Chapter 9: Annuities

KEYWORDS: ANNUITIES

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

403(b) Plan: As defined in Section 403(b) of the IRS tax code, this is a retirement plan for certain employees of public schools, employees of specific tax-exempt organizations, and certain ministers.

1035 Contract Exchange: This provision states that if an annuity is exchanged for another annuity, a “gain” (for tax purposes) is not realized. This is also true if a life insurance policy or endowment contract is exchanged for an annuity. However, an annuity cannot be exchanged for a life insurance policy. This provision in the tax code allows a policy holder to transfer funds from a life insurance, endowment, or annuity to a new annuity policy without being required to pay taxes.

Accumulation Period: During this period, the premiums that an annuitant pays into an annuity are credited as accumulation units. The accumulation period may continue during the period between when the premium payments have ceased, and the payout has not yet begun. At the end of the accumulation period, accumulation units are converted to annuity units.

Accumulation Units: These units represent the value of contributions that are made by the annuitant LESS a deduction for expenses. The value of each accumulation unit is a credit to the individual’s account and varies depending on the value of the underlying stock investment.

Annuitant: This is one to whom an annuity is payable or a person upon whose continued life future payments are dependent.

Annuity Units: These units are used to make payments to the annuitant. Annuity units are received once the accumulation units are converted to begin the pay-out period. At the time of the initial payout, the annuity unit calculation is made and, from then on, the number of annuity units will remain the same for the life of the contract.

Cash Refund Option: Upon the death of an annuitant, this option provides that, before payments totaling the purchase price have been made, the excess of the amount paid by the purchaser over the total annuity payments received will be paid in one lump-sum to designated beneficiaries.

Deferred Annuity: These annuities provide for the postponement of the payment of an annuity until after a specified period or until the annuitant attains a specified age. A deferred annuity may be purchased on either a single-premium or flexible premium basis. Deferred annuities typically don’t begin making income payments for at least one year after the date of purchase.

Equity Indexed Annuity (EIA): This is a fixed deferred annuity that offers the traditional guaranteed minimum interest rate as well as an excess interest feature that’s based on the performance of an external equities market index.

Exclusion Ratio: This is a fraction which is used to determine the amount of annual annuity income that’s exempt from federal income tax. The exclusion ratio is calculated by taking the total contribution or investment in the annuity divided by the expected ratio.

Fixed Annuity: This is an annuity that provides a guaranteed rate of return. The interest payable for any given year is declared in advance by the insurer and is guaranteed to be no less than a minimum that’s specified in the contract. With fixed annuities, the investment risk is assumed by the insurer.

Immediate Annuity: This type of annuity can only be purchased with a single payment and typically begins paying income within one month of purchase.

Joint Life and Survivor Option: This annuity payout option provides for payments to two people. If either person dies, the income payments continue to the survivor for life. When the surviving annuitant dies, no further payments are made to any person. A full survivor option pays the same (i.e., full) benefit amount to the survivor. A two-thirds survivor option pays two-thirds of the original joint benefit to the survivor. A one-half survivor option pays one-half of the original joint benefit to the survivor.

Life with Period Certain (or Life Income with Term-Certain) Option: This payout option is designed to pay the annuitant an income for life, but guarantees a definite minimum period of payments. Therefore, if the annuitant dies during the specified period, benefit payments will continue to the beneficiary for the remainder of that period.

Market Value Adjustment: This adjustment can be attached to a deferred annuity and features fixed interest rate guarantees combined with an interest rate adjustment factor that can cause the actual crediting rates to increase or decrease in response to market conditions. Rather than having the annuity’s interest rate linked to an index (as with the equity-indexed annuity), an MVA annuity’s interest rate is guaranteed to be fixed if the contract is held for the period that’s specified in the policy. The market-value adjustment feature applies only if the contract is surrendered before the contract period expires. If it’s not surrendered, the annuity functions in the same manner as a fixed annuity.

Period Certain Annuity: This is an annuity income option that guarantees a definite minimum period of payments (e.g., 10 years).

Periodic Payment Annuity (Flexible Premium): This refers to an annuity owner making multiple premium payments to accumulate principal. Typically, after the initial premium, these payments are flexible in regard to both frequency and amount.

Principal: This is the original sum of money that’s paid into an annuity through premium(s).

Single Premium Annuity: This is an annuity for which the entire premium is paid in one lump-sum at the beginning of the contract period. This can be a deferred or immediate single premium annuity.

Straight Life Annuity: This is an annuity income option that pays a guaranteed income for the annuitant’s lifetime, but payments cease upon the annuitant’s death.

Variable Annuity: This annuity shifts the investment risk from the insurer to the contract owner. Variable annuities are similar to a traditional, fixed annuity in that retirement payments will be made periodically to the annuitants, usually over the remaining years of their lives. However, with the variable annuity, there’s no guarantee of the dollar amount of the payments. The payments actually fluctuate according to the value of the securities in the account (primarily the value of common stocks). A variable annuity invests deferred annuity payments in an insurer’s separate account rather than the insurer’s general account (which allows the insurer to guarantee interest in a fixed annuity). Since variable annuities are based on non-guaranteed equity investments (e.g., common stock), a sales representative who wants to sell these contracts must be registered with the Financial Industry Regulatory Authority (FINRA) and must hold a state insurance license.

INTRODUCTION

An annuity is a series of periodic benefits or payments that are made to an annuitant and is considered an insurance contract between a contract owner and insurer. The contract owner funds the contracts, while the insurer (at some future date) promises to pay a series of periodic payments for either a fixed period or for the remainder of the annuitant’s life. The state insurance departments regulate traditional, fixed annuity products. Like variable life insurance, variable annuities are regulated at the state level, by the department of insurance, and at the federal level, through the Securities Exchange Commission (SEC), and the Financial Industry Regulatory Authority. This chapter will focus on a description of the various classifications of the annuity product.

This chapter is broken into the following sections:

Purpose and Function
Classification Based on Premium Payments
Classification Based on When Benefits Begin
Classification Based on Source of Income
Classification Based on Disposition of Proceeds (Annuity Payment/Settlement Options)
Classification Based on the Number of Lives Covered
Additional Annuity Characteristics and Aspects
New Types of Annuities
Uses of Annuities
Suitability in Annuity Investments
Annuities and Taxation

The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules, regulations, and statutes for your state. If a conflict exists, state law will supersede the general content.

Review of this chapter will enable a person to:

Understand the concept and structure of an annuity
Differentiate between an annuity contract and a life insurance contract
Differentiate between a fixed annuity and a variable annuity
Understand how an annuity is funded
Understand how annuities are taxed
Differentiate between the different types of annuities based on their payment options
Be familiar with the many uses of annuities
Be familiar with the standards and procedures for recommendations that are made to senior consumers relating to annuities.

PURPOSE AND FUNCTION

An annuity is a product which is only sold by a life insurance company and designed to protect an individual against outliving her income. Primarily, an annuity is a savings-type vehicle that’s used to set aside funds for the future. An annuity can be defined as the liquidation of an estate. This definition is the opposite of life insurance, which involves the immediate creation of an estate. Policy issuance and pricing of both term and whole life insurance is based, in part, on a mortality risk (i.e., mortality factor). However, an annuity is generally an investment product and does not require proof of insurability. The payment made to fund an annuity can be referred to as either a contribution or premium. If an annuity contract owner dies before income commences, there’s a payment made to a beneficiary. This payment is limited to the amount paid into the contract plus any interest credited.

The essential function of an annuity is the systematic reimbursement or liquidation of funds (i.e., savings) for a specified period or for life. Therefore, an annuity is a systematic approach to liquidating an estate (i.e., funds). An individual deposits or makes contributions to an annuity during the annuity’s pay-in or accumulation period. During this phase, the individual is also referred to the policy or contract owner. The policy owner possesses contractual rights in the annuity contract when the contract is purchased.

The annuity period begins once the contract owner starts receiving income. As soon as the insurer makes the first periodic payment, the contract owner is now referred to as the annuitant. Therefore, the annuitant is the person who receives monthly income from the annuity contract. The owner must also designate a beneficiary who will have access to the accumulated funds if the contract owner dies. Unlike the funds paid to beneficiaries of term or whole life insurance policies, this amount is not actually a death benefit since it only includes the amount contributed and accumulated due to any interest that’s credited. This indicates that an annuity possesses an insurance aspect. During the accumulation phase, the principal grows at interest. In fact, the interest that’s earned as the principal grows is tax-deferred. When a periodic payment is received at some point in the future, it’s considered to represent a combination of principal plus interest. Therefore, an annuity contract provides peace of mind to those who are concerned with receiving income for life.

For tax purposes, annuities are classified as either qualified or non-qualified. With a non-qualified annuity, the contributions are made in after-tax dollars. The contract owner receives the tax deferral of interest and growth earned, but there’s no tax deduction of premiums (or yearly tax savings through a salary reduction). Annuities that are purchased outside of qualified pension plans don’t receive tax-favored treatment of premium payments. In other words, premiums are not tax-deductible. Non-qualified annuities may be purchased by any individual or entity, but again, the premium payments or contributions are not tax-deductible.

A qualified annuity is one that’s purchased as part of a tax-qualified retirement plan. If the premium paid for a qualified annuity is in the form of a contribution by an employer to a qualified retirement plan, the premium is tax-deductible. Some qualified annuities also permit employees to fund the plan through a salary reduction (e.g., a tax-sheltered annuity or TSA). In this case, the plan is funded with pre-tax dollars, which lowers the employee’s yearly taxable income. An important note is that, regardless of whether the annuity is qualified or non-qualified, accumulations (i.e., interest earned) are tax-deferred.

A significant reason for a person to purchase an annuity is to provide income at retirement. An annuity does this by guaranteeing income to the recipient. As examined later, an annuity protects an individual against outliving her income. Only a life insurer can guarantee income for the life of an annuitant. An annuity is attractive to investors since insurers generally pay higher interest rates than other traditional savings vehicles (e.g., certificates of deposit or money market funds). If a contract owner withdraws funds prior to a stated period, withdrawal penalties may be assessed. However, if the contract owner dies or becomes disabled, funds may be withdrawn without penalty.

The parties involved in an annuity contract include the insurer, the contract owner, the annuitant, and the beneficiary. The contract owner has the right to name a beneficiary who will have access to the funds in the event of the owner’s death prior to annuitization (i.e., the annuity or pay-out phase). An annuity possesses some insurance aspects in that a mortality factor is used to determine periodic payments, but it’s not the same mortality factor that’s used in term or whole life insurance. In addition, as described previously, a beneficiary must be named in the event that the contract owner dies prior to the annuity phase. If no beneficiary is listed on an annuity contract and the owner dies before annuitization (payout), the proceeds are paid to the owner’s estate.

Annuities can be classified in several categories, including:

(1) based on how the premiums are paid,

(2) based on when benefits begin,

(3) based on the source of income,

(4) based on the disposition of proceeds, and

(5) based on the number of lives covered.

CLASSIFICATION BASED ON PREMIUM PAYMENTS

ANNUITY PREMIUMS

Annuities possess their own mortality tables, which are different from those used for life insurance. Items that are taken into consideration include the interest rate paid, the amount of total contributions or accumulations, and the settlement option selected. An annuitant’s occupation or hobbies don’t influence an annuity since they will not affect the liquidation of funds. Annuities may be funded with either a single premium or periodic premiums. There are two classifications of periodic premium plans.

Single Premium Annuities

Single premium annuities are characterized by a lump-sum (single) premium payment. In other words, the annuity is entirely funded with one premium payment. Monthly income payments that are made to the annuitant may begin immediately (i.e., 30 days following the single premium) or may begin at some point in the future (i.e., deferred). When an annuity is funded with a single, lump-sum payment, the principal is created immediately. Generally, this type of annuity doesn’t permit the contract holder to make any additional deposits into the contract. This means that the contract is fully funded with one lump-sum payment.

Periodic Premium Annuities

Periodic premium annuities are characterized by multiple premium payments over a set period of time. Periodic premium annuities are broken into two classifications, level premium and flexible premium.

A level premium annuity is characterized by level or constant annual payments to fund the annuity. For example, a 35-year-old purchases a level premium annuity with an annual premium of $1,200. The contract owner will pay that level amount each year until retirement at age 65. At that time, he will begin to receive monthly income payments. This type of annuity is also referred to as an annual premium annuity.
A flexible premium annuity is characterized by periodic premiums that may be in variable amounts each year. In this case, the contract owner will contribute an amount with which he’s comfortable each year. These premiums are paid until the contract owner wants to begin receiving income after retirement. As long as a minimum payment is made, the contract owner is permitted to determine the amount he can afford to contribute each year. The future income benefit will be based on the total amount of funds saved once the plan is annuitized (i.e., when income payments begin).

CLASSIFICATION ACCORDING TO WHEN BENEFITS BEGIN

Annuities may be described according to when the payout or distribution phase commences. In other words, they may be characterized as either immediate or deferred annuities.

IMMEDIATE ANNUITY

This class of annuity is designed to generate an income stream to the annuitant soon after it’s purchased. The first installment payment to an annuitant will typically begin 30 days after the annuity is funded or purchased. An insurer will only accept a lump-sum premium for this type of plan. This means that there’s no accumulation period since only a single payment is made. No income will be paid to the annuitant until the lump-sum has been provided to the insurer. The income payments that are made to the annuitant consist of both principal and interest. In addition, the first payment from a single premium immediate annuity must be made within 12 months of the contract date.

As with any annuity, the period during which the annuity generates income for the annuitant will depend on

(1) the total amount contributed to the account; and

(2) the settlement or distribution option selected by the owner.

The longer the period of desired income payments to the annuitant and the more guarantees provided (e.g., period certain), the lower the amount of each installment. The income from the annuity may either be a fixed dollar amount each month or a variable sum. An immediate annuity is best suited for a person who needs “immediate” income (i.e., a person who’s totally disabled or who’s ready to retire).

DEFERRED ANNUITY

This class of annuity may be funded with any type of premium payment plan (single or deferred/flexible). However, this classification is different from the immediate annuity because it includes an accumulation period. This means that there’s a lengthy period between the time of the contract’s purchase and when the income or annuity phase begins. A deferred annuity emphasizes the safety of principal, asset accumulation, and tax deferral of interest. Therefore, a deferred annuity is useful for any person who wants to defer income until the future (e.g., retirement). Contributions may accumulate over time, and every year the insurer credits the funds with a specific rate of interest, which is tax-deferred. When the owner decides to receive cash from the fund in the future, she has three options:

A lump-sum distribution, of which the interest portion that’s credited is taxable
Systematic or periodic withdrawals
Convert the fund to the annuity phase and begin to receive an income stream per month.

For example, a new physician is just beginning her practice and wants to set aside funds for the future. However, if her current expenses are high, she may choose to achieve this objective by purchasing a flexible premium deferred annuity.

CLASSIFICATION ACCORDING TO THE SOURCE OF INCOME

Some annuities may be classified by their investment configuration or the source of income payments that are provided. The investment configuration affects the income benefits paid. For this type of classification there are two types of annuities—fixed annuities and variable annuities.

FIXED ANNUITIES

A fixed annuity guarantees a predetermined income or level benefit payment amount, which is paid each month for the life of the annuitant. The recipient (i.e., the annuitant) will receive this monthly income or fixed dollar amount each month for the remainder of his life. Fixed annuities are derived from the insurer’s general account assets since it’s this account that provides an interest rate guarantee as well as the fixed dollar or income guarantee. The general account of an insurance company is used for the deposits of the premiums that are collected for both insurance and annuity contracts (i.e., this account holds the assets of the insurance company).

As long as the insurer remains solvent, a fixed annuity also guarantees the safety of the principal. In comparison to a variable annuity, this type of annuity is a conservative product. Since it’s characterized by a predetermined amount of income, its purchasing power will be most affected by inflation. Once the predetermined income payments begin for a fixed annuity, the beneficiary receives a guaranteed refund when the annuitant dies (if a period certain has been selected). With a fixed annuity, the investment risk is assumed by the insurance company. This means that the insurer invests the funds in safe and conservative investments so that it’s able to guarantee the annuity benefit. As required under the terms of the contract, the insurer is required to provide the promised benefit regardless of whether it earns its assumed interest rate.

To summarize, a fixed annuity guarantees a minimum amount of interest to be credited to the purchase payment. Income payments don’t vary from one payment to the next. For a fixed annuity, the insurer can afford to make guarantees because the money is placed in the general account of the insurer and this account is part of the insurer’s investment portfolio.

VARIABLE ANNUITIES

A variable annuity is a contract that’s issued by an insurer which provides the contract owner with the option of having premiums invested and managed differently than they are in a fixed annuity. This type of annuity generally consists of two investment accounts—both the general account and a separate account. A guaranteed return is provided when funds are invested in the general account; however, for funds that are invested in a “separate account,” they’re invested in equity products (e.g., common and preferred stocks), bonds, and other investment vehicles.

With a variable annuity, there’s a more significant potential for higher returns from the separate account, but (unlike in the general account) there’s no return guarantee. The separate account holds all of the variable account options of the insurer and allows the contract holder to control the investment of his premiums. This means that the contract owner assumes the investment risk when funds are directed to a separate account. The separate account feature is unique to variable products. As the name implies, the assets in an insurance company’s separate account are segregated from the insurance company’s general account (which is used for fixed annuities). All of the income and capital gains that are generated by the investments in the separate account are credited to the account. Also, any capital losses that are incurred by the separate account are then charged to the account.

Keep in mind, the separate account is not affected by any other gains or losses that are incurred by the insurance company. If the insurance company becomes insolvent, its creditors cannot make claims against the assets in the separate account, but they can make claims against the assets in the general account. The separate accounts of variable products are generally required to be registered as investment companies under the Investment Company Act of 1940.

A variable annuity provides more flexibility since the contract owner is able to determine how much risk he’s willing to assume. The benefits that are ultimately paid by the contract will be determined by the performance of the separate account (i.e., performance of the securities portfolio). If an equity fund (i.e., mutual fund) performs well, the monthly income amount being paid to the annuitant will increase. On the other hand, if the fund does poorly, the monthly installment payment will decrease. Similar to the cash value in a variable whole life insurance policy, the separate account value of a variable annuity contract is not guaranteed.

To be qualified to sell a variable annuity, a FINRA Series 6 or Series 7 securities registration and a life insurance license are required. Variable annuities are considered securities and are subject to SEC, FINRA, and state insurance regulation. As is the case with all variable products, a prospectus must be delivered prior to completing the sale of any variable annuity.

Variable annuities were created to provide investors with greater protection against inflation than what traditional, fixed annuities can offer. The contract owner is also given a level of control over how her contributions are invested. A variable annuity is characterized by variable rates of return, and its performance advances or declines based on the value of the investments that are chosen by the annuitant. During the accumulation period of a variable annuity, contributions that are made by the contract owner (minus expenses) are used to purchase accumulation units.

Variable Annuity Subaccounts

For variable annuities, the separate accounts typically contain a variety of different underlying portfolios or subaccounts (which are similar to the mutual fund choices that investment companies offer to their investors). The contract owners are able to allocate their payments among these different subaccounts based on their investment objectives. Additionally, contract owners are generally allowed to transfer their money from one subaccount to another as their investment goals change. Each of the subaccounts typically corresponds to a different underlying mutual fund, such as a large-cap stock fund, a long-term bond fund, or a money-market fund. The value of these subaccounts will fluctuate based on the changing market conditions for the underlying securities. Another subaccount may have a fixed rate of return which is guaranteed by the insurance company.

During the annuity’s accumulation (pay-in) period, the contract holder is permitted to surrender the annuity in exchange for its current value. However, once a person decides to annuitize (begin receiving income payments from the annuity), she may no longer surrender the annuity or freely withdraw money from it. Instead, she’s receiving payments based on the performance of the assets in the separate account.

At annuitization, the insurance company converts all of the accumulation units that have been purchased into annuity units. Annuity units represent the accounting measurement that’s used to determine the dollar amount of each payment that will be made to the annuitant. At this time, the number of annuity units represented in each payment is fixed. However, going forward, the value of each payment that’s made to the annuitant is based on a fixed number of annuity units which is then multiplied by a fluctuating unit value.

CLASSIFICATION ACCORDING TO DISPOSITION OF PROCEEDS (ANNUITY PAYMENT/SETTLEMENT OPTIONS)

Unlike a term life or whole life insurance policy, an annuity is not a contract that pays a guaranteed death benefit. When determining the income to be paid to the annuitant, the insurer utilizes a mortality table with an extra element which is referred to as a survivorship factor. An annuity may also be described according to the life payout period or life contingency settlement option selected. Let’s analyze the various options.

STRAIGHT LIFE ANNUITY

This contingency option—also referred to as a pure life annuity or “life” annuity—is classified according to the period during which the annuitant will receive income. If a straight life settlement option is chosen, once it commences making payments, the recipient will continue to receive payments for her life with no refund paid to her family or any beneficiary upon her death. This settlement option exposes the annuitant to the most significant amount of risk since there’s no survivorship (i.e., no refund), but it also provides the annuitant with the highest payout of all options. The purpose of a straight life annuity is to protect against an annuitant outliving her income. This means that a straight life annuity protects against superannuation. (i.e., using up income due to longevity).

Insurers that pay out under life annuities may suffer adversely if there’s a sudden decrease in the mortality rate. In other words, people are living longer and, therefore, insurers are paying life incomes longer. In addition, since women have a longer life expectancy than men, monthly payments would be smaller to a female if all other things are equal.

For example, Joe and Joan are twins and inherit an equal amount of money from their favorite aunt. If they both purchase an annuity with the funds and each contract includes the same life income option, Joe’s monthly income payments from the annuity contract will be higher since his life expectancy is shorter than Joan’s.

ANNUITY (PERIOD) CERTAIN

An annuity certain or period certain is a description of income or installments for a fixed period as decided upon by the owner. This means that the monthly income will be paid for a specified period only (i.e., not for life). Payments will cease after the specified period, even if the annuitant is still alive. However, if the annuitant dies prior to the end of that period, payments continue to the designated beneficiary for the remainder of the specified period.

For example, let’s say at age 60 Joe purchases an annuity period certain for 20 years. Joe’s annuity payments will cease at age 80 (20 years later), even if he is still alive. However, if Joe dies at age 70 (after 10 years), his family (or designated beneficiary) will continue to receive his payments for 10 more years.

STRAIGHT LIFE ANNUITY WITH PERIOD CERTAIN

A life annuity with a period certain pays a guaranteed minimum benefit (i.e., income) for the annuitant’s life or for a specified period, whichever is longer. This means that the contract will pay a survivor benefit if the annuitant dies before the end of the period certain (e.g., 10 years). In other words, the annuitant or survivors are entitled to a guaranteed income for at least a specified number of years.

For example, let’s say at age 60 Joe purchases a life annuity with period certain for 20 years. Joe will continue to receive annuity payments for as long as he is alive. He cannot outlive his payments. If Joe dies at age 70 (after 10 years), his family (or designated beneficiary) will continue to receive his payments for 10 more years. However, if Joe dies at age 85 (after 25 years), payments will cease, and his family (or designated beneficiary) will not receive any of the proceeds.

LIFE WITH REFUND OPTION

With a life with refund annuity option, the contract owner makes premium payments to the insurer throughout his life, but the contract also assures the return of the original amount paid into the annuity contract (i.e., the principal). If the annuitant dies before the principal is distributed, the beneficiary receives the remaining amount. Due to this guarantee, the premium for a refund annuity plan is generally higher than other annuity plans. There are two life with refund options available, the installment refund option and the cash refund option.

Installment Refund Option

The installment refund option will pay the beneficiary the same monthly income benefit that the annuitant was receiving until the remaining principal is depleted.

Cash Refund Option

The cash refund option will pay the remaining principal to the beneficiary in one lump sum.

Exam Tip: Remember an annuity certain guarantees payments will be made for at least a certain period of time. A refund annuity guarantees the entire principal will be depleted.

CLASSIFICATION ACCORDING TO THE NUMBER OF LIVES

Annuities may also be classified according to the number of lives covered, whether single or multiple life types. Let’s examine the three basic types.

INDIVIDUAL OR SINGLE LIFE ANNUITY

An individual or single life annuity is the most common form of an annuity. It is are pure life annuity, covering one life, with no survivorship (beneficiary). It provides income to the recipient, once it commences, for life with no refund paid to the annuitant's family upon his or her death. This settlement option possesses the most significant amount of risk to the annuitant as well since there is no survivorship (i.e., no refund). The purpose of a straight life annuity is to protect against outliving one's income.

JOINT LIFE ANNUITY

A joint life annuity is a type of multiple life contract that’s designed to pay benefits to two or more annuitants at the same time. However, all benefits will end once the first annuitant dies. In this manner, it’s similar to a joint life insurance policy.

JOINT AND SURVIVOR ANNUITY

A joint and survivor annuity is another form of a multiple life contract. With this type of annuity, the benefits are paid throughout the lifetime of one or more annuitants. Therefore, payments continue until the last annuitant dies. In other words, joint and survivor annuities guarantees income payments for the duration of two lives.

ADDITIONAL ANNUITY CHARACTERISTICS AND ASPECTS

ACCUMULATION PERIOD

During the pay-in (accumulation) phase, the insurer is obligated to return all (or a portion) of the annuity’s value if the contract owner dies. This value will be equal to the amount of any contributions (minus withdrawals or other expenses), plus interest. Although the contract doesn’t identify the proceeds available at death as a death benefit, the owner must name a beneficiary who’s entitled to proceeds if the owner dies during the accumulation period. Again, the amount or appreciation earned during the accumulation phase is tax-deferred. However, additional surrender charges may also be assessed at withdrawal. The accumulation period will cease when any of the following occur:

The contract owner dies
The annuity or “pay-out” phase begins
The policy is surrendered.

This period will not cease if a premium payment has not been made.

ANNUITY PERIOD

The annuity period, which may also be referred to as “annuitization,” is the period that begins when the contract owner gives up the right to the funds in the contract and, in return, receives a promise of monthly income.

PARTIES OF ANNUITIES

The parties involved in an annuity contract include the insurer, the contract/policy owner, the annuitant, and the beneficiary.

The insurer is the party (insurance company) issuing the annuity.
The contract owner purchases and pays for the annuity, can surrender the annuity and execute nonforfeiture options, and has the right to name a beneficiary who will have access to the funds in the event of the owner’s death prior to annuitization (i.e., the annuity or pay-out phase).
The annuitant is the individual (natural person) who receives the benefits or payments from the annuity.
The beneficiary is the recipient of the annuity assets in the event the annuitant dies during the accumulation period, or a balance of annuity benefit needs to be paid out.

SURRENDER CHARGES

Surrender charges—also referred to as back-end loads—are assessed if the contract owner cancels an annuity. A surrender charge (i.e., penalty) is assessed whenever a cash withdrawal is made in excess of a specified percentage (e.g., 10%), in any policy year. If the total annuity is surrendered, the surrender charges are subtracted from the annuity value. However, for any withdrawals of less than the specified percentage, no surrender charge is assessed. The surrender charge will generally decrease each year. For example, an insurer may assess a surrender charge of 8% if any withdrawals in excess of 10% of the account balance are taken in the first year. This penalty will decrease by 1% per year for the next eight years. In year nine, there will be no surrender charge for excess withdrawals. In other words, after this time period expires, the insurer effects a waiver of surrender charges.

NON-FORFEITURE VALUES

Annuity contracts also identify the non-forfeiture value of a fund. This represents the value of the fund less any surrender charges if the funds are being withdrawn. As is the case for certain types of qualified retirement plans that are available today, funds may be withdrawn without surrender charges being assessed if the owner dies, becomes disabled, or requires specific types of extended medical care in a skilled nursing or extended care facility. Surrender charges are designed to make moving money out of an annuity less attractive to the contract owner. Surrender charges that are assessed by an insurer are different from the 10% federal tax penalty that’s assessed for a premature withdrawal. Therefore, a withdrawal from an annuity may be subject to both a surrender charge and a tax penalty.

EXAM TIP: Before annuitization, the non-forfeiture value of an annuity equals all premiums paid, plus interest, minus any withdrawals and surrender charges. If the annuitant dies before the annuity period start date, the beneficiary receives the premiums paid plus interest earned.

FLEXIBLE PREMIUM DEFERRED ANNUITY (FPDA)

Today, the most popular annuity product being sold is the flexible premium deferred annuity. An FPDA provides for flexible payments and allows for the future supply of income to an annuitant. Any interest earned is tax-deferred. This type of annuity has virtually replaced the annual premium retirement annuity contract, which has a fixed schedule of annual premiums (including bundled premiums) and high expenses. Today’s FPDAs have little or no front-end loads due to the tremendous competition between insurers. However, many FPDAs do assess back-end or surrender charges.

SURRENDER CHARGES

NON-FORFEITURE VALUES

FLEXIBLE PREMIUM DEFERRED ANNUITY (FPDA)

SINGLE PREMIUM ANNUITY

Single premium annuity types may provide either immediate income (SPIA) or deferred income (SPDA). Single premium immediate income annuities are paid for with a lump-sum payment, with income then beginning 30 days later. Single premium deferred annuities are paid for with a lump-sum, with income being paid in the future. At times, SPDAs include a bailout provision which allows the owner to withdraw funds without a penalty if the interest rate falls below a specified rate.

ANNUAL PREMIUM RETIREMENT ANNUITIES

An annual premium retirement annuity is a vehicle that provides tax-deferred income to the owner. Although the amounts deposited into the account are not tax-deductible (i.e., the premiums are paid after-tax), the income earned on the annual premium paid into the contract will not be taxed until it’s removed from the account. In other words, the interest or earnings paid on the principal is tax-deferred. As described earlier, these older types of contracts were characterized by high loads.

FIXED AND VARIABLE ANNUITIES

The following is a review of details regarding fixed and variable annuities.

A fixed annuity pays a guaranteed, predetermined, or level benefit payment amount during the annuity phase. Premiums are placed in the insurer’s general account with other non-variable product premiums. These premiums are invested in fixed-rate products (e.g., CDs, money market, etc.) to provide a “fixed” return based on interest rate guarantees. These contracts include minimum interest rate guarantees and may pay higher rates based on current economic market conditions.

For a variable annuity, premiums are placed in a separate account. These funds are invested in securities, such as equities (i.e., common stock or preferred stock) or debt securities (i.e., bonds). This type of annuity provides the potential for increasing income if the securities perform well. To solicit a variable product, a person must obtain a life insurance license and a FINRA securities registration (i.e., Series 6 or Series 7).

LONG-TERM CARE RIDERS

Long-term care riders may be attached to an annuity or a life insurance policy and they allow for the payment of a percentage of the death benefit if an individual requires long-term care but is not terminally ill.

GUARANTEED MINIMUM WITHDRAWAL BENEFIT (GMWB)

A guaranteed minimum withdrawal benefit is a rider that may be included in an annuity contract. The GMWB guarantees the policy holder a steady stream of retirement income regardless of market volatility. During market downturns, the annuitant can withdraw a maximum percentage of his entire investment in the annuity. Annual maximum percentages that are available for withdrawal vary with contracts, but are generally between 5% and 10% of the initial investment amount until the depletion of the total initial investment is reached. During the withdrawal period, the annuitant may continue to receive income.

GUARANTEED MINIMUM INCOME BENEFIT (GMIB)

This feature assures a guaranteed amount of income after the assets of the contract are annuitized, regardless of investment performance. The guaranteed amount of income is the higher of (1) the account value at annuitization that’s applied to the current annuity purchase rates, or (2) the GMIB benefit base. (The GMIB benefit base is the equivalent of net premiums paid in and compounded at an annual fixed rate, which is then applied to the current annuity purchase rates that are in force at annuitization.) The account must be annuitized for this benefit to be triggered, regardless of the fees that have been paid by the owner to fund the benefit. Regardless of how the market performs while the annuity contract is in force, this feature offers a guaranteed amount of income.

GUARANTEED MINIMUM ACCUMULATION BENEFIT (GMAB)

The GMAB is a feature which guarantees that the premiums paid into the contract by the owner will have a minimum accumulation value after a multi-year waiting period. The net premiums are typically multiplied by a value of one to three to determine this minimum. The contract doesn’t need to be annuitized for this benefit to be triggered.

NEWER TYPES OF ANNUITIES

Insurers also offer equity-indexed annuities and market value adjusted annuities. An equity-indexed annuity (EIA) is a fixed (non-variable) annuity that offers a rate of interest that’s linked to (but the funds are not directly invested in) a stock market-related index (e.g., the Standard & Poor’s 500 Index). This form of annuity may also be referred to as simply an indexed annuity. Index annuities provide the contract owner with the safety of principal (since the principal is guaranteed), and a guaranteed minimum return (e.g., 3%) since a high percentage of the contract owner’s premium is invested in high-grade government bonds. This provides a downside guarantee if the market performs poorly. In other words, this type of contract allows the owner to participate in market gains without assuming the risk of a market decline. An EIA also provides the opportunity for appreciation (i.e., upside potential) in the stock market. Generally, the contract owner is obligated to remain in the contract for a minimum period (e.g., three years) and will receive a return of a percentage of the appreciation (e.g., 10%) in the selected equity index over that period. This “percentage of the appreciation” may also be referred to as the participation rate.

A market value-adjusted annuity (MVA)—also referred to as a modified guaranteed annuity—shifts some (but not all) of the investment risk from the insurer to the contract owner since the annuity account value will fluctuate with the changes in market interest rates. In other words, it’s a type of single premium-deferred annuity that allows contract owners to lock in a guaranteed interest rate over a specified maturity period of typically two to 10 years.

An MVA functions in a manner that’s similar to a bond in times of fluctuating interest rate (i.e., when interest rates fall, bond prices rise, etc.). MVAs generally provide higher interest rates than traditional annuities and also possess lower reserve requirements and pass on more risk to the contract owner. When surrendered, there will generally be both a market value adjustment and a surrender penalty assessed to the owner.

USES OF ANNUITIES

An annuity is a type of insurance contract that may be used for any reason in which the accumulation of cash is the goal, but it’s primarily used to provide income at retirement. By definition, annuities provide a structured and systematic way to liquidate principal. While life insurance is intended to create an estate, annuities are intended to liquidate an estate. This section will examine some of the common uses of annuities.

INDIVIDUAL USES

Again, an annuity is an insurance product that offers the annuitant with tax-deferred growth. Contract owners may elect to receive a lump-sum payout (i.e., settlement) when the annuity phase begins. However, receiving a lump-sum settlement can lead to significant tax liability for the recipient.

By design, an annuity will liquidate principal in a structured, systematic way which guarantees that it will last a lifetime. Since they may be used to fund individual retirement accounts (IRAs), they’re also referred to individual retirement annuities. Annuities may also fund non-qualified retirement plans; however, such plans don’t receive the same tax-advantaged treatment as a qualified plan. Some annuities are used to provide funds for a child’s education or to possibly pay out lottery winnings.

Keep in mind, for most individuals, the primary use of an annuity is to set aside funds for retirement while receiving tax-deferred growth.

QUALIFIED ANNUITY PLANS

Although retirement plans will be covered in detail in a later chapter, the following information describes annuities related to retirement plans. As mentioned above, annuities may be used to fund qualified retirement plans on either an individual or group basis. In some cases, the plans receive tax deferral and tax deductions. Such plans include Keogh plans, simplified employee pensions (SEPs), 401(k) plans, pension plans, and profit-sharing plans. Pension and profit-sharing plans may be established as either defined contribution or defined benefit. A defined contribution plan specifies the amount that each employee will contribute to the plan, while a defined benefit plan specifies the benefit amount the (retired) employee will receive in the future. Ultimately, annuities may be used for employees in a group or on an individual basis.

During the accumulation (pay-in) phase, a qualified deferred annuity may be used to fund an IRA and continued contributions are permitted within the maximum limits that are set by the IRS. Any IRA funds that have been annuitized will no longer permit contributions.

TAX-SHELTERED ANNUITY 403(B) OR 501(C)(3) PLANS

A tax-sheltered annuity (TSA) is a special type of annuity plan that’s reserved for non-profit organizations and their employees. Such a plan is also referred to as a 403(b) plan or 501(c)(3) plan because it was made possible by those sections of the IRS tax code. For many years, the federal government, through its tax laws, has encouraged specified non-profit charitable, educational, and religious organizations to set aside funds for their employees’ retirement.

Regardless of whether the money is set aside by the employers of these organizations, or the funds are contributed by the employees through a reduction in salary, the money being placed in TSAs can be excluded from the employees’ current taxable income.

Upon retirement, payments that are received by employees from the accumulated savings in tax-sheltered annuities are treated as ordinary income. However, since the total annual income of an employee is likely to be less after retirement, the tax to be paid by a retiree is likely to be less than while he was working. Additionally, the benefits can be spread out over a specified period or over the remaining lifetime of the employee. This generally allows the amount of tax owed on the benefits in any one year to be small.

[EXAM TIP: In addition to TSAs and IRAs, annuities are an acceptable funding mechanism for other qualified plans, including pensions and 401(k) plans.]

STRUCTURED SETTLEMENTS

Annuities are also used to distribute funds from the settlement of lawsuits or the winnings of lotteries and other contests. Such arrangements are referred to as structured settlements. Court settlements of lawsuits often require the payment of large sums of money throughout the rest of the life of the injured party. For these settlements, annuities are perfect vehicles because they can be tailored to meet the needs of the claimant. Annuities are also suited for distributing the large awards that people win in state lotteries. These awards are often paid out over a period of several years, usually 10 or 20 years. Because of the extended payout period, the state can advertise large awards and then provide for the distribution of the award by purchasing a structured settlement from an insurance company at a discount. The state can get the discounted price because a $1 million award being distributed over 20 years is not worth $1 million today. Trends indicate that significant growth can be expected from both these markets for annuities.

EDUCATION FUNDS

An annuity provides a steady stream of income, typically used for retirement, but can also be used to fund education for children or family members.

SUITABILITY IN ANNUITY INVESTMENTS

Insurers and insurance producers must have reasonable standards for determining whether an agent’s recommended transactions meet the consumers’ insurance needs and financial objectives. A producer cannot recommend the purchase, sale, or exchange of any annuity contract unless the producer has reasonable grounds to believe that the transaction or recommendation is NOT unsuitable for the person to whom it’s recommended. Suitability is based on the producer conducting a reasonable inquiry regarding the applicant’s insurance objectives, current financial situation, insurance needs, and risk tolerance.

Suitability information is considered information that’s reasonably appropriate to determine the suitability of a recommendation and includes:

The age of applicant and spouse
Annual household income
Financial situation and needs, including the financial resources used for the funding of the annuity
Financial experience of the person
Financial objectives of the prospective purchaser
The intended use of the annuity
Financial time horizon, and
Any existing assets, including investment and life insurance holdings of the prospective buyer

The producer should also take into consideration the liquidity needs of the consumer, his liquid net worth, the risk tolerance of the individual, and tax status information of the consumer (e.g., his tax bracket).

State legislatures have established standards and procedures for recommendations that are made to senior consumers relating to annuities. A senior consumer is defined as any person who’s age 65 or older. For situations in which a joint purchase is being made by more than one party, a purchaser is a senior consumer if any one party is age 65 or older. An agent is required to make reasonable efforts to obtain information concerning the senior’s financial status, tax status, and risk tolerance, among other specified information that’s relevant to determining suitability.

ANNUITIES AND TAXATION

As mentioned earlier, contributions (i.e., premiums) to a qualified individual (or employer-sponsored) annuity are generally tax-deductible. However, contributions to or premiums paid for a non-qualified individual annuity are not tax-deductible. Annuity benefit payments are a combination of the return of principal along with growth (interest, dividends, and capital gains). Since the earnings (i.e., accumulations) in annuities are tax-deferred, the IRS will tax the amount withdrawn above the amount invested as ordinary income (subject to the highest tax rates) However, the portion of the benefit payments that represent a return of principal (i.e., the contributions made by the annuitant) is not taxed. In other words, the result is a tax-free return of the annuitant’s investment and the taxing of the growth.

THE EXCLUSION RATIO

Although a detailed discussion of how to compute the taxable portion of an annuity payment is beyond the scope of this text, the basics are not difficult to understand. A simple formula—referred to as the exclusion ratio—is used to determine the annual annuity income that’s exempt from federal income taxes. The formula is: the total investment in the contract divided by the expected return.

The owner’s investment (cost basis) in the contract is the amount of money that’s been paid into the annuity (the premium). The expected return is the annual guaranteed benefit that the annuitant receives multiplied by the number of years of the annuitant’s life expectancy. The resulting ratio is applied to the benefit payments, thereby allowing the annuitant to exclude from income a like-percentage from income tax.

For example, if $100,000 is invested into an annuity, the expected return each year is $7,500 and the life expectancy is 20 years. The total expected return is $150,000 ($7,500 x 20) and, therefore, the exclusion ratio is 66.66% or rounded up to 67% ($100,000 ÷ $150,000). Since the payment each year is $7,500, 67% of that amount ($5,025 in this case) is excluded from taxes and the remaining $2,475 ($7,500 – $5,025) is taxable.

EARLY / PARTIAL WITHDRAWAL / CASH SURRENDER

Deferred annuities accumulate interest earnings on a tax-deferred basis. Although no taxes are imposed on the annuity during the accumulation phase, taxes are imposed when the contract begins to pay its benefits. To discourage the use of deferred annuities as short-term investments, the Internal Revenue Code imposes a penalty (as well as taxes) on early withdrawals and loans from annuities.

Prematurely withdrawn amounts are generally taxed on a Last-In, First-Out (LIFO) basis which means that accumulations or interest earned is considered withdrawn first when distributions are made. The exception to this rule is that annuities purchased before August 14, 1982, are taxed on a First-In, First-Out (FIFO) bases, which means that the premium paid is considered withdrawn first. These taxes are in addition to, not inclusive of, the federal age-based tax penalty.

For withdrawals from a deferred annuity that are taken prior to the age of 59 1/2, a 10% penalty tax is imposed on the amount withdrawn. Withdrawals that are taken after the age of 59 1/2 are not subject to the 10% penalty tax, but they are still taxable as ordinary income.

Penalties are not assessed on premature distributions if

(1) the owner becomes disabled;

(2) the owner has reached age 59½

(3) the owner has died;

(4) an immediate annuity was purchased; or

(5) funds are received under a qualified pension plan.

Like early withdrawals, partial withdrawals (i.e., loans) and cash surrenders are treated first as earned income and are therefore taxable as ordinary income. Only after all of the earnings have been taxed are withdrawals considered a return of principal.

DISTRIBUTIONS AT DEATH

If the owner dies during the accumulation phase and prior to the annuity phase, the beneficiary will receive the greater of the accumulated value of the annuity or the amount of contribution (i.e., premium payments). Any amount received in excess of premiums paid is taxable as ordinary income to the recipient (i.e., beneficiary). Therefore, whatever gain is realized will be taxable. If the beneficiary chooses to minimize this taxation, he or she may select a life income or installment option. However, this option must be selected within 60 days of the annuitant’s death. The amount paid to the beneficiary when the policy- owner dies is the amount accumulated (i.e., contributions plus interest). The death benefit paid by life insurance is the face amount no matter how few premiums have been paid. Since an annuity is a piece of property, if the policyowner/annuitant dies during the accumulation period, its proceeds are generally includible in the deceased’s estate. Any unpaid annuity benefits following the death of the annuitant are paid to the beneficiary and are taxable.

1035 CONTRACT EXCHANGES

The concept of Section 1035 exchanges was covered when the tax implications related to insurance policies were described. Section 1035 of the Internal Revenue Code also allows for the tax-free exchanges of other types of financial products, including annuity contracts. Remember, no gain will be recognized (and therefore no gain will be taxed) if an annuity contract is exchanged for another annuity contract. The same applies when a life insurance or endowment policy is exchanged for an annuity contract. However, under Section 1035, an annuity contract cannot be exchanged on a tax-free basis for a life insurance contract.

This regulation allows the contract owner to move the cash value from one contract to another without incurring current tax implications. As long as the transfer is transacted within (i.e., intra-company) or between insurance companies and the policy owner receives no money, the exchange is permitted (without tax ramifications). Theoretically, this means that the cost basis remains the same. The result is that taxes are not avoided; instead, they’re postponed to a later date.

CORPORATE-OWNED ANNUITIES

Current tax law states that if a corporation owns an annuity, it must name a natural person as an annuitant. If a non-natural entity is named an annuitant (e.g., the company itself), then the interest earned is taxable as ordinary income in the year in which it’s credited. In some cases, if a natural person is named as the annuitant, the interest credited to the annuity each year may be tax-deferred. At times, this natural person is referred to as a measurable life.

There’s an exception to this non-natural person rule. If the annuity is held by a trust, corporation, or another non-natural person as an agent for a natural person, the interest earned continues to be tax-deferred. Other exceptions to this rule include, but are not limited to:

An annuity contract that’s acquired by a person’s estate following the death of that person
An annuity contract that’s held under a qualified retirement plan (e.g., a TSA) or an IRA, or
A contract which is an immediate annuity purchased with a single premium, with periodic payments to commence within one year

Corporate-owned life insurance is generally treated as a deductible business expense and the proceeds are paid on a tax-free basis up to a certain level ($50,000). If more than this amount is provided to an employee, the excess premium that’s used for the purchase must be reported by the employee as taxable income. An annuity could also be owned by a non-living entity (e.g., a trust) and the tax considerations will be based on whether it’s qualified or non-qualified. Additionally, an annuity can be owned by a 501(c) non-profit entity, as long as there is a named annuitant.

CHAPTER SUMMARY: ANNUITIES

Key points to remember from this chapter include:

The primary use of an annuity is to provide income for retirement.
An annuity is NOT a life insurance contract.
The following four entities are involved in an annuity:
- The insurance company (insurer) invests the annuity contributions and also makes certain guarantees to the contract owner that are stipulated in the annuity contract.
- The policy/contract owner invests in the annuity and has the power to terminate the annuity, withdraw all or part of the money, name the annuitant, name/change the beneficiary, and possibly change the investments.
- The annuitant is the person whose life determines the annuity payouts
- The Beneficiary of an annuity is the person who will benefit or prosper from the annuity upon the death of the annuitant.
Regardless of the entity that’s providing the annuity for sale—banker, financial planner, brokerage firm, or any individual or business that’s licensed to sell annuities—the annuity agreement is always between the contract owner and the insurance company.
A life annuity guarantees that an annuitant cannot outlive the payments.
The death of an annuity contract owner will generally trigger a payout to the beneficiary.
There are two distinct time periods involved with an annuity:
- Accumulation (pay-in) period, and
  - Annuity (pay-out) period
The accumulation period is that time during which funds are being paid into the annuity.
The annuity or pay-out period refers to the point at which the annuity ceases to be an accumulation vehicle and begins to generate regular benefit payments.
Benefits are paid out monthly, quarterly, semiannually, or annually.
Surrender charges apply for the first five to eight years of the contract.
A bailout provision allows the annuity owner to surrender the annuity without surrender charges if interest rates fall below a stated level within a specified period.
Annuity principal is funded in one of two ways:
- Immediately with a single premium, or
  - Over time with a series of periodic premiums
There are two types of annuity investment options:
- Fixed annuities
  - Variable annuities
Fixed annuities provide a guaranteed rate of return
Equity indexed annuities (EIA) are a type of fixed annuity that offer the potential for higher credited rates of return than their traditional counterparts, but also guarantee the owner’s principal.
A market value adjusted (MVA) annuity’s interest rate is fixed and guaranteed if the contract is held for the period specified in the policy.
Variable annuities shift the investment risk from the insurer to the contract owner.
A sales representative who wants to sell variable annuity contracts must be registered with the Financial Industry Regulatory Authority (FINRA) as well as hold a state insurance license.
An immediate annuity is designed to make its first benefit payment to the annuitant one payment interval after the date of purchase.
Deferred annuities accumulate interest earnings on a tax-deferred basis and provide income payments at some specified future date.
The annuity period is the income phase.
There are several annuity income options available:
- Straight life income
  - Cash refund
  - Installment refund
  - Life with period certain
  - Joint and survivor
  - Fixed amount, and
  - Period certain
Under the fixed amount option, the annuitant receives a fixed payment until the contract value is exhausted.
A straight life income annuity option pays the annuitant a guaranteed income for the annuitant’s lifetime.
The period certain income option is not based on life contingency.
The life with period certain option payout approach is designed to pay the annuitant an income for life but guarantees a definite minimum period of payments.
The cash refund option provides a guaranteed income to the annuitant for life.
The installment refund option guarantees that the total annuity fund will be paid to the annuitant or the annuitant’s beneficiary.
Under a temporary annuity certain, the payments are guaranteed to be made for a specified number of years.
The joint and full survivor option provides for payment of the annuity to two people.
An annuity contract cannot be exchanged tax-free for a life insurance contract.
In a joint and two-thirds survivor, the survivor’s income is reduced to two- thirds of the original joint income.
In joint and one-half survivor, the survivor’s income is reduced to one-half of the original joint income.
Annuity benefit payments are a combination of principal and interest.
Corporate-owned life insurance is generally treated as a deductible business expense.
A qualified plan is a tax-deferred arrangement that’s established by an employer to provide retirement benefits for employees.
A tax-sheltered annuity (TSA) is a particular type of annuity plan that’s reserved for non-profit organizations and their employees, as well as school system (educational) employees.