California Annuities 4 Hour CE Course PUBLISHED BY: SANDI KRUISE INSURANCE TRAINING (A DIVISION OF SANDI KRUISE INC) 1-800-517-7500 Copyright Sandi Kruise Insurance Training 2006, all rights reserved 1
California Annuities 4 Hour CE Course... 6 ANNUITY CONTRACT PROVISIONS... 6 PROVISIONS COMMON TO MOST ANNUITIES... 6 INTEREST RATES & COMPENSATION... 6 BONUS PROVISIONS... 6 UNDERSTANDING TWO-TIERED ANNUITIES... 8 ISSUE AGE PROVISIONS... 9 MAXIMUM AGE FOR BENEFITS... 9 CRISIS WAIVER PROVISIONS... 9 Nursing Home Waiver... 10 Terminal Illness Waiver... 10 Unemployment Waiver... 11 Disability Waiver... 11 CRISIS WAIVER CHARGES... 11 PREMIUM PAYMENT PROVISIONS... 11 MISSTATEMENT OF AGE OR SEX... 12 Beneficiary's Rights to Death Benefits Prior To Annuitization... 13 Beneficiary's Rights to Death Benefits after Annuitization... 13 Tax Qualified Plans... 13 STRETCH PROVISIONS FOR QUALIFIED ANNUITIES... 13 Non-Qualified Plans... 14 STRETCH PROVISIONS FOR NON- QUALIFIED ANNUITIES... 14 SURRENDER CHARGES... 15 Senior Citizens and Surrender Charges... 15 Surrender Charges in Flexible Premium Annuities... 16 SURRENDER CHARGES AT DEATH... 16 Surrender Charges Summary... 17 MARKET VALUE ADJUSTMENTS (MVAs)... 17 POLICY ADMINISTRATION CHARGES AND FEES... 18 PREMIUM TAXES...18 WITHDRAWAL PRIVILEGE PROVISIONS... 19 Tax penalties for withdrawal... 19 SYSTEMATIC WITHDRAWAL... 19 Annuitization Payout Options... 20 Single Lump Sum...20 Interest-Only Payments... 20 Designated Dollar Amount... 20 Life Income Option...21 Straight Life... 21 Period Certain and Refund Options... 21 ANNUITIZATION OPTIONS... 22 FIXED ANNUITY CONTRACT PROVISIONS... 23 Death Benefits... 24 Owner s Death... 25 Charges and Fees... 25 Interest Rates... 26 THE MULTI-YEAR GUARANTEE ANNUITY... 26 METHODS OF CREDITING EARNINGS... 26 Copyright Sandi Kruise Insurance Training 2006, all rights reserved 2
Portfolio Rates... 27 New Money Rates... 27 Minimum Guaranteed Interest (CIC10168.25)... 27 Current Interest Rate... 28 Variable Annuities... 28 Accumulation Units... 29 Computation of Annuity Accumulation and Payments... 30 Annuity Units... 31 Fluctuating Value of Annuity Units... 32 VARIABLE ANNUITY INCOME AND LIQUIDITY OPTIONS... 33 Free Withdrawals... 33 VARIABLE ANNUITIZATION... 33 Subaccounts and General Account... 34 Variable Annuity Options...35 Senior Citizen Considerations (CIC 10127.10)... 35 GROWTH STOCK SUBACCOUNT... 35 VALUE STOCK SUBACCOUNT... 36 OTHER SUBACCOUNT STRATEGIES... 36 Global Accounts... 36 Precious Metals Accounts... 36 Social and Environmental Accounts... 37 Index Accounts... 37 Life Cycle Funds... 37 MONEY MARKET SUBACCOUNT... 37 BOND SUBACCOUNT... 38 HIGH YIELD BOND SUBACCOUNT... 38 FIXED RATE SUBACCOUNT... 38 CHARGES AND FEES... 38 Mortality and Expense Charges... 38 Other Fees... 39 Administration Charges... 40 Contract Maintenance Charge... 40 Management Fees... 40 FEES FOR SPECIAL FEATURES... 41 SURRENDER CHARGES... 41 Charges and Fees...41 DOLLAR COST AVERAGING... 41 ASSET ALLOCATION... 42 SUBACCOUNT REALLOCATION... 44 DEATH BENEFIT GUARANTEES... 47 Living Benefits Guarantees...48 Guaranteed Retirement Income Benefit (GRIB)... 48 Guaranteed Minimum Account Value (GMAV)... 48 Guaranteed Minimum Income Benefit (GMIB)... 49 Guaranteed Minimum Income Payments (GMIP)... 49 Guaranteed Minimum Withdrawal Benefit (GMWB)... 49 Living Benefit Guarantees...49 THE EQUITY INDEXED ANNUITY... 50 The Index... 51 Interest Rate Crediting Strategies... 52 THE MONTHLY AVERAGING METHOD... 53 Copyright Sandi Kruise Insurance Training 2006, all rights reserved 3
THE POINT- To- POINT METHOD... 53 THE HIGH WATERMARK METHOD... 54 Low-Water Mark... 55 THE ANNUAL RESET PROVISION... 55 Combination Methods... 56 Spread/Margin/Asset Fee... 56 Cap Rate or Cap...56 PARTICIPATION RATES... 56 MINIMUM GUARANTEED INTEREST RATE... 57 THE NAIC MODEL FOR MINIMUM GUARANTEED INTEREST RATES... 58 PREMATURE SURRENDER CHARGES... 58 EQUITY INDEXED ANNUITY CHARGES & FEES... 59 Annuity Riders... 60 LIFE INSURANCE RIDERS... 60 Enhanced Death Benefit Rider... 61 Estate Protection Rider... 61 Term Insurance Rider... 61 TAXATION OF LIFE INSURANCE RIDER BENEFITS... 61 LONG-TERM CARE INSURANCE RIDERS IN ANNUITIES... 62 TWO TYPES OF LTC RIDERS... 62 Medically Underwritten Long-Term Care Riders... 62 Non-medically Underwritten Long-Term Care Riders... 63 SUITABILITY OF LTC RIDERS... 63 TAXATION OF LTC RIDER BENEFITS... 63 Using Annuities To Pay For LTC Premiums... 65 RIDERS COMPARED TO CRISIS WAIVERS... 65 LOAN PROVISIONS... 66 Sales Practices & Suitability Issues... 66 SENATE BILL 620 (SCOTT, CHAPTER 547, 2003)... 66 DEFINITION OF A SENIOR... 66 NEW TRAINING REQUIREMENTS... 67 IN-HOME PRESENTATIONS... 67 WRITTEN DISCLOSURE... 67 VERBAL DISCLOSURES... 68 California Enacts New Annuity Sales Protections for Seniors... 68 NEW ADVERTISING GUIDELINES... 69 Senior Advertising... 69 Advertising Defined (CIC 787b)... 70 Required Information License Number... 71 Use of the Word "Insurance"... 71 Internet Sales... 71 Seminars, Classes Meetings... 72 Fines and Penalties... 74 Agents... 74 Insurers... 74 Prohibited sales practices... 74 Medi-Cal and Annuities... 74 ANNUITIES USED TO AFFECT MEDI-CAL ELIGIBILITY... 75 More Medi-Cal Restrictions...77 In-Home Solicitations: 24-hour Notice requirement for persons 65 years and older... 77 MISREPRESENTING THE CONTENT OF AN IN-HOME PRESENTATION... 77 Copyright Sandi Kruise Insurance Training 2006, all rights reserved 4
NEW REGULATIONS ON SHARING COMMISSIONS WITH ATTORNEYS... 79 ADDITIONAL REPLACEMENT DEFINITIONS... 79 BAIT AND SWITCH...81 PRETEXT INTERVIEWS... 81 LIVING TRUST MILL...81 Long Term Care Sales...89 Other Unlawful Practices (BPC 6125)... 89 BUSINESS AND PROFESSIONS CODE... 90 NEW GROUNDS FOR REVOKING OR SUSPENDING A LICENSE... 90 Exceptions... 91 PENALTIES FOR VIOLATION... 91 DISCIPLINARY HEARINGS... 92 SUITABILITY... 93 THE NAIC'S SUITABILITY MODEL... 93 VARIABLE ANNUITY LICENSING AND REGISTRATION... 95 WHY PEOPLE BUY ANNUITIES... 95 Diversification... 96 Income... 96 AVOIDING THE SOCIAL SECURITY BENEFIT TAX... 96 ANNUITY SUITABILITY... 96 The Distribution Need... 97 The Accumulation Need... 97 CRITERIA FOR ASSESSING ANNUITY SUITABILITY WITH SENIORS... 98 CONSIDERING FINANCIAL STATUS... 99 TAX STATUS... 99 Consider the senior's income tax bracket.... 99 Consider the income tax bracket of beneficiaries.... 100 Consider the tax consequences of exchange.... 100 Employer-sponsored plans.... 100 Consider the 10% excise penalty tax.... 100 INVESTMENT OBJECTIVES... 100 The senior's risk tolerance and return expectations... 100 The senior's investment horizon... 101 The senior's liquidity needs... 101 The investment frequency... 101 SUITABILITY CONCLUSIONS... 101 Recording Meetings or Presentations... 102 Include an Objective, Third-Party Observer... 102 GOVERNMENT REGULATION... 103 LICENSING AND COMPLIANCE... 103 DISCLOSURE... 103 INTEREST RATES... 103 SURRENDER CHARGES... 104 TAX IMPLICATIONS... 104 PROSPECTUS... 104 PROFILE... 104 Policy Cancellations and Refunds (CIC 10127.10, 10509.6)... 105 NEW FREE- LOOK PROVISIONS... 105 FOR ALL ANNUITIES... 105 FOR VARIABLE ANNUITIES... 105 CD-Type Annuities... 106 Copyright Sandi Kruise Insurance Training 2006, all rights reserved 5
California Annuities 4 Hour CE Course IV. How fixed, variable, and index annuity contract provisions affect consumers 25% ANNUITY CONTRACT PROVISIONS PART IV: Contract Provisions A. Identify and discuss contract provisions that are typically common to annuities PROVISIONS COMMON TO MOST ANNUITIES While each annuity described has its own unique characteristics, certain provisions are common to all contracts. Choices among annuity contracts are numerous and can be quite complex. It is an agent s ethical and legal responsibility to know the difference between various contracts they are selling as well as options that are widely available. In this section we will discuss the provisions commonly found among all annuities, after which we will look at those specific to fixed, equity-indexed and variable annuity contracts. 1. Interest rates and compensation INTEREST RATES & COMPENSATION Insurers have several ways of crediting (paying) interest on the funds in an annuity. The amount of interest the client receives or is credited depends on how long they are willing to commit money and what institution (company) they deposit with. Just like banks, some insurance companies offer higher rates and different maturities. Other forms of compensation provided by annuity contracts include a share in profits as in variable annuities or indexed annuities. Both include risks that could substantially effect earnings and clients need to know this. Again, explore with them any interest floor or cap that is in the contract and, if applicable, the possibility of no earnings at all. All insurance companies provide their contract owners with annual statements that contain basic information relative to account values and transactions. Some insurers prepare this accounting at the end of each contract year, and some do so at the end of each calendar year. Regardless of when a statement is prepared, it provides information on all activity within that account during the year. a. First year bonus teaser rates BONUS PROVISIONS Some companies declare a "bonus" rate of interest that will be paid on top of the current, or "base" rate offered on the contract. Interest rate bonuses are generally guaranteed for one interest-crediting period, which is usually one year. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 6
Not all annuity contracts contain bonuses. Bonus provisions take shape in one of two forms - interest rate bonuses or premium bonuses. Interest rate bonuses vest over the course of a contract year, while premium bonuses vest immediately. In the past, there have been problems with agents misrepresenting bonus annuities in presentations and advertisements. The "teaser rates" attached to the first year rate were never explained properly by the agent or in the context of the advertisements. Upon renewal, buyers saw interest rates far lower than the first year rate and surrender charges associated with such contracts which made liquidation too costly. As an added safeguard, new provisions of the California Insurance Code (CIC) require any product-specific annuity advertisement targeted at seniors 65 and older to have written approval from the insurer ( 787, CIC). Hopefully, this will eliminate deceptive advertising practices with respect to bonus annuities, particularly in the senior market. Agents should be careful when working with clients who already own an annuity and are thinking of exchanging it for a different annuity with a bonus feature. A new surrender period generally will begin when it is exchanged for a new one. This means that, by exchanging the contract, they will forfeit the ability to withdraw money from their account without incurring substantial surrender charges. And the surrender charges and other fees are usually higher on an annuity with the bonus credit than they were on the annuity that was exchanged. In the past, agents often used bonus annuities to offset surrender charges from replaced annuity contracts. Agents who intend to replace an annuity owned by a person aged 65 years and older are governed by new regulations, new definitions (and penalties) for "unnecessary replacement". "Unnecessary Replacement" means the sale of an annuity to replace an existing annuity that requires that the insured will pay a surrender charge for the annuity that is being replaced and that does not confer a substantial financial benefit over the life of the policy to the purchaser so that a reasonable person would believe that the purchase is unnecessary." Using bonus annuities to offset surrender charges with seniors, is particularly risky since the bonus alone may not create a substantial financial benefit over the life of the policy required by law, especially if other provisions are not at least equivalent to the annuity being replaced. If explained and deployed suitably, bonus annuities can be a valuable tool. Unfortunately, many agents fail to explain these products adequately to buyers. With most bonus annuities, there is a base rate and a bonus rate. When the bonus rate expires, the base rate adjusts from year to year. For example an insurer offers a base rate of 5.50% but with a 4.00% first year bonus. Looks great with an advertisement of 9.50% the first year. Another insurer only has a 6.25% overall rate and NO bonus. In seven years the value of the annuity with the bonus would be $150,983. But the value of the one with the 6.25% rate would be $152,863. While this is not a huge difference, the difference gets larger and larger as time goes on. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 7
Assuming that both annuities have the same annual rate of return, prior to expenses, the annuity that will grow the most over the long-haul may well be the one that deducts lower annual charges, even though it does not offer a bonus. Annuities with bonus credits often have higher expenses that can outweigh the benefit of the bonus credit offered. Frequently, insurers will offset bonus credits in one or more of the following ways: Higher surrender charges Surrender charges may be higher for a variable annuity that pays a bonus credit than for a similar contract with no bonus credit. Longer surrender periods Surrender charges may apply for a longer period than they would be under a similar contract with no bonus credit. Higher mortality and expense risk charges and other charges Higher annual mortality and expense risk charges may be deducted for a variable annuity that pays a bonus credit. Although the difference may seem small, over time it can add up. Under some annuity contracts the insurer will take back all bonus payments made within a specified period if clients make a withdrawal, if a death benefit is paid to beneficiaries upon death, or in other circumstances. Before recommending an annuity with a bonus credit agents should determine whether the bonus is worth more than any increased charges for the bonus. This may depend on a variety of factors, including the amount of the bonus credit and the increased charges, how long annuity contract the annuity is held, and the return on the underlying investments. Agents also need to consider the other features of the annuity to determine whether it is a good investment for their clients. UNDERSTANDING TWO-TIERED ANNUITIES These annuities offer relatively high rates, but only if the owner holds the contract for a certain number of years and then annuitizes it. If the annuity is surrendered at any point, interest credited to the contract is recalculated from the contract's inception using a lower tier of rates. The contract owner gets one tier of interest rates by staying with the contract through annuitization and another, lower tier of rates if he or she does not. The policyholder in a two-tiered annuity forfeits the chance to receive a better annuitization by shopping the immediate annuity market. Most commonly, these products are used in the tax-sheltered annuity market with teachers. However, agents should be cautioned that some companies writing annuities in California continue to offer two-tiered annuities for sale to the general public. Some states do not permit sales of two-tiered annuities because of the potential for misunderstanding on the part of consumers or lack of disclosure on the part of agents regarding the conditions that must be met in order for the owner to earn the higher tier of rates. Agents who sell two-tiered annuities must make sure that clients know how the product works and are prepared to commit themselves and their beneficiaries to the annuity for a long term. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 8
2. Issue ages (Section 10112 of the CIC) ISSUE AGE PROVISIONS There is no specific California law governing the maximum issue ages for annuities, and most insurers will issue an annuity contract up to age 85 or even older. There are, however, rules relating to minimum issue ages. In California, a person younger than 18 years of age is a minor. Under provisions of California Probate Code and California Insurance Code (Section 10112), a minor does not have the right to contract for life or disability insurance or annuity contracts. The California Uniform Transfer To Minors Act (UTMA) allows minors to own investments and other types of property. In a California UTMA, a donor appoints a custodian and irrevocably gifts money to a trust. The property then legally belongs to the minor but is controlled by the custodian until the minor reaches the age specified in the trust. In California, this age is 18 and may be extended to a maximum age of 25 (California Probate Code, Section 3920.5). Agents are advised to check with the insurer if using annuities when minors are involved. 3. Maximum ages for benefits to begin MAXIMUM AGE FOR BENEFITS Every deferred annuity contract specifies a maturity date or annuity date, which is the date on which annuitized payments are scheduled to begin. A contract's maturity date usually is the later of 10 contract years or the contract anniversary that falls in the year the annuitant reaches age 85. (In some contracts, the maturity age is 100.) Most insurers allow a contract owner/annuitant to continue the deferral period for some time past the maturity date or annuitize the contract before the maturity date. Typically, an annuity contract provides the insurer has a right to require proof that the annuitant is living on the date of any annuity payment. 4. Crisis waivers CRISIS WAIVER PROVISIONS Crisis waivers allow policyholders to liquidate some or all of the annuity's value due to the occurrence of catastrophic events without surrender charges. The Variable Annuity Research and Data Service (VARDS) reports that 161 variable annuity contracts offer some type of waiver. Similarly, Beacon Research, an annuity-tracking service based in Illinois, surveyed 282 fixed annuities and found that 35 percent have a death waiver; 18.5 percent contain nursing home waivers; 7.4 percent have hospital waivers; and a mere 2.3 percent carry disability waivers. While a death waiver is most common in the fixed annuities survey, VARDS shows the most popular waiver found in variable annuities is the nursing home waiver, with 103 variable annuity Copyright Sandi Kruise Insurance Training 2006, all rights reserved 9
contracts containing that provision; 83 provide death waivers; 69 have terminal illness waivers; and 42 carry disability waivers. Situations that trigger the waiver and allow early annuity withdrawals vary from company to company. The agent should review such provisions carefully to determine whether any definitional restrictions exist and to understand how broadly or narrowly these provisions apply. It's important to read the policy to find out if it contains any provision under which the surrender or withdrawal would be waived. It s also important to determine and to explain to clients of these waivers came at the price of higher fees, lower returns or other undesirable features. Annuity contracts may contain some or all of the following crisis waivers. Not all annuities permit crisis waivers. In general, they seem to be more common and generous in fixed annuities than in variable contracts. Situations that trigger the waiver and allow clients to make early annuity withdrawals vary from company to company. One insurer might require a 90-day nursing home confinement before benefits are activated, while another might require only 60 days. One company may consider that the client is disabled if they're unable to work in any occupation, while another may require that them to be unable to work in their current occupation. a. Nursing home Nursing Home Waiver The nursing home waiver eliminates surrender charges upon withdrawal in the event of a nursing home admission, provided the annuity was purchased prior to admission. May be annuitant or owner triggered May take effect immediately or beginning on the first anniversary Usually requires confinement of 30, 60, or 90 consecutive days Benefit may be reduced for older purchasers Attending physician's statement may be required along with a completed claim form. While a 90-day confinement period before benefits kick in may be typical, some insurers impose a 180-day confinement period to a "licensed nursing facility." b. Terminal illness Terminal Illness Waiver The terminal illness waiver eliminates surrender charges upon withdrawal if diagnosed with terminal illness, provided the annuity was purchased prior to diagnosis. May diagnose terminal illness differently (i.e. less than 6 months to live, less than 12 months to live) May be annuitant or owner triggered May take effect immediately or beginning on the first anniversary Will require certification from a doctor that life expectancy is only a matter of months. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 10
Benefit may be reduced for older purchasers (e.g. for purchaser older than aged 75, only 50% of account value may be surrendered) c. Unemployment Unemployment Waiver The unemployment waiver eliminates surrender charges upon withdrawal if unemployment occurs, provided the annuity was purchased prior to unemployment. Unemployment must be involuntary May require proof of gainful employment May be annuitant or owner triggered Unemployment waivers are very rare. Some allow clients to withdraw from the contract if they are unemployed for more than a certain number of days. d. Disability Disability Waiver Since the risk of disability is greater than the risk of death at all ages between 20 and 65, it makes sense to protect clients financially if they become disabled. The disability waiver eliminates surrender charges upon withdrawal if physical disability develops, provided the annuity was purchased prior. Variations on Disability Waivers include: May require Social Security Disability Benefits as a prerequisite May be annuitant or owner triggered May take effect immediately or beginning on the first anniversary May not be available if over the age of 65 at the time of purchase e. Charges and fees CRISIS WAIVER CHARGES In most cases, there's no extra charge for waivers because they're built into the contract when purchased. Variable annuity contracts may offer crisis waivers for an additional expense. Certain tax consequences could apply to such withdrawals. It is always best to advise clients to check with a tax advisor before taking money out of their contract. 5. Premium payments (Section 10540 of the CIC) PREMIUM PAYMENT PROVISIONS All companies have provisions for the acceptance of premiums. Annuity contracts might be structured to accept flexible premiums or a single premium. Since flexible premium contracts Copyright Sandi Kruise Insurance Training 2006, all rights reserved 11
are designed to encourage systematic saving, insurers typically set relatively low requirements for additional deposits. Companies generally set minimum and maximum limits on the premium amounts they will accept. Minimum limits are set in order to control the administrative costs the company incurs to credit each premium to the contract. Maximum limits are set in order to manage the company's liability for benefit payments under the contract. Minimum and maximum limits vary among companies and types of contracts. Annuities used for tax-qualified plans, like IRAs and 403bs, have maximum allowable contributions that prevail over those set by insurers. For single premium products, minimum premiums are typically $5,000 or $10,000. Many single premium contracts do not allow any premium payments other than the initial premium. However, some are designed to accept a certain number of additional premium payments within a limited period of time. Minimum premiums are much lower on flexible premium annuities compared to single premium annuities, since the flexible premium product is designed specifically to accommodate the payment of a number of relatively small premiums over a period of time. However, typical minimums vary widely depending on the market in which the company expects to sell the product and the amount of administrative cost the company expects to incur. Sometimes the company will also limit the frequency with which premium payments may be made. A separate set of minimums may apply if premiums are being paid via an automatic payment plan (such as automatic monthly transfers from the owner's checking account) or if the annuity is purchased under a qualified plan. MISSTATEMENT OF AGE OR SEX An annuity contract includes a clause that provides for a benefit adjustment if the annuitant's age or sex is misstated in the application. This provision adjusts benefits to those that the premium would have purchased at the correct age or sex. Generally, the payment amount is adjusted and any amounts overpaid are charged against the next payments made to the payee. Any amounts underpaid are added to the next payment. The company sometimes reserves the right to collect from the payee any amounts overpaid. (CIC 10540) An incorporated life insurer issuing life insurance policies on the reserve basis may collect premiums in advance. Such insurers may also accept moneys for the payment of future premiums related to any policies issued by it. No such insurer may accept such moneys in an amount to exceed (1) the sum of future unpaid premiums on any such policy or (2) the sum of 10 such future unpaid annual premiums on any such policy if such sum is less than the sum of future unpaid premiums on any such policy. This section shall not limit the right of such insurers to accept funds under an agreement which provides for an accumulation of such funds for the purpose of purchasing annuities at future dates. 6. Settlement options upon death of owner or annuitant Copyright Sandi Kruise Insurance Training 2006, all rights reserved 12
Beneficiary's Rights to Death Benefits Prior To Annuitization When a contract owner dies before exercising a payout option, the beneficiary has rights to the entire value of the account. Example: When a variable annuity owner dies, the fund value as of the date proof of death is received or the total of all payments paid into the annuity less withdrawals and charges are paid to the beneficiary. Variable annuity contributions remain unchanged even if the subaccounts have lost value. The beneficiary is responsible for taxes on the gain in the contract. Beneficiary's Rights to Death Benefits after Annuitization When a contract owner dies after receiving benefits the beneficiary is entitled to the remaining years of benefits. Not all payout options entitle the beneficiary to payouts if the owner or annuitant dies. These options are discussed later in detail. a. Tax-Qualified Plan Tax Qualified Plans For qualified annuities (purchased through a qualified plan such as a 401(k)), the initial premium, any additional contributions and interest earnings were all pretax (untaxed). Therefore, 100% of each payment received through any settlement plan will be considered taxable income. i. Stretch STRETCH PROVISIONS FOR QUALIFIED ANNUITIES In January, 2001 the IRS issued new rules governing the distribution phase of IRAs. One of the features of the new 2001 rules is that IRA owners are now permitted to take smaller Minimum Required Distributions (MRD). By postponing distributions until Age 70½ the Required Beginning Date (RBD), IRA benefits can now be stretched over a longer period of time, reducing current income taxes and increasing the long-term benefits to family members. Under the old rules, Individual Retirement Accounts (IRAs) were created to let individuals use the advantage of tax deferral to accumulate funds for retirement until they reached the age of 70½. At that point, individuals were required by law to begin withdrawing funds annually because the IRS wanted them to withdraw all of their money and pay all of the taxes before they died. And if a person did not take distributions or if the amount distributed was not large enough, he or she faced a severe tax penalty equal to 50% of the amount by which the required minimum distribution amount exceeded the actual amount distributed. And to make matters worse, the amount of the required minimum distributions increased annually. So not only must they pay taxes on increasing distributions they do not need, but the benefits of future tax deferral and compounding on the amount distributed was also lost. Under the new rules, each beneficiary of an inherited IRA is entitled to spread out or "stretch" the inherited IRA distribution over their individual life expectancy. The result of this change is Copyright Sandi Kruise Insurance Training 2006, all rights reserved 13
that by stretching the death benefits over the course of the beneficiary's life expectancy, the amount remaining in the IRA can continue to benefit from tax-deferred growth. Also, rather than owing income taxes from a short distribution, the beneficiary can lower the tax by lengthening the distribution period. If their spouse was the primary beneficiary and he or she does not need the money when the time comes, it can be "disclaimed" and go to the secondary (contingent) beneficiaries. Or the spouse can roll the IRA into his or her own IRA and name new beneficiaries for that account. Taking advantage of the new rules to stretch IRA distributions over time is not for everyone, but if clients already have all the income they need to maintain their lifestyle and they want to take advantage of tax-deferred growth and compounding to pass greater wealth on to loved ones, they may want to learn more about how the new rules can work for them. The ability to leave more funds in an IRA to benefit from future tax-deferred growth and compounding can have a major impact on the future value of the IRA. For example, if an IRA balance of $100,000 is left untouched while earning a 6 percent rate of return for 60 years, it would grow to $3,298,768.99! The above demonstrates how IRA account values can be dramatically increased by combining the power of compound interest and tax deferred growth with the stretch concept. It is extremely important to continue to maintain tax deferral for as long as possible during the IRA distribution phase. b. Tax-Non-qualified Plan Non-Qualified Plans Once a nonqualified annuity under a settlement plan, each payment is considered part taxable and part nontaxable income. This is because the initial purchase payment and any additional contributions made with after-tax money. An exclusion ratio is determined for each payment which then determines the amount of each payment to be excluded from taxes. In addition to any income tax, there is a potential federal penalty for annuity withdrawals for investors under age 59½. This 10% penalty (IRS Section 72q) was designed to discourage investors from withdrawing early from nonqualified annuities. However, should a client choose the option to settle his contract either on a lifetime or two lifetimes, before age 59½, withdrawals qualify as an exception to the penalty rule and will not be subject to the additional 10% tax. Those who are planning for early retirement may find this option advantageous. i. Stretch STRETCH PROVISIONS FOR NON- QUALIFIED ANNUITIES Not long after the ruling on qualified annuities, the insurance industry challenged the IRS to allow non-qualified annuity distributions upon death to be stretched using the same method. On December 21, 2001, the IRS issued a private letter ruling to the insurance company who made the challenge (PLR 20015103 8). Copyright Sandi Kruise Insurance Training 2006, all rights reserved 14
With some exceptions, Internal Revenue Code allows the death benefit from a nonqualified annuity to be extended over the beneficiary's life expectancy as calculated by the "uniform table" used for determining MRD regulations. By electing a "non-qualified annuity stretch": The income will be less than the income using life only annuitization settlement. Because life expectancies of the "uniform table" are longer than standard mortality tables. The beneficiary maintains the tax-deferred status on the unpaid death benefit. Under an annuitization option, funds no longer benefit from tax-deferral. 7. Surrender charges (Sections 10127.1, 10127.12, and 10127.13 of the CIC) SURRENDER CHARGES A surrender charge is a penalty imposed by the insurance company when annuity funds are withdrawn, prior to the end of the annuity's term. Almost all deferred annuities have surrender charges. These charges are assessed during the early years of a contract if the owner liquidates or surrenders the annuity before the insurer has had an opportunity to recover the cost of issuing the contract. In addition to recovering issuing costs, the surrender charges also provide some protection against the risk that increasing interest rates will result in contract owners surrendering their annuity contracts prematurely, forcing the insurer to liquidate its underlying investments at an inappropriate time. Surrender charges help offset the potential loss in the insurer's portfolio if interest rates escalate after a contract owner purchases the annuity. The penalty is usually expressed as a percentage and assessed against the premium deposited or the account value, as shown below. Example Of Surrender Charge Schedule YEAR 1 2 3 4 5 6 7 8 SURRENDER 7% 7% 6% 5% 4% 3% 2% 0% CHARGE Many annuities have the option to take free withdraws along the way as long as the amount taken out does not exceed the 10% free withdrawal limit. Senior Citizens and Surrender Charges A concern with respect to sales to senior citizens is that they may not fully understand, or that an agent may fail to fully explain, that their access to contract cash values may be subject to surrender charges. To be sure that senior citizens are aware of these limits on liquidity, any individual annuity contract that contains a surrender charge period must also disclose to the senior citizen: the applicable surrender charge period; and any and all penalties associated with surrender of the contract. This requirement can be met through a notice in 12-point bold print on the cover page making the mandated disclosures or by indicating the location of this information in the policy. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 15
Insurers normally furnish their annuity contract owners with annual statements concerning their contracts. When these annual statements are provided to a senior citizen, they must include the contract s current: accumulation value; and cash surrender value. Surrender Charges in Flexible Premium Annuities Some flexible premium annuities incur a new surrender schedule for each additional deposit. Because they no longer have an income from employment, seniors may need to access an annuity sooner than working-aged adults. Therefore, annuities sold to seniors should not subject additional deposits to new surrender charges. SURRENDER CHARGES AT DEATH If death occurs during the surrender period, there are two different types of death benefit provisions - those that waive surrender charges at death and those that do not unless the beneficiary agrees to take the proceeds over a five-year distribution. Agents who sell annuities that require a five-year payout to receive the full value of the annuity need to exercise full disclosure when talking to seniors. While these products may offer attractive rates and first-year bonuses on the front end, agents need to fully explain how a surrender charge would impact their death benefit if heirs elect not to take the distribution over five years. Insurers assess these surrender charges in three ways: Account value Premium deposit Loss of interest The account value method uses a fee structure based on a percentage of the full accumulated account value at the time of surrender, whereas the premium deposit method is based on a percentage of the premium or premiums that the contract owner deposited into the contract. With the loss of interest surrender charge, the contract owner is penalized by a loss of interest over some period of time, usually six months to one year. Loss of interest surrender charges are found on many of the certificate annuities, which creates a close parallel to a bank CD, which typically expresses premature withdrawal penalties as a loss of interest. Surrender charges by year Basis of surrender charge: Amount of surrender charge: Premium Deposit Method 7%, 6%, 5%, 4%, 3%, 2%, 1%, 0% Percentage of premium Account Value Method 4%, 4%, 4%, 4%, 4%, 4%, 0% Percentage of accumulated value Loss of Interest Method Six months loss of interest Annual Interest Copyright Sandi Kruise Insurance Training 2006, all rights reserved 16
Year 1 $7,000 $4,320 $4,000 2 $6,000 $4,666 $4,320 3 $5,000 $5,039 $4,666 4 $4,000 $5,442 $5,039 5 $3,000 $5,877 $5,422 6 $2,000 $6,348 $5,878 7 $1,000 $0 $0 8+ $0 This example assumes an initial deposit of $100,000 and an 8 percent rate. The charge is made against the value of the investment when the annuity is surrendered, and its purpose of the surrender charge is to discourage a short-term investment by the purchaser. For that reason, an annuity should always be considered a long-term investment. Surrender Charges Summary Agents should review the provisions of the contracts they sell to determine whether or not they contain surrender charges and what type and fully disclose them to buyers. Surrender charges come in many different shapes and sizes. Interest rates, bonuses and commissions all have an effect on surrender charges. Higher interest rates usually mean higher or longer surrender charges. Larger bonuses usually mean higher or longer surrender charges. Higher commissions usually mean higher or longer surrender charges. The amount and length of surrender charges is important to consider when evaluating suitability. Selling an annuity with surrender charges any longer than the expected need for access to funds is not suitable and would, therefore, be unethical. a. Market value adjustment MARKET VALUE ADJUSTMENTS (MVAs) Some annuity contracts have a market value adjustment feature. If interest rates are different when the annuity is surrendered than when it was purchased, a market value adjustment may make the cash surrender value higher or lower. Since the contract owner and the insurance company share this risk, an annuity with an MVA feature may credit a higher rate than an annuity without that feature. The MVA can be positive or negative. If interest rates have fallen, the MVA will be positive. It will offset at least a portion of any applicable surrender charges, and perhaps even add to the annuity's surrender value. On the other hand, if interest rates have risen, the MVA will be negative and will be added to any applicable surrender charges, further decreasing the surrender value. Some MVA products on the market today do not guarantee principal or minimum interest. With these contracts, the market value adjustment can be negative enough to cause a loss of Copyright Sandi Kruise Insurance Training 2006, all rights reserved 17
principal, even if a contract owner has owned his or her contract for a number of years. The market conditions that would bring this about would be a rapid and substantial rise in interest rates. Because of this risk, these kinds of MVA products must be registered as securities, and they fall under the category of variable annuities. Example: The value of an annuity is $50,000. In the current year, the surrender charge is 6% or $3,000. However, since the annuity was purchased market interest rates have risen and his insurer indicates a MVA adjustment of $1,500 is necessary to offset the loss they will incur when they sell certain securities to make the payout. So, the current surrender value is $45,500: $50,000 minus $3,000 surrender charge, minus $1,500 MVA adjustment. If interest rates have dropped instead of risen the insurer surrender value would be $48,800: $50,000, less $3,000 surrender charge, plus $1,800 MVA adjustment. 8. Policy administration charges and fees POLICY ADMINISTRATION CHARGES AND FEES Just like other investments, annuities are subject to fees and expenses. Costs vary among companies and contracts, and fees and expenses of a variable annuity are generally higher than those found in fixed annuities. A list of the types of fees for annuities is as follows: The fees or charges that are often incurred in annuities, particularly in variable annuities, include: Investment Management Fees. These fees run from a low of about 0.25 percent to a high of about 1 percent Administration Expense and Mortality Risk Charge. This charge ranges from a low of about 0.5 percent to a high of about 1.3 percent. Annual Maintenance Charge. This charge typically ranges from $0 to $100. Charge Per Fund Exchange. This charge generally ranges from $0 to $10, but most funds will permit a limited number of charge-free exchanges per year. Maximum Surrender Charge. Surrender charges vary by company and policy and generally phase-out over a number of years. If the charge is lower, the phaseout range tends to be longer. For example, typical charges and phaseout periods are 5 percent of premium decreasing to 0 percent over 10 years or 8 percent of premium decreasing to 0 percent over 7 years. PREMIUM TAXES Several states, including California, impose taxes on the annuity premiums that an insurance company collects. However, in most of those states, annuities funding qualified plans are exempt from those taxes. Premium taxes range from.5% to 3.5%, depending on the state. The significance of premium taxes to contract owners is that they ultimately bear the cost. The method of assessing premium taxes should be covered in an annuity contract and should also be explained in the sales presentation. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 18
1. Withdrawal privilege options WITHDRAWAL PRIVILEGE PROVISIONS Annuities are designed to be long-term investments, however, to compete with other investments, insurers needed to provide some liquidity during the term of annuity. Insurers usually allow policyholders to withdraw a portion of the annuity's value free of surrender charges. The amount available differs by contract, but there are usually three types of Free withdrawals: Withdrawals of interest earnings; or Withdrawals equal to a percentage of premium deposited; or Withdrawals equal to a percentage of the annuity's value The penalty-free amount is typically accessible each year. If a larger amount is withdrawn, it may be subject to withdrawal charges. Clients may lose any interest above the minimum guaranteed rate on the amount withdrawn. Some annuities waive withdrawal charges in certain situations, such as death, confinement in a nursing home or terminal illness. Tax penalties for withdrawal Clients should be reminded that even though the withdrawal may be free of surrender charges, tax penalties may still apply. The federal government may impose tax penalties on interest income withdrawn before age 59½. If the annuity is a tax-deferred investment. All interest income is taxable as ordinary income at withdrawal. SYSTEMATIC WITHDRAWAL Some individuals do not wish to give up the control over their capital that annuitization entails. For these individuals, systematic withdrawal plans provide a way to obtain a regular income from their annuity fund. Although the amounts withdrawn are not subject to favorable tax treatment, interest continues to be credited to the annuity fund on a tax-deferred basis. And although the income stream is not guaranteed to last for the individual's lifetime, the fund remains within the individual's control. And the individual still has the option of annuitizing the fund if he or she should wish to do so at some point in the future. Individuals needn't make an all-or-nothing decision regarding annuitization. They can guarantee themselves a certain level of income for life and still keep some capital fully under their control by annuitizing only a portion of their annuity fund. They can then withdraw money from the nonconverted portion of the fund from time to time as necessary or obtain regular income from it under a systematic withdrawal. In either case, the possibility remains of converting that portion of the fund, or just another part of it, to a guaranteed lifetime income stream at some point in the future. Most annuities allow withdrawals of up to 10 and percent per year after an initial waiting period of one year, without cost, fee or penalty. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 19
Example: A client invests $50,000 in an annuity and later adds another 25,000. In a few short years, the account grows to $100,000. The client suddenly needs funds and finds the maximum that can be withdrawn from most companies is $7,500 or 10% of the principal invested. Other companies might allow a withdrawal of $10,000 or 10% of the current account value. Some companies also let people take out all of their account growth (accumulated interest) at any time without a fee or penalty. Others levy penalties only during a prescribed period of time the first five or seven years. Example: On a $250,000 annuity, which is now worth $350,000, the insurer would allow withdrawals up to $100,000 without penalty. Free withdrawals are a nice feature but it is not something that should completely drive your decision to recommend a particular annuity since the majority of people who own annuities never use their free withdrawal option and the restrictions on withdrawals typically fade away in a matter of years. This is something the agent needs to carefully discuss with clients, especially seniors who tend to needs access to funds sooner after purchase than younger clients. 10. Annuitization options Annuitization Payout Options Settlement options refer to the various ways that funds from an annuity will be distributed. The insurance company and the annuity owner agree to settlement terms when the owner wishes to begin receiving income from the annuity. Once an annuity contract is settled, the owner loses the right to make withdrawals beyond the scheduled payments, and the right to surrender the contract. Four major types of settlement options are commonly available. Single Lump Sum The settlement may be made in a single lump sum. This lump sum includes both the amount the owner paid in premiums and the interest the funds have earned. Interest-Only Payments The owner may decide to receive interest-only payments until a later date on which another settlement option will take effect. Designated Dollar Amount The owner may elect to have the settlement paid in a specified number or designated dollar amount of payments over a number of years. For example, the annuitant could receive quarterly checks for equal amounts over a 10-year period. Copyright Sandi Kruise Insurance Training 2006, all rights reserved 20
Life Income Option The life income option is perhaps the one most commonly associated with annuities. With the life option, the annuitant receives payments until he or she dies. Payments may or may not continue after the annuitant s death. Three life income options are straight life, period certain and refund. Straight Life A straight life annuity contract provides for guaranteed periodic payments that terminate upon the annuitant s death. No remaining balance is paid to a beneficiary or to the annuitant s estate after the annuitant dies. The straight life annuity option, therefore, does not guarantee that the annuitant will receive payments equal to the amount paid as premiums on the contract. (In the event of the contract owner s death during the accumulation period, the proceeds will revert to the beneficiary. If no beneficiary has been named, proceeds will revert to the annuitant s estate.) Because this option limits potential payouts, the straight life annuity option provides the maximum income per dollar of outlay compared to other annuity options. Period Certain and Refund Options Period certain and refund options guarantee a minimum amount that the insurance company will pay on an annuity. Both of these options provide for a payment to be made to designated beneficiaries upon the annuitant s death. Because they provide added benefits for the consumer and create additional costs for the insurance company, annuities with period certain and refund options offer the consumer lower income per premium dollars than straight life annuities. Period Certain Period certain refers to a guarantee from the insurance company that it will make annuity payments for a specific number of years, even if the annuitant dies before the end of this period. However, payments to the annuitant will continue as long as he or she lives. Refund Option This option provides that in the event of the annuitant s death, the company will pay out an amount at least equal to the total dollars paid in as premiums. The company will continue to pay the guaranteed amount of monthly income for as long as the annuitant lives. Refund options can be classified into two basic types. With a cash refund, the insurance company agrees that if the annuitant dies, it will refund, in cash, the difference between the income that annuitant received and the amount paid in premiums, plus interest earned. With an installment refund, the insurance company agrees to continue to make periodic payments to the annuitant s beneficiary until the total of the payments made to the annuitant and to the beneficiary equals the amount the owner paid for the annuity contract, plus interest earned. The longer the payout is to continue after the annuitant s death, the smaller the periodic payments will be. Refund and period certain options offer benefits to a consumer who is reluctant to invest a substantial amount of money in a product whose return depends solely on the length of his or Copyright Sandi Kruise Insurance Training 2006, all rights reserved 21