made available to any individual, when the Variable Life Insurance Company (VALIC) in 1960, began to market its own nonqualified variable annuity. It was the variable annuity that boosted the popularity of annuities. Then in 1994, Keyport Life Insurance Company introduced a new type of a fixed annuity called an index annuity. And the rest is history. Annuity Sales For 2012, annuity sales dropped 8 percent, according to LIMRA s fourth quarter 2012 U.S. Individual Annuity Sales survey, which represents data from 95 percent of the market. Fourth quarter sales were also down 8 percent, suggesting the downward trend continues. Total annuity sales were $52.6 billion in the fourth quarter. For the full year, annuity sales were down Total annuity sales were $219.4 billion (see Table 1.1). 13

Annuity Buyers Table 1.1 Total U. S. Individual Annuity Sales and Assets 2000 2012 ($ billions) YEAR SALES ASSETS 2000 $190.0 $1,278.5 2001 187.6 1,236.8 2002 218.3 1,216.6 2003 215.8 1,483.9 2004 217.6 1,634.2 2005 212.6 1,721.3 2006 232.9 1,893.7 2007 255.0 1,996.2 2008 265.0 1,682.8 2009 238.6 1,973.7 2010 210.0 2,035.2 2011 240.3 2,444.1 2012 219.4 2,765.4 Source: Morningstar Inc. and LIMRA International, Windsor, Conn (Estimate from a survey of 60 insurers that account for 95 percent of Total U.S. annuity sales, March 2013). In another survey conducted by LIMRA, more than three-quarters of recent annuity buyers are satisfied with their purchase of an annuity. LIMRA published this finding in a summary of results from a survey of 1,200 consumers age 40 or over who purchased a retail deferred annuity within the past three years. The study was conducted in the third quarter of 2011. Nearly 9 in 10 buyers of traditional fixed annuities are happy with their purchase, new research reveals. The survey reveals that 86% of traditional fixed annuity buyers are satisfied with their deferred annuity purchase. Likewise, most buyers are variable annuities (75%) and indexed annuities (83%) are also satisfied with the purchases, the survey reveals. LIMRA observes that, of those who are satisfied, two-thirds of the VA households (61% for indexed and half for traditional fixed) own two or more annuities. The study also discloses that five of six deferred annuity buyers would recommend an annuity to their friends or family. 14

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

Purchase Option An annuity begins with a sum of money, called principal. Annuity principal is created (or funded) in one of two ways; immediately with a single premium or over time with a series of flexible premiums. Single Premium A single premium annuity is basically just what the name implies; an annuity that is funded with a single, lump-sum premium, in which case the principal is created immediately. Usually, this lump sum is fairly large. Periodic (Flexible) Premium Payments But not everyone has a large lump sum with which to purchase an annuity. Annuities can be funded through a series of periodic (flexible) premiums payments that, over time, will amass an amount large enough to buy a significant annuity benefit. At one time, it was common for insurers to require that periodic annuity premiums be fixed, and level, much like insurance premiums. Today, it is more common to allow contract owner s flexibility as to allowing premiums of any size (within certain minimums and maximums, such as none less than $25 or more than $2,000,000) and at virtually any frequency. Date Income Payments Begin The annuity is the only investment vehicle that has two phases based upon when the income payment begins. The phases are: Deferred (Accumulation Phase); or Immediate. (Pay-out/Distribution Phase) The main difference between deferred and immediate annuities is when annuity payments begin. Every annuity has a scheduled maturity or annuitization date (usually age 90 or age 95), which is the point the accumulated annuity funds are converted to the payout mode and benefit payments to the annuitant are to begin. According to LIMRA, of the $219.4 total sales of annuities in 2012, sales of deferred annuities were $207.0 billion and $12.4 billion were immediate annuities (see Table 1.3). 16

Table 1.3 Annuity Industry Total Sales Deferred vs. Immediate Annuities 2000-2012 ($ billions) YEAR DEFERRED IMMEDIATE TOTAL 2000 $ 181.1 $ 8.8 $189.9 2001 175.0 10.3 185.3 2002 208.6 11.3 219.9 2003 207.5 8.3 215.8 2004 209.2 11.6 220.8 2005 204.9 11.5 216.4 2006 226.3 12.4 238.7 2007 243.8 13.0 256.8 2008 250.6 14.4 265.0 2009 225.4 13.2 238.6 2010 209.0 13.5 221.3 2011 227.1 13.2 240.3 2012 207.0 12.4 219.4 Deferred Annuities Source: Morningstar Inc. and LIMRA International, March, 2013; Includes Structured Settlements reporting sales of $5.1billion Deferred annuities are designed for long-term accumulation and can provide income payments at some specified future date. A deferred annuity can be funded with either periodic payments, commonly called flexible premium deferred annuities (FPDAs), or funded with a single premium, in which case they re called single premium deferred annuities, or SPDAs. While a deferred annuity has the potential of providing a guaranteed lifetime income at some point in the future, the current emphasis in a deferred annuity is on accumulating funds rather than liquidating funds. An advantage that deferred annuities have over many other long-term savings vehicles is that there are no taxes (tax-deferral) paid on the accumulated earnings in an annuity until withdrawals are made. 17

Immediate Annuities An immediate annuity is designed primarily to pay income benefit payments one period after purchase of the annuity. Since most immediate annuities make monthly payments, an immediate annuity would typically pay its first payment one month (30 days) from the purchase date. If, however, a client needs an annual income, the first payment will begin one year from the purchase date. Thus, an immediate annuity has a relatively short accumulation period. As you might guess immediate annuities can only be purchased with a single premium payment and are often called single-premium immediate annuities, or SPIAs. These types of annuities cannot simultaneously accept periodic funding payments by the owner and pay out income to the annuitant. The average age of a SPIA buyer is 73. A once-snubbed annuity product the income annuity appears to be gaining a foothold in the broad annuity marketplace and in the practices of advisors who serve the boomer and retirement income markets. However, for 2012, SPIA sales were $7.7 billion vs. $8.1 billion in 2011, a decline of 5 percent (see Table 1.4). Table 1.4 Total Sales of Immediate Annuities 2000-2012 ($ billions) YEAR VARIABLE FIXED TOTAL 2000 $ 0.6 $ 8.0 $ 8.6 2001 0.6 9.6 10.2 2002 0.5 10.7 11.2 2003 0.5 4.8 5.3 2004 0.4 6.1 6.5 2005 0.6 6.3 6.9 2006 0.8 6.3 7.1 2007 0.3 6.7 7.0 2008 0.4 8.6 9.0 2009 0.1 7.5 7.6 2010 0.1 7.6 7.7 2011 0.1 8.0 8.1 2012 0.1 7.6 7.7 Source: Morningstar Inc. and LIMRA International, March 2013. Does not include Structured Settlements. 18

Investment Options An annuity can be classified by two types of investment options. They are: Fixed Annuity (FA) Variable Annuity (VA) The most popular type of annuity sold is the variable annuity. In 2012, we saw variable annuity sales decrease 7 percent to $147.4 billion from sales of $159.3 billion in 2011. Sales of fixed annuities decreased to $72 billion from $80.5 billion, a decrease of 11 percent. Overall, total annuity sales decreased to $219.4 billion from $238.4 billion, a decrease of 8 percent (see Table 1.5). Table 1.5 Annuity Industry Total Sales Variable vs. Fixed 2000 2012 ($ billions) YEAR VARIABLE FIXED TOTAL SALES 2000 $ 137.3 $ 52.7 $ 190.0 2001 113.3 74.3 187.6 2002 115.0 103.3 218.3 2003 126.4 84.1 215.8 2004 129.7 86.7 217.6 2005 133.1 77.0 212.6 2006 157.3 74.0 235.6 2007 182.2 66.8 255.0 2008 155.6 106.7 264.1 2009 128.0 110.6 238.6 2010 140.5 81.9 222.4 2011 159.3 80.5 238.4 2012 147.4 72.0 219.4 Source: Morningstar Inc. and LIMRA International, March 2013 19

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

the same payments for four more years. Of course, if the annuitant died after receiving monthly annuity payments for ten or more years, his or her beneficiary would receive nothing from the annuity. Joint and Full Survivor Option The joint and full survivor option provides for payment of the annuity to two people. If either person dies, the same income payments continue to the survivor for life. When the surviving annuitant dies, no further payments are made to anyone. There are other joint arrangements offered by many companies: Joint and Two-Thirds Survivor. This is the same as the above arrangement, except that the survivor s income is reduced to two-thirds of the original joint income. Joint and One-Half Survivor. This is the same as the above arrangement except that the survivor s income is reduced to one-half of the original joint income. Period Certain The period certain option is not based on life contingency; instead it guarantees benefit payments for a certain period of time, such as 5, 10, 15, or 20 years, whether or not the annuitant is living. At the end of the specified term, payments cease. Income Payment Options Table 1.6 Comparison of Monthly Settlement Options Male Estimated Monthly Income Cash Flow Female Estimated Monthly Income Cash Flow Single life income no payments to beneficiaries $567 6.80% $517 6.20% Single life w/10 years certain $545 6.54% $505 6.06% Single life w/20 years certain $487 5.84% $460 5.52% Single Life w/installment Refund $515 6.18% $483 5.80% Income Payment Options Estimated Monthly Cash Flow Income Joint Life 100% Survivor (no payments to beneficiaries) $473 5.68% Joint Life 100% Survivor (10 year certain) $470 5.64% 5-Year Period Certain $1,691 20.29% 10-Year Period Certain $907 10.88% *Assumptions: Male age 65; Female age 65; Annuitize $100,000. Source: www.immediateannuities.com 4/25/2013. 21

Chapter 1 Review Questions 1. Annuity comes from the Latin word annuus which means: ( ) A. Yearly ( ) B. Stipend ( ) C. Payment ( ) D. Guaranteed 2. In 1952, the first variable annuity was created by: ( ) A. The Romans ( ) B. College Retirement Equities Fund (CREF) ( ) C. Presbyterian ministers ( ) D. Variable Annuity Life Insurance Company 3. What is the average age of a SPIA buyer? ( ) A. 55 ( ) B. 73 ( ) C. 60 ( ) D. 63 4. Which type of annuity will begin to make annuity payments one month after the purchase payment? ( ) A. Deferred annuity ( ) B. Period certain annuity ( ) C. Immediate annuity ( ) D. Temporary annuity 5. According to LIMRA, what is the major reason a consumer purchases an annuity? ( ) A. Pay for LTC premiums ( ) B. Pay for emergencies only ( ) C. Leave an inheritance ( ) D. Supplement Social Security or pension income 22

CHAPTER 2 FIXED ANNUITIES Overview A fixed annuity is an investment vehicle offered by an insurance company that guarantees to pay a stated rate of interest for a specified period of time. The investor (contract owner) has the choice to accumulate the interest on a tax-deferred basis or take it as income. With a fixed annuity, the insurer, not the insured, accepts the investment risk. In this chapter we will review the fixed annuity market, the various types of fixed annuities, and their advantages and disadvantages. The Fixed Annuity Market Premiums made to a fixed annuity are invested in the insurance companies general account. The company then invests the premiums it receives in a manner that will allow it to credit the rates it has stated it will pay. The interest rate chosen by the insurance company during the first year is meant to be competitive with rates currently offered on other financial vehicles. Of course, one of the major features of a fixed annuity is safety. Safety of principal and also safety in that the rate of return is certain. However, with the low interest rate environment over the past few years we have seen an overall decline in the sales of fixed annuities. According to LIMRA and IRI/Beacon Research, total sales of fixed annuities reached a ten year low of $72.0 in 2012, down 11 percent from $81.0 billion in 2011, (see Table 2.1). On the bright side, index annuities hit a record high of $33.9 billion a five percent increase compared to sales in 2011. And, fourth quarter sales of deferred fixed annuity sales reached $390 million, which is almost 150 percent higher than sales in the first quarter ($160 million). But, they are still a very small part of the overall market. Types of Fixed Annuities The basic types of deferred fixed annuities can be broken down into the following categories. They are: Book value deferred annuity products earn a fixed rate for a guaranteed period. The surrender value is based on the annuity s purchase value plus a credited 23

interest, net of any charges. Book value products are the predominant fixed annuity type sold in banks. Market value adjusted annuities are similar to book value deferred annuities but the surrender value is subject to a market value adjustment based on interest rate changes. Index annuities guarantee that a certain rate of interest will be credited to premiums paid but also provide additional credited amount based on the performance of a specified market index (such as the S&P 500 ). Income Payout Annuities guarantee life of the annuitant (or joint annuitant) either immediately or deferred. Table 2.1 Fixed Annuity Sales and Net Assets 2000-2012 ($ billions) YEAR TOTAL SALES NET ASSETS 2000 $ 52.7 $ 322.0 2001 74.3 351.0 2002 103.3 421.0 2003 84.1 490.0 2004 86.7 510.0 2005 77.0 534.0 2006 74.0 537.0 2007 66.6 511.0 2008 106.7 556.0 2009 104.3 620.0 2010 81.9 659.0 2011 81.0 685.5 2012 72.0 545.0 e Source: LIMRA International and Morningstar, Inc. February 2013. Net Assets are estimated. Types of immediate (fixed income) annuities: Structured settlement annuities are used to provide ongoing payments to an injured party in a lawsuit. Single premium immediate annuities (SPIAs) are usually purchased with a lump sum and payments begin immediately (usually within 30 days) or within one year after the annuity is purchased. 24

As reported by LIMRA International, traditional book value and market value adjusted (MVA) annuity sales were hit hard by the decline in interest rate spreads in 2011 and 2012. Book value sales decreased another 29 percent to $21.2 billion in 2012 from $29.9 billion in 2011, while market-adjusted products also decreased another 13 percent to $4.5 billion from $5.2 billion in 2011. The bright spot was a 5 percent increase in index annuities to $33.9 billion from $32.2 billion in 2011. Immediate fixed annuities decreased 5 percent to $7.7 billion compared to sales of $8.1 billion in 2011 and structured settlements saw a 8 percent decrease to total sales of $4.7 billion from sales of $5.1 billion in 2011 (see Table 2.2). Table 2.2 2012 Fixed Annuity Sales $35.0 $30.0 $25.0 $20.0 $15.0 $10.0 $5.0 $0.0 $25.7 Fixed Rate Deferred $21.2 Book Value $4.5 Market Value adjusted $33.9 Indexed $7.7 Immediate Annuity $4.7 Structured Settlements Source: U.S. Individual Annuities Survey, LIMRA, Windsor, Conn March 2013. Crediting Rates of Interest Typically, a fixed annuity contract will offer two interest rates: a guaranteed rate and a current rate. The guaranteed rate is the minimum rate that will be credited to funds in the annuity contract regardless of how low the current rate sinks or how poorly the issuing insurance company fares with its investment returns. A typical guaranteed interest rate is between 1.5% and 3%. Non-forfeiture Interest Rate In 2003, the National Association of Insurance Commissioners (NAIC) adopted a new annuity Standard Non-forfeiture Law (SNFL) that ties the minimum interest rate that must be paid by fixed annuities to current yields. Prior to this, the state-mandated minimum interest rate was 3% in most states. During times of extremely low interest rates, this made profitably crediting an interest rate above 3% difficult and sometimes impossible. As a result, many companies had no choice but to pull specific products or interest rate guarantee periods from the market. With the new law, the rate floats between 1% and 3%. The standard does not become effective until adopted by individual states, but almost all states now have enacted one of 25

two types of relief either in the form of a 1.5% minimum guaranteed interest rate, or a rate that moves with prevailing interest rates. Current Rate of Interest The current interest rate (excess rate) varies with the insurance company s returns on its investment program. Some annuity contracts revise the current rate on a monthly basis; others change the current interest rate only one time each year. As mentioned earlier, today s low credited interest rates in fixed annuities has caused a major decline in sales. Rates for 2012 however, are even lower than a year ago. According to the Fisher Index (see Table 2.3 below and on the following page), the Index tracks average fixed annuity rates over one-year periods and CD type of annuities. For Example: As of February 7, 2012, the average first year fixed rate for a fixed annuity on the high norm was 2.84% and the low norm was 0.89%. That s for nearly 590 products issued by almost 75 carriers. But a similar pattern holds for five-year CD rates and treasury bonds, with interest rates in both products lower than a year ago. So fixed annuity rates are tracking with trends in the overall environment. As of March 8, 2013, fixed annuity rates continued to remain below 3 percent. The highest-paying five-year fixed annuity was crediting 1.60 percent at the beginning of March 2013, according to the Fisher Annuity Index. Table 2.3 Interest Rate Trends on Fixed Annuities Report Date: 1 st Year Interest Rate Trends On Traditional Fixed Annuities Normal Annuity Range # of # Of Lowest Low Average High Highest Companies Annuities Rate Norm Rate Norm Rate Std. Deviation 04/08/2013 70 543 0.50% 0.76% 2.53% 4.30% 12.20% 2.08% 04/01/2013 71 550 0.50% 0.77% 2.53% 4.29% 12.20% 2.08% 03/11/2013 72 543 0.50% 0.77% 2.55% 4.33% 12.20% 2.09% 10/08/2012 74 564 0.50% 0.79% 2.52% 4.24% 12.20% 2.09% 04/09/2012 74 574 1.00% 0.95% 2.87% 4.79% 12.20% 2.15% 26

Table 2.3 Cont. Average Rates for CD Type or Multi-Year Guarantee (MYG) Annuities Note: Averages and number of annuities count each band/tier as a separate annuity for this summary. Years 1 2 3 4 5 6 7 8 9 10 # of Companies # of Annuities 0 2 15 8 49 17 36 14 15 22 0 3 26 16 105 47 94 34 29 42 04/08/13 1.13% 1.46% 1.52% 1.65% 1.60% 1.78% 2.06% 2.27% 2.18% 04/01/13 1.13% 1.46% 1.52% 1.63% 1.60% 1.76% 2.08% 2.29% 2.20% 03/11/13 1.13% 1.46% 1.52% 1.63% 1.60% 1.75% 2.06% 2.28% 2.19% 10/08/12 1.10% 1.13% 1.49% 1.39% 1.62% 1.54% 1.72% 1.99% 2.15% 2.09% 04/09/12 1.10% 1.08% 1.61% 1.55% 1.75% 1.85% 1.98% 2.30% 2.46% 2.49% Source: Fisher Annuity Index, 13140 Coit Rd #102 Dallas, Texas 75240 Once the interest rate on an annuity contract has been set, there remains at least one other item to understand regarding the method in which the interest will be credited to the funds placed in the annuity. This item is the method of interest rate crediting that the insurance company will apply to the specific annuity contract. Generally, there are two methods of crediting interest: Portfolio (average) Rate Method, and New Money Rate Method. Portfolio Rate The portfolio (average) rate method credits policyholders with a composite of interest that reflects the company s earnings on its entire portfolio of investments during the year of crediting. During periods of rising interest rates, the interest credited to the new contribution received during the year will be heavily influenced by the interest earned on investments attributable to old contributions those received and invested 5, 10, 15 or more years earlier. The interest credited will therefore be stabilized. To illustrate this method under both a rising and declining interest trend, see Illustration 2.4. Under the steadily increasing trend, the contribution made in year 1 earns 3.0%, all funds in the account (new or old) in year 2 earn 4.0%, and all funds in the account during year 3 earn 5.0%. 27

Illustration 2.4 Illustrative Comparison of Increasing and Decreasing Portfolio Rates Increasing Rates Year Year 1 Year 2 Year 3 One 3% 4% 5% Two 4% 5% Three 5% Decreasing Rates Year Year 1 Year 2 Year 3 One 5% 4% 3% Two 4% 3% Three 3% New Money Rate Under the new money rate (sometime referred to as the banding approach, or investment year method of crediting interest), the contributions made by all contract holders in any given period are banded together and credited with a rate of interest consistent with the actual yield that such funds obtained during the period. Thus, even though a company s average return on all money may be only 5% in a given period, the contributions made by all participants during the current period may be credited with the 5.0% if the company was able to make new investments that, on average, returned in excess 5.0% interest. Moreover, the interest rate credited on those contributions should continue to earn 5.0% until the monies are reinvested. After reinvestment, the interest on these contributions will change and the rate credited to contributions banded in the following period could be higher or lower. Under a trend of increasing interest, and assuming monies are reinvested every year, an investment in year 1 earns 5.0% (the new money rate for that year) and then earns 5.25% in the second year and 5.50% in the third year (see Illustration 2.5 on the following page). An investment in year 2 earns 6.0% (the new money rate for that year) and then earns 6.00% in the second year and 6.25% in the third year. Finally, an investment in year 3 earns 7.0%. 28

Illustration 2.5 Illustrative Comparison of Increasing and Decreasing Portfolio Rates Increasing Rates Year Year 1 Year 2 Year 3 One 5.00% 5.25% 5.50% Two 6.00% 6.25% Three 7.00% Decreasing Rates Year Year 1 Year 2 Year 3 One 5.00% 4.50% 4.50% Two 4.00% 4.00% Three 3.00% Note: The higher rates were used for the new money rate illustration. That is because the portfolio rate includes the return on investments made in earlier years at lower rates. The illustrations points out three things. First and most important, it is deceptive to compare the current interest rate between two companies using different approaches. Second, the new money rate method is advantageous to the participant when interest rates are increasing. Third, in a declining interest rate period, the portfolio method has merit. Another consideration in analyzing the products of tax-deferred annuity companies that use the new money approach is how funds are treated when a participant makes a partial withdrawal of funds. There are three approaches that are used: LIFO, FIFO and HIFO. Last In, First Out (LIFO) means that the sum withdrawn will be taken from the most recent contribution band. First In, First Out (FIFO) means that the sum withdrawn will be taken from the earliest contribution band. Highest In, First Out (HIFO) means that the sum withdrawn will be taken from the band that is being credited with the highest interest rate. Keep in mind that, although interest rates are very important, they are but one of several items to be considered when selecting a fixed annuity. Calculating the Rate Whether the portfolio rate or the new money rate method is used, there are several approaches used to arrive at the actual numerical rate to be credited. A common approach is to credit a rate (or rates, in the case of the new money rate method) that reflects the company s earnings on its entire portfolio of investments during the year in question. Another approach would be to use an expected rate of return on the accumulations. 29

Trends In valuing the rate of interest credited (rate of return) on their investments, a number of insurance companies have moved from the calendar year to a quarterly approach. Some have even adopted techniques for valuing the return on a daily basis. The objective of such a move is twofold: The insurance company can move quickly if it believes the spread between the rate of return actually being earned on its investment and the rate credited to the contract is moving in a direction disadvantageous to its best interests, and Competitive position in the marketplace can be maintained, especially when interest rates increase sharply. Interest Rate Projections Most companies sales literature will show projections for the guaranteed interest rate, however, these types of data provide little, if any, information to help select an annuity. Since projected values are hypothetical, their use as an instrument of prediction is significantly flawed. Only when a company has established a trend of consistently high historical current interest rates do projections of future accumulations become significant. Bonus Annuities Some insurance companies declare a bonus rate of interest that will be paid on top of a current or base rate offered on an annuity contract. This bonus is designed to attract new business to the insurance company. The bonus amount offered by many insurance companies can range from one percent to five percent of the original single premium payment. For example, if an applicant purchases an annuity with a single premium of $100,000, and the extra credit sign-up bonus is 5 percent, the account value will be $105,000. Some insurers may credit the bonus with the initial premium payment and or may credit the premium payments made within the first year of the annuity contract. Under some annuity contracts, the insurer will take back all bonus payments made to the annuity holder within the prior year or some other specified date, if the annuity holder makes a withdrawal, if a death benefit is paid to the annuity holder s beneficiaries upon the annuitant s death, or in other circumstances. Though this feature is attractive, there might be some hidden costs. Some companies charge extra fees and/or extend surrender periods. Some contracts may impose higher mortality and expense (M&E) charges, while others may impose a separate fee specifically to pay for the bonus feature. As the insurance producer, it is your responsibility to understand these costs and fully disclose to the purchaser of an annuity. 30

Two-Tiered Annuities A two-tiered annuity is basically a dual-fund, dual-interest rate contract. The two funds are the accumulation account and the surrender value. There is a permanent increasing surrender charge. The interest rate offered is a relatively high interest rate, but only if the owner holds the contract for a certain number of years and then must annuitize the contract. If the annuity is surrendered at any point prior to the contract period, the interest credited to the contract is recalculated from the contract s inception using a lower tier of interest rates. The higher tier of rates is designed to reward annuitization and to make the product more attractive than competing annuities, the lower tier of rates generally makes the contract very unattractive compared to other alternatives. And the interest penalty applies under some contracts even if the annuity is surrendered due to the death of the owner. This type of fixed annuity contract has come under scrutiny by state insurance departments in how they are marketed and sold especially to seniors. Fixed Annuity Fees and Expenses Fixed annuity fees and expenses generally cover the insurance company's administrative expenses, the cost of offering the annuitization guarantee and profits to the insurance company and sales agent. This may be called the Mortality and Expense (M&E) charge. A fixed annuity does not have separate account management (as a variable annuity). Instead, they are claims on the general fund of the insurance company. As such, they don t have expense ratios. But they do have other expenses such as: Contract Charge: The rate quoted is the rate paid. Some fixed annuities may assess an annual contract fee, typically around $30 to $50. Interest Spread: Just like other investments fixed annuities have fees and expenses. Most fees and expenses of a fixed annuity are factored into the stated annual percentage rate (APR) the investor is quoted, this is known as the interest spread. Surrender Charge: Most fixed annuity contracts impose a contract surrender charge on partial and full surrenders from the contract for a period of time after the annuity is purchased. This surrender charge is intended to discourage annuity holders from surrendering the contract and to allow the insurance company to recover its costs if the contract does not remain in force over a specific period of time. 31

Disadvantages of Fixed Annuities Like everything else in life, even though fixed annuities offer several advantages, they also have their disadvantages. Probably the most significant disadvantage is that by locking in the fixed annuity s fixed rate of interest, the policyholder might lose out on any potentially greater gains that could be realized if the same funds were invested in the stock market. A second potential disadvantage of the fixed annuity involves the fact that the benefit payout amount will be a fixed amount. While this fixed payout amount will be viewed by some annuity holders as a decided advantage, others will realize that, over time, the fixed benefit amount will lose ground against inflation with the potential reduction of spending power over time. For example, if we have annual inflation of 4 percent, the purchasing power of the fixed monthly payment would be halved in 18 years. Fixed Annuitization: Calculating Fixed Annuity Payments Another aspect of the fixed annuity that is fixed is the amount of the benefit that will be paid out when the contract is annuitized. Fixed annuity payments are determined by insurance company annuity tables that give the first payment value per $1,000, which depends on: The age of the annuitant, The sex of the annuitant, The payout options chosen, and Deductions for expenses. Thus, if an annuitant has $100,000 in his/her account, and the value is $5 per $1,000, then the first payment will be $500. For a fixed annuity, this will be the value of all subsequent payments. This would be true whether the insurance company s investment returns are better or worse. 32

Chapter 2 Review Questions 1. In a fixed annuity, who assumes the investment risk? ( ) A. Owner ( ) B. Annuitant ( ) C. Insurance company ( ) D. Beneficiary 2. Which of the following is an advantage of investing in a fixed annuity? ( ) A. Safety of principal ( ) B. Protection against inflation ( ) C. Returns tied to the stock market ( ) D. Invest in sub-accounts 3. What type of fixed annuity s account value is subject to a market value adjustment based on interest rate changes? ( ) A. Bonus Annuity ( ) B. Two-tiered Annuity ( ) C. Index Annuity ( ) D. Market Value Adjusted Annuity 4. Which type of interest rate crediting method reflects the company s earnings on its entire portfolio during the year of crediting? ( ) A. Old Money Rate ( ) B. Portfolio Rate ( ) C. New Money Rate ( ) D. Current Money Rate 5. Which method is used when taking a withdrawal from an annuity from funds recently contributed? ( ) A. HILO ( ) B. LIFO ( ) C. HIFO ( ) D. FIFO 33

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CHAPTER 3 VARIABLE ANNUITIES Overview Variable annuities have become part of the retirement and investment plans of many Americans. In this chapter we will define a variable annuity what they are, the market, their features and benefits, as well as the various charges and fees. At the end of the chapter we will review the future trend of VAs and their regulation. VA Defined A variable annuity (VA) is a long-term tax-deferred contract between an investor (contract owner/holder) and an insurance company, under which the insurer agrees to make periodic payments, either immediately or at some time in the future. A VA offers a range of investment options, known as sub-accounts (discussed below). Opposite a fixed annuity, it is the investor (contract owner/holder) who assumes all of the investment risk. The VA Market As previously discussed in Chapter 1, the first variable annuity in the U.S. was created back in 1952 for teachers who participated in the College Retirement Equities Fund (CREF) of the Teachers Insurance and Annuity Association (TIAA). Soon after CREF established its variable annuity, financial planner John D. Marsh conceived a variable annuity that would be available to the general public. Mr. Marsh began his quest in 1955 when he and a group of associates established the Variable Annuity Life Insurance Company (VALIC). However, it wasn t until May 13, 1960, that the first commercial variable annuity prospectus became available in the United States, and, with it, the first insurance company separate account. And the rest is history. For most of this decade, VAs has been one of the most popular investment products offered by insurers. The attractions of tax-deferred growth, guarantees and a broad range of investment choices made VAs one of the fastest growing products in the insurance industry. U.S. VA gross sales had been increasing steadily from 2001 to 2007. By 2005, VA gross sales had rebounded virtually to 2000 levels (a historic high). In 2007, U.S. VA gross sales totaled $182.2 billion, again the highest in history. 35

Then in 2008, the financial market crisis led to a downturn in VA sales. Total gross VA sales in 2008 were $154.8 billion, representing a 15 percent decrease in sales from 2007. VA sales also showed a further decline in 2009, with sales of $125.0 billion, representing a 19 percent decrease from 2008 sales. Beginning in 2010 and 2011, we saw the economy recover and demand for guaranteed income riders surged. VA gross sales increased 13 percent in 2011 to $159.3 billion from 2010 sales of $140.5 billion. Total VA assets at the end of 2011 were $1.5 trillion. However, for 2012, total VA sales decreased 7 percent to $147.4 billion from $159.3 billion in 2011. Unlike historical trends mentioned above, VA sales did not follow equity market growth, which increased 13 percent in 2012. Table 3.1 illustrates the trends in VA gross sales over time from 2000 to 2012. Table 3.1 U. S. Sales of Variable Annuities and Net Assets 2000-2012 ($ billions) YEAR TOTAL SALES ASSETS 2000 $ 137.3 $ 956.5 2001 113.3 885.8 2002 115.0 795.6 2003 126.4 999.3 2004 129.7 1,124.0 2005 133.1 1,187.3 2006 157.3 1,356.7 2007 182.2 1,485.2 2008 154.8 1,126.8 2009 125.0 1,353.7 2010 140.5 1,505.0 2011 159.3 1,502.3 2012 147.4 1,659.5 Source: LIMRA International; Beacon Research, Evanston, Ill. March 2013, Insured Retirement Institute (IRI) 2012 Fact Book. 36

VA Product Features Just as there are characteristics of the fixed annuity that are consistent from product to product, as discussed in Chapter 2, so too there are certain features shared by all variable annuities. Let s begin our discussion with some of the basic features of the variable annuity and then, we will review the optional protection benefits (riders) that are used to design the new versions of the variable product. Separate Accounts The variable annuity is characterized by a separate account (also known as sub-accounts) that holds all of the variable account options. The separate account receives its name because it is not part of the general account assets of the insurance company. Instead they are investment fund options or sub-account that make-up the variable annuity. Actually, the separate account is maintained solely for the purpose of making investments for the contract owner. This transfers the risk from the insurer to the contract owner. The separate accounts are not insured (guaranteed) by the insurance company, except in the event of the owner or annuitant s death. Account values will fluctuate, depending specifically on the performance of the underlying investment of the separate account. All profits and losses, minus fees, are passed along to the contract owner. In the event the insurance company becomes insolvent, separate accounts are not attachable by the insurer s creditors and are normally distributed immediately to the contract owners. A wide variety of funds are available to the contract owner in the separate account. Investment Options As mentioned above, in a variable annuity, investment choices are offered through subaccounts, which invest in a selection of funds, similar to mutual funds that are sold to the public. The value of the funds will fluctuate over time, and the variable annuity s return is based on the investment performance of these funds. Variable annuities have, on average, 49 sub-accounts. A variable annuity contract will generally permit the contract owner to choose from a range of funds (asset classes) with different investment objectives and strategies. The basic asset classes include: Money market fund Equity Fixed accounts Balanced Bonds Alternative Investments Premiums allocated to the guaranteed (fixed) account option are guaranteed against investment risk and are credited with a guaranteed fixed rate of interest. However, 37

insurance companies may calculate the fixed rate payable differently (based on either the portfolio rate or new money rate as discussed in Chapter 2). Under some variable annuity contracts, the various sub-accounts are managed by the insurance company (single management), while others are often managed by different investment advisors (multi-managers), who may or may not be affiliated with the insurance company. In fact, a number of well-known mutual fund companies offer funds that serve as investment options for variable annuities. Recently, a growing number of insurers have added a number of new sub-accounts that will use alternative investments and dynamic asset allocation strategies to the investment options available to VA investors. In 2011, insurers added 102 VA sub-accounts that use alternative strategies which include currencies, long-short, market neutral and precious metals, according to Morningstar Inc. That s up from 63 new additions in 2010. Those numbers don t include commodities which have been included in several VAs in 2012. In fact, in a recent survey by one of the leading VA insurers, they reported that more than nine out of 10 advisers expect to increase their use of alternative asset classes over the next year. Among those advisors who anticipate an increase, more than half said they would increase their use of alternatives by 15 percent or more in the next 12 months. Nearly a third will boost their use of alternatives by 20 percent or more. Of the small percentage of advisors who have not used alternative assets classes to date, more than 90 percent say they are now considering using them. The major goal of using these types of alternative sub-accounts real estate holdings, hedge funds, commodities and the like--in the pursuit of diversification is to allow investors to have tactical management strategies without suffering the tax consequences of frequent trading. It would allow small investors to have access to alternatives that otherwise would be available only to more affluent investors. And most importantly will provide the tax efficiency (tax-deferral). Accumulation Units Once invested into the sub-account, the amount invested is then converted into accumulation units. The use of accumulation units is simply an accounting measure to determine a contract owner s interest in the separate account during the accumulation period of a deferred annuity. Not all purchase payments (gross payments) made by a contract owner goes toward the purchase of accumulation units. Before units can be purchased, the various charges and fees (discussed later in this chapter) are deducted. The money to buy accumulation units is then the net purchase payment. The number of units, which the net payment will buy, depends upon the value of an accumulation unit at that time. This value is determined periodically, usually daily. At 38

the risk of oversimplification, the value of one accumulation unit is reached by dividing the value of the separate account by the number of accumulation units outstanding. As the contract owner continues to buy accumulation units, these are added to those already purchased. The dollar value of all the units owned by the contract owner equal the number of units the contract owner owns times the value one accumulation unit. The following example illustrates how this works out in practice: Initial Value of Accumulation Unit on 01/01 = $5 Monthly Premium Payment = $100 Initial Number of Units Purchased = 20 Subsequent Accumulation Unit Values Number of Units Purchased 02/01 $5.05 19.80 03/01 $4.87 20.53 04/01 $4.94 20.24 05/01 $4.99 20.04 06/01 $5.12 19.53 At the end of the six-month period, the annuity holder would have a total of 120.14 accumulation units. As stated above, the value of these units will continue to fluctuate according to the unit s market value. With each premium payment, the annuity owner adds to the total accumulation units. The accumulation unit price will probably continue to fluctuate. When the annuity matures, the annuity owner will have been credited with a specified number of accumulation units. The only exception to this process/equation is the money market account whose net asset value is maintained on a constant dollar basis, where one dollar buys one unit. The money market account credits a stated interest rate that changes as the underlying assets of the money market changes. 39

VA Charges and Fees The charges and fees levied under variable annuity contracts, while somewhat similar to those charged by fixed annuity contracts, are subject to a greater degree of regulation due to the fact that variable annuities are considered to be securities. (Remember: charges and fees must be disclosed in the annuity s prospectus). With a variable annuity, the fees are calculated on either an annual basis and/or an asset basis. Annual fees are fixed expenses that are deducted from the contract and average about $35 to $50 a year. (Many contracts waive the annual fee at certain account values, for example $50,000.) Asset-based fees are percentages of the total value of the annuity, deducted on a regular basis, usually daily, monthly, or annually. All owners of the same contract pay the same percentage of their assets in these fees, but different dollar amounts. Mortality and Expense (M&E) Charge The asset-based mortality and expense risk fee, also called the M&E charge, on all variable annuity contracts pays for three things: The guaranteed death benefit, The option of a lifetime of income, The assurance of fixed insurance costs including the M&E fee itself, which are guaranteed (frozen) for the life of the contract. In most cases, the fee is subtracted proportionately from each of the variable portfolios that funds are invested in. According to 2013 Morningstar data, the average annual mortality and expense charge was 1.27% in 2012. Management (Fund Expense) Fees The asset-based management fees (fund expenses) that are paid to the sub-account manager for managing sub-account assets are debited from the annuity unit value and are reflected in the investment return. These fees are described in the prospectus, and are sometimes broken down into an investment advisory fee and an operating expense fee. They re often aggregated under the management fees (fund expenses) heading. Because of the large amounts of assets under management, insurance and investment companies are able to offer economies of scale, or competitive fee schedules, to their customers. While operating fees vary amongst contracts, they can vary quite dramatically, based primarily on the way the portfolio invests. For example, fees on index portfolios tend to be significantly lower than the norm because the management costs are lower. On the other hand, fees on foreign equity portfolios or those requiring extensive research and management tend to be higher. These fee structures tend to be fairly consistent from contract to contract. They re also comparable to, but generally lower than, the management fees you pay as part of a mutual fund investment. Remember to 40

compare apples to apples: in this case, similar equities to equities sub-accounts and similar bonds to bonds sub-accounts. Total Fund Expense Averages in 2011, as calculated by Morningstar Inc., was 0.96 basis points--41 basis points lower than the comparable figure for publicly available mutual funds. These figures show that the lower expense ratios of underlying funds in some variable annuities may actually offset part of the additional insurance charges. Contract (Account) Maintenance Fees A yearly contract (account) maintenance fee is commonly assessed to cover the administrative expenses associated with the variable annuity contract. This charge (usually a flat dollar amount), which covers the cost of issuing the contract and providing administrative services, is usually applied at each contract anniversary date and upon a surrender of the contract. The annual flat dollar fee ranges from $25 to $50 dollars. Most insurers waive this fee if the contract value is greater than a certain amount (usually $50,000 to $100,000) depending upon the contract. The average Administrative and Distribution Fee in 2012, as calculated by Morningstar, remained at 0.29%. Summary of Above Fees Based on its averages for Mortality and Expense Risk Charge, Administrative Fees, Annual Records Maintenance Fees and Total Fund Expense Averages, Morningstar calculated the Total Weighted Average Expenses for the year of 2012 was 2.51%. According to Morningstar, the average annual expense ratio for publicly available equity mutual funds was 1.32%, while the typical bond fund charges 1%. The comparable figures show for underlying funds in variable annuities was 0.96% 0.36% lower. These figures show that the lower expense ratio of underlying funds in some VAs may actually offset part of the additional insurance charges and suggest that, on average, the actual cost differential of the two products is about 1.19% (see Table 3.2). Why are the average expense ratios for publicly available mutual funds higher than those of underlying funds in variable annuity sub-accounts? The difference may be attributable to several factors, but a primary reason is the additional handling and administrative expenses incurred by mutual funds that are sold to the public. These mutual funds have thousands of individual shareholders, and each shareholder has an investment account that must be administered by the fund or another service provider. In the case of variable annuities, however, most of these functions are handled by the insurance company and are reflected in the insurance and administrative charges. The insurance company is, in effect, one account holder of the underlying mutual fund. 41

Table 3.2 Mutual Funds vs. VA Expense Comparison 2012 Mutual Funds Variable Annuities Fund Expense 1.32% 0.96% M & E 1.27% Administrative charges 0.19% Distribution 0.09% Total 1.32% 2.51% Difference 1.19% Source: Morningstar and LIMRA International 2013; Insured Retirement Institute (IRI) 2012 Fact Book The potential for variable annuity underlying fund expense ratios to be lower than publicly available mutual funds is an important factor to keep in mind when considering whether to invest in a variable annuity. By choosing carefully and comparing the costs of the investment funds in a variable annuity to those of publicly available mutual funds, the additional cost of the variable annuity may be partially offset by the cost savings offered by the annuity sub-accounts. The point to remember is this although there will be charges for the valuable insurance features of a variable annuity, depending on the product selected and the underlying investment options offered, the total cost differential between the variable annuity and publicly available mutual funds may be less than one might think. Surrender Fees Variable annuity contracts also have a charge, or surrender fee, when an owner withdraws part or all of their annuity contract value during the early years of the contract. These surrender fees are usually calculated as a percentage of the amount of the withdrawal and generally decline each year until the fee disappears, typically seven years after the purchase. With some contracts, the surrender fee period begins with the purchase of the contract. With others, a new surrender fee period begins with each new purchase payment. Surrender fees serve several purposes. First, they make people think of their long-term retirement account. The fee also benefits the insurance company issuing the contract, since the charge can help to offset any losses it may incur in the liquidating holdings or changing investment strategy to pay out the cash. In addition, since the company has significant up-front costs in issuing the contract and is expecting to receive asset-based fees or interest margins over a period of years, the surrender fees cover this loss of income that results when the annuity is surrendered. Remember, many annuities let the owner withdraw a certain percentage, generally up to 10%, from either the premiums paid into the contract, while other contracts may allow the withdrawal from the total net surrender value of the annuity, without. As you can imagine, the amount available to be withdrawn can be significantly different depending on which contract is purchased. 42

VA Sales Charges A number of insurers offer their VA contracts with various charge structures to meet different investor needs. The following are the most common: A-share VAs have up-front sales charges instead of surrender charges. Sales charges are calculated as a percentage of each premium payment. A-share VAs offer breakpoint pricing, which means up-front sales charges decrease depending on the cumulative amount of purchase payments that have been made. In addition, assets that a contract owner has in other products in the company s product line may be recognized in the cumulative payment amount used to determine the breakpoint pricing. A-share contracts often have lower ongoing M&E annual fees than annuities with surrender charges. B-share: Most VA contracts are B-share products. They are offered with no initial sales charge, but cancellation of the contract during the early years may trigger a surrender charge. These charges typically range from 5-7% of the premium in the first policy year, and subsequently decline to zero. C-share - or no surrender charge variable annuities, offer full liquidity to clients at any time, without any up front or surrender charges (although tax penalties may apply to withdrawals prior to age 59½). There are ongoing M&E and administrative fees, however, which may be higher. L-share have no up-front sales charges. They typically have relatively short surrender charge periods, such as three or four years, but may have higher ongoing M&E and administrative charges. X-share - X-Share variable annuity contracts credit an additional amount to the contract value, which is calculated as a percentage of purchase payments added to the contract at or subsequent to contract issue. This category does not include contracts that credit additional amounts to the contract value after a designated period, sometimes referred to as persistency bonuses. There are ongoing M&E and administrative fees, which tend to be higher than B-Share contracts. According to Morningstar Inc., B-shares were the most popular type of surrender charge based on VA Share Class Distribution (Non-Group New Sales) for year-end 2012 (see Table 3.3). Surrender charges underscore the long-term nature of the annuity product. As long as contract owners remain committed to accumulating money for retirement through their variable annuity, they generally will not incur these charges. A number of insurers have begun to offer other types of charge structures to meet different investor needs. 43

Table 3.3 VA Share Class Distribution Non-Group New Sales Data 2012 A-Share 3.2% B-Share 52.8% C-Share 3.2% L-Share 25.8% X-Share 6.7% Multi-share 7.4% No Load 0.9% Source: Morningstar and Annuity Intelligence Metrics, Advanced Sales & Marketing Corp, 4 th Quarter 2012; LIMRA March 2013 Premium Tax A few states impose premium taxes on variable annuity purchases. These taxes range from 0.50% - 5.0% depending on the state of residence but in most cases do not exceed 5% (see Table 3.4). State Table 3.4 State s Charging a Premium Tax on Annuities Qualified Funds Taxed Upfront Qualified Funds Taxed @ Annuitization NQ-Funds Taxed Upfront NQ-Funds Taxed @ Annuitization California 2.35% 0.50% Maine 2.00% Nevada 3.50% South 1.25% Dakota Virgin 5.00% 5.00% Islands West 1.00% 1.00% Virginia Wyoming 1.00% Investment Features A variable annuity offers a wide range of investment options for the contract holder (owner) to invest their premiums in various sub-accounts. To assist the contract holder in their investment strategies the VA contract also offers various investment features such as 44

dollar cost averaging, fund transfers, asset allocation strategies and automatic portfolio (asset) rebalancing. Dollar Cost Averaging Dollar cost averaging may reduce an individual s concern about making an investment at the wrong time. Investors sometimes delay the purchase of a security whose price has been rising rapidly because they feel that it may be due for a correction. Meanwhile the price continues to rise and they lose what had been a good opportunity to buy. Or they may delay the purchase of a security whose price has been falling because they fear it may be in a long-term downward trend. Dollar cost averaging alleviates this problem. With dollar cost averaging, an individual invests the same flat dollar amount in the same securities at regular intervals over a period of time, regardless of whether the price of the securities is rising or falling. If the price of the security rises, the investor cannot purchase as many units of that security for the same flat dollar amount. However, the value of the investment as a whole will have risen. And if the price of the security later falls, the fewer units purchased at the higher price will not drag down the total return on the investment as much as if a large lump sum had been invested at the higher price. If the price falls, the value of the investment also falls, but the investor is able to purchase more units of those securities. If the price of the units later rises, the larger number of units purchased at the lower price will more quickly offset the loss in value caused by the earlier decline. Dollar cost averaging does not offer a guarantee of gain or a guarantee against loss. But over time it helps to average out the highs and lows in the security s price, and that frees the investor from the anxiety of trying to predict the long-and short-term price swings that can fool even the most experienced investor in many cases. With all that said, there are several financial experts who argue that DCA does not work. In an article in the October 2006, Journal of Financial Planning, John G. Greenhut, Ph.D., writes that: the behavior of stock volatility, which has given rise through illustrations to the widespread belief that dollar-cost averaging, allows more shares to be bought over time than would occur through a lump-sum investment. We have exposed that illustration as a mathematical illusion, based on arithmetic changes in a denominator leading to disproportionate changes in the fraction. 45

Fund Transfers A variable annuity will allow the annuity contract holder to transfer funds from one subaccount to another (subject to some restrictions) tax-free. This flexibility to reposition investments under the umbrella of the variable annuity offers the annuity holder the opportunity to change his or her investment focus. It also allows an annuity holder to change the level of risk that he/she is willing to accept. However, most contracts do have some limitations on transfers. They are: May limit the frequency of transfers by stipulating that they must be separated by a certain interval, such as seven or thirty days. There may be a minimum dollar amount or percentage of sub-account value that is being transferred, and a minimum dollar amount or percentage of value that must remain in the sub-account. Some contracts limit the number of transfers that may be made each year. Some contracts have no limits, but reserve the company s right to charge a fee. Because fixed account guarantees are supported by investments that may have to be liquidated at a loss to accommodate a transfer, limits on the timing and amount of transfers from the fixed account are common. Asset Allocation Asset allocation involves the use of a number of different investment options, each of which plays a role in meeting the contract holder s overall financial goals. It also involves adjusting the percentage of assets devoted to each investment option to increase the chances that the contract holder s goals will continue to be met as circumstances change. The essence of asset allocation is to establish a mix of investments to match a contract holder s financial objectives and risk profile, and to change that mix as expectations change in regard to the returns available in each class of investments. Some contracts offer asset allocation services which will move the owner s money according to a professional asset manager s assessment of the outlook for stocks, bonds, interest rates, and so on. Under some other contracts, this is established by allowing the money manager to make the appropriate transfers in the owner s sub-accounts. Other contracts offer an asset allocation sub-account in which the money manager changes the mix of various investments on an on-going basis in an attempt to achieve the next favorable return. 46

Asset Rebalancing Asset rebalancing is a technique used by many portfolio managers to reduce risk and improve a portfolio s overall return. It involves making security trades at certain intervals in order to bring the asset mix back into line with the allocations originally determined for the portfolio. In effect, the portions of the portfolio that have performed the best are reduced so that additional assets can be purchased for the portions of the portfolio that have performed the worst. There are no guarantees, of course, that automatic asset rebalancing will improve a contract holder s return, nor does automatic asset allocation provide any assurances against the chance that the value of the securities underlying the investment option may fall. Guaranteed Minimum Death Benefit A common feature of variable annuities is the death benefit. The contractual payout of the death benefit varies by contract. The death benefit is generally payable as a lump sum payment or as an annuity payment. Variable annuity contracts have traditionally offered a guaranteed minimum death benefit (GMDB) during the accumulation phase that is generally equal to the greater of: The contract value or Premium payments less prior withdrawals. The GMDB gives the contract owners the confidence to invest in the stock market, which is important in order to keep pace with inflation, since we know that their family will be protected against financial loss in the event of an untimely death. Enhanced Death Benefits Over the past ten years, many insurers have offered enhanced death benefit riders. Some type of enhanced death benefit is now available with most variable annuity contracts. There are three types of enhanced death benefit riders. They are: Contract Anniversary (Market Anniversary Value) or Ratchet Initial Purchase Payment with Interest or Rising Floor (Roll-up) Enhanced Earnings Benefit These different types of enhanced GMDBs are riders to the contract and will have additional associated charges. The charges could be applied to the contract value or benefit base. Generally, these optional death benefit riders can only be elected at issue if the owner(s)/annuitant(s) are within the age specifications as set forth in the contract rider 47

and prospectus and are irrevocable once elected. Let s review each of these enhanced guaranteed minimum death benefits in greater detail. Contract Anniversary, Or Ratchet Some insurance companies offer ratchet GMDBs that are equal to the greater of: The contract value Premium payments less prior withdrawals The contract value on a specified prior date The specified date could be a prior contract anniversary date such as the contract anniversary date at the end of every seven-year period, every anniversary date or even more often. A ratchet GMDB locks in the contract s gains on each of the specified prior dates. Initial Purchase Payment with Interest or Rising Floor Some insurers offer rising floor or rollup GMDBs that is equal to the greater of: The standard death benefit, or The purchase payments accumulated at a specified annual rate (5% - 7%) up to a specified age and adjusted for any withdrawals. In some cases, a combination contract anniversary value and a rising floor may be available within the same contract: By stepping up the increasing Death Benefit to the Account Value may start over a new surrender charge period. For Example: Mr. Jones purchased a $100,000 variable annuity with a surrender charge of 5 years. Over the years Mr. Jones owned the contract, his account value jumped around from $150,000 to $250,000. At the end of the five years, Mr. Jones surrender charges had expired and the value of his account was $200,000. At that time, Mr. Jones locks in his step-up death benefit to the account value of $200,000. In exchange, the insurer restarts another 5-year surrender charge penalty schedule. Of course, these types of increasing death benefits do not last forever. Most contracts call for the suspension of the increasing death benefit at ages from age 75 to age 85, depending on the contract. In some cases, a ratchet and a rising floor may be available within the same contract. Some contracts offer a choice of a ratchet or a rising floor. Enhanced Earnings Benefits Some insurers offer enhanced earnings benefits (EEB), which provide a separate death benefit that can be used, for example, to pay the taxes on any gains in the contract. With 48

this feature, beneficiaries will receive not only the death benefit amount, but also an additional amount, which is usually equal to a percentage of earnings. Guaranteed Living Benefit (GLB) Riders Since their inception in 1996, guaranteed living benefit (GLB) riders have become increasingly common in sales of VA contracts. In 2012, about 87% of all variable annuity contracts sold came with a GLB rider, according to Morningstar. GLB riders attached to a variable annuity can be offered as one of the following: Guaranteed Minimum Income Benefits (GMIB), Guaranteed Minimum Accumulation Benefits (GMAB), Guaranteed Minimum Withdrawal Benefits (GMWB), and Guaranteed Minimum Withdrawal Benefit for Lifetime (GMWBL). According to LIMRA, VA GLB Tracking Survey (March 2013), in the 4th quarter of 2012, the rate of election for GLBs was 84% down from 90% in the 4 th quarter 2011. In the 4th quarter of 2012, GLB riders were elected in contracts representing 65% of total VA sales ($18.5 billion out of $28.3 billion). VA assets with GLB riders increased to $650 billion from $530 billion at the end of the 4th quarter of 2011. The GMIB and GMAB election rates in 4th quarter 2012 both decreased three and one percentage points, respectively, whereas GMWBL election rates increased seven percentage points, when compared with the fourth quarter 2011. The GMWBL is the most elected GLB rider (62%), and the GMIB is second at 18% (see Table 3.5). Table 3.5 GLB Election Rates (When any GLB available) 62% 18% 3% 1% GMWBL GMIB GMAB GMWB Source: LIMRA Retirement Research, March 2013. Note: Hybrid election rate less than ½ of 1%. 49

Guaranteed Minimum Income Benefit (GMIB) The GMIB was the first living benefit rider that hit the market back in 1996. What it s designed to do is guarantee the client (contract holder/annuitant) a future income stream. The VA-GMIB has two values: a Contract Value and an Income Benefit Base. The GMIB payment will be based on the Income Benefit Base and the annuitization factor. As of the 3 rd quarter of 2012, approximately 18% of VA contracts purchased elected the guaranteed minimum income benefit rider. GMIB Features and Benefits One of the important features of the VA GMIB rider is how the income credit accumulates. With the GMIB rider, the income credit accumulation can continue whether or not the client (annuity holder/owner) makes a withdrawal. This is different than most GMWBs/GMWBLs contracts, where the credit accumulation stops once you commence withdrawals (discussed below). For Example: If the accumulation rate of the GMIB is 5%, then you can take any amount up to 5%. Whatever you don t take out continues to accumulate in the Income Benefit. Credit accumulation ends when the age limit (usually age 85/91) is reached or when annuitization occurs. Another important feature of the GMIB is annuitization. When your client purchases a GMIB rider, their future annuity rates are stated in the prospectus. These rates are generally lower than the life annuity rates in the open market. It does this via its income base or bases. Today, GMIBs may have both a roll-up base, which increases annually from 4-5 percent depending on the insurance company, and a second income base that steps up to the account (contract) value, typically annually. GMIBs also have a waiting period in which the benefit cannot be exercised. This period ranges from five to ten years depending on the insurance company and benefit. Something to keep in mind is that some insurance companies will require your client to restart the waiting period if you lock in a new value for the step-up base. GMIBs are available at contract issue, provided the oldest annuitant is not over the age specified in the rider and the prospectus at issue (usually, ages 70 or 78). GMIBs are irrevocable, optional living benefits that provide a safety net for retirement assets in the form of a guaranteed minimum income stream no matter how the underlying annuity investments performs as long as no withdrawals are taken. To receive the income benefits from the rider the client must annuitize the contract under the terms of the contract. Note: The guaranteed payout rates with the GMIB are based on 50

conservative actuarial factors and are currently less favorable than the current payout rates used to convert contract values to annuitization income. In other words, there is a haircut on the GMIB annuity actuarial factors. GMIB Costs According to the Insured Retirement Institute (IRI), the cost of the GMIB rider to a variable annuity typically ranges from 20% 1.45% basis points annually. Guaranteed Minimum Account Balance (GMAB) The GMAB rider offers a guarantee of principal while remaining invested in the market after a specific waiting period usually five to ten years. Be aware that there may be conditions and restrictions on this benefit. Most variable annuities using the GMAB come with prepackaged asset allocation models into which you place the premiums invested in the contract by the contract holder. Today, many insurers now offer access to a wider range of investment options so that your client can design a strategy specific to their needs and timelines. Some contracts now offer target maturity date funds in their portfolios, making the job that much easier. What s important with this feature is that the benefit base is a walk away amount. Your client does not need to annuitize the contract. GMAB Costs According to the Insured Retirement Institute (IRI), the cost of the GMAB rider typically ranges from.25 1.25 basis points annually, often depending on the extent of asset allocation required. Guaranteed Minimum Withdrawal Benefit (GMWB) The GMWB rider was the second type of GLB, it evolved in 2002 in response to some of the limitations posed by the GMIB, especially during bull markets. The idea behind the GMWB is to allow the contract holder to withdraw a maximum percentage of their total investment each year for a set number of years, regardless of market performance, until recovery of 100% of the investment. The insurer can be defined as a rider that guarantees a fixed percentage generally 5% (some contracts may be higher) of the annuity premiums can be withdrawn annually for a specified period of time until the entire amount of paid premiums have been withdrawn, regardless of market performance and without annuitizing the annuity. 51

GMWB Costs According to the Insured Retirement Institute (IRI), the cost of the GMWB rider typically ranges from.25 75 basis points annually, often depending on the extent of asset allocation required. Guaranteed Minimum Withdrawal Benefit for Lifetime As discussed above, the earlier GMWB riders covered only a certain term, usually 17-20 years. GWMB s did not provide longevity insurance. All that changed in 2004, with the Guaranteed Minimum Withdrawal Benefit for Lifetime (GMWBL). The GMWBL rider attached to variable annuities provides two market values that will fluctuate similar to a mutual fund (similar to GMIB discussed above): The Contract Value and the Income Benefit Base. The Income Benefit Base s value does not fluctuate with market conditions, but it is used to calculate the income payments. When you first purchase a GMWBL rider, both the Contract Value and the Income Benefit Base are the same, i.e. your initial premium. Even if the contract value goes down to zero in adverse markets, annual payments continue for life of the contract, based on the Income Benefit Base. GMWBL Features and Benefits There are several important features and benefits of GMWBL rider. They are: Guaranteed pay: Most contracts pay, for life, 5% of the Income Benefit Base each year. Some contracts may pay higher. For example, if your client purchases a VA with the GMWBL rider with $100,000 at age 65, he/she is guaranteed to receive at least $5,000 each year for the rest of his or her life (longevity insurance), regardless of how his or her investments perform (portfolio insurance). Step-Up Reset: If the portfolio does well and the contract value exceeds the Income Benefit Base, then the Income Benefit Base is reset higher, equal to the contract value. Most contracts allow for an annual reset. Many insurers put a time limit on step-up resets, such as 30 years from the initial contract date, or until age 80 or 85. Income Credit: If your client buys a VA- with the GMWBL rider prior to needing income, then an income credit may be added to the Income Benefit Base annually, usually 5%. A higher Income Benefit Base pays a higher guaranteed income when it starts. For example, the insurer might agree to pay 4.0% at age 55. But if you wait until age 70 to begin taking income, the insurer might increase to 5.0%. At age 80, it could be 6%. If there is a step-up reset that increases the Income Benefit Base by more than the income credit amount in that year, then no income credit is added. There is usually a time or an age limit on income credit. 52

Other Benefits: The same benefits that are available for a regular variable annuity also apply to a VA GMWBL; such as death benefits, principal protection, and conversion to a life annuity. Keep in mind that these benefits, or riders, differ from contract to contract, and usually come with additional costs. Jim Otar, in his book: Unveiling The Retirement Myth: An Advanced Retirement Planning based on Market History, writes about the VA GMWBL as one of the most versatile income classes in an advisors toolbox. They convert longevity and market risks into inflation risk. They go a long way in minimizing the fear for the retiree. Note: The annuity starting date on most annuity contracts is age 95. Most insurance companies will force the individual to annuitize the contract at that point in time. Some contracts may pay out the larger of: the annuitization factor or the withdrawal benefit amount. GMWBL Costs The benefit of the GMWBL rider does not come free. Most insurance companies calculate these costs as a percentage of the Income Benefit Base. Some base it on the market value. Over the long-term, the portfolio value always declines more than the Income Benefit Base. As a result, the rider costs that are based on the portfolio value cost about 30% or 35% less than those based on the Income Benefit Base in the long run. According to the Insured Retirement Institute (IRI), the cost of the GMWBL rider typically ranges from.25 2.50 basis points annually. Treatment of Withdrawals Let s review the two different treatments of withdrawals and how they affect the income base of the guaranteed living benefit chosen. The first and simplest is a dollar-for-dollar withdrawal, in which the base is simply reduced by the same amount as the withdrawal. The second type of withdrawal, pro-rata, is a little more difficult to calculate. The income is reduced on a proportionate basis in relation to the current account value when the withdrawal is taken. Let s look at these examples: Dollar-for-Dollar Withdrawal. With a dollar-for-dollar withdrawal an account value of $100,000 and an income base of $200,000, a withdrawal of $10,000 from the account value will lower the income base to $190,000 ($200,000 - $10,000). Pro-rata Withdrawal. Pro-rata works differently. Using the same scenario as above, with a $100,000 account value and a $200,000 benefit base, this time when we withdraw the $10,000 we have to look to the current account value to calculate the reduction in the benefit base. The $10,000 represents 10 percent of the account value, or $10,000 divided by $100,000. We then reduce the income base a proportionate amount of the 10 percent, or $20,000. This is simply 10 percent of the $200,000 income base. We end up with an income base of $180,000. 53

Recent Innovations and Trends of GLBs Companies in the industry responded to the recent market conditions in several ways. Some companies pulled back dramatically: dropping riders, removing some of the richest features. A few insurers got out of the business completely (Sun Life, John Hancock). Others instituted large fee increases for their products. Over the last several months, we have seen many new product releases that generally involve product derisking. Significant fee increases (it is now not uncommon to see fee levels on riders of 100 bps or more) Removing or scaling back costly GMWBL features, of the roll-up benefit Modifying other features, such as increasing the minimum age for the 5 percent lifetime withdrawals from age 60 to age 65 Adding or enhancing asset allocation restrictions (although mandatory asset allocation was not uncommon prior to the economic downturn, it is now much more prevalent also, lower limits on the maximum percentage of equities have been implemented) Not allowing allocations to overly volatile funds, or funds that did not track well to select hedging indices, if the underlying VA contract has the guarantee. On the other hand, a number of insurers have developed a new-generation of re-designed variable annuities. Some insurers have developed their variable annuities with a simple fee structure, while another has incorporated market gains into their benefit base based upon a floating rate. The rate will be set annually at one percentage point above the 10- year Treasury, ranging from 4% to 8%, according to the insurer s marketing material. Despite these changes, the GLB rider features still are fairly rich and continue to present exposure to equity market risk (although the higher fees have helped mitigate this somewhat). In almost all cases, prices for these product features have been set based on the new paradigm, instituting an assessment of market conditions in the current environment. Outlook for Variable Annuities The fact that two major insurers exited from the annuity business should tell us all we need to know about the health and viability of the industry heading into 2012. If only it were that simple, since the industry, like the product itself, is a bit more complicated. Hedging issues, suitability, 77 million baby boomers going into retirement, the living benefit arms race and also let s not forget, the worst global financial crisis in the history of the world are issues the industry has dealt with in recent years; issues that seem to be coming to a head as the New Year begins. In fact, during the first quarter of 2012, companies filed 59 annuity product changes with the SEC, which is moderate compared to the 130 filing that were posted in the fourth quarter of 2011. With these filing the 54

popular theme in the VA product development has been to de-risk mostly by using investment models that minimize volatility risk to the insurer or by reducing income and withdrawal benefit features which are sensitive to low interest rates. In fact, the insurance industry s exposure to variable annuities that are in the money, where the account value is smaller than the guaranteed living benefit base, continues to shrink. In 2011, life insurers had $721.3 billion in assets under management tied to variable annuities with these features, while benefit bases were worth $823.4 billion. That leaves the industry under water on these benefits by $102.1 billion, according to Morningstar. During the crisis in 2008, insurers were underwater on these benefits by $253.7 billion. In 2006, the halcyon days prior to the downturn and the living benefits arms race, carriers were only underwater by $3 million. As the markets return to normalcy, the appetite for variable annuities is poised for a comeback, which will perhaps outshine the growth of the past decade. The reason for this optimistic outlook is that many investors continue to face volatile financial markets, dwindling pensions and a money-strapped Social Security system that may be incapable of providing the income they need for a secure and, very likely, extended retirement. Given the various challenges in retirement funding within today s risk-averse investment climate, the VA, coupled with an appropriately diversified portfolio, can serve as an important retirement-income solution. In the end, variable annuities providers with the best risk management capabilities should emerge from the current crisis in a stronger position with solid products that continue to play a critical role in meeting retirement needs. There are compelling reasons to believe that a surge in demand is just over the horizon. And insurers who persist in refining their products and hedging programs should be in the best position to exploit it. Ultimately, investors (especially baby boomers) will continue to seek ways to allocate a portion of their portfolio to the kind of guaranteed, lifelong income their parents enjoyed via their company pensions. As these investors intensify the search for defined benefitlike retirement alternatives, variable annuities may increasingly be seen as a vehicle of choice, given their role in portfolio diversification and providing a potential source of stable income. Variable Annuitization: Calculating Variable Annuity Income Payouts Annuitization is one of the least utilized and often misunderstood options of a variable annuity contract. The annuity contract holder may elect to allocate all or part of the value of the contract to either the fixed account and/or the separate account. Allocations to the fixed account will provide annuity payments on a fixed basis; amounts allocated to the separate account will provide annuity payments on a variable basis reflecting the investment performance of the underlying sub-account. 55

To understand why and how the income payout amount will vary under the variable payout option, it is necessary to understand the two important concepts: Annuity units and Assumed interest rate (AIR) Annuity Units An annuity unit is a unit of measure used to determine the value of each income payment made under the variable annuity option. How the value of one unit is calculated is a fairly complex process involving certain assumptions about investment returns. It is probably sufficient to understand that the amount of each month s variable annuity income payout is equal to the number of annuity units owned by the contract holder in each investment account multiplied by the value of one annuity unit for that investment account. For example: Let s assume that on January 1, the date the annuitant retires, he or she has collected a total of 10,000 accumulation units. Assume further that at that time the 10,000 units have a market value of $50,000. Using the above process, the insurance company then converts the annuitant s 10,000 accumulation units to 100 annuity units. On the first payment, each annuity unit is worth $10. If the annuitant chooses the fixed payment option, the $1,000 monthly payment, as listed in the example below as of January 1, would remain constant for the balance of the payout period. Assume that the annuitant chooses a variable payout; in that case, a six-month projection of monthly payments would be as follows: Date Annuity Unit Value Monthly Payment to Annuitant 01/11 $10.00 $1,000 02/11 10.17 1,017 03/11 9.73 973 04/11 9.89 989 05/11 10.11 1,011 The major benefit of using the variable accounts during the annuitization phase of a variable annuity is that it gives the annuity contract holder the opportunity for his/her 56

income payment amounts to increase sufficiently so that they may keep up with inflation. However, as shown above there is the risk that the income payment may also decrease. To accommodate those clients who are concerned with that risk, many insurers allow the annuity contract holder to place a portion of the accumulation value in the guaranteed general account and thus receive a fixed income payment (fixed annuitization) and place the remainder of the accumulation value into a separate investment account (variable annuitization) and receive a variable benefit amount from these funds. Assumed Interest Rate (AIR) The selection of the assumed interest rate (AIR) is unique to a variable annuity and requires a high degree of knowledge about the subject. The AIR is the most significant component in the conversion factor for a variable annuity. A poor decision could result in receiving less than the maximum possible benefit. All variable annuities require an AIR as the basis for the initial and subsequent payments. Also, the AIR will have a significant impact on the initial payment level and on the pattern of subsequent payments. Many contracts allow the annuity contract holder to select the interest rate to be assumed (AIR) in calculating the initial payment level. Other companies only offer one AIR. A higher AIR produces a larger initial payment than a lower AIR. Since the AIR is an assumption and not a guarantee, subsequent payments will vary according to the relationship between actual investment performance and the selected AIR. If actual investment returns are exactly to the AIR, then the payment amount will not change. If actual investment returns are greater than the AIR, then the payment amount will increase. If investment returns are less than the AIR, payments will decrease. A higher AIR means not only that the initial payment level will be higher, but also that subsequent payments will increase more slowly or decline more quickly than payments determined with a lower AIR. If the annuity contract holder lived long enough and had two annuities alike except for the AIR, the payments based upon two different AIRs would eventually cross, and the payments based upon the higher AIR would thereafter always be less than those based upon the lower AIR. Typically, the payment patterns of a high AIR and a low AIR will cross after eight or nine years of payments; however, the total payments received will not be equal until after about 14 or 15 years of payments. In other words, an annuity contract holder who lives less than 15 years would receive more annuity benefits under a higher AIR than under a lower AIR; conversely, an annuity contract holder who lives more than 15 years would receive more annuity benefits under a lower AIR than under a higher AIR. Favorable investment performance will result in an increase under all AIRs. 57

Here is an example of the impact of the AIR on payment levels: Monthly payments under alternative AIRs based on a 6 percent actual investment return and a $10k annuity purchase at age 65 would mean $100 at year five. On a basis of 3 percent actual investment return at age 65 would be $91 at year five. The monthly payment for a 9 percent actual investment return at age 65 would increase to $108 at year five. 58

Chapter 3 Review Questions 1. In a variable annuity who assumes all of the risk in the sub-accounts? ( ) A. Contract holder (owner) ( ) B. Insurance Company ( ) C. Investment Company ( ) D. Management Company 2. Mortality and Expense (M&E) charges in a variable annuity pay for all of the following fees and charges, EXCEPT? ( ) A. Guaranteed death benefit ( ) B. Investment Management fees ( ) C. The option of a lifetime of income ( ) D. The assurance of fixed insurance costs 3. Asset-based management fees (fund expenses) for managing sub-account assets are debited from the and are reflected in the investment return. ( ) A. Accumulation unit ( ) B. Assumed interest rate ( ) C. Net asset value ( ) D. Annuity unit value 4. Which of the following provides a separate death benefit that can be used to pay taxes on gains in the variable annuity contract? ( ) A. GMAB ( ) B. GWSIP ( ) C. Enhanced Earnings Benefit ( ) D. GMIB 5. Which of the following statements about the use of dollar cost averaging (DCA) in a variable annuity is FALSE? ( ) A. DCA may reduce an individual s concern about making an investment at the wrong time. ( ) B. DCA offers a guaranteed gain in the investment portfolio ( ) C. With DCA an individual invests the same flat dollar amount in the same securities at regular intervals over a period of time. ( ) D. DCA does not offer a guarantee against loss 59

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CHAPTER 4 INDEX ANNUITIES Overview Since 1994, there have been numerous articles written about the positives as well as the negatives of Index Annuities (IAs). And of course, the issue of whether the IA is a security and who should regulate them, had drawn a lot of attention to the industry and to the producers who sell IAs. The Securities Exchange Commission (SEC) proposed Section 151 A, which tried to reclassify IAs as investments and to take over regulatory control. However, with the passage of the Dodd-Frank Wall Street Reform Act, Democratic Senator Tom Harkin, who is from Iowa, the home of several major IA insurers, he slipped an amendment in the bill that affirmed that IAs are not investments and will continue to be regulated by the states. This chapter will define an Index Annuity (IA), review the IA market and history, the various terms and provisions specific to a IA, and the regulatory issues of IAs. IA Defined An Index Annuity (IA) is an annuity that earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the Standard & Poor's 500 Composite Stock Price Index (the S&P 500). IAs offer consumers what could be described as the best of both worlds: a market-driven investment with potentially attractive returns, plus a guaranteed minimum return. In short: You get less upside but much less downside. Because of these features, many people invest in this type of investment for their retirement planning. IA Market IAs began to be marketed in the U.S. back in 1994. Back then some insurance and marketing companies (most notably Keyport Life Insurance Company) began to explore the concept of IAs. The theory behind this concept was similar to how insurance companies were able to link renewal rates to an interest index; the question was whether or not something similar could be done with respect to an equity index. The first IA was purchased February 15, 1995 by a 60 year old from Massachusetts. Over the next five years the original $21,000 premium placed in a Keyport Key Index annuity grew to $51,779. The IA era had begun. 61

According to Advantage Compendium, from 1997 to 2007, IAs were one of the hottest insurance products being marketed in the U.S. Between 2003 and 2004 alone, sales doubled, going from $14 billion to nearly $22 billion, respectively. However, in 2006 IA sales took a hit dropping by 7.05 percent to $25 billion from $27.3 billion in 2005, and remained flat in 2007. Sales were nearly $25 billion in 2007. Then in 2008 the Securities Exchange Commission (SEC) cracked down on the abusive sales practices used to promote the product to seniors. An inquiry at a national senior s summit revealed that IAs were among the securities involved in senior investment fraud. The SEC worked on a new rule (Rule 151A) that would consider IAs as securities, and therefore would have protections afforded by securities law. Many commentators called the end of sales of IAs. But, IA assets and sales continued to grow and by the close of 2009, over $200 billion of IAs had been purchased. In 2012, IA sales reached a record high of $33.9 billion a percent increase compared to sales of $32.4 billion in 2011. The market share for IAs reached 47% of Fixed Annuity total sales in 2012, compared to 43% in 2010 (see Table 4.1). Table 4.1 Sales Index Annuities 2000-2012 ($ billions) Year Total IA Assets Total IA Sales Sales as a % of Total FA Sales 2000 $19.0 $ 5.5 10% 2001 25.0 6.8 9 2002 35.0 11.8 11 2003 47.0 11.3 14 2004 71.0 21.1 24 2005 93.0 26.8 35 2006 103.0 25.1 34 2007 125.0 25.0 38 2008 138.0 26.7 25 2009 157.2 29.5 28 2010 185.0 32.4 43 2011 205.0 32.2 44 2012 255.7 $33.9 47 Source: LIMRA; Beacon Research, Evanston, Ill. March 2013; IRI 2012 Fact Book 62

Profile of an IA Buyer Who would be a typical IA buyer? Index annuities are designed for people that are averse to risk. The type of person whom, if given a choice between an investment that has an equal chance of doubling in a year or losing 20% of its value versus an investment that will make 6%, will always choose the low risk/low return alternative. Certificate of deposit and traditional fixed annuity buyers fit this profile. IAs can be used to overcome this aversion to risk by providing the potential for higher returns than traditional savings vehicles without market risk to principal. Next, let s review some of the various terms and provisions of an IA. IA Basic Terms and Provisions If there is one major complaint about IAs, it is that there are too many moving parts, terms and provisions, to understand. For an example, in 2012 there were 48 insurance companies offering IAs with over 27 variations according to Advantage Compendium. Let s now review some of the basic terms and provisions that are part of an IA. Index Period The index period of an IA is defined as the length of time that index interest credits are linked to the particular index used in the contract. The initial index period must be listed on the contract data page. Index periods vary from contract to contract, and can be as short as one year and as long as twelve years. Using a shorter index period limits the percentage of index growth that the client can receive as an index interest credit when compared with the percentage of longer index periods. Participation Rate Also known as the Index Rate, this is the percentage of the increase in the index (for example, the S&P 500 and or the Dow Jones Index) that will be credited to the account value. (The amount credited to the account value may be subject to a Cap Rate in some contracts.) The participation rate may be stated as a fixed annual fee or administrative charge. Participation rates cannot be compared among IA products without also considering the indexing method used. To add to some of the confusion, a contract with a 100% participation rate does not necessarily produce a greater index benefit than an IA contract with an 85% participation rate. If guaranteed for the term, an 85% participation rate, and a 14% cap would become 65% and 12% respectively. Realize, you have a design similar to a traditional interest based annuity and a long-term guarantee of these participation and cap rates would create significant surplus strain. 63

Cap Rate The cap rate is the maximum annual account value percentage increase allowed. A cap can be an annual cap or a limit on an annual index interest rate type of an IA: it is the maximum for any one year during the index period. The cap can also be a total cap or limit on how much interest can be credited for the entire index period with a type that credits one total index interest rate. A common cap rate right now is 3 percent. Over the past decade the cap rate has been as high as 13 percent. Cap rates can be either guaranteed or non-guaranteed. Typically, caps are applied after the interest calculation is made and the participation rate applied or the spread or margin deducted. The cap is the last element applied before the index interest rate for the year or the index period is determined. For Example: Let us assume that a particular IA has a 75 percent participation rate and a 3 percent annual cap. Assuming that for a given year (or for the entire index period) the indexing method produces an index growth of 5.5 percent, the 75 percent participation rate will result in a net of 4.125 percent (75 x 5.50). However, with the cap of 3 percent, the client receives an index interest rate of only 3 percent. Spreads or Margins The spread or margin, also referred to as an administrative fee, is another way of determining the interest rate for the year or for the index period. Instead of multiplying by a participation rate, some IA contracts simply deduct a spread or margin from the growth of the index as measured by the particular indexing method chosen by the issuing company. Note: Spreads and margins can be issued in the contract as either guaranteed or non-guaranteed. For Example: If the calculated change in the index is 7.75%, the contract might specify that 2.25% will be subtracted from the rate to determine the interest credited. In this example, the rate would be 5.50% (7.75% - 2.25% = 5.50%). In this example the insurer subtracts the percentage only if the change in the index produces a positive interest rate. Some IA contracts may use a hybrid approach with the use of a participation rate and also deduct a spread or margin. Typically, these methods have higher participation rates and then utilize the spread or margin as the main working calculation element. Why would a company choose both of these methods? There are two main reasons: First, it allows the insurance company to express a very high participation rate compared with designs in which do not add a spread or margin. At first glance, the higher participation rate can attract interest in the product and produce a marketing advantage. The second reason has to do with pricing. When the company is able to incorporate two different interest rate determiners into its pricing, it has more flexibility in dealing with market changes that occur during the index period. 64

Caution: Some IA contracts allow the insurance company to change participation rates, cap rates, or spread/asset/margin fees either annually or at the start of the next contract term. If an insurer subsequently lowers the participation rate or cap rate or increases the spread/asset/margin fee, this could adversely affect the return on the contract. As the insurance producer, you must read your contracts carefully to see if it allows the insurer to change these features. No-Loss Provision The no-loss provision in an IA, means that once a premium payment has been made or interest has been credited to the account, the account value will never decrease below that amount. This provides safety against the volatility of the index (S&P 500). Guaranteed Minimum Account Value In order for the IA to be classified as a fixed annuity it must comply with the Guaranteed Minimum Account Value (GMAV) rules specified in the Standard Non-Forfeiture Law for Individual Annuities. Pertaining to fixed annuities, Section 4 states that they: provide for a guaranteed minimum account value at all times no less than 90 percent of the single premium amount compounded by interest of no less than 3 percent per year. For a declared fixed rate annuity the insurance companies base their GMAVs on 100 percent of the single premium amount compounded at 3 percent per year. This means that after the first policy year, the declared fixed rate annuity buyer will never receive an annual statement where the GMAV is less than the single premium amount, unless a withdrawal has been made. However, with an IA contracts value at any point in time is the greater of a guaranteed floor value or an accumulation value less a surrender charge. Under the new nonforfeiture regulation, the guaranteed floor is 87.5 percent of premium compounded at a value based on the 5-year treasury yield (no less than 1 percent, usually no greater than 3 percent). So then, it is possible to see a guaranteed minimum account value of less than the single premium amount on the policy statement. This is not necessarily a bad thing. However, it is different from what is customary with most fixed rate annuities. That fact may cause a concern for your client who is looking to purchase an IA and will need to be explained. Liquidity Generally a 10% withdrawal is allowed annually without surrender penalty and some IA contracts offer more standard withdrawal provisions. (Some contracts allow 15% annually.) Reminder: Most articles analyzing appropriate withdrawal rates for retirees range in the 4-6% range annually, depending upon various methods of thought. This 65

being said, a 10% withdrawal privilege should not be an issue for most retirees and individuals. Nearly all IAs provide a full surrender value upon death of the owner or annuitant. Many IA issuers offer full surrender for nursing home stays, extended hospital visits and terminal illness. Several carriers offer full surrender for unemployment if under 65 years of age. IA opponents commonly cite surrender fees in some older IA products that were marketed that were as long as 15-20 years and fees as high as 20% in the earlier years of surrender, as an issue. But, proponents of IAs claim that, if you review the various free withdrawal privileges and based on the appropriate range of annual withdrawals, most individuals who purchase an IA will not encounter a penalty except through their choice. Second, surrender fees are required by state insurance regulators in order for policies to be qualified for sale. The existence of surrender fees helps an insurer recapture up-font costs on products that were designed to be held for several years, and protects persisting policies from the imposition of extra costs by those who choose to surrender early. Third, the idea that securities do not have penalties is not only flawed but simply not accurate. Even if the actual mutual fund one is holding does not assess surrender charges, it is subject to annual management fees and market risk. Furthermore, they claim, IAs provide a guaranteed minimum return along with principal preservation which mutual funds and other similar investments do not provide. Fees and Expenses Unlike mutual funds, an IA does not deduct sales charges, management fees or 12b-1 marketing fees. Instead, the insurance company uses a small amount from the underlying portfolio which lowers participation rates in the market index to cover administrative costs and commissions to agents. Because the IA provides policy crediting rate formulae and periodic annuity owner reports net of any fees and management expenses, it does not separately disclose them. Surrender Charges All IAs charge a penalty if the policy is surrendered, cashed-in, prior to the end of the surrender period. Depending on the policy purchased, surrender periods vary in length from one to eighteen years, and penalties can be as high as 25 percent of the initial premium (although very high penalties are usually offset by a premium bonus.) Keep in mind, it is usually because of the high up-front bonuses that result in the very high surrender charge schedules. Surrender penalties do not usually apply if the policy is paid out due to death of the owner (and all deferred annuities issued after January 18, 1985 must pay out upon the death of the owner) or if the policy is annuitized. A typical surrender charge is expressed either as a percentage of the accumulated value of the annuity or as a percentage of the 66

original premium. Note: Although IA principal is protected from market risk, most index annuities would return less than the original premium if surrendered too early. A number of IA contracts do not state a specific surrender charge, but instead base the net surrender value on the minimum guaranteed value. Although this calculation may not be called a surrender charge, it has the same effect. For Example: If the minimum guaranteed surrender value is based on 3 per cent interest compounded on 90 per cent of the premium, then the cash received upon surrender would be 90% during the first contract year, 92.7 per cent during the second, 95.5 per cent during the third and 98.3 per cent during the fourth year. This is really a de facto declining penalty of 10%, 7.3%, 4.5% and 1.7% for the first four years of the IA contract. Interest Calculation The way an insurance company calculates interest (compounding or simple) earned during the term of the IA can make a big difference in the amount credited to the annuity. Some IA contracts pay simple interest during the term of the annuity. Because there is no compounding of interest, the return credited will be lower. While the annuity may earn less from simple interest, it may have other features more beneficial to the client, such as a higher participation rate. Exclusion of Dividends Depending on the index used, stock dividends may or may not be included in the index s value. For example, the S&P 500 is a price index and only considers the prices of stocks. It does not recognize any dividends paid on those stocks. Since the annuity is not being credited dividends, it will not earn as much as if invested directly in the market. Crediting Interest In a fixed rate annuity, as was discussed in Chapter 2, when the investor (contract owner/holder) pays the premium to the insurance company, the insurance company invests this money, earns a return, and after subtracting their costs, pays the fixed annuity purchaser a stated interest rate. The difference between the fixed rate annuity and the IA is that the return earned above the minimum guarantee is used to buy an index-link tied to the performance of an external index. This index-link permits the IA investor to share in the potential increase in the index during the period without losing interest already credited if the index declines. Receiving excess interest earned on an external index gives the IA investor the potential for more interest if the index increases in value. If the index goes the opposite way, goes 67

down instead of up, the IA investor earns no index-linked interest for the period, but the IA investor does not lose what they already have earned. Interest Crediting Methods It s important to remember, that IAs typically have no stated interest rate at the time of issue. As we discussed above, the actual interest rate received by the IA investor is determined according to the indexing method used in administering the particular IA contract. The problem is that a contract s crediting method the formula that determines how much the IA investor earns can change each year at the whim of the issuer. With over 42 different crediting methods currently available in more than 95 IA products, an understanding of how crediting methods work is integral to your recommendation ability. The interest credit strategy selected for an IA determines several factors, the participation rate, the cap and the interest spread. The differences are what set IAs apart from each other as we will discuss later. Looking back over the past several years, only one completely new IA interest crediting method structure has been created, and that is called the rainbow method. All other crediting methods, including the balanced allocation method, (earlier called the equity kicker method), hurdle, and low water mark designs, had their beginnings based on one of the three basic indexed-linked crediting methods used back in 1990 s. The three most common interest crediting methods are: Point-to-Point, High Water Mark, Annual Reset. Let s discuss each of these in greater detail. We will begin with the term point-to-point, also known as term end point. Point-to-Point Point-to-Point compares the change in the index at two discrete points in time, such as the beginning and the ending dates of the contract term, usually greater than a year or two. With a term you get the higher of the minimum guarantee or the index linked interest. That is how a term end point participation rate crediting method works. Possibly the most basic type of index method is the Long Term Point-to-Point method. As the name implies, there are only two days in this index calculation method, the starting point and the ending point. For Example: Your client decides to buy an IA with an index-linked interest based on the performance of an index (currently 100) and the insurance company 68

says that at the end of nine years they will credit the greater of the minimum guarantee or 100 percent of any index-linked interest earned calculated by dividing the ending index value (assume 170) by the beginning index value. The client earned a total of 70 percent interest for nine years. That number would then be multiplied by the participation rate to determine the index gain for that period. The advantage is that the contract may be combined with other features, such as higher cap and participation rates, that may credit more interest to the IA contract. The disadvantage is that the contract relies on a single point in time to calculate interest. Therefore, even if the index that the contract is linked to is going up throughout the term of the contract, if it declines dramatically on the last day of the term, then part or all of the earlier gain can be lost. However, some IA contracts using the equity kicker design (Balanced Allocation Method) did allow the IA purchaser to lock in the realized gain prior to the term end point. Note: A typical point-to-point IA only credits interest realized from index movements at the end of the term. Interest is not calculated and credited annually. Therefore, if the IA purchaser surrendered the IA contract prior to the end of the term they would not usually receive any interest based on positive index movements. Unfortunately, the index has generally been weak since term end point products were introduced, which is why the market share of term point to point products has declined, from representing a third of sales in 1996 to a couple percent in more recent years. It is rare to find a pure, stand-alone term end point product. Today, there are a number of IA products that combine a point-to-point with a fixed account (e.g.: the Balanced Allocation Method). A few of the products use the summed index movement of several indices and use this composite to compute index gain or loss. When using this multiple blended index method, you add up the returns from different indices and apply a participation rate to the overall index gain or loss. The index annuity performance over multiple years uses a percentage of the gains and losses of the different indices. For Example: A strategy might blend the following crediting interest rate for the term based on 35% of the S&P 500 gain or loss over, say five years, 35% of the Dow Jones Index, 10% of the Nasdaq 100, and 20% of the 10 Year US Treasury. We will also assume that the respective gains or losses for the term were 60%, 50%, 45%, and 20%. Note: The allocation of the indices is fixed and does not change based on index performance. If the gain participation rate was 100 percent the index annuity would be credited 49.5% index-linked interest. At the end of the term a new participation rate is determined for the next term (see Table 4.2). This method may also allow for at least some participation if the blended movement was negative. Let s say that the blended index movement was a loss of 25%. A preset 69

participation rate of 5%, 10%, or more would be applied. At a 10% participation rate the policy would credit 2.5% index-linked interest even though the actual index performance was negative. Table 4.2 Blended Interest Rate Calculated Index Gain/Loss Credited Rate Index-linked Interest S&P 500 60% 35% 21.0% DJIA 50% 35% 17.5% Nasdaq 100 45% 20% 9.0% 10 Year US Treasury 20% 10% 2.0% Blended Index Movement 49.5% Next, let s review the first successful index interest crediting method High Water Mark. High Water Mark (Term High Point) The high water mark method, also known as the look back method, looks at the index value at various points during the contract, and will credit interest based on either the end of the period value or the highest previous annual un-averaged anniversary value. For Example: The index starting value is 100, and reaches a value of 160 at the end of the contract year during the period, and ended the period at 150. A term high point method would use the 160 value-the highest contract anniversary point reached during the period, as the end point and the gross index gain would be 60% (160 100/100). The company would then apply the participation rate. The advantage is that it may credit the contract with more interest than other indexing methods and protect against declines in the index. The disadvantage is that because interest is not credited until the end of the term, the contract may not receive any index-link gain if the contract is surrendered early. It can also be combined with other features, such as lower cap rates and participation rates that will limit the amount of interest credited to the contract. Due to the fact that this method is very expensive for the insurance company, this crediting method has not been used since 2004. Next, we will review the most popular index-linked interest crediting method to an IA used today the Annual Reset Method. 70

Annual Reset (Ratchet) The annual reset method, also known as the annual ratchet method, credits interest at the end of each contract year. This method begins the calculation of the next period s index movement using the closing value of the previous period. It compares the index from the beginning to the end of each year. Any declines are ignored. The advantage is that since the interest earned is locked in and the index value is reset at the end of each year, future decreases in the index will not affect the interest already earned. Therefore, the IA contract using the annual reset method may credit more interest than IAs using other methods when the index fluctuates up and down often during the term. This design is more likely than others to give access to index-linked interest before the term ends. The disadvantage is that the IAs participation rate may change each year and generally will be lower than that of other indexing methods. Also, an annual reset design may use a cap or averaging to limit the total amount of interest credited to the IA each year. Note: Annual Point-to-Point designs of greater than one year generally have an annual reset of the starting point feature. Gains are registered below the initial starting point, which can be about half of the total possible gains. Also, all annual gains are added or combined together for a term total, as opposed to Long Term Point-to-Point, Average End, or High Water Anniversary Mark, Look Back designs, where only one point is derived from the index formula, and then a number and an effective annual yield are calculated. Index Averaging The majority of IA contracts sold today are structured with annual reset designs that average index values to determine the index movement. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity. Averaging at the beginning of a term protects the client from buying their annuity at a high point, which would reduce the amount of interest earned. Averaging at the end of the term protects against severe declines in the index and losing index-linked interest as a result. On the other hand, averaging may reduce the amount of indexed-linked interest earned when the index rises either near the start or at the end of the term. It is important that you and your client understands that a 100% index participation rate, when applied to a contract using averaging, will never credit precisely the same return reported for that index in the financial section of the newspaper. Occasionally it may be higher, but usually it will be lower. 71

Other Interest Crediting Methods The annual reset method and the point to point method discussed above represent the bulk of the IA sales. Most of the IAs sold use some degree of averaging, a significant number of IAs apply ceilings or caps on maximum interest credited, and whether a participation or yield spread is used often depends on the marketing climate. Design structures are often combined. Several annual reset structures use averaging of index values, have a cap, and either use a participation rate or a yield spread. There are several other crediting methods used. Multiple (Blended) Indices The multiple indices method, as it name implies adds up returns from different indices and applies a participation rate to the overall index gain or loss. The IA performance over multiple years uses a percentage of the gains or losses of the different indices. Note: This is not a rainbow method (described below) because the allocation of the indices is fixed and does not change based on index performance. Monthly Cap (Monthly Point-to-Point) The monthly cap calculates gains losses of the index on a monthly basis, adds up the monthly figures, and the final number is the interest credited for the period; the period s interest can never be less than zero. The maximum monthly gain recognized is subject to a cap., but monthly losses are not subject to a cap. This method is also called monthly point-to-point, the difference between this method and an annual point-to-point is that the values are not locked each month. Assuming a 2% cap, a best case scenario would be where the index increases 2% each month for 12 months, producing a 24% interest for the year. On the flip side, a worst case scenario would be if the index were to increase, say, 35% over eleven months, but then decline 25% in the twelfth month. The maximum possible gain for the eleven months would be 22% (2 x 11), which would be offset by the 25% decline in the 12 th month resulting in zero gain, even though the index would have increased by 14% for the year. Binary, Non-Negative (Trigger) Annual Reset This design method will pay a stated interest rate if the index does not go down. The insurer will declare that the trigger rate for the coming year is 5. If the index does not end lower a year from now the trigger method will credit 5% interest. Whether the index goes up 1% or 90% the trigger method will credit 5%. Even if the index ends up exactly where it started, posting neither gain nor loss for the previous twelve months, the trigger method will credit 5%. 72

Bond-Linked Interest with Base Don t get confused, although there are a few IAs offering a bond index, or a bond index in addition to equity choices, that is not what we are describing. This crediting method links interest crediting to U.S. Treasury Notes. If the T-note rate is higher at contract anniversary, the IA renewal rate is credited with a like increase. If the T-note rate is lower in subsequent years, the IA rate goes down the same amount, but the IA rate can never be less than the initial rate. Hurdle With this method, the IA is credited with the gain above the floor (the hurdle), but nothing below. For example, say the current participation rate is 50% above a floor of 5%. If the index increased 10% next year the IA would credit 2.5% (10% - 5% = 5% x 50%). But, if the index increased 45% the IA would credit 20% (45% - 5% = 40% x 50%). Annual Fixed Rate with Equity Component There a couple of IAs that credit a fixed rate to a portion of the premium with the remainder participates in the index. A yield spread or asset fee is then deducted from the total. Net gains are credited as interest and net losses are treated as zero interest earned. Another method, known as the balanced allocation method, uses a fixed rate component (the range of rates depends on the interest rate environment) and also a term end point part that participates in positive index movements over a four, five or six year period. The higher the fixed interest rate selected, the lower the participation rate applied to the index. At the end of the period, gains from the fixed rate and index-linked components are combined and credited. An annualized asset fee (yield spread) may be deducted from the combined return. The equity kicker or balanced structure might look at a six year time period and offer a couple of options. For example, one option may be to allocate 50% into a fixed account paying, let s say 3% and the remaining 50% would provide a 100% participation rate on any gains in the index from start to end of the six year period. Another option might allocate 20% into a fixed account paying 3% and the remaining 80% would provide a 100% participation rate on any gains in the index from start to end of the six year period; however, a 2% yield spread would be deducted from the combined annualized gain before net interest was credited. For Example: Let s suppose that the index has increased from 100 to 150 (50%) in six years, and that the 4% fixed rate gain, compounded over six years is 26.5%. What is the return under these two balanced method options? Since the yield spread was not deducted from the 50/50 allocation the total gain remains 38.3% for the six year period and that translates into an annualized return of 73

5.5%, while the 80/20 allocation produced a total gain of 29.7% (after application of the yield spread) for an annualized return of 4.4%. In this example the better choice would have been putting half of the premium into the fixed rate. When would the 80/20 allocation have won? If the index had gone up more than 87% the total net yield, even after the 2% yield spread, would have been higher than the yield on the 80/20 allocation. Rainbow Method The latest trend in the IA market is a new type of crediting method, commonly referred to as a rainbow method. It is an option basket whose best-performing indices are weighted more heavily than those that perform less well. It is always a look back because the money is allocated based on the rankings of the performance after the period is over. Not all allocation methods are rainbows. Theoretically, the rainbow method can be used on any of the methods we have discussed. However, it is used mainly with the monthly averaging and annual point-to-point strategies. Note: A couple of insurers IA products credit interest based on the blended performance of multiple indices, but the specific index allocation is fixed at the beginning of each year so they are not rainbow methods. Here s how it works: The IA contract offers a choice of 2 or more indices on a single crediting method during a term. This is different from traditional IA products which typically offer only one index per crediting method during the term. (Note: In the rainbow products, the contract currently credits their interest in anywhere from 1-3 years.) The so-called rainbow products now on the market tend to credit interest by using one of the following two approaches. In the first approach, the contract applies a stated percentage weighting to each index; these percentages stay the same over the stated term of the crediting method. Potential indexed gains will be credited based on those weightings at the end of the crediting period, in view of each index s performance. For Example: An insurer offers indices A, B, and C on a monthly averaging crediting method in an index annuity with a 3-year period. Index A will receive a weighting of 40% over the 3-year period; Index B will receive a weighting of 35%; and Index C will receive a weighting of 25%. The carrier then deducts a spread from any potential indexed gains at the end of the term, and then applies the remainder to policy s account value. The second approach, after the end of the crediting period, the insurer does a look-back on the performance of the indices. Then, it ranks the best performing indices for that term. From that ranking, the carrier applies a stated percentage per index, and then credits 74

any potential index interest accordingly. (These calculations can vary; some will use participation rates, while others may use caps or spreads.) For Example: An insurer offers indices A, B, and C on an annual point-to-point crediting method on an IA contract with a 1-year term. The best performing index over the one-year period gets 75% weighting in the crediting calculation; the nextbest performing index gets 25% weighting; and the least-best performing index gets zero credit. The carrier then applies a participation rate to any potential indexed gains to determine the amount to credit to the policy. Many insurance producers/agents are drawn to the appeal of a we ll give you the best performing index approach. Besides the S& P 500, the Nasdaq and the Dow Jones, many carriers allow a number of international indices such as, The DJ Euro Stoxx 50, the FTSE 100, Heng Seng and the Nikkei 225. Most recently one insurer has added a commodity index using the S&P GSCI Index from Standard & Poor s, New York. Naysayers who have argued about lack of diversification in the IA product line may now have difficulty finding an argument not to recommend these fixed products. IA Waivers and Riders Index annuity contracts offer a number of waivers and riders for policy owners to enjoy and use at their discretion. Before we discuss the various waivers and riders, let s differentiate between a waiver and a rider. A waiver allows the policy owner to withdraw funds from the IA without incurring a surrender charge. There are no additional charges for a waiver. On the other hand, a rider is an extra feature that can be added to an IA and there are additional costs. Types of Waivers Most IAs provide the following waivers to their contracts. They are: Death Benefit Waiver: When the policy owner dies, the beneficiary receives the payment or payout from the annuity Nursing Home Waiver: Annuity holders will not be charged a surrender fee when the client enters a nursing home. Most contracts allow for this rider to be exercised after the first year and the policyholder s Doctor must verify. paperwork Terminal Illness Waiver: If the policy owner becomes terminally ill, the policy will allow him or her to surrender the policy early without a surrender charge. 75

Types of Riders Most IA contracts offer the following riders: Death Benefit Rider: Most IAs may provide a rider that acts like a life insurance benefit. (Note: Annuity death benefits to heirs have a different tax status than life insurance benefits which pass to beneficiaries tax free.) If the policy owner dies before he/she collects the full value of the annuity, the rider pays to their heirs the amount invested plus interest or the market value of the funds minus whatever the policy owner has collected in payouts. Long-Term Care Rider: A Long-Term Care rider provides long term care insurance in addition to a steady stream of income. The 2006 Pension Protection act now allows for withdrawals from an annuity or life insurance policy with a long term care rider to be tax free to the individual for qualified long term care expenses. Note: This only applies to nonqualified contracts. Guaranteed Lifetime Withdrawal Benefit Riders (GLWB): GLWBs have grown in prominence, but they have also become more complex. More than 20 companies now offer the GLWB rider with their IAs. According to LIMRA, a GLWB was available on 87 percent of IAs sold in 2012 and 67 percent of policyholders purchased this rider. It is important to remember every GLWB is different. Some offer rollups with simple interest, when most pay compound interest on their rollups (and no, double-digit simple interest is not always greater than single-digit compound interest). Some GLWB riders do not have an explicit cost where others charge as much as 0.95 percent annually. Some have a charge that is calculated on the benefit base value of the GLWB, where a few have charges that are calculated on the lower account value of the contract (remember, charges based on the benefit base always cost more because the Benefit Base is always higher). Some have bonuses on the benefit base value, where most do not. Some have greater withdrawal percentages than others. A few IA contracts provided inflation adjusted withdrawals (or withdrawals that will increase by a stated percentage each year). IAs with Bonuses For IAs, the most common type of bonuses are: Income account bonuses; or Premium bonuses Income account bonuses are added to the amount from which future guaranteed lifetime withdrawals will be made. These bonuses were less frequently offered in 2012 than in prior years. Premium bonuses (usually a percentage of the initial purchase amount) are added to the annuity s accumulation (cash) value. Along with the GLWB rider, premium bonuses were the main feature used to promote indexed annuities in 2009 and 2010. Some companies offered these bonuses with a vesting schedule, entitling owners to an 76

increasing percentage of the bonus over time. Fixed rate annuities sometimes offer premium bonuses as well. But interest rate bonuses are more frequent. These bonuses make the initial credited rate more attractive. In 2011, they were most often offered on contracts with credited rates that can change annually during the surrender charge period. Two other bonus types were less frequently offered in 2012. They were: Persistency bonuses reward owners for keeping their annuity for a specified period. Annuitization bonuses reward owners who convert their deferred annuity contract into an income annuity. A number of IA products will give the annuity owner a bonus for buying the index annuity. A sampling of the current marketplace shows that one company has a 10% first year bonus, which would mean that if a client put $100,000 into the annuity, the account balance would be $110,000 to start off with. Another has a 1% bonus each year for the first 12 years (based on the first year s premium), which would mean in the $100,000 example that the annuity company contributes into the IA $1,000 a year for the client no matter what is happening with the measuring index. But remember the saying, there is no free lunch. Typically when an insurance company offers bonuses, the surrender charges in the annuity are greater and for a longer period of time. As the insurance producer/agent, it is your responsibility to understand those charges, as well as to disclose and explain them to your clients prior to them purchasing an IA. Regulation of IAs As was discussed earlier, over the years, IAs have been subjected to increasing regulatory scrutiny. Back in August, 2005, the then National Association of Security Dealers (NASD), now known as the Financial Industry Regulatory Authority (FINRA) issued Notice to Members 05-50, which detailed the responsibility of member firms for supervising sales of unregistered IAs, in which the Notice referred to as Equity Index Annuities (EIAs). The Notice began with a section titled Investor Protection Issues Presented By Equity-Indexed Annuities, and noted, in the opening sentence, the following, EIAs are complex investments. After detailing some of the complexities of these products, the Notice declared that, NASD is concerned about the manner in which associate [persons [individuals engaged in the sales of securities, including Registered Representatives, in NASD member firms] are marketing and selling unregistered EIAs, and the absence of adequate supervision of these sales practices. In other words, the NASD was sufficiently concerned that registered representatives of NASD member firms, over which it had regulatory authority, might have been marketing these unregistered products (over which it did not have authority) in ways that could confuse or mislead investors. Moreover, it continued, because of the products complexity, some associated persons might have difficulty understanding all the features of the 77

product and determining the extent to which those features meet the need of the customer. In Section 3 of the Notice entitled Supervision under Rule 3030 and Rule 3040, the Notice outlined the supervisory methods that it deemed necessary for NASD member firms to implement with regard to equity index annuities. It began by acknowledging that many BDs treat the sale of unregistered EIAs as outside business activities, beyond the reach of their supervision. It declared that A broker-dealer (BD) runs certain risks in applying Rule 3030 to the sale of an unregistered EIA on the assumption that the product is not a security. As a result, if a particular EIA did not qualify for the exemption, a firm might incorrectly treat the EIA transaction as an outside business activity under Rule 3030 rather than a private securities transaction under Rule 3040 and thereby fail to supervise sales of the product as required by NASD rules. This was the justification used by the NASD in 05-50 to why BDs should require their registered representatives to submit all IA business through them. Then in 2006, the SEC adopted Rule 151, a safe harbor under the Securities Act which clarifies when certain annuity contracts are exempted securities under Section 3(a)(8). However, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, with the work of Iowa Senator Harkin, changed all that and removed the uncertainty of IAs by preserving them as fixed insurance products and not as a security. In order to meet this requirement under the Act, the IA must satisfy the standard non-forfeiture laws and be issued by an insurer that is either from a state that has adopted the NAIC Annuity Suitability rules or the company itself has implemented practices contained in the annuity suitability rules (see Chapter 7). 78

Chapter 4 Review Questions 1. In what year were Index Annuities (IA) first marketed in the U.S? ( ) A. 1974 ( ) B. 1994 ( ) C. 2001 ( ) D. 1984 2. What is the term used in an IA which is the percentage of the increase in the index that will be credited to the account value? ( ) A. Participation rate ( ) B. Spread ( ) C. Cap rate ( ) D. Margin 3. What is the term used in an IA that defines the maximum annual account value percentage increase allowed in an index annuity? ( ) A. Participation rate ( ) B. Spread ( ) C. Cap rate ( ) D. Margin 4. What is the interest crediting method that compares two points in time, such as the beginning and ending dates of the IA contract term? ( ) A. Annual reset (Ratchet) ( ) B. High water ( ) C. Point-to-point ( ) D. Interest averaging 5. In an IA contract, what is the interest crediting method also known as the look-back period method? ( ) A. Point-to-point method ( ) B. Annual reset method ( ) C. Ratchet method ( ) D. High water mark method 79

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CHAPTER 5 PARTIES TO THE CONTRACT Overview An annuity is a contract between an annuity owner and an insurance company. However, while most other types of contracts involve only two parties, an annuity contract involves more because the contract rights and benefits are measured by the life of a third party, which is called the annuitant. In many cases the owner and the annuitant are the same person. In addition, because disbursement of annuity values can occur after the death of the contract owner or annuitant, another party is usually named in the contract, a beneficiary. Let s discuss the rights and benefits of each of these parties, beginning with the owner. The Owner The contract owner, also known as the contract holder, is the individual who purchases the annuity. As the owner of the contract, the individual is given certain rights. Rights of the Owner The annuity contract gives the owner of the contract certain key rights. While the annuitant is living, the contract owner generally has the power to do the following: Name the annuitant. State and change the annuity starting date. Choose (and change, prior to the annuity starting date) the payout option. Name and change the beneficiary. Request and receive the proceeds of a partial or full surrender. Initiate and change the status of a systematic withdrawal. Assign or otherwise transfer ownership of the contract to other parties. Amend the contract with the issuing company s consent. Changing the Annuitant Note that change the annuitant was not included in our general list of rights. Some annuity contracts specifically give the owner the right to change the annuitant and some do not. If the owner of the contract is a not a natural person, a change of annuitant is treated as the death of an owner for income tax purposes, which means that certain distributions are required to be made from the contract. Therefore, even if the contract 81

specifically allows the owner to change the annuitant, care should be taken in naming the annuitant when the owner is a non-natural person in order to avoid the possibility that unfavorable tax consequences may be incurred if a change of annuitant is later desired. Duration of Ownership As noted earlier, when we introduced the general list of owner s rights with the clause while the annuitant is living, under some annuities, the owner s rights in the contract cease to exist when the annuitant dies. One of two things can happen; either the value of the annuity is paid to the beneficiary or the beneficiary becomes the new owner. This is fine where the owner and the annuitant are the same person. But care must be taken in those situations where the owner and the annuitant are different parties. Under some contracts, the owner s rights do not automatically cease when the annuitant dies. If the owner is not the annuitant and the annuitant dies first, some contracts provide that the owner automatically becomes the annuitant. Other contracts provide for a period of time in which the owner can name a new annuitant, after which, if a new annuitant is not named, the owner becomes the new annuitant. Still other contracts provide for a contingent owner to assume ownership of the contract in the event the original owner dies before the annuitant. Purchaser, Others as Owner In most cases the purchaser of the contract names himself or herself as owner. However, sometimes the purchaser names another party, such as a trust, as owner. For example, trust ownership may be used when the purchaser wishes to make a gift to a minor. Certain forms of trust ownership may shift income and estate taxation of the benefits of the contract away from the purchaser. However, the purchaser may be liable for gift taxes on the value of the annuity and/or the premiums paid on it. In any case, by giving up ownership of the contract, the purchaser also gives up all contractual rights to control the annuity. A purchaser could name a trust as owner and still retain control over the trust, but such a trust would not shift income or estate tax away from the purchaser. Purchasers should consult tax and legal counsel before giving ownership of an annuity to anyone other than himself or herself. Taxation of Owner In general, it is the owner of the annuity who is taxed on any amounts disbursed from the annuity during the annuitant s lifetime. This is true even if someone else is receiving annuity benefit payments: naming another person as annuitant does not shift tax liability away from the owner. Only a gift or other transfer of ownership can do that. However, you should note that under some contracts, once the contract is annuitized, the annuitant automatically would become the owner. This change of owner may have tax consequences to the old owner. 82

Remember that, with certain exceptions, if the owner of the annuity is not a natural person, the annuity does not provide income tax-deferral on accumulations. The major exceptions to the nonqualified person rule are a trust acting as agent for a natural person, a qualified plan, or the estate of the deceased owner (IRC 72(u)). Death of Owner: Required Distribution Federal tax law requires that certain distributions be made from an annuity in the event that any owner of the contract dies. If the owner of the contract is not a natural person, then the annuitant will be considered the owner and a change of annuitant is treated the same as the death of an owner for tax purposes. Required distributions are as follows: If an owner dies after the annuity starting date, any remaining payments that are due under the annuity must continue to be made at least as quickly as payments were being made prior to the death of the owner. If an owner dies before the annuity starting date, the entire value of the annuity must either be distributed within five years of the date of such owner s death, or the value of the annuity must be annuitized within one year of the date of such owner s death. Spousal Exception There is an exception to the rule requiring distributions in the event of an owner s death. If, the beneficiary of the annuity is the surviving spouse of the deceased owner, then the surviving spouse is permitted to become the owner. Distributions will not be required until the surviving spouse s subsequent death (IRC 72(s)(3)). The Annuitant Many annuity contracts define the annuitant as the individual who is designated to receive income benefits, under the contract. However, under some contracts, as well as in the tax law, the annuitant is the individual whose life is of primary importance in affecting the timing or amount of the payout under the contract. In other words, the annuitant s life is the measuring life in the contract. A Natural Person The annuitant must be an individual (or in the case of joint annuitants, two individuals). If, a trust, a corporation or other non-natural person were the annuitant, there would be no natural life by which to measure the benefits of the contract. 83

Role of the Annuitant The role of the annuitant as the measuring life under an annuity contract is similar to the role of the insured under a life insurance policy. Just as it is the insured s age in which determines the premium rates for a life insurance policy, it is the annuitant s age in which determines the benefits payable under an annuity contract. And just as it is the insured s death in which triggers the payment of benefits under a life insurance policy, it is the attainment of a given age on the part of the annuitant that triggers the annuity starting date under an annuity. And just as the insured is usually also the owner of a life insurance policy, the annuitant is usually also the owner of an annuity, though there are exceptions, as we have discussed previously. Naming Joint Annuitants/Co-Annuitants Some contracts allow the owner to name joint or co-annuitants. However, having joint annuitants to a deferred annuity may unnecessarily increase the risk that unwanted changes would be made to the contract prior to the annuity starting date. This is because the risk of death for either two people is higher than the risk of death for one person. Under some contracts, the value of the annuity would be paid immediately to the beneficiary. Under others, the owner could change the annuitant designation. But if the owner is not an individual, this change would be treated the same for tax purposes as a death of an owner, triggering required distribution from the contract. The increased risk of naming joint annuitants may be unnecessary because even if only one annuitant is named under a deferred annuity contract, a joint-and-survivor income option can be chosen at the annuity starting date. If a guaranteed lifetime income stream over the lives of two individuals is desired, this objective can be achieved without naming joint annuitants during the accumulation (deferral) period. Taxation of Annuitant As mentioned earlier, it is generally the owner rather than the annuitant who is taxed on annuity payments. If the owner and the annuitant are the same person, of course, it is the owner/annuitant who is taxed. As a reminder, some annuity contracts provide that the annuitant will become the owner of the contract after the annuity starting date. In that case, the annuitant, as owner, would become liable for the tax on the income-taxable portion of those payments earned after the annuity starting date. Earnings before annuity starting date should be taxed to old owner on the annuity starting date or as distributions are made after the annuity starting date. Death of Annuitant The death of the annuitant can cause some major changes to the contract or in some cases even the cessation of the contract, because the annuitant is the measuring life under the 84

contract. We ve already discussed above the possible effects of the annuitant s death prior to the annuity starting date. Under an annuitant-driven contract, when the annuitant dies, the guaranteed death benefit is paid and the contract ceases. Under an owner-driven contract, the annuity remains in force if the annuitant dies. The owner must name a new annuitant, or the contract may specify that the owner also becomes the annuitant. If there is a contingent annuitant, then the contingent annuitant becomes the annuitant; the owner typically may not name a new contingent annuitant. However, if it is a contingent annuitant who dies, not the primary annuitant, the owner may simply name a new contingent annuitant. If the annuitant dies after the annuity starting date, the income option under which annuity payments are being made controls what happens next. Under a life only income option, payments cease. Under a period certain or refund payment option, the balance of any remaining guaranteed payments will be made to the beneficiary. Under a joint and survivor payment option, payments will continue to the surviving annuitant for the remainder of his or her life. The Beneficiary The beneficiary is the person designated under the contract to receive any payments that may be due upon the death of the owner (owner driven contracts) or annuitant (annuitant driven contracts). Death Benefit The death benefit payable to the beneficiary of a deferred annuity prior to the annuity starting date is usually equal to the greater of either: The total premium paid for the annuity to date, minus any withdrawals, or The current accumulated value of the annuity fund. For variable annuities, this protects the beneficiary in case of declines in the financial markets. Under some variable annuities, item 2 above may be increased by crediting interest at the guaranteed rate. Generally, no surrender charges or market value adjustments are applied in determining the amount of a deferred annuity s death benefit. Today, most variable annuities offer stepped-up death benefit features or resets under which gains achieved in the separate account investment options may be preserved for the purpose of calculating the death benefit even if the accumulated value later drops. The stepped-up death benefit is generally calculated with reference to the highest accumulated value recorded at certain intervals for example, every third or every fifth 85

policy anniversary. The stepped-up death benefit may also include any premiums paid (minus any withdrawals taken) since that time. Whose Death Triggers the Death Benefit A similarity between a life insurance contract and an annuity contract is that death is the event in which triggers the payment of benefits to the beneficiary. However, with a life insurance contract, the benefit is paid at the death of the insured. With an annuity, the payment of the death benefit is triggered upon the death of the owner (owner-driven contracts) and may also be triggered by the death of the annuitant (annuitant-driven contracts), depending on how the pertinent provisions in the contract are worded. If the owner and the annuitant are the same person, this potential complexity does not come into play. Remember that, regardless of the type of contract, the value of the contract must be distributed or annuitized if an owner dies. This forced distribution is not the same as a guaranteed death benefit. Changing the Beneficiary Most annuities reserve the contract owner s right to change the beneficiary at any time during the annuitant s life. However, some contracts, give the owner the option of naming a permanent, or irrevocable, beneficiary. If an irrevocable beneficiary is named, the beneficiary designation can later be changed only with the beneficiary s consent. Designated Beneficiary The term designated beneficiary is defined in Section 72(s)(4) to mean any individual designated a beneficiary by the holder of the contract. Spouse or Children as Beneficiaries In most cases, the beneficiary is the owner s spouse so that the spousal exception to the required distribution rules can be used to continue the contract in the event of the owner s death. Sometimes it is appropriate for the owner to name his or her child or children as beneficiaries. If a beneficiary is a minor child, the owner should have a will and name a guardian to receive the benefits on the child s behalf. Otherwise, the child s lack of legal competence will likely cause the insurer to delay paying the benefits until the court names a guardian. Non-Natural Person as Beneficiary In some cases, it may be appropriate to name a trust or estate beneficiary under an annuity a beneficiary need not be a natural person. If the proceeds are paid to a nonnatural person as a required distribution upon the owner s death prior to the annuity 86

starting date, proceeds must be distributed within five years the annuitization option will not be available, since the beneficiary is not a natural person. Multiple Beneficiaries An annuity contract can have more than one beneficiary. Most annuities provide that if more than one beneficiary is named, equal shares will be paid out to each named beneficiary unless a specific percentage is mandated. Taxation of Beneficiary With an annuity-driven contract, upon the annuitant s death, the beneficiary becomes liable for income tax on any gain paid out of the contract, if owner and annuitant are the same person. If, owner is still alive, amounts earned before annuitant s death are taxable to owner. Also, in some cases, the beneficiary may become liable for the 10% penalty tax on premature distributions. This is because of the way the definition of the premature distributions is written in the tax law for annuities purchased on a nonqualified basis. For annuities purchased on a nonqualified basis: The definition of a premature distribution is written with reference to the taxpayer s age. Upon the death of the annuitant, to the extent the beneficiary becomes the taxpayer rather than the owner, the beneficiary s age must be used to determine whether a penalty is due. In addition, the distribution-at-death exception to the definition of premature distribution refers to the death of the contract owner or to the annuitant only if the owner is not a natural person. If the owner and annuitant are different persons and the owner is a natural person, the distribution-at-death exception does not apply at the death of the annuitant. Therefore, if an annuity is purchased on a nonqualified basis and the owner of the annuity is a natural person and is not the annuitant; the annuitant s beneficiary will be liable for the 10% penalty tax if he or she receives taxable death proceeds from the annuity when he or she is under age 59½. The situation is not as unlikely as it may sound. Most annuities are purchased on a nonqualified basis, and if the husband of a married couple is the purchaser, he is likely to name himself owner. However, it is also common for a married couple to assume that the husband will die before the wife, since men have a shorter average life expectancy than women, so the owner may name his spouse as annuitant. And since it is assumed that the husband will have already died by the time the wife dies, the couple s child or children may be named beneficiary. However, as we have already discussed, depending on the provisions in the contract, if the wife dies first, the husband s ownership rights may cease and the value of the annuity 87

may be paid to the children. The surviving husband-owner will have to pay income tax on any gain existing in the contract at the time of the wife s death. If the husband is under age 59½, they ll be liable for the 10% penalty tax as well as regular income tax on any future income paid out of the contract. Better results can be obtained by having either the husband or wife as both owner and annuitant, and naming the other spouse beneficiary. Then regardless of who dies first, the spousal exception is available to continue the contract without income tax consequences. The children can be named as contingent beneficiaries in the event of a common disaster involving both the husband and wife. Death of Beneficiary The death of the beneficiary does not affect the contract itself. If death of the beneficiary occurs prior to the death of the owner or annuitant, the owner could name a new beneficiary or if one was named in the contract, the contingent beneficiary, would become the primary beneficiary. However, if the beneficiary dies before the owner or annuitant and a new beneficiary is not named, benefits may end up being paid to the owner s or annuitant s estate. Insurance Company The insurance company that issues the annuity contract assumes a number of financial and fiduciary obligations to the owner, the annuitant, the beneficiary, and to the agent who sold the contract. Depending on the type of annuity contract, such as Individual Retirement Annuities (IRAs), Tax-Sheltered Annuities (TSAs), and annuities issued in connection with qualified retirement plans, those financial and fiduciary obligations will differ especially from a nonqualified annuity. It is important to be aware of these differences even though many insurance companies use the same single annuity contract form for nonqualified as well as qualified retirement plan purposes. Collecting and Investing the Premium In its simplest form, it is the insurance company that issues an annuity contract, collects the premium, and then promises to invest the premiums collected responsibly and then credit interest to the funds placed in the annuity. How the premium payments are invested and how much, if any, control the owner retains over the investment decisions affecting his or her funds varies depending upon which type of annuity is purchased. Some annuities provide variable annuitization. Paying the Guaranteed Death Benefit In addition to investing the owner s premium payments and crediting funds with interest, the issuing insurance company of the annuity also promises to pay the guaranteed death 88

benefit in the contract, as determined in the provisions of the contract, at the death of the owner and/or the annuitant prior to annuitization of the contract. Paying the Guaranteed Income Option As discussed earlier, an annuity has one basic purpose to provide a series of payments over a period of time. It is the responsibility and the financial obligation of the insurance company who issues the annuity contract to set aside reserves and to invest those reserves conservatively to meet the future obligations of those guaranteed income payments to its policyholders. By fulfilling these contractual obligations, the insurance company meets the objective of the annuity to avoid the annuity owner from outliving his or her financial means. While it may seem at first glance that an annuity contract issued by one company is just the same as a contract issued by any other company, the truth is that annuity contracts do differ from one company to the next. 89

Chapter 5 Review Questions 1. The parties to a nonqualified annuity contract are: ( ) A. The third party administrator, the annuitant, the owner, and the beneficiary ( ) B. The pension plan trustee, the annuitant, the owner, the insurance company and the beneficiary ( ) C. The owner, the annuitant, the beneficiary, and the insurance company ( ) D. The owner, the annuitant, the tax partner, the beneficiary and the insurance company. 2. Generally, all of the following are basic rights of the owner of an annuity contract, EXCEPT? ( ) A. Name or change the beneficiary ( ) B. Request a withdrawal ( ) C. State and change the annuity starting date ( ) D. Change the annuitant 3. The contract rights and benefits to an annuity are measured on whose life? ( ) A. Beneficiary ( ) B. Annuitant ( ) C. Owner ( ) D. Contingent owner 4. What happens at the death of the annuitant during the accumulation phase in an annuitant-driven contract? ( ) A. Contract continues with the owner as the annuitant ( ) B. Contract owner names a new annuitant ( ) C. Contract ceases to exist and is paid out to the beneficiary ( ) D. Contract ceases to exist and is paid out to the owner 5. What is the basic purpose of an annuity? ( ) A. Provide a series of payments over a period of time. ( ) B. Tax-free ( ) C. Provide a lump-sum payment to lottery winners ( ) D. Safety 90

CHAPTER 6 ANNUITIES INSIDE QUALIFIED RETIREMENT PLANS Overview There seems to be continued controversy in the financial world about placing an annuity inside a qualified retirement plan, especially a deferred variable annuity. Critics charge that since both annuities and qualified retirement plans offer income tax-deferral, putting an annuity in a qualified retirement plan is redundant and inappropriate. They also charge that the annuity is more costly and that additional costs will reduce the overall performance over the long run. And finally, they contend that government regulations and ethical guidelines militate against placing an annuity into qualified retirement plans. This concept has received much negative attention in recent years ranging from class action lawsuits, to FINRA arbitrations, to critical press, even to FINRA and SEC commentary all questioning the appropriateness of using annuities within qualified retirement plans. This chapter will look at some of this negative attention and hopefully will show you that these unfavorable views concerning annuities (especially variable annuities) in qualified retirement plans are based on a lack of understanding of the features, benefits and expenses of the annuity. And, depending on your client s financial goals and needs, you will see that an annuity, specifically a variable annuity, may be a superior method for funding tax-qualified retirement programs. Background Fixed and variable annuities have been used extensively as funding vehicles for qualified retirement programs for many years. This is due to the favorable design of these products, which provides not only professional investment management of retirement assets, but also incorporates important insurance protections of assets and a future stream of guaranteed lifetime income. According to a new report from Conning Research & Consulting, The Big Payout: Growing Individual Retirement Income Opportunities, reports that at the end of 2011, individual and group annuities held 46% of all defined contribution plan assets. Congressional Mandate The history of variable annuities in qualified retirement plans is strong and clear, with the basis formed by Congress through statutory provisions (Sections) in the Internal Revenue Code ( IRC ) of 1986. Let s review some of those specific provisions: 91

IRC 401 Qualified plans: Defined Benefit and Defined Contribution Plans, IRC 401(f) Annuity Contract shall be treated as Qualified Trust. IRC 403(a) Qualified Annuity Plan. IRC 403(b) Annuity purchased by IRC 501(c)(3) organization or public school. IRC 408 (b) Individual Retirement Annuity. IRC 457 Plans established for state and local government employees, funded with annuities. It seems quite clear from this legislation that annuities have been recognized by the U.S. Congress to be a legitimate funding vehicle for qualified plans. It should also be noted Congress provided specifically for annuity investments in tax-qualified plans well before the Internal Revenue Code of 1954 was enacted, funding these programs with fixed annuities at the time. By using variable annuities as the investment within these tax-qualified retirement plans, regulators at both FINRA and the SEC have recognized that the disclosure with regard to the variable annuity benefits, risks and costs must be complete, and the investment must meet the suitability criteria applicable to the customer s situation (as was discussed in Chapter 3). Annuities in an IRA Individuals may also open a traditional IRA and or a Roth IRA with an annuity provider and build an annuity-based plan. With this plan, the IRA stands for Individual Retirement Annuity (IRC 408(b)). An individual retirement annuity operates much like a traditional individual retirement account. The main difference is that an individual retirement annuity involves purchasing an annuity contract or an endowment contract from an insurance company. An endowment contract is an annuity that also provides life insurance protection. An individual retirement annuity must be issued in the name of the owner. The owner or the owner s surviving beneficiaries are the only ones who can receive benefits or payments from the annuity. The annuity contract must also meet the following requirements: The owner s interest in the annuity contract must be non-forfeitable (i.e., fully vested). The contract must provide that the owner cannot transfer any portion of it to any person other than the issuer (i.e., the insurance company). The contract must allow for flexible premiums so that if the owner s compensation changes, the amount of the payments can also change. Yearly contributions cannot exceed $5,000 for 2012, or if 50 or older, a total of $6,000 (includes $1,000 catch-up contribution). 92

Any refunds of premiums can only be used to pay for future premiums or to buy more benefits before the end of the calendar year after the year the refund is received. Distributions from the annuity must begin to be made by April 1 of the year following the year the owner reaches age 70½ (if not, 50% penalty). Advantages of Annuities inside a Qualified Retirement Plan Some of the advantages of owning a variable annuity inside a qualified retirement plan and/or IRA that may debunk those critics are the following: Investment Portfolio Choice. Variable annuities typically offer a number of investment portfolios so that your client can choose those that are best suited to match their goals and tolerance for risk. Most variable annuities also offer a guaranteed fixed rate of return, which can be valuable for some plan participants. (Note: Some of the fixed rate portfolios may be subject to a market value adjustment). Today, most variable annuities offer guaranteed living benefit riders to protect the annuity owner from the volatility in the market with portfolio insurance. Guaranteed Death Benefit. Variable annuities often guarantee the owner that regardless of what happens to the underlying funds held in his or her annuity, their beneficiary would receive the greater of the market value of the annuity at death, or the net value of contributions paid into the annuity. Several annuity issuers pay a death benefit that automatically adjusts or ratchet upward every few years (at an additional cost). Other issuers allow a variable annuity owner to purchase a death benefit that is guaranteed to increase in value each year at a set rate (at an additional cost). These guaranteed death benefits ensure that the owner s beneficiaries will always receive at minimum, proceeds that will exceed net contributions made by the annuity owner. In fact, FINRA has held that the death benefit offered by variable annuities may be an appropriate reason for placing a variable annuity inside a qualified plan. Guarantees of Income for Life. Annuities provide the guarantee of income payments for the life of an individual or the joint life of two individuals, no matter how long the individuals live. With people living longer lives, this annuitization guarantee of income payments that cannot be outlived is increasingly important as individual s fear of running out of money during their lifetimes. With the variable annuity people are buying longevity insurance. Also, with variable annuitization it provides an added benefit of basing lifetime payments on a portfolio of equity investments, which may provide an important hedge against inflation. In combination with a fixed annuity, a portion of the regular payments can be a guaranteed fixed dollar amount, with the balance providing the opportunity for growth through variable payments. Guaranteed Living Benefits. Guaranteed living benefits, optional riders on a growing number of variable annuities, create a variety of guarantees for investors while they are still living, as opposed to a variable annuity standard death benefit, 93

which are really only guarantees for the investor s beneficiaries. The growth of living benefits during the bear market years defined their success. Today, variable annuities with guaranteed living benefits are becoming the norm, rather than the exception. Guarantee of Annuity Purchase Rates (Annuitization). Annuity contracts also provide minimum annuitization payments for any given amount applied through contractually guaranteed initial annuity purchase rates. These minimum purchase rates are guaranteed at the time the contract is initiated and continue in force for the life of the contract, no matter what the changes are in economic conditions, life expectancies, interest rate climate, etc. At the time of inception, the individual knows the very minimum rate, which could be paid upon annuitization at any time in the future, with the opportunity for higher payments based upon conditions when payments commence. The variable annuity s annuitization benefit has been cited by industry regulators as appropriate reason for placing a variable annuity in a qualified plan. Expense Guarantee. Most variable annuity contracts guarantee that the mortality and expense risk charges and administrative fees within the contract will never be increased for as long as the contract is owned by the individual. It seems evident that this guaranteed lock on contract expenses is very meaningful over a 30 40 year period, which is typical of contract ownership, particularly when one considers how account and administrative fees have increased over recent years for other financial service products. Building/Replacing a Defined Benefit Plan. Over the past few years there has been numerous reports talking about the changing retirement landscape and how retirees in the 21 st century will need to build their own retirement plans. A new acronym has been developed: YoYo plans. Which stands for: You re On Your Own. Gone are the days when an employee could depend upon their employer (defined benefit plans) and the government (social security) to retire for the golden years. For many new retirees, the largest retirement plan they may own may be their 401(k) plan. This defined contribution plan does not guarantee the income for life that a defined benefit plan would. Then it would seem logical that the opportunity would present itself for many of these retirees to rollover their qualified plan (401(k)) into an IRA and inside the IRA purchase an annuity. The annuity would accomplish all that a defined benefit plan would: Guaranteed income for life of the annuitant and/or his or her beneficiary. These important guarantees provide real protection and benefits to the participant-owners who own an annuity inside a qualified plan and/or IRA. The tax deferral in the annuity is a matter of law it is not a benefit provided by the insurance company, and there is no fee or charge for tax deferral. RMD Rule Requirements on Variable Annuity Contracts For RMD calculation purposes the entire interest of an individual s qualified assets in their qualified retirement account or certain self-directed qualified annuity is the sum of 94

all their individual assets held within their qualified retirement account or self-directed qualified annuity as of December 31 of a given year. To determine the RMD for a qualified retirement account or self-directed qualified annuity for a given year, the total account value or contract interest for self-directed annuities is then divided by the owner s life expectancy using the appropriate IRS tables as provided in the Treasury Regulations. The new rules require that the actuarial present value of additional benefits, must be combined with the actual account value of the contract to determine the entire interest. Previously, if a deferred annuity was held as an asset in a qualified account or as a selfdirected IRA annuity, only the contract value of the annuity was used to determine the entire interest for RMD purposes. Actuarial Present Value Defined The actuarial present value (APV) is determined by projecting the actuarial value of the guaranteed benefit provided under the contract into the future and then estimating its present value. In determining this value, companies may consider what the benefit will be worth in the future and how likely it is that the benefit will become payable, taking into account the likelihood of various occurrences such as death and contract surrender value. This likely future value is then discounted at a reasonable rate of interest at the present value. RMD Calculation under the New Rules To determine a contract s value for RMD calculation purposes, the amount derived from the calculation of the actuarial present value of any guaranteed benefit is added to the December 31 account value of the previous year. This value is then divided by the owner s life expectancy using the appropriate IRS tables. The resulting number is the RMD for the year. Safe Harbor Rules There is a safe harbor under the rules. This safe harbor provision states that an additional benefit under a deferred annuity contract can be disregarded for purposes of determining the actuarial present value requirement if it fits at least one of two circumstances: When the only additional benefit is a death benefit that does not exceed the premiums paid less the amount of prior withdrawals (Return of Premium GMDB), or When withdrawals impact benefits of a pro-rata basis and the actuarial present value of all guaranteed benefits under the contract do not exceed 20% of the contract value. 95

Example: Calculating RMD Under New Rules Detailed below is a hypothetical example of how the APV may be determined for a qualified annuity contract with a guaranteed minimum death benefit (GMDB) and guaranteed minimum income benefit (GMIB). This example is based on assumptions that a hypothetical company may deem reasonable. Other annuity issuers may determine different values based on the assumptions they have selected. Note: Under the Workers Retirement Employer s Rescue Act of 2008, RMDs for 2009 are not required. GMDB Example 1: Assume the Owner (who is also the Annuitant) is 75 years old with a variable annuity with a pro-rata Maximum Anniversary Value (MAV) GMDB. On December 31, 2010, the annuity contract value is $500,000 and the MAV GMDB is $1,000,000. o Step 1: Using the life expectancy tables prescribed by the IRS, the RMD factor for a 75-year old is 22.9. To determine the client s RMD for this contract prior to determining an actuarial present value calculation for the GMDB, divide the annuity contract value by the RMD factor: $500,000 / 22.9 = $21,834. o Step 2: To calculate the actuarial present value of the GMDB, an insurance company must reflect the net amount at risk (i.e. the difference between the contract value and GMDB) and the maximum age through which such a benefit may be paid. Let s assume the following: The company requires annuitization at age 95; the Company assumes the net market performance for this product is 6.5% and a discount rate of 5.0% is appropriate to reflect the time value of money. Based on these hypothetical assumptions, an actuarial present value of the $1,000,000 MAV GMDB would be $65,519. o Step 3: Next determine whether the actuarial present value of the GMDB falls within he safe harbor prescribed by the rules. To calculate this value, divide the actuarial present value of the GMDB by the annuity contract value: $65,519 / $500,000 = 13.1%. Since this value is less than 20% and the MAV GMDB design is pro-rata, there would be no impact on the previously RMD of $21,834 (Step 1). As previously noted, the safe harbor does not apply to benefits that are adjusted on a dollar-for-dollar basis for withdrawals. Based on the assumptions above, if a 75 year old owner had a dollar-for-dollar MAV GMDB design, the RMD would be increased as follows: ($500,000 + $65,519) / 22.9 = $24,695. This RMD is 13.1% INCREASE over the previously calculated RMD of $21,834. GMDB Example 2: Using the same assumptions described above, suppose the annuity contract value is $400,000. 96

o Step 1: Determine the client s RMD for this contract prior to determining an actuarial present value calculation for the GMDB by dividing the annuity contract value by the RMD factor: $400,000 / 22.9 = $17,467 o Step 2: The actuarial present value of the $1,000,000 MAV GMDB is now $104,317. o Step 3: Determine whether the actuarial present value of the GMDB falls within the safe harbor set by the new rules. To make this determination, divide the actuarial present value of the GMDB by the annuity contract value to get: $104,317 / $400,000 = 26.1%. Here the actuarial present value does not fall within the safe harbor. o Step 4: Determine the RMD for this contract by adding the actuarial present value of the GMDB to the annuity contract value and divide it by the RMD factor to get the RMD for the year ($4000,000 + $104,317) / 22.9 = $22,023. As previously outlined in Step 1, under the old rules the RMD for a client in this scenario would have been: $400,000 / 22.9 = $17,467. This new RMD is a 26.1% INCREASE over the old RMD. New Proposed Treasury Regulation Longevity Contracts On February 9, 2012, the U.S. Treasury Department proposed new regulations (Treasury Regulation 26 CFR 115089-11) to allow participants in qualified retirement plans (401(a), 403(b), 408 and 457 plans) to purchase longevity annuity contracts. The proposal would allow participants to purchase a fixed annuity contract and be allowed to defer until age 80 85 years old. The purchase would be limited to the lesser of $100,000 or 25% of plan balance. Husband and wife are allowed separate accounts. The Treasury is now accepting comments. Stay tuned! 97

Chapter 6 Review Questions 1. The safe harbor provision allows for disregarding the actuarial present value (APV) if certain conditions are met. ( ) A. True ( ) B. False 2. Which of the following are criticisms of owning a variable annuity inside a qualified retirement plan? ( ) A. Duplication of tax-deferral ( ) B. Costly ( ) C. Ethical guidelines ( ) D. All of the above 3. Which type of individual retirement arrangement involves the purchase of an annuity or an endowment contract? ( ) A. Individual Retirement Annuity ( ) B. Individual Retirement Account ( ) C. Tax-sheltered Annuity ( ) D. Individual Roth Account 4. Which Section of the Internal Revenue Code (IRC) allows teachers to invest in a variable annuity within their qualified retirement plan? ( ) A. IRC Section 401(a) ( ) B. IRC Section 403(b) ( ) C. IRC Section 408 ( ) D. IRC Section 408A 5. To determine an annuity contract s value for RMD calculation purposes, the amount derived from the calculation of the actuarial present value of any guaranteed benefit is added to the which of the following? ( ) A. Account value as of April 15 th of the current tax year ( ) B. Account value as of April 15 th of the previous tax year ( ) C. Account value as of December 31 of the current tax year ( ) D. Account value as of December 31 of the previous tax year 98

CHAPTER 7 SUITABILITY OF ANNUITIES Overview Suitability should be a concept that is familiar to all of us. Whether it is a routine purchase or a life decision, we are always assessing our choices based upon what best suits our needs. The topic is no different in the world of insurance. When we carefully align a client s needs and objectives with a life insurance or annuity product, we can conclude that the sale is suitable. According to LIMRA s (Life Insurance Marketing Research) Producer Guide to Market Conduct, a suitable life insurance or annuity sales is one that is appropriate for the customer in light of his or her total financial situation one that balances adequate coverage with affordability. However, like any industry there will always be a few bad apples that try to take advantage of a situation and put their own interests first. Regretfully, because of these few rogue salespersons, many state insurance regulators and other regulatory bodies, such as the NAIC, FINRA and the SEC have been forced to mandate new reporting, disclosure and suitability requirements on all insurance producers/agents selling annuity products. NAIC Suitability Model The National Association of Insurance Commissioners (NAIC) has taken specific action to require that insurance producers/agents and insurers selling annuities to senior citizens, and to all Americans, for that matter, take affirmative steps to ensure the suitability of the annuity for the consumer. Senior Protection in Annuity Transactions Model Regulation In 2000, the NAIC adopted a white paper calling for the development of suitability standards for non-registered products similar to those existed for some time under the Securities and Exchange Commission (SEC) for registered products (discussed below). The result of the white paper was a working group of the NAIC under the Life Insurance and Annuities Committee that drafted a model setting suitability standards for all life insurance and annuity products. 99

The NAIC Life Insurance and Annuity Committee decided to focus first on the area that had been identified as subject to the greatest abuse: the inappropriate sales of annuities to persons (seniors) age 65 and over. The resulting Senior Protection in Annuity Transactions Model Regulation ( Suitability Model ) was adopted by the NAIC in 2003. This Model Regulation was another tool that regulators could use to protect consumers from inappropriate sales practices in addition to the NAIC s Annuity Disclosure Model Regulation. Then in 2006, still concerned about the abusive and unsuitable sales of both life insurance and annuity products not just to seniors, age 65 and older, the NAIC membership overwhelmingly adopted revisions to the Suitability Model to have its requirements apply to all consumers regardless of age. The amended Suitability Model imposes certain duties and responsibilities on insurers and insurance producers regarding the suitability of a sale or exchange of an annuity to a consumer. Specifically, in recommending to a consumer the purchase of an annuity or the exchange of an annuity, the insurance producer/agent, or the insurer if no producer is involved, must have reasonable grounds for believing that the recommendation is suitable for the consumer. This is based on facts disclosed by the consumer as to his or her investments and other insurance products and as to his or her financial situation and needs. To ascertain the product s suitability, prior to the execution of a purchase or exchange of the recommended annuity, the insurance producer/agent, or insurer if no producer is involved, must make all reasonable efforts to obtain information concerning: Consumer s financial status; Consumer s tax status; Consumer s investment objectives, and Any other information used or considered to be reasonable in making the recommendation to the consumer. 2010 NAIC Suitability in Annuity Transactions Model Regulation This Model Regulation was adopted to set standards and procedures for suitability annuity recommendations and to require insurers to establish a system to supervise recommendations so that the insurance needs and financial objectives of consumers are appropriately addressed. Specifically, this Model Regulation was adapted to: Establish a regulatory framework that holds insurers responsible for ensuring that annuity transactions are suitable (based on the criteria in Section 5I, discussed below), whether or not the insurer contracts with a third party to supervise or monitor the recommendations made in the marketing and sale of annuities. Require that producers be trained on the provisions of annuities in general, and the specific products they are selling. 100

Where feasible and rational, to make suitability standards consistent with the suitability standards imposed by the Financial Industry Regulatory Authority (FINRA). Determining Suitability As discussed above, the 2006 version of the NAIC Model Regulation required that, prior to recommending an annuity, an insurance producer/agent or an insurer must make reasonable efforts to obtain information about the consumer's financial status, tax status, and investment objectives, as well as other information that could be used in making a recommendation to the consumer. However, the newly revised 2010 Model Regulation, Section 6, imposes a substantially higher benchmark for determining the "suitability" of all types of annuities, closely approximating FINRA standards applicable to variable annuity sales. First, the 2010 Model Regulation requires that the insurance producer/agent have "reasonable grounds" to believe that the annuity recommendation is suitable for the consumer. This suitability determination is to be made from "suitability information" disclosed by the consumer about his investments and other insurance products and his financial situation and needs. Such "suitability information" consists of 12 different factors, including the consumer's intended use of the annuity, financial time horizon, existing assets, liquidity needs, liquid net worth, and risk tolerance. These 12 suitability factors are clearly more expansive than the few listed in the 2006 version of the Model Regulation. They are: Age; Annual income; Financial situation and needs, including the financial resources used for the funding of the annuity; Financial objectives; Financial experience; Intended use of the annuity Financial time horizon; Existing assets, including investment and life insurance holdings; Liquidity needs; Liquid net worth; Risk tolerance; and Tax status. Note: California added a 13 point: Whether or not the consumer has a reverse mortgage. Second, duties of insurers and of the insurance producer/agent must also have a "reasonable basis" to believe that the annuity as a whole, its unique features, and the transaction itself are in the best interests of, and can be understood by, the consumer. 101

Specifically, Under Section 6A, the insurance producer/agent, or the insurer where no producer is involved, shall have reasonable grounds for believing that the recommendation is suitable for the consumer on the basis of the facts disclosed by the consumer as to his or her investments and other insurance products and as to his or her financial situation and needs, including the consumer s suitability information, and that there is a reasonable basis to believe all of the following: The consumer is reasonably informed of the annuity's features; The consumer will benefit from certain features of the annuity, such as taxdeferred growth, annuitization, or a death or living benefit; The particular transaction, the annuity as a whole, the underlying sub-accounts, and any riders and similar product enhancements are suitable for the particular consumer; and As applicable, the exchange or replacement is suitable, considering surrender charges, increased fees, benefits from product enhancements and improvements, and other exchanges or replacements within the preceding 36 months. Both the 2006 and 2010 versions of the Model Regulation limit the producers' obligations to the consumer where the consumer refuses to provide complete or accurate suitability information or enters into an annuity transaction that expressly is not recommended. Section 6D of the 2010 Model Regulation states that neither a producer nor an insurer has any obligation to a consumer under the provisions of this regulation if: No recommendation is made; The consumer provided materially inaccurate information which led to an unsuitable recommendation; A consumer fails to provide relevant suitability information and the transaction is not recommended of an insurance producer; However, an insurer s issuance of an annuity is to be reasonable under all circumstances actually known to the insurer, even if the situations listed above apply. Systems of Supervision and Training The 2006 version of the Model Regulation merely required insurers and insurance producers/agents to maintain written procedures and to conduct periodic reviews of their records in order to prevent violations. The 2010 Model Regulation, Section 6F, now provides additional guidance for establishing effective supervisory procedures. Under the newly amended Model Regulation, insurance producers/agents must make a record of any annuity recommendation and obtain a consumer signed statement if the consumer refuses to provide the required suitability information or decides to purchase an annuity not based on a recommendation. In addition, prior to the issuance of an annuity contract, the insurer (or a third party with whom the insurer has contracted) must review annuity recommendations to ensure that 102

there is a reasonable basis to believe the transaction is suitable. This may be accomplished by a screening system that would identify selected transactions for additional scrutiny. The insurer also will be required to maintain reasonable procedures to detect recommendations that are not suitable, including confirming consumer suitability information, conducting customer surveys and interviews, sending confirmation letters and establishing internal monitoring programs. Finally, the 2010 Model Regulation mandates that insurers train their insurance producers/agents on the new suitability requirements and on the products themselves. Section 7A requires the insurance producer to have adequate product training, prior to soliciting an annuity product. In addition, Section 7B requires a one-time, minimum four (4) credit hour general annuity training course offered by an insurance-department approved educational provider and approved by an insurance department in accordance with applicable insurance education training laws or regulations. For this mandated course, the provider may not train in sales or marketing techniques or product specific information. Section 7B(3) outlines the minimum required topics for this program of instruction, which can be offered in the classroom or via an insurance department approved self-study method. If an insurance producer is licensed with a life insurance line of authority prior to the effective date of the regulation, there is a six month grace period to comply with the training requirements; insurance producers /agents who obtain the life authority on or after the effective date of the regulation must complete the training prior to the sale of an annuity product. FINRA Compliance It should be noted that under Section 6H of the Model Regulation's safe harbor provision, sales of annuities already in compliance with FINRA rules must comply with the new NAIC suitability regulation as well. Broker-Dealers may subject fixed annuity sales to FINRA suitability and supervision rules; and sales made in compliance with such rules would also qualify as complying with the NAIC suitability regulation. However, since, FINRA does not have authority to enforce its rules on the sale of fixed annuities, brokerdealers supervising fixed annuity sales may be subject to more intensive insurance examination than for the sale of security insurance products. Representatives of a brokerdealer, who are not required by the broker-dealer to comply with the FINRA requirements on the sale of fixed annuities, will have to comply with the insurance suitability regulation adopted by the state. In any case, insurers are responsible for any unsuitable annuity transactions no matter what suitability regulation or rule is applied by a broker-dealer. 103

FINRA Regulation of VA The Financial Industry Regulatory Authority (FINRA), previously known as the National Association of Security Dealers (NASD), is an independent self-regulatory organization charged with regulating the securities industry, including sellers of variable annuities. FINRA has issued several investor alerts on the topic of variable annuities and has issued a number of Rules pertaining to the sale and suitability of variable annuities (discussed below). FINRA Rule 2821 Based on the findings of a joint report Examinations Findings Regarding Broker- Dealer Sales of Variable Insurance Products (Joint Report) which identified weak practices regarding the suitability of variable annuity sales practices for investors and the lack of adequate disclosure of the risks, fees and tax consequences, FINRA published Rule 2821. FINRA Rule 2821 imposed stringent sales practice standards and supervisory requirements on the sale of variable annuities by its members. The Rule set forth disclosure and information-gathering responsibilities regarding the sale of deferred variable annuities, as well as supervisory requirements to increase disclosure and sales force training. The key requirements of the rule include: Suitability (Rule 2821(b)): Requires that no recommendation shall be made unless reasonable efforts have been made to obtain, at a minimum, information concerning the customer s: o Age, o Annual income, o Financial situation and needs, o Investment experience, o Investment objectives, o Intended use of the deferred variable annuity, o Investment time horizon, o Existing investment and life insurance holdings, o Liquidity needs, o Liquid net worth, o Risk tolerance, and o Tax status. Under the new rules, the insurance producer/registered representative would be required to ascertain the following key pieces of information from the client: Has the client been informed of the unique features of the variable annuity? Does the client have a long-term objective? 104

o Is the annuity and its underlying sub-accounts the right match for the particular client? Once the suitability requirements are reviewed, the insurance producer/registered representative would need to sign off on their validity. At the end of the day, the insurance producer/registered representative should be able to answer yes to the above checklist of suitability guidelines. Disclosure: The member firm or its representative would be required to provide the client with a current prospectus and a separate, brief, plain English risk disclosure document highlighting the main features of the particular variable annuity transaction. Those features would include: o Liquidity issues, such as potential surrender charges and IRS penalties; o Sales charges; o Fees (including mortality and administrative fees, investment advisory fees and charges for riders or special features); o Federal tax treatment for variable annuities; o Any applicable state and local government premium taxes, and o Market risk. The risk disclosure document would be required to inform the client whether a free look period applies to the variable annuity contract, during which the client could terminate the contract without paying any surrender charges and receive a refund of his or her purchase payments. Principal Review (Rule 2821 (c)): Requires that a registered principal must review and sign off on suitability and disclosure requirements, no later than seven (7) business day following the date when a firm s office of supervisory jurisdiction (OSJ) receives a complete an correct application package. The registered principal will be required to retrace the suitability requirements that the writing agent addressed, including: o What is the client s age and liquidity need? o Does the amount of money exceed a specific percentage of the client s net worth or more than a set dollar amount? o Does the transaction involve an exchange or replacement? o Is the purchase of the VA for a tax-qualified retirement account? If a transaction has an exchange or replacement clause, the registered principal would need to review and approve a separate exchange or replacement document. Justification for the FINRA s new rules, according to the agency, is that the principal review requirements ultimately give the client the ability to review, complete and execute an application for a VA in a quick one-step process. 105

Training (Rule 2821 (e)): Registered firms would be required to develop and document specific training policies or programs designed to ensure that registered representatives and registered principals comply with the rule s requirements and that they understand the unique features of deferred variable annuities. The Security Exchange Commission (SEC), after years of review and discussion, approved Rule 2821 on September 7, 2007 with an effective date of May 5, 2008. The SEC made several changes to Rule 2821. The rules application applies to the purchase or exchange (not sale or surrender) of a deferred variable annuity and the initial sub-account allocations. The rule does not apply to reallocations of sub-accounts made or to funds paid after the initial purchase or exchange of a deferred variable annuity. Note: There are other FINRA rules, however, that are applicable to such transactions. For instance, FINRA s general suitability rule (FINRA Rule 2310) continues to apply to any recommendations to reallocate sub-accounts or to sell a deferred variable annuity. FINRA Rule 2821 applies to the use of deferred variable annuities to fund IRAs, but not to deferred variable annuities sold to certain tax-qualified, employer-sponsored retirement or benefit plans, unless a member firm makes a recommendation to an individual plan participant, in which case the rule would apply to that recommendation. The new rule applies to sales to all investors and not just to seniors. The SEC published the order approving the new rules in Release Number 34-56375, which relates to File Number SR-NASD-2004-183. FINRA Rule 2330 January 2010, FINRA consolidated Rule 2821 on deferred variable annuities into FINRA Rule 2330. The consolidated rule establishes sales practice standards regarding recommended purchases and exchanges of deferred variable annuities. All of the rule s provisions became applicable as of February 8, 2010. The rule has the following six main sections: General considerations, such as the rule s applicability; Recommendation requirements, including suitability and disclosure obligations; Principal review and approval obligations; Requirements for establishing and maintaining supervisory procedures; Training obligations; and Supplementary material that addresses a variety of issues ranging from the handling of customer funds and checks to information gathering and sharing. 106

FINRA Rule 2111 As part of the process to develop a new consolidated rulebook (the Consolidated FINRA Rulebook), Regulatory Notice 09-25, calls for the elimination of FINRA Rule 2310 to be consolidated with the new FINRA Rule 2111 ( Suitability Rule ). The modified rule would codify various interpretations regarding the scope of the suitability rule, clarify the information to be gathered and used as part of a suitability analysis and create a clear exemption for recommended transactions involving institutional customers, subject to specified conditions. Scope of FINRA Rule 2111: FINRA Rule 2111 will explicitly apply suitability obligations to a recommended transaction or investment strategy involving a security or securities. In this regard, the Rule would codify longstanding SEC and FINRA decisions and other interpretations stating that FINRA Rule 2111 covers both recommended securities and strategies. FINRA also proposes to codify in one place the discussions of the three main suitability obligations (reasonable basis, customer specific and quantitative), which are currently located in various IMs following FINRA Rule 2310. Information Gathering Regarding the Proposed Suitability Rule: FINRA Rule 2111 contains a number of minor changes regarding the gathering and use of information as part of the suitability analysis. For instance, the information that must be analyzed in determining whether a recommendation is suitable would include not only information disclosed by the member firm s or associated person s reasonable efforts to obtain it, but also information about the customer that is known by the member or associated person. The Rule also requires members or associated persons to make reasonable efforts to obtain more information than is explicitly required by FINRA Rule 2310 (age, investment experience, investment time horizon, liquidity needs and risk tolerance). FINRA Rule 2090: Know Your Customer FINRA Rule 2090, will also transfer into the Consolidated FINRA Rulebook a modified version of NTSE Rule 405(1) requiring firms to use due diligence to know their customers and eliminate the NYSE version and its related supplementary material and rule interpretation. The Rule would eliminate paragraphs (2) and (3) of NYSE Rule 405 and their related supplementary materials and rule interpretations as duplicative of NASD provisions that FINRA has proposed (or will be proposing) to be transferred into the Consolidated FINRA Rulebook. For instance, NYSE Rule 405(2) (Supervision of Accounts) is duplicative of NASD Rule 3110 (c )(1)(C )(Customer Account Information) and 3011 (Anti Money Laundering Compliance Program) and, to a certain extent, the proposed modified version of NYSE Rule 405(1), discussed below. FINRA Rule 2090, know-your-customer obligation, captures the main ethical standard of NYSE Rule 405(1). Firms would be required to use due diligence, in regard to the opening and maintenance of every account, to know the essential facts concerning every customer (including the customer s financial profile and investment objectives or policy). 107

This information may be used to aid the firm in all aspects of the customer/broker relationship, including, among other things, determining whether to approve the account, where to assign the account, whether to extend margin (and the extent thereof) and whether the customer has the financial ability to pay for transactions. The obligation arises at the beginning of the customer/broker relationship and does not depend on whether a recommendation has been made. SEC Approves Consolidated FINRA Rules The SEC approved FINRA s proposal (Regulatory Notice 09-25) to adopt rules governing know-your-customer (FINRA Rule 2090) and suitability (FINRA Rule 2111) obligations for the consolidated FINRA rulebook. The new rules are based in part on and replace provisions in the NASD and NYSE rules and are discussed below. Effective Date These rules were scheduled to take effect on October 7, 2011, but were extended to July 9, 2012. 108

Chapter 7 Review Questions 1. New FINRA Rule 2111 is modeled after former NASD Rule: ( ) A. 2090 ( ) B. 2310 ( ) C. 2111 ( ) D. 2110 2. The original NAIC Senior Protection in Annuity Transaction Model Act set forth standards and procedures for recommendations to seniors of what age? ( ) A. 65 and older ( ) B. 55 and older ( ) C. 70 and older ( ) D. 60 and older 3. In the 2010 Suitability in Annuity Transaction Model Regulation, Section 7B, recommends that insurance producers who sell annuities take a one-time general annuity training program consisting of a minimum of how many hours? ( ) A. 2 hours ( ) B. 3 hours ( ) C. 4 hours ( ) D. 8 hours 4. The Senior model regulation applies to which type of insurance products sold to seniors (age 65 and older)? ( ) A. Fixed annuities only ( ) B. Variable annuities only ( ) C. Both fixed and variable annuities ( ) D. Variable life insurance and variable annuities only. 5. Which of the following proposed FINRA Rules would use the NASD suitability rule as the model for a modified suitability rule for the Consolidated FINRA Rulebook and eliminate NASD Rule 2310? ( ) A. Rule 2810 ( ) B. Rule 2110 ( ) C. Rule 2090 ( ) D. Rule 2111 109

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CHAPTER 8 UNFAIR MARKETING PRACTICES Overview The Unfair Marketing Practices Act was created by the National Association of Insurance Commissioners (NAIC) back in the 1940 s and since then has been amended and expanded. The Act is divided into two parts Unfair Marketing Practices and Unfair Claims Practices. In each state, statutes define and prohibit certain marketing practices and claims practices, which are unfair, unethical, misleading and deceptive. Let s review several of these unfair marketing practices as well as the NAIC s Model Regulation for Replacements and Use of Senior Specific Certifications and Designations. Misrepresentation Misrepresentation is simply a false statement of fact; that is a lie. For many insurance producers, the biggest market conduct danger they may face is making a misrepresentation during a sales presentation. Sometimes, it is the result of overenthusiasm of selling the benefits of a policy too strongly. It may also be the result of a willingness to stretch the advantages of a particular product and sidestep the disadvantages. While on the other hand, providing vague or elusive responses is just as serious a form of misrepresentation as is deliberately lying about a policy s features and benefits or expected performance. Fraud If an insurance producer intentionally misrepresents any information in an insurance transaction, he or she is guilty of fraud. An insurance producer found guilty of fraud may be subject to fines and/or imprisonment as well as the possible loss of their license to sell insurance as well as public disgrace. Altering Applications Altering applications, for any purpose, is not permitted. It is illegal and insurance producers must not engage in altering applications. In the past, applications have been altered for a number of fraudulent reasons, such as to: Change underwriting information to get a more favorable premium rate, or Switch the type of coverage applied for, or Add additional zeroes to the amount of coverage applied for. 111

Premium Theft Of all the prohibited activities, premium theft ranks among the worst offense an insurance producer can commit. In addition to the outright theft of the premium money, failure to turn over a premium on a policy prevents the policy from going into effect. The consumer believes he or she is insured, but in fact, the application was never submitted to the insurance company. These situations are quickly discovered if any inquiry is made by the prospective insured or the insurance company. Premium theft is rigorously punished by every state Insurance Department. False or Misleading Advertising The potential for false (deceptive) advertising or promotion by insurance companies and or insurance producers alike is significant and the consequences to the consumer can be grave. Accordingly, all states regulate insurance advertising. The NAIC has created a model regulation more specifically directed at advertising the Rules Governing Advertising of Life Insurance. This model regulation, which so far has been adopted by more than 31 states, defines advertising and attempts to address those actions that have caused the most problems in the industry. It also mandates the proper identification of insurance producers and companies, a system of control over its advertisement, a description of the type of policy advertised, and the disclosure of graded or modified benefits over time and so forth. Recently, several states have passed specific legislation (For example in California, two bills were passed by the legislators, SB 620 and SB 618) for regulating advertising to seniors age 65 and older. Defamation Defamation is any false maliciously critical or derogatory communication written or oral that injures another s reputation, fame or character. Without the element of communication there can be no defamation. Both insurance producers and insurers can be defamed. Unethical insurance producers participate in defamation by spreading rumors or falsehoods about the character of a competing insurance producer or the financial condition of another insurer. Boycott, Coercion, Intimidation 112

Boycott, coercion and intimidation are unethical trade practices, which attempt to limit or restrain trade in the sale of insurance. No person or company has the right or the power to force, coerce or intimidate any person into purchasing insurance from a specific insurance producer or insurer. Twisting Twisting is the unethical act of inducing a client to lapse, surrender or terminate an existing insurance product solely for the purpose of selling another policy with another insurer without regard to the possible disadvantages to the policy owner. By definition, twisting involves some kind of misrepresentation by the insurance producer to convince the policy owner to switch insurers. The key word in the definition of twisting is inducement. Twisting is illegal and should not be confused with replacement, which is legal if done in accordance with specific state laws. Churning Related to twisting is churning. If an insurance producer induces a prospect/client to replace a policy with a new policy with the same insurer and if the replacement is not in the client s best interest, the insurance producer is guilty of churning. In cases involving churning, there is no demonstrated benefit to the policy owner with the new policy or contract. Churning is unethical and illegal. Discrimination Discrimination is both illegal and unethical in accordance with state and federal laws. From an insurer s perspective, it is unlawful to permit discrimination between individuals of the same class and life expectancy regarding life insurance rates, dividends or other policy benefits. It is unlawful to discriminate because of age in the issuance of and rates for automobile insurance. It is unethical and illegal to permit or cause discrimination due to race, creed, color or national origin regarding the issuance or the rates charged for insurance. Rebating Splitting a commission or paying a client for his or her business is considered "rebating." Rebating occurs if the buyer of an insurance policy receives any part of the insurance producer's commission or anything else of significant value as an inducement to purchase the insurance product being sold by the insurance producer. Rebating is illegal in all but two states: 113

California (Rules regarding unfair practices are outlined in CA Assembly Bill 689 specific to annuity sales and suitability to seniors, and in CIC 790-790.15 for all insurance transactions); and Florida (Rules specific to the allowance of rebating are found in the 2012 Florida Statues, Title XXXVII, Section 626.572). However, most insurers forbid their insurance producers to rebate even in jurisdictions where it is legal. It is acceptable to provide gifts of nominal value (pens, calendars, coffee mugs, etc.) to prospects and clients when those gifts are given regardless of whether or not you make a sale. If you provide a nominal gift, you must provide it to everyone you approach. Unsuitable Replacements Similar to the Suitability Model Regulation, as discussed in Chapter 8, the National Association of Insurance Commissioners (NAIC) also developed a model regulation that serves as a basis for state replacement regulations and is designed to ensure that insurers and agents/producers provide consumers with fair and accurate information about life insurance and annuity products. The NAIC Model Life Insurance Replacement Regulation is a first step toward providing the consumer with clear, relevant information. Purpose The purpose of the NAIC Model Replacement Regulation is to protect the interests of life insurance and annuity purchasers by establishing minimum standards of conduct by agents and insurers to be observed during the replacement of or financed purchase transactions. Purchasers of such products are to receive clear investment information that also reduces the opportunity for misrepresentation. Failure to comply with provisions may be subject to penalty (discussed below). Application The replacement regulation applies to both life insurance and annuities. It imposes producer obligations with respect to internal and external replacements; insurer obligations with respect to internal and external replacements solicited through producers and through the mail, telephone, Internet or other mass communication media, and conservation by existing insurers. Replacement is defined to include any purchase of new life insurance or annuity where the producer knows or should know, or the proposing insurer that, by reason of the transaction, an existing policy or contract has been or is to be: Lapsed, forfeited, surrendered or partially surrendered, assigned to a replacing insurer, or otherwise terminated; Converted to reduced paid-up insurance, continued as extended term insurance, or otherwise reduced in value by the use of non-forfeiture benefits or other policy values; 114

Amended so as to effect a reduction in benefits or in the term for which coverage would otherwise remain in force or for which benefits would be paid; Reissued with any reduction in cash value; or Used in a financed purchase. A financed purchase means the purchase of a new policy involving the actual or intended use of funds obtained by the withdrawal or surrender of, or by borrowing from, values of an existing policy to pay all or part of any premium due on a new policy. The NAIC Replacement Rules does not apply to transactions involving: Credit life insurance; Group life insurance or group annuities where there is no direct solicitation of individuals by the insurance producer. Group life & annuity certificates marketed through direct response solicitation are subject to the provisions for this regulation. Group life insurance and annuities used to fund prearranged funeral contracts, An application to the existing insurer when a contractual change or conversion privilege is being exercised, or when the existing policy or contract is being replaced by a program filed with and approved by the executive director, Proposed life insurance under a binding or conditional receipt issued by the same company; Policies or contract used to fund an employee pension or welfare plan covered by ERISA, a plan described in Section 401(a), 401(k) or 403(b) of the Internal Revenue Code (IRC), a government or church plan defined in section 414 of the IRC, or a nonqualified deferred compensation arrangement established or maintained by an employer or plan sponsor. However, this exemption does not apply to contracts or policies used to fund a plan that are solely funded by the employee, where the employee has a choice between two or more insurers or products, and there is direct agent solicitation; New coverage provided under a life insurance policy or contract where the cost is borne wholly by the insured s employer or an association of which the insured is a member; Existing life insurance that is non-convertible term life insurance policy that will expire in 5 years or less and cannot be renewed; Immediate annuities purchased from the proceeds of an existing annuity. However, immediate annuities purchased from the proceeds of a life insurance policy are not exempt; Structured settlement annuities. Certain requirements of the replacement regulation, such as the requirement for signed statements with all applications when the applicant has existing life insurance policies or annuity contracts, apply even when no replacement is involved. Duties of Insurance Producers 115

An insurance producer/agent who initiates an application for a life insurance policy or annuity contract shall submit to the insurer, with or as part of the application, a statement signed by both the applicant and the agent as to whether the applicant has existing policies or contracts. If the applicant states that the applicant does not have existing policies or contracts, the agent's duties, with respect to replacement are complete. However, if the applicant states that the applicant does have existing policies or contracts, the insurance producer/agent shall present and read to the applicant, not later than at the time of taking the application, a Notice Regarding Replacements. The Notice Regarding Replacement must be given in a form adopted or approved by the commissioner. The notice shall be signed by both the applicant and the agent attesting that the notice has been read aloud by the agent or that the applicant did not wish the notice to be read aloud, in which case the agent is not required to read the notice aloud. The notice must be left with the applicant unless it is presented to the applicant by electronic means and signed electronically, in which case the insurer shall mail the applicant a copy of the notice not later than the third business day after the date the application is received by the insurer. The notice must list all life insurance policies or annuities proposed to be replaced, properly identified by the name of the insurer, the name of the insured or annuitant, and the policy or contract number if available, and include a statement as to whether each policy or contract will be replaced or whether a policy will be used as a source of financing for the new policy or contract. If a policy or contract number has not been issued by the existing insurer, alternative identification, such as an application or receipt number, must be listed. In connection with a replacement transaction, the insurance producer/agent shall leave with the applicant, at the time an application for a new policy or contract is completed, the original of all sales material or a copy of that material. Electronically presented sales material must be provided to the policy or contract owner in printed form not later than the date that the policy or contract is delivered. The insurance producer/agent shall also submit to the insurer to which an application for a policy or contract is presented: A copy of each document required by this section; A statement identifying any preprinted or electronically presented insurerapproved sales materials used; and Copies of any individualized sales materials, including any illustrations related to the specific policy or contract purchased. Duties of Insurers That Use Agents 116

The replacement regulations require that all insurers shall maintain a system of supervision and control to ensure compliance. Under the system, the insurer must, at minimum: Inform its agents of the Replacement Regulations and guidance as to the appropriateness of replacements; Provide each agent a written statement of the insurer's position with respect to the acceptability of replacements and provide guidance to the agent as to the appropriateness of these transactions; Review the appropriateness of each replacement transaction; Implement procedures to confirm that the requirements of the Replacement Regulations have been met; and Implement procedures to detect transactions that are replacements of existing policies or contracts by the existing insurer but that have not been reported as such by the applicant or insurance producer/agent. Each insurer must have the capacity to monitor each insurance producer s/agent's life insurance policy and annuity contract replacements for that insurer. The insurer shall maintain records regarding the monitoring and shall produce and make the records available to the department on request. The capacity to monitor under this subsection must include the ability to produce records for: Each agent's life insurance replacements, including financed purchases, as a percentage of the agent's total annual sales for life insurance; The number of lapses of policies by the agent as a percentage of the agent's total annual sales for life insurance; Each agent's annuity contract replacements as a percentage of the agent's total annual annuity contract sales; The number of transactions that are unreported replacements of existing policies or contracts by the existing insurer detected by the insurers monitoring system; and Replacements, indexed by replacing agent and existing insurer. Each insurer shall require, with or as a part of each application for life insurance or an annuity, a signed statement by both the applicant and the agent as to whether the applicant has existing policies or contracts. Each insurer shall require, with each application for life insurance or an annuity that indicates an existing policy or contract, a completed notice regarding replacements. If the applicant has existing policies or contracts, each insurer must be able to produce, for at least five years after the date of termination or expiration of the proposed policy or contract, copies of any sales material required by Section 1114.051(g), the basic illustration and any supplemental illustrations related to the specific policy or contract that is purchased, and the agent's and applicant's signed statements with respect to financing and replacement. 117

The insurer shall ascertain that the sales material and illustrations required by Section 1114.051(g) meet the requirements of this chapter and are complete and accurate for the proposed policy or contract. Under subsection (i) if an application does not meet the requirements of this chapter, the insurer shall notify the agent and applicant and fulfill the outstanding requirements. Under Subsection (j) the insurer shall maintain records required by this section in paper, photographic, microprocess, magnetic, mechanical, or electronic media or by any process that accurately reproduces the actual document. Duties of Replacing Insurers that Use Agents The replacing insurer shall verify that the required forms are received and are in compliance. The replacing insurer shall: Notify any existing insurer that may be affected by the proposed replacement not later than the fifth (5) business day after: o (A) the date of receipt of a completed application indicating replacement; or o (B) the date that replacement is identified if it is not indicated on the application; and Mail a copy of the available illustration or policy summary for the proposed policy or available disclosure document for the proposed contract to the existing insurer not later than the fifth business day after the date of a request from the existing insurer. The replacing insurer must also be able to produce copies of the notification regarding replacement indexed by agent, until the later of: The fifth anniversary of the date of the notification; or The date of the replacing insurer's next regular examination by the insurance regulatory authority of the insurer's state of domicile. The replacing insurer shall provide to the policy or contract owner notice of the owner's right to return the policy or contract within thirty (30) days of the delivery of the policy or contract and to receive an unconditional full refund of all premiums or considerations paid on the policy or contract, including any policy fees or charges or, in the case of a variable or market value adjustment policy or contract, a payment of the cash surrender value provided under the policy or contract plus the fees and other charges deducted from the gross premiums or considerations or imposed under the policy or contract. The notice may be combined with other notices required under this chapter in accordance with rules of the commissioner. 118

In transactions in which the replacing insurer and the existing insurer are the same or are subsidiaries or affiliates under common ownership or control, the replacing insurer shall allow credit for the period that has elapsed under the replaced policy's or contract's incontestability and suicide period up to the face amount of the existing policy or contract. With regard to financed purchases, the credit may be limited to the amount that the face amount of the existing policy is reduced by the use of existing policy values to fund the new policy or contract. If an insurer prohibits the use of sales material other than that approved by the insurer, as an alternative to the requirements under Section 1114.051(g), the insurer shall: (1) require with each application a statement signed by the agent that: o (A) represents that the agent used only insurer approved sales material; and o (B) states that copies of all sales material were left with the applicant in accordance with Section 1114.051(f); (2) not later than the 10th day after the date of issuance of the policy or contract: o (A) notify the applicant by sending a letter, or by verbal communication with the applicant by a person whose duties are separate from the marketing area of the insurer, that the agent has represented that copies of all sales material have been left with the applicant in accordance with Section 1114.051(f); o (B) provide the applicant with a toll-free telephone number to contact the insurer's personnel involved in the compliance function if copies of all sales material have not been left with the applicant in accordance with Section 1114.051(f); and o (C) stress the importance of retaining copies of the sales material for future reference; and (3) be able to produce a copy of the letter or other verification in the policy file until the fifth anniversary of the date of termination or expiration of the policy or contract. Duties of Existing Insurer If a transaction involves a replacement, the existing insurer shall comply with the following. The existing insurer shall retain and be able to produce all replacement notifications received, indexed by the replacing insurer, until the later of: The fifth anniversary of the date of receipt of the notification; or The date of conclusion of the next regular examination conducted by the insurance regulatory authority of the existing insurer's state of domicile. The existing insurer shall send a letter to the policy or contract owner regarding the owner's right to receive information regarding the existing policy or contract values. The letter must include, if available, an in force illustration or, if an in force illustration cannot be produced not later than the fifth business day after the date of receipt of a notice that 119

an existing policy or contract is being replaced, a policy summary. The information must be provided not later than the fifth business day after the date of receipt of the request from the policy or contract owner. On receipt of a request to borrow, surrender, or withdraw any policy values, the existing insurer shall send a notice advising the policy owner that the release of policy values may affect the guaranteed elements, nonguaranteed elements, face amount, or surrender value of the policy from which the values are released. The notice must be sent separately from the payment if the payment is sent to any person other than the policy owner. In the case of consecutive automatic premium loans, the insurer is only required to send the notice at the time of the first loan. Use of Senior Specific Certifications and Designations The NAIC membership gave its final approval (Fall Meeting-September 2008) on the Model Regulation on the Use of Senior-Specific Certifications and Professional Designations in the Sale of Life Insurance and Annuities. The new model follows the approach for regulating senior-specific designations taken in the model rule adopted on April 1, 2008 by the North American Securities Administrators Association (NASDSA). Both models are designed to stop the use of misleading senior-specific designations by establishing a standard of whether the use of a particular designation indicates or implies, in a way that misleads the consumer, that the agent has special certification or training in advising seniors. Neither model references specific designations; rather, individual designations will be measured against this standard. The models establish what is essentially a safe harbor for designations that: Are not primarily sales/marketing oriented and Are issued/accredited by the American National Standards Institute, the National Commission for Certifying Agencies, or an institution of higher education. The models also expressly prohibit the use of designations that have not been legitimately earned, that are nonexistent, or that misrepresent a level of expertise of education that does not exist. The NAIC Model applies to the sale of insurance-related products. Under Section 5 A(1) of the Model Act it states: It is unfair and deceptive act of practice in the business of insurance for an insurance producer to use a senior-specific certification or professional designation that indicates or implies in such a way as to mislead a purchaser or prospective purchaser that insurance producer has special certification or training in advising or servicing seniors in connection with the solicitation, sale or purchase of a life insurance or annuity product or in the provision of advice as to the value of or the advisability of purchasing or selling a life insurance or 120

annuity product, either directly or indirectly through publications or writings, or by issuing or promulgating analyses or reports related to a life insurance or annuity product. The prohibited use of senior-specific certifications or professional designations includes, but is not limited to, the following: Use of a certification or professional designation by an insurance producer who has not actually earned or is otherwise ineligible to use such certification or designation; Use of a nonexistent or self-conferred certification or professional designation; use of a certification or professional designation that indicates or implies a level of occupational qualifications obtained through education, training or experience that the insurance producer using the certification or designation does not have; and Use of a certification or professional designation that was obtained from a certifying or designating organization that: o Is primarily engaged in the business of instruction in sales or marketing; o Does not have reasonable standards or procedures for assuring the competency of its certificants or designees; o Does not have reasonable standards or procedures for monitoring and disciplining its certificants or designees for improper or unethical conduct; or o Does not have reasonable continuing education requirements for its certificants or designees in order to maintain the certificate or designation. Annuity Disclosure Model Regulation On August 3, 2011, the NAIC Life Insurance and Annuities (A) Committee adopted revisions to the Annuity Disclosure Model Regulation, Model 245 ("Annuity Disclosure Model" or "Model"). The revised Annuity Disclosure Model continues to require that consumers be provided a Buyer's Guide and a disclosure document. The revised Annuity Disclosure Model applies to fixed, fixed indexed and variable annuities. Fixed and Index Annuities The most substantive change to the Annuity Disclosure Model is the addition of the standards for fixed and fixed indexed annuity illustrations. New Section 6 applies to an "illustration," which is defined to mean "a personalized presentation or depiction prepared for and provided to an individual consumer that includes non-guaranteed elements of an annuity contract over a period of years." In addition to setting forth the parameters for non-guaranteed and guaranteed elements of illustrated values and the manner of presentation of such values, the new illustration standards require: A narrative summary (unless the information is provided at the same time in a disclosure document). 121

A numeric summary. If the annuity contains a market value adjustment ("MVA"), a narrative explanation of the MVA, a demonstration of the MVA under at least one positive and one negative scenario, and actual MVA floors and ceilings. New Section 6 includes additional specific requirements for a fixed indexed annuity illustration. These requirements include illustrating the nonguaranteed values for three different scenarios: The last continuous 10 calendar years. A continuous 10 calendar year period out of the last 20 that would produce the least index value growth. A continuous 10 calendar year period out of the last 20 that would produce the most index value growth. If any index has not been in existence for at least 10 calendar years, then that index may not be illustrated. The Model also was revised to include additional disclosure items for fixed indexed annuities. Variable Annuities Previously, the Annuity Disclosure Model did not apply to the sale of registered variable annuities. The Model was revised to require the following be delivered in connection with a sale of a registered variable annuity: A Buyer's Guide. After January 1, 2014, a disclosure document, unless prior to such date, the SEC adopts a summary prospectus rule or FINRA approves for use a simplified disclosure form applicable to variable annuities. Variable annuity illustrations, however, are not subject to the revised Annuity Disclosure Model's new standards for illustrations. The Annuity Disclosure Model was revised to include a new exception from the Model for non-registered variable annuities issued exclusively to accredited investors or qualified purchasers. Recordkeeping 122

The Model was revised to include a requirement to maintain or make available to the insurance regulatory authorities records of the information collected from the consumer and other information provided in the disclosure statement (including illustrations). 123

Chapter 8 Review Questions 1. What year was the Unfair Marketing Practices Act created? ( ) A. 1940 ( ) B. 1955 ( ) C. 1960 ( ) D. 1980 2. What is the biggest market conduct danger an insurance producer may face during a sales presentation? ( ) A. Rebating ( ) B. Fraud ( ) C. Misrepresentation ( ) D. False advertising 3. The replacing insurer shall verify that the required forms are received and are in compliance and must notify any existing insurer with how many days after receipt of the application indicating a replacement? ( ) A. 3 business days ( ) B. 7 business days ( ) C. 5 business days ( ) D. 10 business days 4. Which of the following statements is true regarding twisting and churning? ( ) A. Churning is legal, but twisting is illegal ( ) B. Twisting and churning are both illegal and unethical ( ) C. Twisting and churning are both legal, but they are also unethical ( ) D. Twisting is legal, but churning is illegal 5. Under the NAIC replacement rules, the replacing insurer shall provide to the policy or contract owner notice of the owner's right to return the policy or contract within how many days of the delivery of the policy or contract? ( ) A. 7 days ( ) B. 10 days ( ) C. 14 days ( ) D. 30 days 124

Chapter Review Answers Chapter 1 Chapter 2 Chapter 3 Chapter 4 1. A 2. B 3. B 4. C 5. D 1. C 2. A 3. D 4. B 5. B 1. A 2. B 3. D 4. C 5. B 1. B 2. A 3. C 4. C 5. D Chapter 5 Chapter 6 Chapter 7 Chapter 8 1. C 2. D 3. B 4. C 5. A 1. A 2. D 3. A 4. B 5. D 1. B 2. A 3. C 4. C 5. D 1. A 2. C 3. C 4. B 5. D 125

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