TABLE OF CONTENTS
CHAPTER ONE - WHAT ARE ANNUITIES .............................................................................. 1
OWNERSHIP OF AN ANNUITY ......................................................................................... 1
THE ANNUITANT ................................................................................................................ 2
THE BENEFICIARY ............................................................................................................. 3
MULTIPLE TITLES .......................................................................................................... 3
HOW THE CONTRACT IS "DRIVEN" ................................................................................ 3
WHEN DO BENEFITS BEGIN? ........................................................................................... 4
IMMEDIATE ANNUITY –START PAYING NOW ............................................................ 4
DEFERRED ANNUITY-START PAYING LATER. ............................................................ 4
HOW ARE ANNUITIES PURCHASED? ............................................................................. 5
PREMIUM PAYMENTS. .................................................................................................. 5
HOW ARE ANNUITY PREMIUMS PAID? ..................................................................... 6
HOW LONG WILL BENEFIT PAYMENTS CONTINUE? ................................................. 6
ANNUITY CERTAIN (PERIOD CERTAIN).................................................................... 6
LIFE ANNUITIES (STRAIGHT LIFE ANNUITIES)....................................................... 7
LIFE INCOME WITH PERIOD CERTAIN ...................................................................... 7
LIFE INCOME WITH REFUND ANNUITY .................................................................... 8
TEMPORARY LIFE ANNUITY ....................................................................................... 8
JOINT AND SURVIVOR ANNUITIES ................................................................................ 8
COMPARISON OF ANNUITY vs CD NET RETURNS ...................................................... 9
COMPARISON OF ANNUITY vs CD NET RETURNS ...................................................... 9
WITHDRAWAL OPTIONS ....................................................................................................... 9
ANNUITIZATION ................................................................................................................... 10
CHAPTER TWO - HOW ANNUITIES ARE USED................................................................... 13
SOME BASIC CONSIDERATIONS ....................................................................................... 13
LONG-TERM INVESTMENT STRATEGIES ............................................................... 13
QUALIFIED AND NON QUALIFIED ANNUITIES ......................................................... 13
INDIVIDUAL RETIREMENT ANNUITY (IRA) ............................................................... 14
ELIGIBILITY AND MAXIMUM CONTRIBUTION ..................................................... 15
SPOUSAL IRA ................................................................................................................. 15
IS IT DEDUCTIBLE? .......................................................................................................... 15
NON QUALIFIED INDIVIDUAL ANNUITIES .................................................................... 16
ANNUITIES FOR SENIOR AGE GROUPS ....................................................................... 17
FEATURES AND OPTIONS ............................................................................................... 17
GROUP/BUSINESS-OWNED ANNUITIES .............................................................................. 17
KEOGH PLANS ....................................................................................................................... 18
DEFINED BENEFIT PLAN..................................................................................................... 18
DEFINED CONTRIBUTION PLAN ................................................................................... 18
CORPORATE PENSION AND PROFIT SHARING PLANS ................................................ 18
GROUP DEFERRED ANNUITY ........................................................................................ 19
GROUP DEPOSIT ADMINISTRATION CONTRACT ..................................................... 19
401(K) PLANS ......................................................................................................................... 20
CHAPTER THREE - TAXATION OF ANNUITIES .................................................................. 23
PREMIUM PAYMENTS ..................................................................................................... 23
CURRENT INCOME TAXATION ..................................................................................... 23
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STATE PREMIUM TAXES................................................................................................. 23
TAX DEFERRAL OF INTEREST ACCUMULATIONS ................................................... 24
DISTRIBUTIONS OF QUALIFIED PLANS ...................................................................... 24
INSTALLMENT PAYMENTS OF QUALIFIED PLAN DISTRIBUTIONS ............. 25
REQUIREMENTS FOR LUMP SUM DISTRIBUTIONS .......................................... 25
TAX RELIEF ACT 1986 ...................................................................................................... 25
ROLLOVERS (1035 EXCHANGES) ...................................................................................... 26
INCOME TAX AND THE INTEREST-OUT-FIRST RULE .............................................. 27
WITHDRAWALS, LOANS AND SURRENDERS ............................................................ 27
PENALTY TAX ....................................................................................................................... 27
LOANS ................................................................................................................................. 28
ANNUITY LIQUIDATION PAYMENTS........................................................................... 28
EXCLUSION RATIO ............................................................................................................... 29
TAXATION OF DEATH BENEFITS.................................................................................. 30
DEATH PRIOR TO LIQUIDATION PHASE ................................................................. 30
FEDERAL ESTATE TAXES ............................................................................................... 30
MORE ABOUT TAXES ...................................................................................................... 31
CHAPTER FOUR - TAX SHELTERED ANNUITIES ............................................................... 33
TAXATION OF TSA‘s ............................................................................................................ 34
CONTRIBUTIONS (ACCUMULATION PERIOD) ............................................................... 34
DISTRIBUTION....................................................................................................................... 34
FUNDING................................................................................................................................. 35
OPTIONS UPON RETIREMENT ....................................................................................... 35
LOANS ..................................................................................................................................... 36
DEATH BENEFITS ................................................................................................................. 37
EXPENSES ............................................................................................................................... 37
EXCLUSION RATIO AS IT PERTAINS TO DEATH BENEFITS ............................... 37
CHAPTER FIVE - VARIABLE ANNUITIES............................................................................. 40
THE SEPARATE ACCOUNT THAT VARIES ...................................................................... 40
SECURITIES AND INSURANCE REGULATION................................................................ 41
THE VALUE OF THE FUND: ACCUMULATION UNITS .................................................. 41
LOADING AND OTHER CHARGES ..................................................................................... 42
IMMEDIATE VARIABLE ANNUITIES ................................................................................ 43
VARIABLE ANNUITIES EXCLUSION RATIO ............................................................... 44
COMPANY MANAGED VS. SELF DIRECTED ACCOUNTS, ....................................... 44
OPTIONS AVAILABLE AT DEATH ................................................................................. 45
RATCHETED OR STEP-UP DEATH BENEFIT ........................................................... 45
DEATH BENEFIT ADJUSTMENT ................................................................................ 45
ANNUALLY INCREASING DEATH BENEFIT ........................................................... 45
FIXED AND VARIABLE PAYOUTS .................................................................................... 46
FIXED PAYMENTS ................................................................................................................ 46
VARIABLE PAYMENTS ........................................................................................................ 46
VARIABLE ANNUITY UNITS AT LIQUIDATION ......................................................... 47
HOW MUCH RISK? ............................................................................................................ 47
EARNINGS, GUARANTEED OR NOT ............................................................................. 48
LIQUIDITY – GETTING TO THE MONEY .......................................................................... 48
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DETERMINING THE RIGHT PRODUCT FOR YOUR CLIENT ......................................... 49
EXTRA-CREDIT ANNUITIES ........................................................................................... 50
DIRECT-MARKETED ANNUITIES .................................................................................. 51
LIVING BENEFITS ............................................................................................................. 52
TAXATION OF VARIABLE ANNUITIES ............................................................................ 53
USING A VARIABLE ANNUITY ...................................................................................... 54
CHAPTER SIX - EQUITY INDEXED ANNUITIES.................................................................. 58
BACKGROUND ...................................................................................................................... 58
WHAT IS AN EIA? .................................................................................................................. 58
WHERE DID THEY COME FROM? .................................................................................. 59
WHY INDEXING? ............................................................................................................... 60
―TRUST ME‖ ....................................................................................................................... 61
WHO SELLS THEM? .......................................................................................................... 62
IS IT A SECURITY OR NOT? ............................................................................................ 62
PROVISIONS OF EQUITY INDEXED ANNUITIES ............................................................ 63
CALCULATION OF YIELD ................................................................................................... 64
HOW THE INTEREST RATE IS DETERMINED ............................................................. 65
THE SIMPLE POINT-TO-POINT INDEXING METHOD ................................................ 65
THE HIGH WATER MARK INDEXING METHOD ......................................................... 66
THE RATCHETING (ANNUAL RESET) INDEXING METHOD .................................... 67
END POINT OR LOW WATER MARK INDEXING METHOD ...................................... 68
THE LIGHT SWITCH (DIGITAL) INDEXING METHOD ............................................... 68
THE MULTI-YEAR RESET INDEXING METHOD ......................................................... 69
SHOCK ABSORBERS - AVERAGING.............................................................................. 69
CHAPTER SEVEN – FUNCTIONS AND USES OF EIA‘S ...................................................... 72
HOW ABOUT DIVIDENDS? .............................................................................................. 72
GUARANTEED RATE – THE SAFETY CUSHION ......................................................... 72
HOW LONG WILL THE CONTRACT RUN? ................................................................... 73
HOW MUCH IS SUBJECT TO INTEREST PARTICIPATION ........................................ 73
CAPS – IS THE SKY THE LIMIT?..................................................................................... 74
WHAT IF THE INDEX NOSEDIVES? – THE FLOOR .................................................... 75
EARLY OUT – VESTING AND SURRENDER ................................................................ 75
THE END PRODUCT - ANNUITIZATION ....................................................................... 76
RELATIONSHIP OF RETURN AND RISK ....................................................................... 77
COMPARISONS WITH OTHER ANNUITIES OR MUTUAL FUNDS ........................... 78
ANNUITIES ..................................................................................................................... 78
MUTUAL FUNDS ........................................................................................................... 79
2001- WHAT HAPPENS NOW? ......................................................................................... 80
WHAT‘S OUT THERE? SUMMARY OF PRESENT PRODUCTS ..................................... 82
Types of Premiums ....................................................................................................... 82
Methods of Indexing ..................................................................................................... 82
Features as Gauged By Use In Current Products .......................................................... 82
Interest Calculation ....................................................................................................... 82
RECENT (2001) MARKETING COMMENTS ON EIAS .................................................. 83
NOW THAT WE KNOW WHAT THEY ARE, HOW ARE THEY USED?.......................... 84
WHAT DO THE AGENTS THINK ABOUT EIAs? ........................................................... 87
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THE MARKET ..................................................................................................................... 87
THE DREAM PRODUCT .................................................................................................... 88
SUMMARY .............................................................................................................................. 89
CHAPTER EIGHT - DISADVANTAGES OF ANNUITIES ...................................................... 92
IRS PENALTY ......................................................................................................................... 92
ORDINARY INCOME TAXES ........................................................................................... 93
PARTIAL WITHDRAWALS CAN RESULT IN HIGH TAXATION ........................... 94
ANNUITY AGGREGATION RULE ............................................................................... 95
TAX DEFERRAL AND STEPPED UP BASIS ............................................................... 96
STATE PREMIUM TAX ................................................................................................. 97
PENALTIES IMPOSED BY THE INSURER ................................................................. 97
MORTALITY AND EXPENSE FEE ............................................................................... 98
ANNUAL CONTRACT MAINTENANCE CHARGE ................................................... 98
CHAPTER NINE - THE FINANCIAL STRENGTH OF INSURERS ...................................... 101
COMPANY RATING ............................................................................................................ 101
STANDARD & POOR'S .................................................................................................... 102
MOODY'S .......................................................................................................................... 103
DUFF & PHELPS ............................................................................................................... 104
WEISS RESEARCH, INC. ................................................................................................. 104
CLAIMS PAYING ABILITY ................................................................................................ 105
ANNUAL STATEMENTS..................................................................................................... 105
INVESTMENT PORTFOLIO ................................................................................................ 105
PAST INSOLVENCY‘S ..................................................................................................... 106
STATE GUARANTY LAWS ............................................................................................ 106
JUDGING RATING SERVICES ........................................................................................... 107
CHAPTER TEN - POTPOURRI ................................................................................................ 110
―TAXLESS‖ ANNUITIES ..................................................................................................... 110
WHAT IS HAPPENING TO ANNUITIES TODAY? ........................................................... 112
WHAT‘S OUT THERE IN THE S.P.D.A. MARKET .......................................................... 113
ROTH IRA .............................................................................................................................. 115
CONVERTING AN IRA TO A ROTH IRA ...................................................................... 116
ROTH vs ANNUITY .......................................................................................................... 116
ANNUITY AND A ROTH? ............................................................................................... 116
THE RULE OF 72 .................................................................................................................. 117
PERFORMANCE OF VARIABLE ANNUITIES VS MUTUAL FUNDS ........................... 119
SPLIT ANNUITY ................................................................................................................... 122
THE AFTER-TAX ADVANTAGES OF AN ANNUITY ..................................................... 123
SAMPLE FIXED ANNUITY FORM ........................................................................................ 126
BIBLIOGRAPHY ....................................................................................................................... 131
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CHAPTER ONE - WHAT ARE ANNUITIES
―An annuity is a contract sold by insurance companies that pays a monthly (or quarterly,
semiannual, or annual) income benefit for the life of a person (the annuitant), for the lives of two
or more persons, or for a specified period of time. The annuitant can never outlive the income
from the annuity. While the basic purpose of life insurance is to provide an income for a
beneficiary at the death of the insured, the annuity is intended to provide an income for life for
the annuitant. There are variations in both the way that payments are made by a buyer during the
accumulation period, and in the way payments are made to the annuitant during the liquidation
period.
An annuity may be bought by means of installments, with benefits scheduled to begin at a
specified age such as 65; or, it may be bought by means of a single lump sum, with benefits
scheduled to begin immediately or at a later date. No physical examination is required.
(Dictionary of Insurance Terms, Third Edition)
Simply put, an annuity is defined as a policy contract that agrees to pay the insured a regular
income over a specified number of years. Often called ―life insurance in reverse‖ because while
life insurance protects against loss by premature death. Annuities, on the other hand, protect
against ―living too long.‖ However, most annuities have some sort of death benefit. By assuring
continued payments for a specified or unlimited number of years, annuities guarantee that the
insured will not deplete his or her source of income.
The time period over which the insurance company promises to provide income varies by
type of contract is logically called the Annuity Period. The contract may specify an exact
number of years or the individual‘s lifetime (an unspecified number).
The person who purchases the annuity is the owner. The person who received payments
from the annuity is the annuitant. The annuitant may or may not be the contract owner.
Annuities may be written on an individual, joint or group basis. The most common is the
individual annuity that is usually purchased for retirement purposes. The ―Joint and Survivor‖
annuity is also a common form for married persons. With this type of annuity, there are two
persons insured and payments are guaranteed to continue to the surviving spouse upon the
other‘s death. Annuity payments can be either the same or different amount, usually designated
as a percentage of the original amount (discussed in more detail later). Group annuities are
generally part of a group pension or similar employee benefit plan.
OWNERSHIP OF AN ANNUITY
When the owner of an annuity enters into an agreement they must always understand all of
the terms to the best of their ability. If there are additions, withdrawals, or a complete liquidation
to be made, there may be restrictions or penalties.
The contract owner can be an individual, couple, trust, corporation, or partnership. The only
requirement is that the owner must be an adult or legal entity. A minor can be the owner as long
as the policy lists the minor's custodian (example: ―James Jones, as custodian for the benefit of
Johnny Jones"). Since the contract owner controls this investment, the owner has total control,
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and can give the contract to anyone, or will part or all of the contract to anyone or any entity at
any time.
THE ANNUITANT
The most difficult party to an annuity for a person to fully understand, is the annuitant. The
best way to understand this party to an annuity would be to compare it to the functions of a life
insurance policy. When a life insurance policy is issued, the person insured is named on the
contract and continues as the insured until the owner of the policy either terminates the contract
or does not make any required premium payments - or, of course the insured dies.
With the annuity, the terms remain in force until the contract owner makes a change or the
annuitant (the person named in the contract as annuitant) dies. Therefore, the annuitant
resembles the insured in a life insurance policy. But with an annuity, the death of the annuitant
does not necessarily mean the contract is about to terminate. Even though every annuity contract
must designate an annuitant, the annuitant has no voice or control over the investment or its
disposition, unless the annuitant is also the contract owner. If the contract is a Variable Annuity,
and if the annuitant dies, this may create certain insurance company guarantees.
Annuitants are often called the "measuring life." This means that the length of time that the
contract covers must have a specific time frame. The annuitant is then used as the time frame
that is considered and referred to by the contract. Just like in life insurance, the annuitant has no
voice or control over the contract. The annuitant can benefit from an annuity ONLY when it
―annuitizes.‖
The person named as annuitant can be any person so designated by the annuity, with the only
restriction being that is must be an actual living person under a specified age, and not a trust,
business, corporation, etc. The maximum age of the proposed annuitant depends on the
requirements of the insurance company – usually the annuitant must be under age of 75 when the
contract is first executed. It is of prime importance that the investment (contract) stay in force
after the annuitant reaches this maximum age.
Generally, the contract owner may change the annuitant at any time provided the annuitant is
alive when the contact was originally executed. Some contracts allow for the contract owner to
name a co-annuitant. By naming a co-annuitant, the contract could last longer because any
―forced‖ annuitization or the termination of the contract, could possibly be postponed until the
death of the second annuitant. The co-annuitant can be compared to a ―second-to-die‖ life
insurance policy, as the death of one annuitant will not force distribution of the annuity. Naming
a co-annuitant means the death of one annuitant will not trigger a possible forced distribution.
Only a small number of insurers include a co-annuitant option as part of the annuity
application.
Some annuity contracts require a distribution or ―orderly liquidation‖ of the funds, once the
annuitant reaches a certain specified age - typically 80 or 85. The death of an annuitant may
require liquidation within a specified period, usually five years.
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THE BENEFICIARY
To use an analogy, in a life insurance policy, the beneficiary has no ―status‖ until the death of
the named insured. In an annuity, the beneficiary has no ―status‖ until the death of the annuitant.
Similarly, the beneficiary of an annuity has no control of the policy and has no say in the
management of the policy. The beneficiary benefits from an annuity only when the annuitant
dies.
The beneficiary can be either an individual, or a trust, corporation or partnership. There does
not have to be any relationship between the beneficiary and the annuitant – indeed, they could
conceivably be (but highly unlikely) total strangers. The application form used for an annuity
allows the owner to state multiple beneficiaries, and to designate the percentage of each
beneficiary if so desired.
Frequently, one spouse would be the owner of the contract, and the other spouse would be
the beneficiary. With some companies, co-ownership is allowed, thereby allowing both spouses
to be owners. This can be quite valuable in case the annuitant dies as the annuity proceeds
would not go to a beneficiary as long as one of the spouses was still alive.
Generally, a single person (or widow or widower) will designate themselves as the owner of
the contract and also the annuitant, naming another party as the beneficiary (such as a church,
charity, etc.). By doing this, the person has complete control over the investment during their
lifetime, and upon their death, the annuity proceeds will automatically pass to the intended heir.
Since the owner of the contract can change the beneficiary at any time, they do not need to
notify a listed beneficiary that they have been so designated, or indeed, even tell them if they are
removed as beneficiary.
MULTIPLE TITLES
When the original investment(s) is/are made, the owner(s), annuitant, and beneficiary(s) must
be so stated. As stated above, only the annuitant has to be a natural person. The person can hold
more than one ―title.‖ For instance, they could be the contract owner and beneficiary of the same
contract. It is also possible that the annuity owner, annuitant and beneficiary are the same
person. It should always be remembered that a non-person entity (such as a corporation,
partnership, living trust, etc.) can only be specified as contract owner and/or beneficiary. The
annuitant must be a living individual under a certain age.
HOW THE CONTRACT IS "DRIVEN"
Most annuities are considered as "annuitant-driven," i.e., if the annuitant reaches a certain
age, died, or became disabled, certain provisions of the annuity would govern. Some of these
provisions could waiver any penalties enacted by the insurer, or the death benefit, IRS penalty,
and/or the required annuitization or distribution of the contract would go into effect, depending
upon the situation of the annuitant (such as the contract owner dying, reaching a certain age, or
becoming disabled). Some, but few, annuities state that certain provision can come into being if
either the owner, co-owner, or annuitant dies, reaches the age of annuitization, or becomes
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disabled. This flexibility makes the annuity more appealing in some circumstances.
WHEN DO BENEFITS BEGIN?
There are two basic types of annuities in respect to when benefits start (when the annuity
―annuitizes‖).
IMMEDIATE ANNUITY –START PAYING NOW
With an immediate annuity, annuity payments will commence after a predetermined
―period.‖ The period can be one year, for instance, in which case the first benefit payment
will be one year after the purchase of the immediate annuity. Payments can be monthly,
quarterly, semi-annual or annual. If the period is one month, annuity payments start one
month after purchase.
DEFERRED ANNUITY-START PAYING LATER.
With annuitization, the payment period is scheduled to begin at some future date. The period
when the contract annuitizes, is called the maturity date. Conversely, for definition purposes,
the period prior to the maturity date is called the accumulation period. Further, the period
following the maturity date during which payments are made is the liquidation or distribution
period.
If death occurs before the annuitization period as stated in the contract, the cash value paid to
the annuitant‘s beneficiary would equal the amount of premiums paid in. However, most
contacts provide for payment to the beneficiary of at least the amounts paid in - plus interest
and regardless of sales charges.
The owner of a Deferred Annuity is permitted to alter the date that payments are scheduled to
begin but within certain conditions that are plainly stated in the annuity.
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HOW ARE ANNUITIES PURCHASED?
PREMIUM PAYMENTS.
The specific premium amount depends on several factors, primarily the length of the
guaranteed benefit payment period. The ―Straight life‖ (discussed later) annuity offers
maximum income per dollar of outlay. Obviously, the reason for this is that some annuitants will
die prematurely, or in the early part of the annuitization, thereby restricting the total amount of
payout. Period certain and refund options provide less income per dollar of outlay, as the
element of mortality does not enter the equation.
The interest the company earns on investments is an important factor in determining annuity
premiums. The higher the interest, the more income per dollar of outlay. During the discussion
of Equity Indexed Annuities, the effect of the company‘s investment portfolio is extremely
important. Obviously, the higher the investment return the lower the premiums to the annuitants.
The third factor is the expenses of the insurer. If the insurer has high expenses (such as high
commissions and overrides), the higher the premium to the policyholder. In other words, the
lower the expenses, the lower the premiums paid to the insurer which are required by the insurer
to pay all claims and satisfy their stockholders.
CONSUMER APPLICATION
Bertrand, age 66, and his wife, Louise, also age 66, talk to their insurance agent about the
purchase of an annuity that will pay $1,000 to each of them for his/her lifetime. Since Bertrand
is a CPA, he has an interest on how the premiums are calculated. Their agent refers to his
company‘s actuarial department, who offers the following explanation:
The Insurance company assumes an earned interest rate of 8% on the investments that they
purchase using the premiums paid by the insured.
Bertrand‘s single premium cost would be $9088. Louise‘s premium would be $8890.
Difference in premium would be $198. Therefore $198 would be liquidated the first year (one-
year difference in ages).
8% of $9088 = $727.04.
Added to the one year cost difference ($198) would be $925.04.
Since the company promises to pay $1,000, the company would be $74.96 short.
This (annuity) concept may be difficult for people used to Certificates of Deposit and other
savings vehicles to comprehend. As an insurance product, annuities are calculated on the
participation of many people. Thus, when they start receiving annuity payments, those funds
will come from a pool of funds that provides this income to those who live long enough to
receive it. The $74.96 represents the insurance benefit that annuitants that survive to age 66
would receive, based on calculations on the number of annuitants that are likely to die that year.
Therefore, the death benefit to surviving annuitants will grow larger each year during the
liquidation period. If the annuitant lives long enough, both principal and interest eventually will
be exhausted, and entire payment will come from the insurance benefit.
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HOW ARE ANNUITY PREMIUMS PAID?
Single Premium immediate annuity premiums are paid when the contract is signed, hence the
term ―lump sum payments.‖ The funds for the payment of premiums can come from a variety of
sources such as Employee profit-sharing plan, Savings Accounts, Cash Value of life insurance
policy or sale of home or property, etc.
In today‘s market, many annuities are purchased as the result of an IRA, 401(k) or 403(b)
rollover. When this is done, it is extremely important that it be a ―Section 1035‖ exchange, i.e.
that it not be a taxable exchange unless, for some reason, the customer wants to pay taxes on the
amount of the rollover at that time. The insurance company will furnish the papers that must be
executed for such a rollover to exist and as discussed elsewhere in this text, the funds must be
automatically transferred to the new annuity.
Periodic Level Premiums is a typical payment method of deferred annuities. The annuitant
pays equal premium amounts at regular intervals, until the benefits are scheduled to begin. Some
individuals choose this option, as it is similar to making deposits into a regular savings type
account.
Periodic Flexible Premiums is a premium payment method that is more ―in tune‖ with
today‘s investment world. The annuitant pays the premiums over a period of time, until they are
paid off. Since the premiums are flexible, they appeal to those who want flexibility in the timing
and amount of premium payments and is particularly attractive to those who want a program in
which they can vary the amounts they save each year. This also appeals to those who earn
commissions, or other types of irregular income such as actors, truck drivers, artists, etc., not to
mention families with growing children. As long as the annuity remains in effect, funds will
continue to accrue interest. The principal disadvantage is that the actual amount of annuity
benefit cannot be determined in advance, which may be essential in financial planning.
HOW LONG WILL BENEFIT PAYMENTS CONTINUE?
ANNUITY CERTAIN (PERIOD CERTAIN)
An Annuity Certain specifies the number of benefits payments of a set amount. This option
will guarantee a minimum amount that the insurance company will pay on an annuity. The
annuity has a Death Benefit that provides for payment to be made to the designated beneficiary
upon the annuitant‘s death and will continue as long as the beneficiary lives. In effect, this
annuity says that it will pay the benefits remaining of the period certain to the beneficiary.
However, if the annuitant should survive the period certain, then the annuity performs as a Life
Annuity.
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CONSUMER APPLICATION
Cecil dies 3 years after taking out an Annuity with a 5-year period certain. The Annuity
Company will continue to make payments to his beneficiary for next two years. Insurance
companies usually pay the present value of the remaining payments in a lump sum, so Cecil‘s
beneficiary will receive 2 annual payments.
If Cecil had survived the first five years of annuitization (liquidation period), the annuity
would have continued to be paid out in the normal manner, ceasing upon the annuitant‘s death.
―A Life Annuity Certain is an annuity that … guarantees a given number of income
payments whether or not the annuitant is alive to receive them. If the annuitant is living after the
guaranteed number of payments have been made, the income continues for life. If the annuitant
dies within the guarantee period, the balance is paid to a beneficiary. For example, under one
common contract, a life annuity certain for 10 years, income payments are guaranteed for a
minimum of 10 years. If the annuitant dies after receiving two years of payments, the
beneficiary would receive the remaining eight years of income. An annuitant who lives out the
10 years would receive income payments for life, but there would be none available to a
beneficiary.‖ (Dictionary of Insurance Terms, Third Edition)
LIFE ANNUITIES (STRAIGHT LIFE ANNUITIES)
This is the most common type of annuity. The simple ―Straight Life Annuity‖ provides for
guaranteed periodic payments that terminate upon the death of the annuitant. Once the annuitant
dies, the contract is fulfilled and no payments are made. This type of annuity does not guarantee
that the annuitant will receive payments equal to the amount paid as premiums on the contract.
If the annuitant lives a long time, they will recover more than all of the premiums they have paid;
if they die soon after annuitization, the insurance company will only pay the benefits up until the
time of death.
In the event the annuitant dies during the accumulation period (i.e. the time that payments are
being made on the annuity, but prior to annuitization) proceeds will revert to the beneficiary, or
if none is named, to the estate. Because this limits potential payouts, it will provide a higher
return than other plans.
The Straight Life Annuity provides the maximum income per dollar of outlay.
LIFE INCOME WITH PERIOD CERTAIN
The Life Income with Period Certain guarantees that annuity payments to a beneficiary will
be made for a specific number of years, even if the annuitant dies before the end of this period.
Payments to the annuitant will continue as long as he or she lives.
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LIFE INCOME WITH REFUND ANNUITY
The Life Income with Refund type of Annuity states that in the event of the annuitant‘s
death, the company will pay 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.
There are two types of this annuity:
Cash Refund: The Company agrees that if the annuitant dies, it will refund in cash the
difference between the income that annuitant received and the amount that was paid in premiums
plus interest earned.
Installment Refund: The Company agrees to continue to make payments to the beneficiary
until the total of the payments made to the annuitant and to the beneficiary equals the amount the
owner paid for the annuity plus the interest earned. The longer the payout is to continue after the
annuitant‘s death, the smaller will be the periodic payments.
Annuities with refund options pay annuitants lower amounts of income than do
comparable contracts without them. The refund option represents an extra benefit for the
contract owner and an extra cost for the company.
TEMPORARY LIFE ANNUITY
The Temporary Life Annuity is a ―combination‖ plan. Annuity payments will be made until
either (a) the end of a pre-determined number of years, or (b) until the death of the annuitant,
whichever comes first.
JOINT AND SURVIVOR ANNUITIES
Under this arrangement, two people are annuitants, usually husband and wife. Beginning on
the date set in the contract, payments are paid to the annuitants. Payments are guaranteed to
continue to the surviving spouse upon the other spouse‘s death. Depending on the terms, the
continuing payments will either be in the same amount as when both annuitants were alive, or be
reduced. Obviously, the premiums are higher than those for life income annuities are since the
likelihood of a long annuity payment period is greater when more than one life is covered.
Two types are commonly used.
1. Joint and 2/3 survivor, the surviving spouse receives two thirds of the income paid to the
original annuitant.
2. Joint and one-half survivor, surviving spouse receives half of the income.
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COMPARISON OF ANNUITY VS CD NET RETURNS
Because of the tax treatment, the net return of an annuity will always exceed that of a
Certificate of Deposit. The following chart shows this difference quite dramatically.
COMPARISON OF ANNUITY VS CD NET RETURNS
From this bar chart, it is obvious that one is much better putting assets into annuities, instead
of CD‘s, and the longer the period of time that funds remain in annuities, the better performance.
WITHDRAWAL OPTIONS
Receiving the funds from an annuity, either fixed-rate or variable, is a double-edged sword.
The owner can always take out part or all of his/her money at any time. However, any
withdrawal may be subject to a penalty.
Generally, an annuity will allow withdrawals of up to 10 percent per year without any
penalty or other cost. The ―free‖ withdrawal is usually based on a percentage of the principal
(not the current value). If, for example, an annuity owner invests $25,000 into an annuity, and
then later adds another $25,000, the owner may withdraw up to $5,000 every year, without
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penalty. Even with investment growth, this would be the maximum that they could withdraw
without penalty. However, some annuities do allow a free withdrawal which is based upon the
greater of (a) the current value, or (b) the principal contribution(s).
The contracts must be read carefully, as some companies will allow withdrawals of up to
15% per year, and others will allow free withdrawals of the growth at any time – or based upon
the current value of the annuity (principal plus growth).
In respect to the withdrawals, recent statistics indicate that nearly three/fourths of those who
invest in annuities, never take any money out of the annuities. It should also be kept in mind that
those restrictions on withdrawals eventually disappear.
Those restrictions on withdrawals, usually lasting about 5 to 7 years, do not apply to certain
no-load annuities. A ―true‖ no-load annuity will usually allow withdrawals of any amount, at
any time, without cost or penalty.
These restrictions do not mean that the owner cannot take out more than the specified amount
– such as 10% - but if funds are taken out, a penalty will apply. The amount of the penalty
depends upon the type of annuity and the insurer.
CONSUMER APPLICATION
Paul purchases an annuity from the Permanent Life Insurance Company, and invested
$500,000. The contract allowed a withdrawal of 10% without penalties for a period of five
years. Paul could therefore take out $50,000 each year without penalty.
The second year that the annuity was in force, Paul decides to invest in his brother-in-laws
business, and needs $70,000. At that particular time, the fund had grown to $550,000. There
would be a penalty applied to the amount over 10% of the original investment, or $20,000. The
penalty would (typically) be 5% of the amount over the original investment, in this case, or
$1,000.
Therefore, the insurance company would issue a check to Paul in the amount of $69,000.
ANNUITIZATION
Annuitization is the even distribution of both principal and interest, or growth of the annuity,
over a specified period of time. There is a distinct advantage to annuitization inasmuch as the
disbursements are tax-favored. Those situations where funds are sporadic, the tax-favorable
status does not apply.
Annuitization is allowed under nearly all annuity contracts. When the annuity is annuitized,
the owner of the contract makes the decision as to how to receive the funds, i.e. what will be the
mode of payment (monthly, semi-annually, annually, quarterly, etc.). Variable contracts and
fixed rate contracts may be annuitized.
There is a disadvantage to annuitization. Once the annuitization procedure has been
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established, it cannot be changed (except for a very few exceptions). There can also be a
disadvantage if a Variable Annuity is annuitized. In those cases, the amount of the check will
vary, depending upon the results of the sub-accounts selected and the amount of money allocated
to these sub-accounts. With a Variable Annuity, the investment ―ups-or-downs‖ are risks of the
person receiving the checks, which is usually the contract owner/annuitant, and is not that of the
insurer.
Obviously, and as discussed in more detail later, the more ―aggressively‖ the money is
invested, the less predictable is the payout stream. On the flip-side, if the annuity funds are
invested in short-term bonds, utilities or money market sub-accounts, the more predictable the
income will be from time to time.
Another possible disadvantage for annuitizing a fixed rate annuity is that the amount of each
check depends upon the competitiveness of the insurer, what the current rates happen to be at
that time, the duration of the withdrawals, and of course, the principal amount annuitized.
STUDY QUESTIONS
CHAPTER 1
1. If the annuitant dies before the annuity period starts, the cash value paid to the
beneficiary:
A. will equal the face amount.
B. will equal the anticipated annuitized amount.
C. will equal the amount of premiums paid in.
2. The Annuity period is
A. the time the contract owner makes payments.
B. the time period during which the insurance company will make payments.
C. the time between, when the contract ends, and payments begin.
3. The annuity owner
A. can be a trust.
B. cannot give the contract to another person.
C. must be the annuitant.
4. __________________are often called the ―measuring life‖
A. Annuitants.
B. Contract owners.
C. Corporations.
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5. The person named as an annuitant can be any person so designated by the annuity
A. and it may be a trust or corporation.
B. and it must be an actual living person under a specified age.
C. who may be of any age.
6. An annuity that starts paying benefits after a period of time, usually at least a year, is
called
A. an annual annuity.
B. a deferred annuity.
C. an immediate annuity.
7. The premium for an annuity depends primarily on
A. the length of the benefit period.
B. the commissions paid to the agent.
C. the interest the insurance company makes on the investment.
8. With a Cash Refund Annuity the company agrees
A. to pay until the annuitant dies, then all payments stop.
B. that if the annuitant dies, it will refund in cash the difference the annuitant
received and the premiums paid plus interest.
C. that if the annuitant dies it will refund in cash all the premiums paid plus interest.
9. The ________________________annuity provides the maximum income per dollar
for the annuitant.
A. Life Certain.
B. Life income with refund.
C. Straight Life.
10. An annuity that allows withdrawals of up to 10% per year without penalties, usually
bases the percentage on
A. the present value of the annuity, including growth.
B. the principal.
C. the growth portion of the annuity only.
ANSWERS: 1 A 2B 3A 4A 5B 6B 7A 8B 9C 10B
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CHAPTER TWO - HOW ANNUITIES ARE USED
SOME BASIC CONSIDERATIONS
Obviously, Annuities are important for a person who needs a vehicle to meet their financial
needs. The financial needs of corporations that provide group benefits also benefit from
annuities. Financial planners use annuities for a variety of reasons, and in today‘s market,
annuities must compete with other investment vehicles. Therefore, for annuities to take their
proper place in the area of investments there are some basic considerations that must be kept in
mind.
LONG-TERM INVESTMENT STRATEGIES
As a general rule, annuities should be considered part of a long-term investment strategy
rather than as a short-term liquid savings account (with one notable exception – the immediate
annuity). This statement will be repeated in one form or another throughout this text, as it
underlies the entire subject of annuities used as an investment. One of the primary benefits of
annuities— the tax-deferral on interest—applies only as long as the funds deposited in the
annuity are not withdrawn. When discussing the precise tax consequences, it is apparent that
Internal Revenue Service tax penalties can be quite severe. As discussed elsewhere also, it be
noted that the insurance company imposes its own penalties in the form of surrender charges or
interest rate adjustments when annuity funds are withdrawn under certain circumstances.
The exception to the long-term investment strategy is the use of a single premium immediate
annuity to begin providing income payments as soon as possible. In this case, of course, the
purpose is to pay an immediate stream of income, not to build up funds for the future.
Generally annuities are purchased with flexible premiums so as to defer the income return
until some future date and to reap the tax benefits in the meantime. Annuitants who adhere to
the long-term strategy are thus ―rewarded‖ and annuitants who do not are ―penalized.‖ At the
same time, the flexibility and withdrawal privileges of newer annuities are more sensitive to
changing financial circumstances, therefore annuity owners who encounter large, unexpected.
immediate financial needs are able to access their annuity funds to some extent.
In particular, Variable Annuities are best perceived as long-term investments. When the
stockmarket is a ―bull‖ market, that also means that the investments underlying a Variable
Annuity will also perform well over the long term.
Historically, a mix of securities, such as those that are investments for variable annuities and
mutual funds, has been profitable over an extended period of time. The key is avoiding the
temptation to withdraw from the investment during temporary downturns in the market.
QUALIFIED AND NON QUALIFIED ANNUITIES
Annuities may be written as either qualified or nonqualified contracts. ―Qualified‖ means the
annuity is established and maintained according to Internal Revenue Service rules that permit a
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tax deduction for the premiums paid. This also means that no current income tax is required on
the portion of income used to pay the premiums for a qualified annuity. On the other hand,
nonqualified annuities are paid for with after-tax dollars, which means contributions are not tax
deductible.
The only qualified annuities available for most individuals are those used to fund Individual
Retirement Accounts (IRAs). For corporations and other business entities, group annuities
designed to fund employee or other group retirement plans may also be qualified. In both
individual and group situations, the annuities must be designed for and operate under stringent
IRS qualification guidelines.
Most insurance companies offer both qualified and nonqualified annuities, but some do not.
An insurer may offer types that may be written only as qualified plans while others may be
written only as nonqualified annuities. Some may restrict their qualified annuity offerings to
certain uses, such as for IRAs or for 403(b) organizations.
INDIVIDUAL RETIREMENT ANNUITY (IRA)
Individual retirement annuities (IRAs) which are established on an individual basis allow
wage earners to make independent contributions to their own retirement plans. Either a fixed or
Variable Annuity may be used and:
- an IRA is always a flexible premium deferred annuity.
IRAs provide a limited tax deduction for the individual‘s contribution as well as interest
accumulation on a tax-deferred basis. (Instruments other than annuities may be used to establish
individual retirement accounts, but our discussion is limited to annuities used for this purpose.)
Originally, the purpose of an IRA was to offer retirement savings incentives to people not
included in a corporate or employer-sponsored plan. This is still the primary use for an IRA. But
some people who are covered by employer plans may establish tax-deductible IRAs as well.
Because Congress tinkers with IRAs every few years, the regulations and limitations change
from time to time and at this time of writing, other changes are being discussed in Congress. The
purpose of this discussion is to better understand annuities; therefore the following applications
of annuities into retirement plans emphasize the position and applicability of the annuities only.
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ELIGIBILITY AND MAXIMUM CONTRIBUTION
IRAs are available to every wage earner who is under 70½ years old; after age 70½,
individuals may not establish an IRA. Each wage earner is limited to an annual contribution of
$4,000 or 100% of earnings, whichever is less. For example, an individual earning a total of
$1,500 annually may contribute no more than 100% or $1,500 per year to an IRA. Someone who
earns $4,001 or more per year may contribute only the $4,000 maximum rather than 100% of
earnings for the year 2007.
SPOUSAL IRA
There is an exception to the ―wage earner rule.‖ The wage earner may make an additional
contribution on behalf of a non-employed spouse. For a spousal IRA, which provides retirement
funds for both the wage earner and spouse, the wage earner may contribute up to $4,000 a year
or 100% of earnings. Spousal IRAs can be set up in a single IRA with two accounts—one for
each person—or in two completely separate IRA accounts. The $6,000 may be divided between
the accounts in almost any proportions desired as long as no more than $3,000 per year is
contributed to just one of the accounts. Note that if one spouse is over age 70 ½, the other
spouse, if employed, cannot make more than the one contribution of $2,000.Even people
participating in employer-established retirement plans may contribute to IRAs and enjoy tax
deferral on the interest build-up. How much, if any, of the IRA contribution is tax deductible to
the individual depends upon his or her adjusted gross income.
NOTE: In 2005 the annual contribution limit will be $4000.00
In 2008 the annual contribution limit will be $5000.00
IS IT DEDUCTIBLE?
As indicated, any wage earner who contributes to an IRA receives the benefit of earning
interest without paying taxes on the earnings until the funds are withdrawn. Wage earners who
are not included in an employer-sponsored qualified retirement plan may deduct the entire
amount of the contribution from taxable income for the year the contribution is made.
Wage earners who do participate in a qualified retirement plan at their place of employment
are also eligible to take a tax deduction for the amount contributed provided they meet Internal
Revenue Service guidelines, as briefly outlined in the next paragraph.
The entire amount of the contribution is deductible for a single taxpayer whose adjusted
gross income (AGI) is less than $34,000 annually and for married taxpayers filing jointly whose
AGI is less than $54,000 per year. (These amounts will be indexed in later years). The portion
of the contribution that is deductible is gradually reduced as income rises until it phases out
completely. No deduction is available for a single wage earner when AGI reaches $44,001, nor
for joint filers when their AGI reaches $64,001. But remember the tax deferral on interest
continues even though the contribution is not tax deductible.
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A popular use for an individual annuity is as a rollover IRA to receive money from a
company-sponsored pension or profit sharing plan. Individuals who leave an employer take with
them any such monies in which they are fully vested—which means they own 100% of their
share of the plan. To protect themselves from adverse tax consequences, they must have the
funds immediately reinvested in another tax-favored plan. A rollover IRA provides this
protection.
At one time, individuals could have possession of such funds for 60 days before rolling the
funds into another plan. However, a federal law now states that to avoid all penalties, the
corporate plan proceeds must be paid from the former employer‘s plan directly into another
instrument. If the individual chooses to have a check made payable to him or herself while
deciding where to re-invest the money, the employer is required by law to withhold 20% and
send it to the government.
The individual still will not be required to pay any taxes if the money is rolled over within 60
days, but there‘s a huge hitch in this plan. The individual must roll over the entire amount,
which includes the 20% that has been sent to the government. Therefore, the individual must
find that 20% somewhere else, add it to the funds actually received, and. roll all of that into the
rollover instrument. Not only does the individual get only part of the funds, but if the person
cannot pay the additional 20% to make up the entire amount, the 20% already sent to the
government is taxed as current income—even though the individual never had access to it.
However, the 20% previously sent to the IRS will be reclaimed on the individual‘s tax return,
but meanwhile the government has had temporary use of the individual‘s money and has also
forced the person either to find another 20% to complete the rollover or to pay taxes on money
the individual never had because the government took it. A bill has been introduced to repeal
this highly unfair law that penalizes anyone who is ill-informed, but as of this writing, the rule
applies.
In the meantime, a rollover IRA that is used properly keeps the funds intact and retains the
tax-deferral benefits on the pension funds.
NON QUALIFIED INDIVIDUAL ANNUITIES
Unless an individual annuity is used to fund an IRA, it is nonqualified. While premium
deposits to a nonqualified annuity are not tax deductible, interest earnings are tax deferred and
enjoy all of the other related advantages.
In addition, nonqualified individual annuities are not subject to the strict contribution
limitations of an IRA. As a result, individuals may deposit much more cash into a nonqualified
annuity each year than they are permitted to deposit into an IRA. For many people, the
flexibility, the potential for depositing greater sums for retirement savings and the relatively
fewer Internal Revenue Code requirements and limitations on nonqualified annuities, add up to a
better choice than an IRA.
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ANNUITIES FOR SENIOR AGE GROUPS
In the development of innovative annuity products, insurers have not missed the opportunity
arising from the so-called ―graying of America,‖ the phenomenon of many millions of people
over age 65 who are currently alive and in need of income. People in the senior age groups
control a high proportion of both personal financial assets and savings dollars. Some insurers
have begun to offer annuities with features especially for older adults, aiming at those age 55 and
higher — although the products may be purchased by younger people as well.
FEATURES AND OPTIONS
Typically, nonqualified annuities geared to senior needs have many of the same features of
other flexible premium or single premium deferred annuities already discussed. The seniors
have free withdrawal privileges and a nursing home withdrawal or bailout feature is usually
an automatic feature. In addition, the senior age annuity owner is generally permitted to
annuitize at anytime without paying surrender or withdrawal charges and begin receiving
income payments regularly.
Interest rates are as competitive on senior-directed annuities as on other annuities, although
rates may be graded downward at the upper age range. One company, for example, reduces
the current interest rate by one-fourth percent for ages 80 to 90, and another one-fourth
percent reduction for those ages 91 to 100.
A death benefit typically applies following a stipulated period of time. The benefit may
become larger as the policy ages. For example, after the first year, the benefit might be just a
return of premiums; followed by return of premiums plus the minimum guaranteed rate; then,
in later years, premiums plus all interest earned.
With the burgeoning senior population, who control a large percentage of financial assets and
savings dollars, the insurers have developed annuities with their needs in mind, leading to
what has been called, ―the senior industry.‖
GROUP/BUSINESS-OWNED ANNUITIES
This section will discuss uses for group annuities and other types that are owned by
businesses rather than by individuals. These will be qualified annuities – i.e. those used to fund
qualified retirement plans that benefit employees. By definition, a Group Annuity is a contract
providing a monthly income benefit to members of a group of employees. A group annuity has
the same characteristics as an individual annuity, except that it is underwritten on a group basis.
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KEOGH PLANS
People who are self-employed, whether as sole proprietors or as business partners, may
establish retirement plans for themselves under a law named for the congressman who
introduced it. Known as Keogh or HR-10 plans, they receive beneficial tax deferrals provided
they qualify under the Internal Revenue Code. While the extensive details of the legal
requirements are beyond the scope of this course, the following paragraphs highlight critical
features.
In addition to covering the self-employed person, Keogh plans must cover some employees
as stipulated by law, while other employees, such as certain part-timers, may be excluded. The
plan must have a funding formula that doesn‘t discriminate unfairly among employees who are
required to be covered, specifically not penalizing lower-paid employees while providing an
unfairly greater benefit for highly-paid employees. The amount that may be contributed to a
Keogh plan is limited by law.
Self-employed individuals who contribute to a Keogh plan may take a business tax deduction
for contributions made for themselves and for employees. The contributions and interest earned
are not taxed as current income. These amounts are taxed when they are paid out as retirement
income or otherwise withdrawn. Employees may make their own personal contributions to the
Keogh plan. While these voluntary contributions are not tax deductible to the employees, they
do accumulate and earn interest on a tax-deferred basis, with tax payable on the interest only
when funds are withdrawn.
Annuities may be used to fund Keogh plan benefits as either a defined benefit plan or a
defined contribution plan.
DEFINED BENEFIT PLAN
As the name implies, a defined benefit plan is one that specifies or defines the amount of the
benefit that will be paid at retirement. When the plan is established, a formula is included for
determining the benefit amount. Contributions to the plan are then made in order to provide
that predetermined benefit.
DEFINED CONTRIBUTION PLAN
A defined contribution plan specifies a formula for the amount of the contribution that will
be made, rather than the amount of the benefit to be paid at retirement. The law stipulates a
maximum amount that may be contributed. While the future benefit amount is unknown, it
can be estimated at various points based upon the participant‘s length of service, amounts
actually contributed, and the estimated and actual earnings on contributions.
CORPORATE PENSION AND PROFIT SHARING PLANS
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Annuities may also be used to fund corporate pension and profit sharing plans. While Keoghs
are designed for self-employeds, these plans are aimed at retirement for people employed by
corporations. Like Keogh plans these corporate plans must meet strictly-written requirements to
be considered ―qualified‖ for special tax treatment.
A corporate pension plan may be either a defined contribution or a defined benefit plan. By
law, pension plans must be established specifically to pay retirement benefits to employees.
Contributions are paid by the employer on behalf of employees, subject to very detailed
nondiscrimination requirements with regard to lower-paid and highly-compensated employees.
Pension plans must conform to a formula for determining the amount of contributions or the
amount of benefits.
Corporate profit sharing plans which are designed to share actual company profits with
employees, are more flexible in terms of how contributions are made. Some plans have a
formula to determine what portion of profits will be distributed to employee accounts, while
others do not. Even when no formula exists, non-discrimination controls must be in place to
ensure individual employee contributions will be made fairly.
GROUP DEFERRED ANNUITY
A group deferred annuity is one option available to corporations for funding defined benefit
or defined contribution plans. Every year, the employer uses the contribution to purchase a
Single Premium Deferred Annuity for each employee included in the plan. After many years,
the employee receives the benefits from all annuities purchased on his other behalf.
Group deferred annuity plans have been popular because, first, they guarantee income since
they are provided by an insurance company with the same guarantees any other annuity enjoys;
and second, the insurer takes responsibility for all of the administrative details. As new forms of
funding have been developed, however, group deferred annuities have become less popular with
larger businesses, although many smaller businesses still find them attractive.
GROUP DEPOSIT ADMINISTRATION CONTRACT
A more popular way to use annuities for retirement funding is through a group deposit
administration contract. Under this arrangement, funds deposited with the insurer are not
allocated for individual annuities, but instead, provide a pool that the insurer invests as a whole.
The employer may choose investments providing a fixed rate, equity Investments with variable
rates, or a combination. Typically, a group deposit administration plan allows the employer to
move funds between investment accounts from time to time to capitalize on changes in the
market.
Under this type of plan, no annuity exists for an individual employee until the employee
retires. The insurance company transfers funds from the pool of money to purchase a single
premium immediate annuity for the employee, beginning retirement income payments at that
time.
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401(K) PLANS
Corporations that have a qualified profit sharing plan in place may use annuities to offer
employees another type of qualified plan popularly called 401(k) plans (in reference to a section
of the Internal Revenue Code). The actual terminology for a 40l(k) is a Cash or Deferred
Arrangement (CODA) wherein the employee defers receiving some portion of current income in
order for the 401(k) contribution to be made. Still another name for this arrangement is a salary
reduction plan, again referring to a reduction in current salary with the remainder of the salary
contributed to the 401(k).
Under a 401 (k), employee participation must be optional. Whether the income to be
deferred is actually a salary reduction or included additional compensation such as bonuses, the
individual must be able to choose whether to take the cash when earned and be taxed as usual, or
defer receiving the salary or bonus, and therefore defer taxation until sometime in the future.
One of the primary advantages of a 401(k) plan from the employer‘s point of view is that the
contribution is essentially made with the employee‘s money, rather than from an employer
contribution over and above regular salary or bonuses paid. At first glance, a 401(k) might
appear less advantageous for the employee since that person‘s current salary will be smaller or a
bonus will not be received currently. However, the employee not only has the benefit of tax
deferral on accumulations, but also avoids paying federal income taxes on salary and bonuses
deferred. Some state and local governments also defer income taxes for 401(k) funds.
A 401(k) plan is subject to many of the same rules as other qualified plans, plus additional
rules unique to the 401(k). A fairly low maximum amount may be deferred into a 401(k) plan
annually. The specific amount is indexed for inflation, so it changes periodically. This upper
limit is the total deferral permitted for all CODAs in which an employee may be eligible to
participate. Under certain circumstances, employees could be involved in more than one deferral
arrangement, and the total maximum is specified by law. As a result, participants must be
careful to coordinate how much is deferred into each plan or face penalties for paying in more
than the maximum.
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STUDY QUESTIONS
CHAPTER 2
1. Annuities are generally purchased with _________________
A. fixed premiums.
B. 401(k) roll over funds.
C. flexible premiums.
2. IRAs are available to everyone who is
A. under 59 ½ years old.
B. under 70 ½ years old.
C. unemployed with no income.
3. The retirement plans known as ―Keogh‖ plans are only for the use of
A. those employees also covered under an employer-sponsored retirement plan.
B. self employed persons, either sole- proprietors or partners. plan he/she receives.
C. those employees of large publicity traded corporations.
4. Interest paid on deferred annuities
A. is not taxed.
B. is not taxed until the funds are withdrawn.
C. is taxed each year it is earned.
5. An annuity that offers free withdrawal and nursing home withdrawal privileges is
designed for
A. IRA rollovers.
B. aggressive investors.
C. the senior market.
6. From the viewpoint of the employer, one of the advantages of a 401(k) plan is
A. the contributions are made from the employers money only.
B. the contributions are made from the employees money.
C. the contributions are from bonus or merit pay of the employees.
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7. Group Deferred Annuity plans are popular because
A. it does not cost the employer anything -it is 100% contributory.
B. they get a much better return than any other type of annuity if the market drops.
C. they guarantee income and the insurer handles the administrative details.
8. As a general rule, annuities should be considered
A. part of a short term investment strategy.
B. outside the purvey of being used for investments.
C. part of a long term investment strategy. -
9. A Single Premium Immediate Annuity is used to
A. begin paying an immediate income stream.
B. balance out other annuities in long term investment programs.
C. form the basis for an Equity Adjusted Indexed annuity.
10. If income tax is not required on the premium used to fund an annuity then the annuity
would be
A. a qualified annuity.
B. a flexible premium annuity.
C. a non-qualified annuity
Answers: 1.A, 2B, 3B, 4B, 5C, 6B, 7C, 8C, 9A, 10A
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CHAPTER THREE - TAXATION OF ANNUITIES
The taxation of annuities has remained functionally the same in recent years, with taxation
changes being more applicable to ―methods‖ instead of ―instruments.‖ For example, the rather
recent regulations regarding Individual Retirement Accounts (IRA) and the addition of the Roth
IRA affects the taxation of the method of accumulating funds, and not whether the underlying
mechanism to fund the IRA is taxed differently than previously. However, a note of caution:
while annuity products have retained tax advantages through numerous revisions in tax laws and
Internal Revenue Service and tax court rulings, both laws and interpretations are subject to
change. When the precise details of taxation are important to decisions regarding annuities,
professional counsel is imperative. The information in this textbook does not represent legal or
professional advice of any kind.
PREMIUM PAYMENTS
The premiums an individual pays for a nonqualified annuity are not tax deductible for federal
income taxation purposes. For a qualified annuity, an Individual Retirement Annuity (IRA), the
premiums are deductible according to the rules as described elsewhere. When the IRA owner is
also covered by an employer-sponsored retirement plan, the amount of the tax deduction
permitted gradually decreases until it reaches zero (when the stipulated adjusted gross income
maximums are reached).
Annuities may be used to fund group retirement plans. When these are qualified retirement
plans, the premiums, or contribution as they are often called, are tax deductible to the employer
who makes the deductions on behalf of employees. A Keogh plan can appear to provide an
individual tax deduction when the plan benefits only a sole-proprietor that has no employees. In
this case, the effect is the same as an individual‘s deduction.
CURRENT INCOME TAXATION
Payments made to qualified annuities are either tax deductible or the amounts used for this
purpose are not declared as current income when paying income taxes. For example, an
employer‘s contributions to a group annuity are not reported as income when the contribution is
made. And, while the employer‘s contribution to an employer-sponsored IRA must be reported
as income, it is ―washed out‖ by the tax deduction the employee takes.
STATE PREMIUM TAXES
Some states assess state premium taxes on annuity premiums. When this is the case, the
purchaser does not pay a separate tax. Instead, the insurance company deducts the correct
amount from each premium payment and pays the tax directly to the state. Where state premium
taxes apply they generally equal about 2% or 2.5% of the premium. Some insurers pay the
premium taxes themselves and do not deduct the taxes from the annuity premiums.
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TAX DEFERRAL OF INTEREST ACCUMULATIONS
During the accumulation period, qualified or non-qualified annuity values build on a
tax-deferred basis, with the interest remaining untaxed until money is withdrawn from the
annuity.
As stated earlier, interest paid on deferred annuities is not taxed until annuity funds are
withdrawn. Because this tax benefit is intended to encourage long-term savings for retirement,
the Internal Revenue Code requires immediate tax consequences for early withdrawals— defined
as withdrawals before the individuals age 59½. These tax consequences include current income
taxation and an additional penalty tax.
DISTRIBUTIONS OF QUALIFIED PLANS
Generally, speaking a distribution occurs when the employment is terminated, the employee
retires, or the plan is terminated. However, there is a premature distribution tax of 10%, which is
applicable to many distributions from qualified retirement plans. This premature distribution tax
is in addition to any income tax due on the distributions.
As with most laws or regulations, there are exceptions. They have been divided into three
categories by many accountants and other tax practitioners.
Generally, the first exception(s) treats the reason as to why the distribution was made.
Obvious exceptions are death or disability before age 59 ½. The least obvious exceptions are
Distributions to cover certain medical expenses to the extent they are deductibles under
the IRS Code.
As the result of a court order in a divorce situation.
An employee who resigns and then retires after attaining age 55.
Refunds if there are excess contributions &/or elective salary deferrals under the
appropriate 401(k) provisions.
The second exception(s) allows distributions because of separation of service for any reason,
as long as they are in the form of a ―Qualifying Annuity.‖ Basically, a qualifying annuity is an
annuity starting at any age and paid in (substantially) equal payments and not less frequently
than annually, for the life of the participant and his/her beneficiary. The qualified plan may
purchase commercial annuities to satisfy the requirements of this exception. (Does this bring
visions of ―golden parachutes‖ funded by annuities?)
The third is the ―roll over‖ discussed briefly earlier. The key words for this exception is
―timely‖ and ―fully.‖ This exception can be lost if it takes more than 60 days for a participant to
make up their mind, and if less than the entire plan distribution is rolled into the new IRA or
other qualified retirement plan.
There is no specific tax penalty for those who retire after age 59 ½, but there is a reduced benefit
in Social Security payments for retiring prior to age 65.
Funds that are paid to a participant at normal retirement age escape taxation only on the
funds that they have contributed to the plan. The funds that the employee contributes have been
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taxed earlier, so are not subject to tax again at retirement.
Distributions can be made either in installments or annuitized.
INSTALLMENT PAYMENTS OF QUALIFIED PLAN DISTRIBUTIONS
Distributions that are made in installments are taxed as ordinary income in the year
they are received.
For annuitization, there are separate rules. First, as can be expected, if the person receiving
the distribution (the distributee) has not paid any money into the plan (i.e. has no cost basis), then
all payments are taxed as ordinary income.
Secondly, if there is a cost basis (i.e. the distributee has paid for part of the retirement plan)
and if any distributions are made before the annuity starts, then part of the distribution will be
taxed as ordinary income, and part as a ―return of cost basis.‖ In order to determine the cost
basis portion of the distribution, the following formula can be applied:
Total amount of previously taxed employee contributions.
Total present value of annuitant‘s account balance or accrued benefit.
Lastly, the formula may be used only until the distributee has recovered the entire cost basis.
If the distributee/annuitant dies and has not recovered the entire cost basis, then the amount that
has not been recovered can be used as a deduction on the annuitant‘s last income tax return.
REQUIREMENTS FOR LUMP SUM DISTRIBUTIONS
If a person chooses to take the distribution in a lump sum, they can do so and qualify for the
favorable tax treatment, but the employee must be at least age 59 ½, or dies, separated from
service (common-law employees), or become disabled (self-employeds). The distribution must
be 100% of the employee‘s account balance/accrued benefit, and further, the entire distribution
must be made in one taxable year!
TAX RELIEF ACT 1986
Mention should be made of the TRA ‘86 related to those who reached age 50 by 1/1/86, and
who elected to receive lump sum distributions on contributions made prior to 1/1/1974. Without
going into all of the technicalities of this rule, this allowed for some of them to be taxed on the
capital gains basis. These rules do not apply to distributions from tax sheltered annuities.
For those who attained age 50 after 1/1/86, the rules are more pertinent. They cannot have
portions of a lump sum distribution on pre-1974 contributions taxed as capital gains as opposed
to ordinary income. They lose the right to any income averaging on lump sum distributions
before they reach age 59 ½. In addition, under TRA ‗86 there was a 10 year averaging of a lump
sum distribution, that was reduced to 5 years, but effective 1/1/2000 even the 5-year averaging
will not be available.
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This TRA ‘86 is discussed here as it is still applicable in certain situations. For example, for
an individual retiring at this time, and who has contributed to their retirement plan, there are
several choices that reflect the taxation of distributions. The following are some of the choices
that may or may not be applicable:
Five or ten-year income averaging can be elected on the ordinary income part of the
distribution.
If the 10-year averaging method is allowed, the distributions would be taxed as if the
recipient were single and taxed at the rate effective in 1986. If this method were used,
the distribution and all other income would be separated for tax purposes.
The capital gains tax rate that was effective prior to 1974 can be used for any portion of
the distributions that can be attributed to any contributions made prior to 1974.
The entire distribution can be rolled over into an IRA (see below) and taxes would be
postponed, therefore, until the funds are withdrawn. The right to do any 5 or 10 year
averaging would be lost if the funds were rolled-over into an IRA.
As should be obvious, this is a highly technical area of taxation but if it should arise, it would
call for the professional expertise of a highly qualified tax accountant.
ROLLOVERS (1035 EXCHANGES)
This subject has been approached previously, but deserves more detail and some repetition.
Any income tax on an annuity or insurance contract that has been distributed from a qualified
plan can be postponed by converting the annuity or insurance contract to a ―nontransferable‖
annuity within 60 days. Current taxation on the qualified distribution can be avoided if it is
rolled over into a regular IRA.
Important: The funds must be rolled over directly into the IRA to avoid tax consequences. If
the funds are not rolled over directly into the IRA or if they receive the money and then roll it
over within 60 days, the taxable portion of this distribution is subject to withholding tax of 20%,
i.e. the IRS requires that 20% of the money be withheld in anticipation of income taxes being
due on that money. Oh yes, the ―distributee‖ can recover that 20% at the end of the year when
the individual income tax is filed. But (and it‘s a big ―but‖) the distributee must pay into the new
rollover account (IRA) the total amount. This means that the distributee would have to dig deep
into their own pockets to pay the 20% that the IRS is holding, and which the distributee cannot
recover until they have filed their next income tax.
If the distributee just deposits 80% of the amount into the IRA, the 20% that is being held in
account for the distributee or the IRS will be taxed as ordinary income – even though the
distributee only has 80% of the fund. In addition, there is a possibility that the distributee would
be subject to a 10% penalty tax.
Once the funds have been deposited into the IRA, taxes will not have to be paid on the
rollover until the IRA starts to distribute its assets. Any lump sum distribution will be taxed as
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ordinary income, and any annuity distributions will be taxed as previously discussed.
A partial distribution to an employee of the funds held in their account may be rolled over
into a regular IRA unless (1) the employee reaches age 70 ½, (2) payments will be made for 10
years periodically or for the life expectancy of the employee, or (3) the amounts are not included
in the gross income in the absence of the roll over.
INCOME TAX AND THE INTEREST-OUT-FIRST RULE
The income tax that must be paid on an early withdrawal or surrender is based upon whether
or not the cash accumulation value of the annuity is greater than the premiums paid at the time of
withdrawal. When the cash value is greater, the so-called interest-out-first rule applies and the
withdrawal is taxed entirely as interest to the extent of the cash value excess.
CONSUMER APPLICATION
Billy has paid $15,000 into his annuity which has a present cash value of $20,000.when he
decides to withdraw $3,000. The value of the annuity is $5,000 more than he has personally paid
in. Therefore, the $3,000 will be subject to taxation as interest.
Billy decides that if he has to pay taxes on his withdrawal, he will have to take out more
money in order to purchase what he wants, so he withdraws $6,000. Then the first $5,000 is
treated as interest, and the other $1,000 is treated as both interest and principal, with taxes to be
paid only on the interest portion of the $1,000.
WITHDRAWALS, LOANS AND SURRENDERS
To reiterate, interest paid on deferred annuities is not taxed until annuity funds are
withdrawn. Because this tax benefit is intended to encourage long-term savings for retirement,
the Internal Revenue Code requires immediate tax consequences for early withdrawals— defined
as withdrawals before the individuals age 59½. These tax consequences include current income
taxation and an additional penalty tax.
PENALTY TAX
A penalty tax also applies to early withdrawals from the annuity, taken in a lump sum before
age 59 1/2. This penalty, requiring an additional tax of 10% of the withdrawal, applies whether
or not the annuity is a tax-privileged retirement plan. However, the tax law lists several specific
situations under which the 10% penalty is not assessed even if the withdrawal or distribution
begins before age 59½:
The annuity owner dies before the withdrawal.
The annuity owner becomes disabled before the withdrawal.
The annuity is an Immediate annuity.
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In addition, if the withdrawal is not taken in a lump sum, and is paid out in installments, each
of about the same amount and paid over the annuitant‘s lifetime, the penalty tax is not assessed.
LOANS
While only a few insurers offer loan options with annuities, it must be understood that a loan
from an annuity is treated as the receipt of current income. As a result, the amount of the loan is
taxed as income. Besides having to pay income taxes, the annuity buyer also pays interest to the
insurer, so loans from annuities are not particularly attractive.
ANNUITY LIQUIDATION PAYMENTS
When the annuity liquidation phase begins as scheduled, special tax rules apply to annuity
distributions provided the income payments meet the Internal Revenue Code requirements to be
considered amounts received as an annuity. The requirements are:
The first income payment must be made on or after the annuity start date specified in the
annuity contract or after age 59½.
The income payments must be made on a regular basis and over a period of more than
one year.
The amount, of the payments must be based upon the annuity contract agreements,
standard mortality tables, and/or compound interest tables or a combination of two or
more of these items.
By meeting these requirements each income payment is divided into taxable and nontaxable
segments. The part that is considered return of premium is not taxed, but the interest portion is
taxed. How the taxable portion is calculated is a function of the ―exclusion ratio‖ discussed in
more detail on the next page.
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EXCLUSION RATIO
The Exclusion Ratio is the proportion of an annuitized payment that is considered as a
return of capital and is not taxed.
The exclusion ratio is a percentage determined by dividing all premiums paid for the annuity
by the expected benefits:
Total Premiums Paid = Exclusion Ratio
Total Benefits Expected
While some fairly complex rules govern this calculation, the following example describes
basically how it works. The IRS provides tables to help determine the expected benefits, using a
number called a multiple which is the number of years the annuitant is expected to live
(assuming there is only one annuitant). This multiple is applied to the monthly annuity benefit
that will be paid and also factors in the age at which the annuitant‘s benefits are to begin.
CONSUMER APPLICATION
Tim Foyt has paid $90,000 for an annuity that will pay him $1,000 per month for life
beginning at his age 65. The multiple from the IRS table is 20 at age 65 (and would be a
different number at other ages). The multiple times the monthly benefit times 12 months equals
the expected benefits:
20x$1,000x12 = $240,000
After the expected benefits are calculated, the exclusion ratio is then determined:
37.5% (the exclusion ratio)
This means that of each $1,000 monthly payment Foyt receives, 37.5% or $375 is excluded
from taxation. The balance, $625 per month, is taxed as current income. To say it another way,
62.5% of every monthly payment is taxed for this particular person.
The specific numbers that apply to each situation will differ depending upon premiums paid,
monthly benefit promised and the age at which liquidation begins. For Joint annuitants, IRS
tables take into consideration the life expectancies of both people at their ages when annuity
payments start. Once the exclusion ratio is calculated, that same ratio applies to every payment
as long as payments are made.
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TAXATION OF DEATH BENEFITS
When an annuity has a death benefit payable to a beneficiary, the exclusion ratio still applies
under certain circumstances. If the annuitant dies after payments have begun in the liquidation
phase, the beneficiary must receive the death benefit in installments, either on the same schedule
as the deceased or faster, in order for the exclusion ratio to be used.
DEATH PRIOR TO LIQUIDATION PHASE
Different rules apply if the annuity owner dies before the liquidation phase begins. If the
beneficiary is the spouse of the annuity owner, the spouse is permitted to receive payments on
the same schedule the deceased would have received them, using the same exclusion ratio.
The exclusion ratio also applies to distributions to beneficiaries other than the spouse if the
death benefit is handled in one of these ways:
The beneficiary either receives the entire annuity value within five years after the annuity
owner‘s death, or
Within one year, the beneficiary takes the death benefit in a lump sum and uses it to buy
a life annuity or to begin receiving installment payments that will end when the
beneficiary dies.
If, on the other hand, the survivor simply receives the annuity death benefit as a lump sum, taxes
are due on the entire amount that represents interest earned. This results in taxes being due
currently on a larger amount than is the case when the exclusion ratio applies.
FEDERAL ESTATE TAXES
People whose estates at death are va1ued at more than $600,000 must deal with federal estate
taxes. The value of the annuity at the time of death must be included in the annuitant‘s estate in
proportion to the amount the deceased person personally contributed to the premiums that bought
the annuity. The value of the annuity is the accumulated cash value to date if the individual dies
before the liquidation phase begins. After liquidation payouts have begun, the insurance
company determines the value of the annuity at the time the annuitant died.
The determination of how much of the annuity‘s value must be included in the estate for
federal estate taxation must be made. If the annuitant had paid 100% of the premiums, 100% of
the annuity value would go into the estate. On the other hand if the annuitant had paid 50% and
someone else had paid 50% of the premiums, only 50% of the annuity value would be included
in the estate.
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MORE ABOUT TAXES
This text addresses the simpler aspects of annuity taxation. Tax laws can be quite complex
when a particular type of annuity is used in any given case since different people have a variety
of personal, business and financial situations that can affect taxation. Professional counsel is
always recommended for determining the tax consequences of financial transactions.
STUDY QUESTIONS
CHAPTER 3
1. The premiums an individual pays
A. for a nonqualified annuity are tax deductible.
B. for a qualified annuity are tax deductible.
C. for a non qualified annuity are taxed when distribution occurs..
2. If a qualified plan is distributed, prior to normal distribution, there may be a premature
distribution tax
A. that is in addition to any income tax.
B. if the employee resigns and then retires after 55.
C. there is a court order in a divorce situation.
3. Distributions, from qualified plans, that are made in installments after age 59 ½
A. are taxed as ordinary income.
B. are not taxed.
C. are taxed as capital gains.
4. Interest paid on a deferred annuity
A. is not taxed.
B. is not taxed until the funds are withdrawn.
C. is taxed each year it is earned.
5. The income tax due on an early withdrawal or surrender is based upon whether the cash
accumulation value of the annuity is
A. the same as the amount paid when the annuity was purchased.
B. is based on the interest earned by the annuity.
C. based on the total value of the annuity at the time of the withdrawal.
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6. Interest paid on deferred annuities
A. is not taxed until annuity funds are withdrawn.
B. is tax free.
C. is added to the premiums paid in and is taxed as capital gains.
7. The portion of an annuitized payment that is considered a return of capital
A. is taxed as ordinary income.
B. is the exclusion ratio.
C. is added to the interest portion and is taxed.
8. If an annuity owner dies before the liquidation begins, and the beneficiary takes the death
benefit as a lump sum,
A. taxes are due on the amount that represents interest earned.
B. taxes are due on the entire amount..
C. taxes are due on the amount that is considered original investment.
9. At the time of an annuitant‘s death, for estate tax purposes, the value of the annuity
A. will not be considered as part of the estate.
B. would be considered in proportion to the amount the deceased contributed to the
original purchase.
C. is that portion of the annuity paid as premiums, and not the interest earned.
10. If an owner of an annuity ―borrows‖ from the annuity
A. it is treated as a return of premiums.
B. the loan is interest free.
C. the amount ―borrowed‖ is taxed.
Answers: 1B, 2A, 3A, 4B, 5B, 6A, 7B, 8A, 9B, 10C
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CHAPTER FOUR - TAX SHELTERED ANNUITIES
Teachers, school personnel, doctors, nurses, hospital employees, and members of nonprofit
organizations are eligible to participate in a retirement plan referred to as a tax-sheltered annuity
(TSA) under IRS Code Section 403(b). TSAs offer advantages not found in other types of
annuities and retirement plans. While the market for these types of annuities are quite large,
many, if not most, of the persons that can purchase TSA‘s are served by large insurance agencies
that have arrangements with particular schools, school districts, hospitals, etc. Therefore, some
agents will never have an opportunity to market TSAs, but if the agent is with one of the large
agencies that specialize in this type of business, it can prove quite profitable.
TSAs are simply annuities purchased from an insurance company and sold to those as
mentioned above. The ―participants‖ have a choice of either a fixed annuity, or a Variable
Annuity. These annuities may be issued either on an individual basis, but many times on a group
basis since the insurer receives contributions on a payroll basis – they are named on a pre-tax
basis. Even though the premiums are paid on a pre-tax basis, the Social Security taxes are
withheld on the salary reduction amount.
Tax-sheltered annuities (and other types of 403(b) plans) are intended to provide retirement
benefits, with some stipulation that funds can be released prior to retirement if there is financial
hardship, death, disability, or termination of employment.
TSA‘s can be either individual or group, as stated above, and the individual contract differs
from the group inasmuch as the individual in the plan receives their own contract. If a person is
under a group contract, the participant receives a certificate, which states that the agreement is
between the insurer and the employer. This is common practice for group insurance and TSA‘s
are no exception.
The big difference between individual and group TSA’s, is in the area of flexibility.
Individual contracts, for instance, have certain guarantees that last until the contract is
terminated. Group plans, on the other hand, have certain guarantees or assumptions that last for
a specified period of time, such as 5 years. But the big difference is portability.
Under an individual contract, if the individual changes jobs, they may do one of several
things: freeze the account, transfer part (or all) of the account to a new employer‘s program (if
they have a TSA program), or rollover the funds into an IRA. Regardless of which action is
taken, the account will be allowed to grow and to compound tax-deferred. If the Section 1035
rollover is accomplished properly, no tax event will be triggered.
While moving a TSA to another plan can escape the IRS penalties and taxes, there may be
withdrawal charges from the previous insurer. Group contracts, in particular, may contain some
sort of withdrawal fee, not usually the situation with individual plans.
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TAXATION OF TSA’S
Obviously, the attraction of the TSA plan is the income tax implications. In a nutshell, there
are three major tax benefits:
1. Any contributions reduce the taxable income of the participant, dollar for dollar!
2. After the plan is started, the money invested grows and is compounded, deferred.
3. When withdrawals are usually made, the participant is usually in a lower tax bracket, thereby
lowering the taxes.
CONTRIBUTIONS (ACCUMULATION PERIOD)
While contributions are being made to the plan on behalf of the employee by the employer,
these contributions are made with before-tax dollars, and can be made bi-weekly, semi-monthly
or monthly (usually), and the insurer then deposits the contribution (or most of it – see next
paragraph) into the participant's account. The actual investment is determined by the options
available and those elected by the employee.
When these deposits are made, there may be a transaction charge (thereby reducing the
contribution). There can also be a maintenance fee deducted from the account balance. Some
companies may instead levy an expense charge when the funds are withdrawn.
DISTRIBUTION
When the participant is ready to receive the distribution, they may take it out in a lump sum;
make a partial withdrawal of a part of the total funds available; rollover the account into another
TSA or into an IRA; or they could annuitize the contract and start receiving periodic payments.
If the contract is annuitized, the amount of the payment will depend upon the rate offered by
the insurance company, the amount being annuitized of course, and the annuity option selected
by the participant. Recently, some insurance companies allow the contract owner to select either
a fixed or a variable account during payout, regardless of whether the contract was variable or
fixed originally.
The participant must understand that there will be no guarantees as to the amount of the
monthly benefit if they choose a variable account. The insurer assumes and states an assumed
interest rate of return. If the account does well (the invested amount) the monthly benefits will
increase, if it does poorly, they will not increase.
The two most common methods used to determine the current interest rate to be credited to
employees' accounts are the (1) portfolio average and (2) banding methods. The ―portfolio
average‖ is determined by the insurer's earnings on its entire portfolio during the particular year
34
and all policy owners are credited with a single composite rate. On the other hand, the banding
approach uses a different technique that changes from year to year. All employee contributions
are treated as one amount (banded) and each account is credited with the actual yield that the
deposits actually earn. If, for instance, during the present year the money contributed is
receiving 9%, then that is what the individual will receive. If, however, the previous year these
funds had only earned 8%, then part of the portfolio will reflect 8% and part 9%. This method is
best for the investor when interest rates are rising, when interest rates are declining, the portfolio
method is best.
WARNING. It is not wise to compare the current rate of return between insurers, as
the methods of determining the return vary widely from company to company.
FUNDING
It is estimated that about 70% of all TSA contributions are made by the employee and the
remaining 30% are made by the employer. The insurance company specifies the details, with no
more than the IRS limitations on contributions. The employee's paycheck may be reduced by
either a specified dollar amount, or a percentage or a percentage of pay and are sent to the insurer
on a specified schedule – usually monthly.
Contributions can also be made by the employee transferring funds from one insurance
company to another, or even from one sub-account to another sub-account offered by the same
insurer. The reasons for transfer are various, but can include the employee‘s general
dissatisfaction with the current portfolio's performance. Of course, if the employer is changed
&/or the new employer does not offer TSAs, this can be a definite reason. Other reasons could
be that the investor‘s retirement date has changed, or simply the investor is not in a position
where they want a fixed plan instead of a variable plan, as they have no interest or ability to
continue to take a risk.
OPTIONS UPON RETIREMENT
When the employee retires, there are several options open.
1. They can withdraw all of the account – a total withdrawal.
2. They may elect to just leave the money where it is and let it grow.
3. They may decide to annuitize, and use either a fixed rate or a variable contract.
4. They may decide to simply take out the account balance in form of payments over a particular
time period.
5. Perhaps they will just transfer the balance to another insurer.
6. They could possibly use a 1035 exchange and rollover the account to an IRA (that may be
invested in another annuity).
If the person decides to transfer the entire account to another insurer that may offer a better
annuitization schedule, make sure that all withdrawal costs are spelled out.
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If the person decides to annuitize, the type of plan should depend upon the particular person‘s
situation. For instance, if the health is bad, a straight life annuity is probably not a good choice,
but a life annuity with period certain or a joint and last survivor option should be seriously
considered. If there are those dependent upon the employee and who will continue to need
financial assistance after the death of the annuitant, the same recommendation could be offered
to them as if the health of the annuitant was bad. If there are no dependents, a life annuity would
provide the highest payouts. But, if the person retiring does not want to outlive their income, a
life option should be considered, in lieu of a lump sum or installment option.
LOANS
Some companies may allow a contract holder to borrow part of the TSA, however there are
certain IRS regulations that restrict the amount and period of the loan, as follows:
1. If the loan exceeds 100% of the employee‘s account, or $10,000, whichever is less, and if the
account is less than or equal to $120,000, then the loan is taxable.
2. If a loan is at least or greater than $10,000, then the loan is taxed if the employee‘s account is
more than $10,000 but less than $20,000.
3. A loan is also taxable if the value of the account is more than $20,000 and if the amount
borrowed is 50 percent of the value of the account (or $50,000, whichever is less), with the
$50,000 reduced by any net loan repayments made by the employee during the preceding 12
months.
4. With the exception of some stated certain real-estate loans, loans must be repaid within five
years.
5. If the loan is in arrears, any and all outstanding amount is immediately subject to taxation
and could also be subject to a 10 percent penalty tax.
6. The insurance company must notify the IRS and the participant if the loan is in default
The insurance companies also may have rules and restrictions regarding loans, for instance
they may require that a certain minimum be loaned out and that a certain amount remain in the
investment after the loan is made. Those companies that permit loans may also charge a fee
when a loan is taken out, and it may be stated as an administration or maintenance fee. And to
top it off, there is a provision in the TSA contract that allows insurance companies to charge
interest on the amount of the outstanding loan. The interest charged may be either a flat fee, or
tied to an index and generally, second loans are not allowed until the first loan is fully repaid.
It should also be understood that a late payment (sometimes considered a ―technical default‖)
may be deducted from the remaining funds in the individual‘s account. This can have adverse
tax and penalty consequences. It is important that this be thoroughly understood by the
employee.
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DEATH BENEFITS
As with nearly all annuity contracts, there is no fee or penalty for a liquidation due to the
death of the participant. In those rare cases where a penalty is levied, it would usually take the
form of an interest reduction.
When the employee dies, most companies will automatically pay out the total account value
to the beneficiary. The beneficiary may receive the funds either in a lump sum, or may elect to
annuitize the contract. Some insurers offer other payment options also.
EXPENSES
As with every insurance company policy and investment vehicle, there are certain expenses
inherent in the business. Some of these are more readily identifiable, which are called ―explicit‖
fees. Other fees, not so obvious, are called ―implicit.‖ The explicit fees are stated in the
contract, and are applied throughout the year and are triggered by certain business situations.
Examples would be when the account is valued, when a contribution is received, the granting of
a loan, or the making of a withdrawal.
Implicit charges are indirect charges and in some circumstances, may be much higher than
explicit charges. One such implicit charge could be a charge against the difference between the
returns actually made by the insurer, as compared to the amount credited to the account. Another
implicit charge could occur when the contract is annuitized, and would reflect the difference
between what the individual receives and what the account actually earns, plus expense charges.
Many times implicit charges can be ignored and in too many cases, underestimated.
The insurance companies have quite broad privileges to alter, change, or amend TSA
contracts. This can include actions that can affect the amount of charges, the amount of interest
credited to the account in the future, the annuity rates on the amount annuitized, and other such
provisions. It certainly behooves the professional agent to become familiar with any such
provisions, and to makes certain that the client fully understands what they entail. The good
news is that generally only group contracts can be altered without the permission of the
employee. While individual TSAs can be changed, they can be changed only with the approval
of the investor.
EXCLUSION RATIO AS IT PERTAINS TO DEATH BENEFITS
When an annuity has a death benefit payable to a beneficiary, the exclusion ratio still applies
under certain circumstances. If the annuitant dies after payments have begun in the liquidation
phase, the beneficiary must receive the death benefit in installments, either on the same schedule
as the deceased or faster, in order for the exclusion ratio to be used.
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STUDY QUESTIONS
1. Under IRS Code Section 403(b), who are (is) entitled to participate in a retirement plan which
is ―tax-sheltered?‖
A. Any individual who is not covered under an employer‘s group retirement plan.
B. Any person under the age of 70 ½.
C. Only teachers, school personnel, doctors, nurses, hospital employees and members of
nonprofit organizations.
D. Persons not covered by an employers retirement plan.
2. Funds under a 403(b), or TSA, plan
A. may not be released prior to retirement under any circumstances.
B. may be released prior to retirement only if rolled over into a 401(k) or an IRA.
C. can be released prior to retirement if there is financial hardship, death, disability or
termination of employment.
D. maybe released prior retirement only in case of death of the annuitant.
3. The biggest difference between individual and group TSAs is
A. flexibility.
B. termination requirements.
C. tax treatment.
D. commissions.
4. Contributions to a TSA are made with
A. employer funds only.
B. pre-tax dollars.
C. after-tax dollars.
D. cash-out of IRAs.
5. The participant in a TSA may receive the distribution
A. only in a lump sum.
B. lump sum, partial withdrawal, rollover into an IRA, or annuitize and receive periodic
payments.
C. only in periodic payments.
D. after it has been distributed to a federally chartered bank.
6. With a TSA, using a portfolio average or banding method are descriptions of methods used
A. to determine the current interest rate to be credited to the employee‘s accounts.
B. to determine how much of the distribution will be taxed as ordinary income.
C. to determine how much of the distribution can be rolled over into an IRA tax-free.
D. to determine the commissions to be paid to the agent.
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7. When the employee covered by a TSA retires
A. they must take all of the money in a lump sum.
B. the funds are combined with Social Security so not as to exceed $2,000 per month.
C. they may not roll it over into an IRA that is invested in another annuity.
D. they have several alternatives as to distribution.
8. If a TSA participant wants a loan against the annuity
A. they must withdraw all of the account.
B. the loan is tax-free, regardless of the amount.
C. there are several IRS regulations that restrict the amount and period of the loan.
D. it must be taxed regardless of the amount or circumstances.
9. In order for the exclusion ratio to be used with a TSA when the annuitant dies after payments
have begun,
A. the beneficiary must receive the payments in a lump sum.
B. the TSA must be converted to an IRA.
C. the beneficiary must receive the death benefit in installments.
D. the amount of the annuity must exceed $200,000.
10. An expense charge against the difference between the returns actually made by the insurer,
as compared to the amount credited to the account,
A. is an implicit charge and would be stated in the contract.
B. is an implicit charge and is not stated in the contract.
C. is an explicit charge but would not be stated in the contract.
D. is an explicit charge and would be stated in the contract.
ANSWERS TO STUDY QUESTIONS
1C 2C 3A 4B 5B 6A 7D 8C 9C 10B
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CHAPTER FIVE - VARIABLE ANNUITIES
The first Variable Annuity was the College Retirement & Equities Fund (CREF) designed by
Teachers Annuity and Insurance Association. Since that time it has grown into one of the most
successful and heavily used insurance product in financial planning.
One of the earliest deviations from traditional fixed annuities was the Variable Annuity,
which offers the potential for a greater rate of return if the annuity owner is willing to take a
greater investment risk. Fixed annuity premiums are deposited in the insurance company's
general investment account so that every annuity buyer's funds are commingled and the
insurance company takes the risk on the investments it makes as a whole. With a Variable
Annuity, however, premiums are invested separately, with the buyer assuming all of the
investment risk.
According to the 1999 Life Insurance Marketing & Research (LIMRA) Deferred Annuity
Buyer Study, 81% of annuity buyers and their spouses own life insurance, compared with 62%
of the general adult population. However, only 15% of the 29.4 million economic households
owning individual permanent life insurance own an individual annuity (leaving 85% of life
insurance owners available for annuity discussion!). And in the same vein, the number of
companies that offer Variable Annuities has grown from 48 companies with 108 products, to 64
companies offering 383 products (Variable Annuity Research and Data Service [VARD]).
The annuity started as a tax-deferred, simple payout product, but now is an investment
―vehicle‖, offering tax deferment plus several various payout options, plans that allow for
systematic withdrawals, dollar cost averaging and other options.
THE SEPARATE ACCOUNT THAT VARIES
Premiums deposited in a Variable Annuity go into a separate account where they are invested
in a variety of securities, similar to investing in a mutual fund. Because Variable Annuity
premiums are used to buy securities, they are subject to fluctuating market conditions, resulting
in a variable rate of return that depends upon the performance of those securities. There are no
guarantees about the value of the annuity at any given time since the value depends upon the
separate account performance. Not even the principal amount invested by the annuity owner is
guaranteed, which means it could be diminished or lost entirely.
Insurance companies continue to add optional types of investment portfolios from which
variable annuity buyers may choose. Typically, investors may choose from such securities as
common stocks, bond funds, U.S. government securities, short-term money market instruments
and others depending upon their investment needs. For example, the insurer might offer
different funds whose separate goals are long-term growth, capital preservation, high yields, or
some combination. The annuity buyer may switch investments, if desired, subject to any insurer
limits on the number of times changes may be made.
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Historically, over many years, the markets rise and fall periodically but generally provide an
average long-term rate of return that is greater than fixed rates. However, regardless of past
performance, it is important to note again that absolutely no guarantees are made about the
performance of the Variable Annuity separate account.
SECURITIES AND INSURANCE REGULATION
Because the separate account is invested in securities, Variable Annuities are regulated in
part by the Securities and Exchange Commission (SEC) and in part by state insurance
departments. The SEC requires that potential purchasers of Variable Annuities must be provided
with a prospectus that discloses certain information about the underlying investments. This is
the same regulation that applies to all securities Investments, such as mutual funds.
Agents who sell Variable Annuities must be licensed as securities sales people and registered
as brokers with the National Association of Securities Dealers (NASD).
THE VALUE OF THE FUND: ACCUMULATION UNITS
Funds invested in a Variable Annuity separate account are referred to as Accumulation
Units.
Rather than buying a certain number of stocks or having a specific dollar value, the buyer
purchases "units" based upon the dollars invested and the total value of the stocks on the day of
purchase.
A formula is used to determine the value of one Accumulation Unit:
Separate Account Value = Accumulation
Total of All Accumulation Units Unit Value
As an example: The insurance company managed separate account value is $5 million and all of
the investors own a total of one million Accumulation Units. Therefore, using the above
formula, dividing the $5 million account value by one million total Accumulation Units results in
a value of $5 per accumulation unit
$5,000,000 = $5
1,000,000
Therefore, a Variable Annuity buyer who invests $1,000 when the value of each
Accumulation Unit is $5, can purchase 200 Accumulation Units: ($1,000 = 200)
$ 5.00
Because the $5,000,000 account value can change daily according to market conditions, the
value of this Variable Annuity could be higher or lower than $1,000 as early as the next day. For
example, if the market took a nosedive and dropped to $4,000,000, with everything else
remaining equal, the Accumulation Unit value would now be $4. This investment value is now
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$800 ($4 x 200 Accumulation Units) instead of $1,000.
Conversely, if the market improves markedly to where the separate account value is
$6,000,000, and everything else remains equal, this investment value grows to $1,200.
Obviously, this is a simplistic illustration of how the values fluctuate, as realistically, within a
short period of time the values would fluctuate much more modestly and the total Accumulation
Units would change as other Variable Annuity Units are purchased.
Note that while the value of the investment changed the number of Accumulation Units the
individual purchased (200) did not change. The investor will never have fewer Accumulation
Units than the number purchased, although the value of those units changes in response to
market fluctuations.
Every time investors make additional annuity payments, they buy more Accumulation Units
based upon the value of one unit at that time. Using the same example, if the investor would
then pay $1,000 to the insurance company, the value of the separate account has risen and so has
the total Accumulation Units owned by all investors.
$8,000,000
2,000,000 = $4
Annuity Premium $1,000 = 250 units
Accumulation Unit Value
At this point the investor purchases 250 additional Accumulation Units with the same dollars
that previously purchased 200 units, although at this purchase each unit is worth less. This
investor now owns 450 Accumulation Units and will always own at least that many units
regardless of their value.
Because of the variability that characterizes these annuities, a similar mathematical
computation occurs when the liquidation phase begins, as discussed later.
LOADING AND OTHER CHARGES
Loading is an addition to the pure cost of insurance that reflects agent‘s commissions,
premium taxes, administrative costs associated with the acquisition of new business, and other
contingencies. The previous examples do not show the effect of loading (as part of the cost to
the consumer of a Variable Annuity) on the amount of money that actually goes to work for the
investor, nor of other charges imposed by the insurer.
The Variable Annuity has, in many cases, a death benefit which is payable to the heirs, and
is, at least, equal to the amount of money invested into the Variable Annuity. This insurance
guarantee will cost approximately 0.6% more in fees than a similar investment without this
guarantee. In addition, most charge annual account fees from $30 to $40, which also diminish
the investor‘s total return. Loading and fees are not returned to the customer and do not
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contribute to the investment value of the Variable Annuity.
Immediate Variable Annuity fees vary by company, but one survey indicated that they
approximate 1.8%. By comparison, some mutual funds will only charge 0.3 percent.
IMMEDIATE VARIABLE ANNUITIES
While most Variable Annuities are deferred annuities, the Immediate Variable Annuity has
emerged as an interesting vehicle for some investors.
When an immediate Variable Annuity is purchased, the customer pays a lump sum to an
insurance company and immediately starts receiving monthly payment. The payments will rise
or fall, just as with a deferred Variable Annuity. And, comparing the immediate Variable
Annuity to immediate fixed annuities, some investors like the idea of receiving different amounts
each month, depending upon the performance of the stock market. It is generally believed that
investments in the stock market will always beat inflation, therefore an immediate Variable
Annuity will provide inflation protection that a fixed immediate annuity will not do.
People, who are approaching retirement and have a large sum of money, are the best
customers for this type of Variable Annuity. They have been around for several years, but only
within the past 2 years have they grown in popularity. The reason, some experts believe, for the
increased interest, is that older ―baby-boomers‖ are willing to take on some risk, probably
because the baby-boomer generation simply have not been saving enough, plus there is concern
as to whether the Social Security program will continue when they reach retirement age.
However, most financial planners do not recommend an immediate Variable Annuity if the
customer is not of retirement age. It is much less expensive for younger persons to maximize
their 401(k) plans first. Actually, it may be cheaper for the person retiring with a substantial
401(k) to simply roll over the money into an IRA and it would be less expensive. It could also
be rolled over to a mutual fund for less expense; however, the security of the financial strength of
the insurer is not present.
While some investors are ―queasy‖ about the Variable Annuity‘s unfettered payouts – which
is appealing to some, as stated earlier – one immediate Variable Annuity on the market (and
there may be more) guarantees that monthly payments will never fall below 80 percent of the
first payment received. As an example, if the first payment of the immediate Variable Annuity
was $1,000, the annuitant would never receive less than $800. Please note, however, as
mentioned various times in this text, for this ―safety feature‖ there is a price. There is always a
trade-off. With this particular annuity, the fee with the 80% guarantee is 1.4%, while without the
guarantee, the fee is .55 per cent.
Most insurance companies do not offer such ―safety‖ features, as reinsurance companies
have declined to reinsure this business (reinsurers provide financial assistance to insurers by
providing cash reserves) because they are afraid that they will have to pay large unanticipated
sums if clients live beyond their life expectancy by 20 or 30 years.
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Annuitization of the Variable Annuity has not been as popular as what the industry had
anticipated; therefore the variable immediate annuity has not experienced the success of variable
deferred annuities. 1999 sales of immediate annuities represented less than 2% of the $164
billion annuity market, which was down from the 2.4% of the immediate annuity market of 1997.
There are several reasons for the failure of the variable immediate annuity‘s projected
success. One of the principal reasons is because the immediate annuities are difficult to
understand, even for trained professionals in the investment field. Besides having a complex
sales process for the marketing of an annuity, the explanation of how an immediate annuity
works and the various payout option can be quite overwhelming at times.
The length of time needed to explain the product and to ―close the sale‖ can run into hours.
By the time that the sale has been completed, and commission hardly seems worth the time –
especially to a financial planner who has many products that are easier to explain and pay more
commission.
Another impediment to selling variable immediate annuities is that in the past, they offered
no liquidity. Not everyone selling these products are really aware that liquidity options have
been added and clients now can set up portions of their funds in guaranteed length of payment
arrangements.
VARIABLE ANNUITIES EXCLUSION RATIO
The ―Exclusion Ratio‖ was discussed earlier, but Variable Annuities have their own
situations and rules. You‘ll recall that the amount of each Variable Annuity payout can
fluctuate, which makes it impossible to determine the total benefits expected. However, assume
an Individual had paid taxes of $90,000 and expected to receive payments for 20 years. Dividing
$90,000 by 20 years results in $4,500 per year - representing return of premiums only. Then, for
example, if the earnings on the account resulted in the annuitant receiving $6,000 for one year,
$1,500 (―interest‖ paid over and above the $4,500 base) would be taxable. If this annuitant
received only$3,000 for one year, none of it would be taxable since it all represents return of
premium, no interest. With a Variable Annuity, the exclusion could be recalculated when
payments change, following IRS procedures.
COMPANY MANAGED VS. SELF DIRECTED ACCOUNTS,
One of the benefits of a Variable Annuity is management of the account by professionals
when the separate account is company managed. With a company managed account,
professional investment managers employed by the insurer decide which particular securities are
included in the accounts made available to the investor. Again, this is similar to mutual fund
investment management. As a result, the annuity owner is not required to monitor individual
securities and decide whether to buy or sell.
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For investors who have the time, temperament and desire, a self-directed annuity account
might be appealing. Experienced investors can personally choose their investment portfolios and
decide how much of each premium will be allocated to the available investment funds. The
investor typically may make changes in investment strategies during both the accumulation and
liquidation phases. Although the annuity buyer bears the risk of any Variable Annuity, self-
directed annuities can be even riskier if the investor does not have the knowledge and ability to
follow the stock market carefully and consistently.
OPTIONS AVAILABLE AT DEATH
The Death Benefit option was briefly considered in the discussion of loading and fees. To
continue discussions of this option, as a matter of practice (and of law in some jurisdictions)
deferred annuities provide some type of death benefit when the owner dies before liquidation
begins. Variable Annuities create a special situation because account values can fluctuate
violently enough to erase any death benefit provided by traditional means. Therefore, insurers
have developed innovative optional death benefit provisions in order to guarantee minimum
death benefits and take into consideration the potential increases.
RATCHETED OR STEP-UP DEATH BENEFIT
A ratcheted or step-up death benefit is an increase in the guaranteed "floor," which is the
account value, provided the value of the investments has increased. The increase could occur
every five years or at whatever interval the insurance company specifies. If death occurs, the
survivors would receive the greater of two amounts: (1) the accumulated cash value (typically
premiums paid plus separate account earnings) or (2) the increased value that last went into
effect before the annuity buyer died. Under this option, the increase is tied directly to the
performance of the underlying investments in the separate account.
DEATH BENEFIT ADJUSTMENT
The Death Benefit Adjustment is similar to the step-up death benefit. Under this
arrangement, at the end of the surrender charge period, the annuity owner may adjust the benefit
to match what will be, (it is hoped) the increased value of the account. Again, any increase in
death benefits is tied to the separate account performance.
ANNUALLY INCREASING DEATH BENEFIT
A third death benefit option is more concrete than the ones previously discussed. The
Annually Increasing Death Benefit specifies a percentage by which the death benefit wi1l
increase each year (e.g. by 5% of the year‘s premiums), with an overall cap of 200%. This is
tied only to the amount of premiums paid, not to the performance of the Variable Annuity
separate account. At death, the survivors may choose to receive the account value if it is greater
than the death benefit provided by this option.
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Insurers who offer any of these options typically make them part of the standard Variable
Annuity with no additional premium required. Where appropriate, additional costs to the insurer
are built into the premium, but for the most part, the annuity buyer is expected to live to the
liquidation phase, so annuity death benefit costs are not usually a big risk for the insurance
company.
FIXED AND VARIABLE PAYOUTS
FIXED PAYMENTS
When the liquidation phase begins the insurer starts paying income to the annuitant on a
regular basis. The total cash value accumulated for the amount of the lump sum with a single
premium payment is annuitized by the insurer using established procedures that consider:
The annuitant's age and hence, life expectancy.
Frequency of each income payment.
Interest or account earnings that will continue to be paid on the diminishing annuity
principal amount during the liquidation period.
Guarantees the insurer has made (or not made) about the length of time income
payments will continue. In some annuities, provisions are made to make payments to
the survivors after the annuitant dies. Obviously, guarantees such as this require each
income payment to be smaller to make certain the accumulated funds last long
enough.
The age consideration involves the annuitant's age when the liquidation phase begins. For
example, an annuitant that wants to begin receiving lifetime income at age 55 will receive
smaller payments than one who waits until age 65. In the former case, the insurer makes a
commitment to pay lifetime income for what is assumed will be a longer period.
As discussed earlier, since some states use ―Unisex‖ ratings, premiums would be the same
for male and female. From all of the factors considered (as discussed earlier), the insurer arrives
at a certain "fixed" dollar amount of income the annuitant will receive every time an annuity
payment is made.
VARIABLE PAYMENTS
In their original concept of Variable Annuities, one of the "variable‖ parts of Variable
Annuities was the amount of each income payment. However, many annuitants were unhappy
with the uncertainty of each payment amount, so insurers now permit payments from Variable
Annuities to be determined in the same way as fixed annuity payments, therefore each payment
remains constant during the liquidation phase. The amount is based upon the value of the
annuity when liquidation begins. Therefore, at the liquidation phase, the only remaining
"variable" in the Variable Annuity is the interest rate, or earnings, paid on the remaining
principal. While most annuitants (about 90% currently) prefer this type of payout, insurers will
make variable fluctuating-amount payouts if the annuitant desires.
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VARIABLE ANNUITY UNITS AT LIQUIDATION
Under the original variable payment method, Variable Annuities require a different means to
determine the payout. When the liquidation phase begins, the insurer uses the number of
Accumulation Units to arrive at a number of Annuity Units. Annuity Units are an accounting
measure representing a fixed number of payout units rather than a fixed number of dollars. The
determination of the exact number of Annuity Units resulting from the annuity‘s accumulation
value, is as follows:
First, the insurer determines the dollar value of the accumulation account by multiplying the
number of Accumulation Units times the value of each. (This is the same calculation used to
determine value during the accumulation period.) If the value of each unit is, for example,
$5 and the annuitant has 50,000 Accumulation Units, the value is $250,000.
Then, using annuity tables that consider such things as age, sex (where permitted), the
insured‘s guarantees and any transaction charges or loading, the insurer then determines the
dollar amount that will be paid per $1,000. For example, assume the payment will be made
monthly and the tables indicate a payment of $10 for every $1, 000 of value. The annuitant
in the example has $250,000 or "250 thousands" - $10 times 250 equals a monthly payment
of $2,500, which is the amount the annuitant will receive for the first payment. Once the
number of Annuity Units has been determined, that number remains the same during the
entire payout phase. However, the value of each annuity unit varies according to the
performance of the investments in the separate account. This means the amount of each
payment can vary. Sounds complicated? Keep reading…
In the previous example, the value of each annuity unit was $5. Dividing the $2,500
payment by $5 results in the number of Annuity Units - 500 in this case. From this point
forward, the monthly payment is equal to 500 Annuity Units times the value per unit at the
time the payment is made.
Using the same example, if, during the next month, the value per unit has dropped from $5 to
$4, then the monthly will be ($4 times 500) Annuity Units or $2,000. Later during the
annuitant's lifetime if the value rises to $7, it would result in a monthly payment of $3,500.
Throughout the ―liquidation period‖ fluctuations continue as the separate account
investments fluctuate.
HOW MUCH RISK?
Fixed annuities have been perceived as essentially risk-free in terms of safety of the principal
amount invested. The primary risk associated with fixed annuities was inflation risk - the
possible loss of purchasing power resulting from high inflation. Variable annuities, on the other
hand, greatly increase the investment risk to the annuity owner with the hope of offsetting the
inflation risk. To reiterate the obvious:
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The higher the risk, the greater the reward.
Insurance company annuities have on occasion, been compared negatively to bank savings
instruments in regard to safety of principal since bank deposits are protected by deposit insurance
and annuities are not. However, careful selection of the insurance company that provides the
annuity virtually eliminates the question of financial soundness. Also, remember the previous
chart that shows comparative results of annuities and CD‘s.
In addition, many states have guaranty funds or associations that basically serve the same
purpose as bank deposit insurance. If an insurer becomes insolvent, guaranty funds provide the
means to continue servicing the insolvent company's policyowners, including annuity owners.
Funding comes from assessments all insurers in the state are required to pay. In some cases,
guaranty laws apply only to insurers domiciled in the state, while others cover any insurer doing
business in the state. Still, to be fair, the FDIC guarantees up to $100,000 per person for
investments in bank CD‘s, funded by the Federal Government and applies anywhere in the U.S.
As for risks involving future income, only an annuity can guarantee a lifetime income stream
to the buyer. For example, money deposited in a savings account and withdrawn periodically
during retirement can run out eventually. But the annuity buyer can be guaranteed lifetime
income even if the annuitant is still alive when the original principal and interest amounts are
depleted.
EARNINGS, GUARANTEED OR NOT
While both fixed and variable annuities are capable of earning a competitive rate of return,
Variable Annuities, in particular, provide greater opportunity to earn a higher rate of return on
investments in the separate account but, of course, earnings may fluctuate during the life of the
annuity. Interest rate guarantees vary widely among insurers, providing a broad range of
options. Careful shoppers will also look at the investment management track records of
companies offering Variable Annuities. While past performance is no guarantee of effective
future account management investors can identify companies whose annuity returns have
increased over time.
To repeat so that it will always be remembered, not only have annuity interest rates become
competitive with other investment products, but annuities also enjoy deferral of income taxation
on earnings. Returns on bank products and securities are taxed as current income in the year
they are paid to the investor. Even Variable Annuities, with their reliance upon securities to
determine income, are eligible for tax-deferred interest.
LIQUIDITY – GETTING TO THE MONEY
Annuities are not as easily converted into cash as some investments, bank accounts for
example, but they are relatively liquid subject to certain costs. Since annuities are intended to be
long-term investments, penalties are assessed under certain circumstances if the owner
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withdraws all or part of the annuity's value. These charges can be substantial in some situations.
Typically, the annuity owner can withdraw 10% during the first year, with an additional 10%
increase each year until the final year of the annuity term. As an example, with a 7-year annuity
period, the first year 10% could be withdrawn without penalty, the second year it would be 20%,
30% the third year, etc., until the end of the accumulation (annuity) period.
Some of the plans offer surrender-free withdrawals for terminal illness, for confinement in
nursing homes, and other similar situations.
DETERMINING THE RIGHT PRODUCT FOR YOUR CLIENT
Many are the agents who have lost an existing annuity case by way of a Section 1035
exchange to another annuity that offered an extra credit payment (See following discussion on
Extra Credit Annuities). Or perhaps the client wanted to know why he (or she) is paying over
200 basis points in variable annuity fees while at the same time, his brother-in-law pays less than
100 basis points on an annuity purchased directly from a mutual fund company. Perhaps the
agent lost a sale because a competitor‘s product offers a guaranteed minimum income benefit.
As with most things nowadays, new annuity products seem to appear every month and even
more companies are offering annuities. While this is good for the consumers, it makes it more
difficult for the agent to determine which products are best for the interests of the customers.
The first thing that a true professional should do would be to determine whether the annuity
has certain important features that must be present on all annuities offered to customers.
According to professionals, the proper annuity should always have all of the following four
features.
1. The annuity must have ―reasonable‖ fees and loads.
2. Depending upon what the client needs and wants, there must be appropriate investment
choices.
3. With all of the offerings of the various products and companies, the annuity must have
features that fit the prospect‘s needs.
4. The insurer must be a strong, highly-rated company.
An analogy could be the purchase of an automobile. While Dad would love to have a
Corvette, Mom might not feel that it is appropriate, considering that she is 7 months pregnant –
and with their 3rd child. And even a family van with leather seats and built-in television, might
not be the right car if they lived on a ranch accessed only by a 3-mile dirt road that can be deep
in snow in the winter. Similarly, extra features do not make an annuity the right choice for the
agent‘s prospects if the product doesn‘t meet their needs or if it obviously is not the proper
product to begin with.
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EXTRA-CREDIT ANNUITIES
More than 10 companies offer ―Extra-credit‖ annuities, and they have become quite popular.
These VAs credit investors‘ payments with an additional payment, generally ranging from 3% to
5%. One of the most frequent usage of this annuity is for Section 1035 exchanges.
Unfortunately, some agents have moved annuities by explaining that their current annuity has a
surrender charge of 2% (as an example) while the proposed annuity will pay a bonus of 4%
(example). This, therefore, covers the surrender charge plus credits an additional 2% to the
account.
While this sounds good, one must always remember that insurance companies are not in the
business of ―giving away‖ money. If something sounds too good to be true, it probably is.
While there are differences among the various extra-credit products, it should be kept in mind
that most of them come with high charges – known as M+E (mortality and expense, plus
administration) charges, plus investment management fees, high surrender charges, and limited
standard death benefits. This proves, once again, that there is no such thing as a ―free lunch.‖
A recent study of VARD statistics show that six of the most popular VAs are extra-credit
products. Further study of these products indicate:
M+Es range from 140 to 155 basis points (bps).
The average investment fee defined as the average of all of their variable sub-
accounts, range from 77 to 120 bps.
By totaling the M+E and the average investment fee, the ―total average expense‖
ranges from 217 to 260 bps, with an average of 240 bps - considerably above the
industry average of 210 bps for all VAs.
By reviewing the death benefits, it appears that the standard death benefit for five of the six
contracts is the greater of (a) the current account value or, (b) all of the premiums paid. Note
that many other VAs offers a standard enhanced death benefit that increases every year, or is
reset after a certain number of years. Four of the six extra-credit products offer these enhanced
death benefits for an additional fee.
It is also interesting to note that all six contracts have surrender charges that are longer and
higher than most VAs. As an example, the lowest surrender charge in the fourth year is 7%, 6%
in the fifth year, and 3.5% in the seventh year — all of which are much higher than the average
VA.
Obviously, the higher fees associated with the extra-credit annuities will lessen the benefits
of the extra-credit payments over a period of time.
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CONSUMER APPLICATION
Ridley, a financial planner and agent, has a 60-year-old client with an annuity valued at
$100,000. James, an insurance broker, suggested to the client that they move the annuity into an
extra-credit annuity. By doing this, the client would receive a bonus of $4,000, just for
exchanging the annuity. However, this would fall a little short of the $4,100 surrender charge
that would be charged against her account.
Since this is almost a ―wash‖, the client reported this to Ridley, who pointed out that the fees
on the extra-credit product were 30 basis points higher than the current product. These fees
would reduce her account value by about $25,000 after 20 years - and more than $80,000 after
30 years (assuming a steady 10% growth per year before fees).
Ridley also pointed out that there would be a new surrender charge when the client purchased
the replacement annuity. With her current annuity, the client would be free of any surrender
charge after three more contract years. On the other hand, the extra credit annuity imposed a 7%
sales charge for the first four contract years, 6% in the fifth year, 5% in the sixth year, and 4% in
the seventh year.
Ridley also discovered that the extra-credit product did not offer a better standard death
benefit than the one the client she currently had. Then, as frosting on the cake, the company
offering the extra-credit has a lower rating than the existing annuity carrier.
This is not to say that extra-credit products are never appropriate. However, a professional
will carefully weigh all of the product‘s costs and features when doing any comparison. Since
the extra-credit annuities have higher fees than many other VA‘s, these fees will generally offset
the bonus payment over a period of time. Further, if the product is being used as a Section 1035
exchange vehicle for contracts still subject to surrender charges, the performance will suffer
further as the bonus is partially or fully offset by the surrender charge.
DIRECT-MARKETED ANNUITIES
An insurance company or mutual fund company may direct-market annuities directly to
consumers with the result that the annuities have lower total costs as a result of low M+E
charges. One might understandably feel that an agent cannot compete with direct-marketed
annuities. However the client usually gets what they pay for.
A review of the 10 most popular direct-marketed annuities shows their average total expense
is 124 basis points, 86 basis points lower than the average VA (according to VARD's Profilers —
Third Quarter 1999). Not good news for an agent trying to compete! But a legitimate
comparison would take into consideration whether the other VA offers additional features or
options to justify the added expense. Another, deeper, look at these same 10 direct-marketed
annuities, reveal some interesting facts:
Only one of the 10 offers a standard death benefit beyond the return of premium or
account value.
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By averaging the number of variable sub-accounts within these VAs, it is found that the
average is 14 - less than the number of sub-accounts offered by most other top selling
annuities.
In the 3 lowest-cost direct-marketing annuities, the equity funds averaged a 21.47%
return in 1992, well below the average return of 29.24% return for all VA equity funds in
1993. These 3 particular annuities rely heavily on index funds and do not cover the same
range of investment categories, as do many other Variable Annuities. One should
remember that, in general, the performance of a VA equals investment returns minus
fees. The aggregate number is what is important.
Dollar-cost-averaging plans, asset allocation and re-balancing programs, and terminal
illness benefits are product features that are common in many VA‘s but do not appear in
all direct-marketed annuities.
Perhaps most importantly, the direct-marketed annuity buyer loses the valuable services
of an investment professional. Annuities sold by individuals cost more mainly because of
commission which must be offset by the valuable and effective counsel and services
provided by a real, live, person that knows the annuitant and can advise on such subject
as: Is the client properly diversified in the right sub-accounts? How does the annuity fit
with the client‘s financial objectives? Should the client annuitize or take systematic
withdrawals?
LIVING BENEFITS
Additional benefits are living benefit options that provide additional guarantees to the policy
owner. Some of these benefits are:
Guaranteed minimum income benefit: This guarantees upon annuitization, that the
person‘s monthly income will not fall below a certain amount.
Guaranteed minimum accumulation benefit: This guarantees the account value will not
be below a floor level after a set number of years.
Long-term care coverage: This provides a monthly income if the insured is confined to a
long-term care facility.
While these benefits are worthwhile for many customers, as with many extra-credit products,
the options are only as good as the underlying product, and an inferior product with a living
benefit still is an inferior product. And, as usual, there is generally an additional fee for these
options those limits the account‘s growth potential. Because, as illustrated previously, an extra
25 or 30 bps can limit the client‘s growth potential by tens of thousands of dollars over the
contract‘s life. In some cases, the expense might be worth it, but the benefits should be weighed
against the additional cost.
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However, the person must annuitize and usually must take a fixed annuitization. This can
rightfully be conceived as a negative. While the monthly payment is guaranteed, the amount
over the years may not be as high as it could be with variable annuitization which could possibly
harm the client financially during inflationary periods. This is one of the most misunderstood
options.
When discussing the appropriateness of a product for a particular client, one should consider
if the fees and loads are appropriate for the situation. As an example, a no-surrender-charge
product may be appropriate for an older prospect but not for a younger prospect because of tax
considerations. The fees should be considered in respect to the death benefit (and other product
features). For instance, is the M+E lower than other products but are the sub-account fees
higher? The availability of diversifying investments may be of considerable importance to the
particular annuitant.
TAXATION OF VARIABLE ANNUITIES
Variable Annuities are generally a tax-favored investment product when purchased by an
individual on a non-qualified basis. When purchased as part of a qualified retirement plan, such
as an IRA, 401(k), TSA-403 (b), or Deferred Compensation Plan, they are taxed under the
special tax provisions governing that qualified retirement plan.
The Taxpayer Relief Act of 1997 brought two key changes that can affect Variable Annuities as
to their marketability.
1. Long-term capital gains rates were pared to a maximum of 20%. Those who own
investments outside of tax-deferred accounts and meet the 18-month holding-period
requirement, face a much lower tax burden on any gain realized. On the other hand,
investment income from a variable annuity is taxed at the ordinary income rate, which in
many cases is higher than the top capital-gains rate.
2. The Roth IRA (discussed in detail in another section of this text) was created. It works much
like a tax-favored retirement account that mimics a variable annuity. The customer puts
money into the account and investment earnings are not taxed unless the money is withdrawn
too early. The funds can be shifted between investment vehicles without tax consequences as
long as the funds stay in the IRA.
In a Roth IRA, as long as the money stays in the IRA for at least 5 years, and it is not
withdrawn before retirement; the funds are withdrawn tax-free. If, conversely, the money were
put into a Variable Annuity, the annuitant would pay tax at the ordinary income tax rate at
retirement. (Also there are restrictions for Roth IRA – single income must be below $95,000, or
$150,000 married filing jointly – see later discussion.) Since there are no restrictions as to
income for a Variable Annuity, if a person made too much money to contribute to a Roth IRA
and trades too actively to enjoy the long-term capital gains rate, a Variable Annuity would be the
way to go.
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USING A VARIABLE ANNUITY
The Variable Annuity has proven that it is a formidable financial planning tool and with its
―sister‖ annuity, the Equity Indexed Annuity (discussed later) has grown significantly in usage
for estate and financial planning purposes. Some of those applications are:
Since under some state laws, Variable Annuities allow protection from certain creditors,
those who may be thinking about entering a nursing home could be interested.
Some products offer surrender-free withdrawals for terminal illness, nursing home
confinement, and other similar situations, so those who don‘t like surprises would be
interested.
To anyone who has dividends to reinvest, or capital gains, they would like a VA because
any growth in the value of the account would avoid current taxation.
There are those who just like to transfer there funds between various investment vehicles,
for whatever reason, and they would like the transferability of the Variable Annuities.
The VA can be transferred without tax being due and it also can help to avoid sales
charges.
There are those investors who are knowledgeable about the market and are concerned
about the volatility, understand better than most that if assets are passed to the beneficiary
while the market is down, the ―stepped-up‖ death benefits provide a concrete amount for
the protection of their beneficiaries.
Variable Annuities (and especially, Equity Indexed Annuities) often offer guarantees
through a fixed account, which allows annuitants to change their financial objectives
because of the volatility of the markets.
Those who are concerned about estate planning may use Variable Annuities as they may
avoid probate as well as its costs and the loss of privacy.
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CONSUMER APPLICATION
Loren is 42 years old and has just inherited $25,000. He does not really need the money at
this time so he purchases a Variable Annuity. The annuity returns 7% after subtracting a
management fee and other expenses - which include a mortality fee that guarantees that when
Loren dies, the Variable Annuity will not be less than $25,000.
20 years later, when Loren reaches age 62 and is concerned about retirement funds; the
$25,000 has now grown to $97,000, an increase of $72,000. This amount ($72,000) is
considered regular income and not as a capital gain. Depending upon the tax laws at that time, it
is possible that Loren‘s taxes may be higher than if the money had been invested in a mutual
fund if capital gains taxes are lower than taxes on regular income. It would probably be best for
Loren to take a series of payments, instead of a lump-sum payment, which would spread the
taxes out over the payment period.
If the stock market should collapse after Loren has had the Variable Annuity for about 3
years, unfortunately Loren would have to pay a sizeable penalty for early withdrawal should he
desire to do so. However, since a Variable Annuity should be purchased as a long-term
investment, over the 20-year period, the market should probably also go up again before he
annuitizes.
CONSUMER APPLICATION
Chris and Bertha are in there 70‘s and received $100,000 from the sale of the estate of
Bertha‘s sister. They have been retired for several years and really do not need additional
retirement funds. They contact their agent, Lambert, who is an insurance agent and registered
representative. They told Lambert that they wanted as much of this money available as possible
in case of an emergency. Also, they wanted as much money available as possible to the survivor
when one of them died.
Lambert recommended a Variable Annuity because of the tax-deferral features and because
of the growth of the stock market. Lambert had to search the market in order to find the ―right‖
Variable Annuity, i.e. an annuity that provided the best returns and still allowed an easy ―way
out‖ in case of an emergency. He found a product with a 1.25% insurance and administrative
charge. The product had a death benefit, which was equal to the highest account value the
contract had ever reached. It also allowed for early withdrawal for certain situations, nursing
home confinements, terminal illness, divorce and disability, plus it had a death benefit feature
that resets the contract value each anniversary, and then arrives at a guaranteed amount at age 81.
It also had an optional death benefit which pays 15% of the annual contract growth as an
estate benefit which means that the surviving spouse can have the money if they so desire, or it
can be kept in the contract if they do not need the money immediately.
Under this option, the surviving spouse would incur no income taxes, and the taxes can be
deferred throughout his/her lifetime. This amount is added to the contract value and if not paid
out, it will continue to grow, in effect increasing the size of the estate. On an annuity of
$100,000, over 10 years this $15,000 would grow into nearly $30,000 (at continued growth of
7% which would be far surpassed if the stock market continues to grow at the rate it has over the
past 10 years) which could be used to help pay taxes if this money is needed, or it can be passed
to the heirs.
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STUDY QUESTIONS
1. Fixed annuity payments are deposited in the insurance company‘s general investment account
and the insurance company takes the risk on investments it makes on the whole. With
Variable Annuities
A. the same procedure is applied.
B. premiums are invested separately with the buyer assuming the investment risk.
C. premiums are invested into sub-accounts, with the insurer assuming all the investment
risk.
D. payments are deposited into a trust department of a Federally regulated bank.
2. Since Variable Annuities are invested in securities,
A. the rate of return is always stable.
B. the rate of return is always guaranteed.
C. the rate of return depends upon the Dow Jones average.
D. the rate of return depends upon the performance of those securities.
3. Variable Annuities are regulated
A. in part by the SEC and in part by the State Insurance Department.
B. by the State Insurance Department only.
C. by the SEC only.
D. by the Federal Treasury Department.
4. Funds invested in a Variable Annuity separate account are referred to as
A. slush funds.
B. accumulation units.
C. equity indexed funds.
D. qualified funds.
5. The value of the Accumulation Units is based upon
A. the value as stated in the annuity contract.
B. the value of the market on the day the funds are invested.
C. the average value of the funds over the past year.
D. the Standard & Poors 500 index.
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6. An addition to the pure cost of insurance that is intended to cover commissions, premium
taxes, administrative costs and other such contingencies, is called
A. an Accumulation Unit fee.
B. loading.
C. an administrative penalty.
D. an over-ride.
7.. When a customer pays a lump sum to an insurance company and starts receiving payments
immediately from a Variable Annuity, the Variable Annuity is called
A. an immediate fixed annuity.
B. a deferred immediate annuity.
C. an immediate Variable Annuity.
D. an Equity Indexed Annuity.
8. The ____________ death benefit of a Variable Annuity is an increase in the guaranteed
―floor‖, or account value, provided the investments have increased in value.
A. annually increasing
B. decreasing benefit option
C. the ratcheted (or step-up)
D. level
9. The primary risk associated with fixed annuities was
A. the downturn in the stock market.
B. the lack of guarantee of principal.
C. the enhancement rate.
D. the inflation risk.
10. When recommending an annuity, which of the following of the following should not be
considered:
A. reasonable fees and loads.
B. restricted or unrestricted investment choices.
C. the insurer must be a strong, highly-rated company.
D. agents commissions.
ANSWERS TO STUDY QUESTIONS
1B 2D 3A 4B 5B 6B 7C 8C 9D 10D
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CHAPTER SIX - EQUITY INDEXED ANNUITIES
BACKGROUND
The Equity Indexed Annuity (EIA) is not only a new product; it is a somewhat complicated
product that is extremely unusual. For starters, it is an insurance product that determines the
annuity payments by the use of an index that is ―geared‖ to the fluctuations of the stock market.
So far, it is still considered as ―insurance‖ and not as security, therefore an insurance-only agent
can market the plan, and a securities license is not needed (although it may be recommended as
described later in the discussion). This text will explain how the product is devised and how it is
used correctly, and the education thus afforded may help to keep the product out of the
regulation of the Securities and Exchange Commission because of misuse or misrepresentation
by insurance agents.
The Equity Indexed Annuity is NOT a security, and should never be directly compared
to a security (stock, bond, etc.)
In particular, this product offers a unique planning opportunity for financial planners.
However, there are many provisions and elements of this new product and many new options and
changes are introduced with regularity.
It must be stressed that a financial planner that uses the Equity Indexed Annuity as part of a
planning process, should be very familiar with the product offered by the particular company that
he/she represents, and also familiar with products offered by other companies. In most cases,
insurers have done a creditable job of providing information regarding the products that they
offer, including seminars and training courses.
Terminology is important with this product, as being a new product it has introduced new
words and new definitions of existing words, into the vocabulary of the financial community. In
this text are results of surveys among those professionals who market EIA‘s and it is readily
apparent that unless a person had some knowledge of the product, there is no way that they could
understand the statements made by these professionals.
WHAT IS AN EIA?
An Equity Indexed Annuity is, simply put: a fixed deferred annuity.
It is not a new type of annuity, it is not a security, it is not a Variable Annuity – it is a fixed
deferred annuity with all of the guarantees and features. The biggest difference between an EIA
and a ―regular‖ fixed deferred annuity is how interest is credited to the contract.
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Traditionally on a fixed annuity, the interest rate credited to the annuity is based on existing
and current interest rates which is guaranteed by the insurance company and is guaranteed
payable for the term of the annuity. Since most fixed annuities use a one-year period, they are
renewed for another year, one year at a time. While it may have a guaranteed interest rate of,
typically, 3 percent, it will use current rates each year, but never less than the guaranteed rate.
With an EIA, the interest rate is based on a formula linked to an independent stock market
index – usually Standard & Poor‘s Composite Stock Price Index (S&P 500). So, to summarize:
an Equity Indexed Annuity is a fixed deferred annuity that uses an external index that reflects the
fluctuations of the stock market to determine the interest earned.
The EIA is not a security, indexed mutual fund, nor an investment in the stock market, nor a
Variable Annuity; it is also NOT a substitute for any of these investment vehicles. However:
The conservation of the principal of the Equity Indexed Annuity is GUARANTEED!
(Blaring of trumpets, rolling of drums, resounding applause of thousands of investors….)
Remember that it is a fixed annuity. A fixed annuity protects the annuitant from the risk of
losing their invested money (principal) because of the vagaries of the stock market. This is the
safety factor that has made fixed annuities attractive throughout the years and which are then
used for ―safe‖ investments that will not be accessed for a period of years. Remember also, as
stressed throughout this text, risk and return work in tandem – as the risk increases, the return
increases. Therefore, the security of a fixed annuity would indicate that the return would be
provided at a low rate of return.
With an EIA, the investor is provided with an opportunity to share in increasing rates because
of increasing values in the stock market, and still do so with a guarantee that the principal will
not be touched. It can be used to provide the annuitant with a steady stream of income, and can
be used to supplement other income like Social Security, pension plans and income from
savings.
WHERE DID THEY COME FROM?
The EIA was introduced first in the late 1980‘s but not marketed successfully. Neither the
product nor the company is still in existence. In 1994 two companies reintroduced the Equity
Indexed Annuity. In 1996, $1.4 billion in premium was sold, in 1997, it went to $3.5 billion, and
in 1998, it was $5 billion. The 1999 figures are not available yet, but it has been estimated as
approaching $15 billion. Today, there are more than 80 different products from more than 40
companies.
As this product is dissected in this text, the question will usually arise as to why there are so
many and varied forms of EIA‘s. There are a variety of reasons that are the result of experience
of the market, the marketing effort, the customer‘s viewpoint, and the home office concerns.
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There are a variety of means used by insurance companies to measure the movement of the
index used by the company, and each method is responsible for some form of variation. Since
the assets of the insurance company ―guarantee‖ the returns, including the guarantee of the
―minimum‖, the portfolio containing the reserves for these products must mirror or closely
imitate the index at any particular time. As experience in persistency, for instance, becomes
more valid, the length of time that the assets must be invested becomes more apparent.
This is a new product and any new product is the result of the ―best guess‖ of the marketing
staff, the investment and underwriting philosophy of the carrier, and the product creation by the
actuaries based on their assumptions. Rarely has any insurance product (or most any product)
been so perfect when first introduced that no changes were necessary later.
Although rarely discussed publicly, there is continued concern by the insurance companies as
to whether the product will be considered as a ―security‖ by the SEC, which would require much
additional administration, compensation methods, securities licensing of their sales people and
the general headaches connected with dual regulation – the State Department of Insurance, and
the Federal Government‘s Securities and Exchange Commission.
Probably the most significant changes come as a result of input from the marketing area. If
the product does not sell, all of the expertise and expense available is of no consequence. The
customer tells the agent/financial planner as to what they want and what they need, plus any
reason that they do NOT want to purchase the product.
Then, of course, arguably as important as marketing input, is the actual fluctuation of the
market. As noted later in this text, the various types operate best when the market is performing
in a particular manner. When this product was first introduced the stock market and other
investments were behaving much differently than they are today. What appealed to a certain
class of customer at that time is probably much different today.
Competition plays an important role in developing types of EIA‘s, as it does in the
development and revision of all products. Since two companies introduced the plan in its present
basic form, and that has expanded to around 40 companies now, it is self-evident that
competition was involved. It should be pointed out that any time an insurance company
introduces a new product, it must go through a lengthy period of approval by various
Departments of Insurance, and during this period of time it cannot make any changes of any
type. If it does make even minor changes in most cases, it will have to resubmit the plan for
approval all over again, causing another delay. In the meantime, another company can create a
―better‖ plan and submit it to another Department.
WHY INDEXING?
Indexing is nearly as old as the stock market. The government and industries use the
Consumer Price Index (CPI) as a method of measuring goods and services used to measure
inflation.
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Some of the most brilliant of actions seem so elementary in retrospect that one must wonder
why no one else had thought of it before. In the mid 1970‘s, a company that markets mutual
funds, decided to ―index‖ the mutual fund by buying the same stocks as the Standard & Poor‘s
500. Other mutual funds followed, as later did banks and financial institutions that offer
financial products. While actually the Standard & Poor‘s 500 Index is an ―index‖, it is also an
industry guideline that measures stock prices of 500 leaders in their particular industries.
Therefore, to ―mirror‖ the index, invest in the same 500 companies.
The Dow Jones Industrial Average is another ―index‖ that tracks the activity of 30 ―blue-
chip‖ companies. It is important to note that both Dow Jones and S&P 500 are ―averaging‖
indexes, e.g. they use the average stock value for their index. S&P‘s 500 uses a ―weighted‖
average which is believed to more accurately reflect the action of their stocks over a period of
time.
Indexing is popular because, for instance, an investor in a mutual fund that tracks the S&P
can feel secure knowing that the ―best‖ stocks in the market comprise the portfolio of which he is
a part owner. While most mutual funds are ―managed‖, there are those that are not managed
because they so closely follow the S&P or DJ indexes. Many pension fund managers use these
indexed stocks as it automatically creates diversity in the market.
One other factor, that is not of much importance at this time but could become more
important in the future, is that historically the stock market has outperformed the inflation rate
(as well as most other types of investments). Therefore, an indexed product should provide a
―hedge‖ against inflation.
“TRUST ME”
One of the problems with fixed annuities is that the insurance company makes the
investments that will determine the annuity‘s return. In effect, the insurer is telling its customer
that he/she should ―trust me to make the best investments on your behalf.‖ Remember that
deferred annuities are annual products, and the interest rate used during any one period is the
result of the insurance company‘s declaring what interest rate it will use. Also, if the customer
does not like the interest rate at the end of any year, there is a surrender charge that can be quite
severe in the early years of the annuity. Therefore, the annuitant cannot decide that they can
make more money just by following the S&P or Dow Jones, cash out their annuity and invest it
otherwise – without paying a large penalty.
With an EIA, there is no “trust me” factor. The annuity is indexed and moves according to
the fluctuations of the market. Some EIA‘s have some restrictions by making their plans subject
to changes in the participation rates or ―caps‖ during the limited liquidity years.
Indexed annuities are different from indexed mutual funds in one primary and substantial
reason. With a mutual fund, if the index should take a dive, the monetary risk is with the holder
of mutual fund shares. With an indexed annuity, however, the insurance company is the one that
is at risk, as the annuitant does not lose his/her principal. This is guaranteed by the assets of the
insurance company (and in most states, backed by guarantee funds also).
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WHO SELLS THEM?
In the early 1990‘s, EIA‘s were introduced to the securities market through national stock
brokerage firms, independent broker-dealer firms and regional brokerage firms. The national
stock brokerage firms have not been very successful in marketing the EIA‘s, as they have
traditionally marketed investments with a risk factor and they have not actively marketed
products with limited risk. The sale of EIA‘s by these firms is increasing but not significantly.
The independent broker-dealers have embraced this product however, as they usually take more
of a professional financial planning approach with their customers and they recognized early
how the EIA could be an integral part of their client‘s portfolio. They have produced a large
portion of EIA sales.
This product was a natural to life insurance agents who are accustomed to selling fixed
annuities and life insurance that provides for safety of principal and interest rate guarantees. At
last they can offer an equity-indexed annuity that is an insurance product and they do not have to
go through the licensing routine of a securities dealer (although a recent survey indicated that
nearly 80% of those agents who have sold EIA‘s, are registered representatives). They can now
actually offer their customers an opportunity to participate in greater growth in their annuities
without the risk of losing their principal. Agents, as can be expected, are the largest marketers of
the EIA product.
Banks have been interested in the EIA and bank sales have grown consistently. Many feel
that banks will become a major marketing source as bank customers are perceived as
conservative in their investments, and are not comfortable with risk products. With the
guarantee of no market risk, they should be perfect for bank annuity customers.
IS IT A SECURITY OR NOT?
Most of the EIA‘s marketed today are not considered as security products and actually fit a
heretofore vacant area between fixed annuities (insurance products) and Variable Annuities
(security product). The few EIA‘s that are registered are structured differently than the annuity
type of EIA. The registered EIA must be sold with a prospectus and the agent must hold a
NASD Series 6 or 7 license. Some states may require that the agent also pass the Series 63
examination.
Without going into detail as to the appropriate government regulations that determine what is
a security product as opposed to an insurance product, basically in order not to be classified as a
security, it must meet the following conditions:
1. The product must be issued by an insurance company.
2. The insurer must assume the investment risk. The contract‘s value must not vary with
investment experience, a minimum rate of interest is credited to the contract, and the current
interest rate must be declared in advance and not modified more than once a year.
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3. It must not be marketed as a security or sold (primarily) as an investment. There are
substantial marketing requirements, such as it must be accurately described, both the
investment and the insurance contract, and the long-term retirement or income security
features of the contract must be emphasized.
It should be noted that under government regulations as summarized in (2) above, the EIA
does definitely qualify as an insurance product because it declares the interest rate in advance.
It would be fair to ask why some insurance companies have registered their EIA versions.
Probably, their sales force is mostly registered representatives who are used to selling Variable
Annuities and other securities. Also, a registered product allows the salespeople to emphasize
the product‘s investment aspects.
It should be recognized that the S.E.C. could at any time decide that the product is a security
and the agents must be registered representatives. Even though the best legal minds in the
business maintain that such a decision would be contrary to the law, it could be costly and
useless to appeal any such decision. Companies are still relying on the legal opinions of their
attorneys and are treating the EIA as an insurance-only product.
PROVISIONS OF EQUITY INDEXED ANNUITIES
An Equity Indexed Annuity is a Retirement Savings product.
The following discussion of provisions features the uniqueness of the Equity Indexed
Annuity and it certainly does not cover all of the variations that are available on the market
today. This product, still in its infancy, has already undergone changes and will undoubtedly
undergo more in the future. Certain features are basic to all of the plans, and will be discussed in
some detail.
The most significant and principal difference between the EIA and other annuity products is
simply that the interest credited to these accounts is based on a market index. The index used in
most EIA products is based on the Standard & Poor‘s 500 because:
The S&P 500 is widely quoted and understood.
It measures the changes in the prices of 500 stocks, which represent at least 70% of
the equity market in the U.S., therefore it is an excellent indicator of the overall stock
market movements.
The S&P 500 stocks are traded on the New York Stock Exchange, the American
Stock Exchange and the National Association of Securities Dealers Automated
Quotation System. They represent different economic sectors, divided into various
industry groups and are linked to excess of $600 billion in public and institutional
funds.
The S&P 500 is a ―market-value‖ index, i.e. each company‘s value is determined by
multiplying the number of shares outstanding times the stock price. It is a ―weighted‖ index,
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which means that each company‘s ―influence‖ on its performance is directly proportional to its
market value.
CALCULATION OF YIELD
To calculate the yield that changes in the index‘s value, the formula is like that used to
determine the changes in value of mutual funds, i.e. the value of the index at the end of the
period measured, less the value of the index at the beginning of the period – divided by the value
of the index at the beginning of the period.
Example: If the value of the S&P were 1000 on Jan. 1, 1999 and 1200 on Dec. 31, 1999, the
yield for 1999 would be 20%. (1200 less 1000 = 200) divided by 1000 = .20
2d example: if the value of the S&P dropped by 50 points, then (950 less 1000) divided by 1000
equals a minus .05 or negative 5 percent.
S&P 500 index is reported daily in the Wall Street Journal, USA Today and many other
newspapers. The index is reported by the following:
HIGH: The highest average price the 500 reported during the day reported.
LOW: The lowest average price the 500 reported during the day reported.
CLOSE: The index value at the end of the trading day.
NET CHANGE: The change in the index for that day.
FROM DEC. 31: The change in the index from December 31 of the previous year.
% CHANGE: The change in the index from Dec. 31 previous year reported in
percentages.
There are a few indexed annuities that use other indexes, in particular foreign stocks. By
doing so, the annuitant can participate in the returns of overseas securities.
The Dow Jones Industrial Average, the Dow Jones Transportation Average, and the Dow
Jones Utility Average are considered as the leading indicators of the stock market movement.
Therefore it should be no surprise to discover that some companies are using the Dow Jones
Indexes for EIA‘s instead of the S&P 500.
Which is the best? The Dow Jones Industrial Average (DJIA) is weighted by price, as
opposed to market value of the S&P 500. This means that within the DJIA, the high-priced
stocks carry more weight than those lower-priced stocks. Therefore, a 3 or 4 % change in the
price of a $100 share will have more of an impact on the DJIA than the same change in the S&P
500.
Using the S&P 500 as an index, a change in the price of a stock is multiplied by the number
of outstanding stock. Therefore, a change of 3 – 4% in the price of a stock with a small market
value will have a much smaller impact than a comparable price of a stock with a large market
value.
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While other indexes may appear, the key point is that it is very necessary to keep the process
simple. Since the S&P 500 and the DJIA are both well known and well regarded, and somewhat
understood by the majority of potential customers, there is little chance that any other indexes
will have much of an effect.
HOW THE INTEREST RATE IS DETERMINED
Most investors are familiar with indexed mutual funds, but that has little to do with indexing
of equity indexed annuities. With mutual funds the fund itself purchases stock that comprise the
index. With EIAs, there can be – and is – a variety of indexing methods. In today‘s rapidly
changing financial environment, there can be methods that are beneficial if the market goes up,
or if it goes down, or if it stays the same, if it goes up and down over a short period of time, etc.
Some of the new products have new methods of indexing, but traditionally (if you can have a
―tradition‖ for a 6-year old product) there are six variations and will be discussed in detail.
These are point-to-point, high water mark (look back), annual reset, low water mark, multi-year
reset and digital. The other features of the EIA, such as floors, caps, participation rates/margins,
and averaging, may work together with the methods of indexing.
THE SIMPLE POINT-TO-POINT INDEXING METHOD
The simplest indexing method is the point-to-point method. The beginning ―point‖ is the
beginning date of the contract, i.e. the day that the premium deposit is made. The end ―point‖ is
the last day of the contract‘s initial term. The difference in the index value between the two
points is the amount of interest that will be credited to the annuity. For the mathematically
minded, the formula is simply: The ―Beginning Point‖ is subtracted from the ―End Point‖, and
the result is divided by the Beginning Point.
CONSUMER APPLICATION
Ralph has a 5 year EIA with 100% participation and the S&P 500 index is at 1000. His
Initial premium deposit would be $10,000. At the end of the initial term, the index stood at
1500. Therefore, subtracting 1000 from 1500 is 500. 500 divided by 1000 is .50 or 50%. The
full 50% would be credited (100% participation) and the credited interest would be $5,000 (50%
of $10,000).
If the market ―went south‖, the minimum rate would still be 3%. This is discussed later in
this section. This would be true of any of the methods of indexing used.
Some have expressed concern that if the market should ―soar to exhilarating heights‖ during
the term of the annuity, but then falls off just before the end of the annuity, the annuitant doesn‘t
receive the benefits of the increases since only the beginning and ending points are used. The
movement of the market during the annuity term does have an effect, though, as the last (end)
point would almost certainly be higher if the trend during the annuity period was continual gains.
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The Point-to-Point method of indexing is good in bullish markets, but is very dependent upon
a single end point. A little bad timing at the end could wipe out the result of several upward
years. Another criticisms leveled against this method is that at the end of the second year, or
even later years, an annuitant has no way of knowing how much his/her annuity value will
increase. This has been referred to as the lack of ―instant gratification.‖ This is similar to the
advice of financial ―experts‖ in the stock market, whereby they tell investors, ―Don‘t look at
your stock returns every single day.‖ Much easier said than done. It is human nature to want to
know your financial standing at any particular time, or at least be able to approximate it.
Vesting, as discussed later, and an averaging technique, serves to alleviate these problems.
For instance, vesting means that at the end of each year, a certain percentage of the account value
will be ―vested‖ and credited to the account, subject to participation rates and surrender charges.
Point-to-Point products work best in an upward or bullish market.
THE HIGH WATER MARK INDEXING METHOD
The ―high-water mark‖ method is a popular indexing method, and is used heavily by one of
the companies who ―started‖ the modern equity indexed annuity. Many agents consider this
method as the method that they would like in their ―ideal‖ EIA.
As in the point-to-point system, this method uses two points in time: the beginning point is
when the premium is deposited into the annuity. The other point is not an ―end‖ point, but is a
point during the annuity period when the index value was the highest. The mechanics are the
same as the point-to-point method, except that the ―high‖ points substitutes for the ―end‖ point.
This method satisfies the ―instant gratification‖ problem as the contract holder knows that the
value has been locked in when they reach that point. Therefore, even if the market index
declines, it will not have the same negative effect that the point-to-point method has.
It will be noted in this discussion, that on occasion, certain provisions of an EIA will be more
conservative in order to allow more liberal provisions elsewhere in the contract. This is one of
those situations. A product using the High Water Mark method normally has a lower
participation rate. The reason is that the cost to the insurer in investing to compensate for this
feature is much higher than in other products.
The High-Water Mark method performs best in a market that peaks early during the
contract period, and then declines for the rest of the contract period.
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THE RATCHETING (ANNUAL RESET) INDEXING METHOD
This is also a method that appears on agent‘s ―wish lists‖ as it can be very powerful if the
market is right. Simply put, instead of the index covering the annuity period as a single entity, it
allows the experience of each year to stand on its own. If it were a 7- year annuity, there would
be a new calculation at the end of each year. In effect, it measures the changes in the index with
a series of beginning & ending points. Today (2003) this is most popular indexing method.
Mathematically, the formula is the same as the point-to-point, but it is performed at the end
of each year. If the ―end point‖ minus the ―beginning point‖ is negative at any year, then the
index is zero for that year.
This type of method suits the equity-indexed annuity perfectly in a lot of ways. If the market
goes up, the annuitant participates through the index method. However, if the market drops, the
annuity will show a zero interest contribution for that year. (This is where the ―floor‖ comes in,
which is usually ―zero‖ in most contracts). However, and it is a big ―however‖, the next year the
annuitant can start over. Historically, the stock market usually performs the best after it has
reached a substantial low. Talk about timing!! The annuitant participates in the ―good‖ years
and ―just goes along for the ride‖ during the ―bad‖ years.
As good as this product is, there are still a couple of drawbacks. Nothing is perfect. One
factor is that it is confusing to the ordinary investor, inasmuch as the contract extends over
several years but the method operates on an annual basis.
The annual reset design is expensive for the insurer. Since the formulas differ each year, not
only the investment costs are high, but also so are the administrative costs. Therefore (trade-off
time again) this method usually has the lowest participation rates of any EIA plans.
Perhaps the greatest handicap of the annual reset method is that the interest credited to the
account each year is compounded. Certainly the compounding of interest into the product design
would appeal to clients. However, since this method is very expensive for insurers, some
insurers do not include a compounding feature. Some companies do allow compounding but
include a ―cap‖ (described later) which limits the amount of interest credited in any inter-
crediting period.
Annual reset annuities work best in a market that is highly volatile over the contract
term, and performs the worst if the market is steadily rising and has low volatility.
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END POINT OR LOW WATER MARK INDEXING METHOD
Forget the ―low‖ terminology as this method can produce good yields. Under this method
the ―end point‖ is the last day of the contract term. The beginning point is the contract
anniversary date when the index reached its lowest value. The mathematical formula would be
―Earning Point minus the Lowest Point, divided by the Lowest Point.‖
The thing that should be emphasized is that the lower the starting point, the higher the index will
become. This method works well in many different environments, however:
The Low-Water Mark method works best in a market that takes a deep dive in the
early part of the contract term, then rises throughout the rest of the contract term. It will
not do well if the market declines early and does not recover during the contract term
THE LIGHT SWITCH (DIGITAL) INDEXING METHOD
This is another method renowned for its simplicity. This method credits a particular rate of
return every year that the index is positive; and credits another particular rate of return every year
that the index is negative (usually zero). As an example, if the particular rate of return is 15%
and zero (-0-) when the index is negative, either one or the other, hence the ―on and off‖
connotation. Generally the rate of return for years when the index is positive will continue
throughout the policy duration and will not change for the policy duration.
The index is evaluated each year. In comparison to the annual reset method, if there is an
upswing in the index performance after a downswing, the annual reset method allows for a
substantial increase in the interest credited to the contract for that year. However, if the contract
uses the digital method, then the ―upswing‖ would be restricted to whatever the contract states.
The ―trade-off‖ for the digital method pertains to the interest compounding. Contracts using
the digital method may allow for compounding or not, but those that allow for compounding may
have a lower rate of interest than those that do not allow compounding.
The Digital Method works best in a modestly rising market, and works worst if the
market is alternating large upswings with downturns – especially if the downturns are
small.
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THE MULTI-YEAR RESET INDEXING METHOD
The Multi-year Reset method operates much like the Annual Reset method, except that the
rate is based on the result of more-than-one year (takes a larger ―bite‖). For instance, if the
contract term were 10 years, the Multi-year Reset Method would be calculated every two years
(or more – in any event it is always less than the contract duration). At the end of each period, a
new beginning reset period is determined and another multi-year period will start.
The formula is the typical Ending Period minus the Beginning Period value, divided by the
Beginning Period Value. However for the life of the contract, it would apply at the end of each
term. Using the 2-year example, that would mean that it would be ―reset‖ every two-years.
If the index performance is positive during any multi-year period, the participation rate is
applied to determine interest earnings for the contract. Conversely, if the performance of the
index is negative during any multi-year period, no interest is credited to the contract, but also, no
interest is lost.
If the contract allows compounding of the interest, the results of each multi-year period are
multiplied together to determine the total amount of the end-of-term interest. If the contract
allows for simple interest, then the results of each multi-year period is added together.
Multi-year reset contracts works well in a rather modestly capricious market,
particularly if the upsurges and the downswing parallel the contract’s reset points. It
performs worst in a market that is rising steadily and smoothly.
SHOCK ABSORBERS - AVERAGING
Some persons believe that ―averaging‖ is a method of calculating indexed returns. Not true.
Averaging is incorporated into many indexing methods however. Averaging is used so that the
experience of a single day cannot be used as the starting point or ending point in indexing. In
April 2000, the markets all took huge losses, including the S&P 500. What if a contract just
happened to have an end-date on the day of the crash!
Averaging is accomplished by taking the closing index prices over a pre-determined number
of days, adds them together and then multiplying by the number of days. It can be performed the
same way by using months or quarters, but usually it is days.
An averaged point can be either the end point or the beginning point, but usually it is the end
point, and is usually averaged during the last year of a point-to-point contract.
Averaging accomplishes what shock absorbers do to the ride of a car – it levels out the
bumps and holes. Years when the stock market rises during a year, and then declines toward the
end of the year, the averaging will produce excellent results. However, if the stock prices rise
steadily during the year, the return will be halved.
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For the mathematically inclined: if the contract has a 7-year term, and averaging is used
during the last year, the last year‘s average would be: 1st Quarter+2d Quarter+3rd Quarter+4th
Quarter, the total divided by 4. Just like in the 4th grade.
STUDY QUESTIONS
1. The Equity Indexed Annuity (EIA) is not a (an)__________ and should never be directly
compared to a ____________.
A. annuity – annuity
B. security – security
C. insurance plan-annuity
D. annuity - security
2. Simply put, an EIA is
A. an immediate Variable Annuity.
B. an adjustable Variable Annuity.
C. a fixed deferred annuity.
D. a fixed premium Variable immediate annuity.
3. One of the big advantages to a purchaser of an EIA over a fixed annuity is that
A. he knows that his funds are all invested with the other funds of the insurance company.
B. the annuity is indexed and moves in accordance with fluctuations in the market.
C. the fixed annuity principal is not guaranteed.
D. the annuity funds are all held separately as with Variable Annuities.
4. In order for the EIA product to remain an insurance product,
A. the product must be issued by an insurance company.
B. the investment risk must be assumed by the purchaser/investor.
C. it must be marketed as a security.
D. the funds must be guaranteed by the Federal Government.
5. The index used by most EIA‘s is
A. the Russell index.
B. Dow Jones Industrial Average.
C. Standard & Poor's 500.
D. Merrill Lynch Averages.
6. Point-to-point products work best in
A. an upward or bullish market.
B. in a market that huge downward swings.
C. a declining market.
D. a wildly fluctuating market with huge increases in value.
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7. An indexing method that uses the beginning point and a point when the index was the highest,
is called
A. The High Water Mark method.
B. The Annual Reset method.
C. The Low Water Mark method.
D. The Multi-Year Reset indexing Method.
8. When an index covering the annuity period allows the experience of each year to stand on its
own, is called
A. the Multi-Year Reset Indexing Method.
B. the Annual Reset Method.
C. the Digital Indexing Method.
D. the Low-Water Mark Indexing Method
9. When the formula of ―earning point minus the lowest point, divided by the lowest point‖ is
used, the method is the
A. Digital Indexing Method.
B. End point indexing method.
C. Annual Reset Indexing Method.
D. Multi-Year Reset Indexing Method.
10. This indexing method credits a particular rate of return every year that the index is positive,
and credits another particular rate of return every year that the return is negative. It is the
A. Annual Reset Method.
B. End-Point Method.
C. Digital Method.
D. High Water Mark Method.
ANSWERS TO STUDY QUESTIONS
1B 2C 3B 4A 5C 6A 7A 8B 9B 10C
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CHAPTER SEVEN – FUNCTIONS AND USES OF EIA’S
HOW ABOUT DIVIDENDS?
The S&P 500 and nearly all other listed indexes are called ―price‖ indexes, meaning that they
reflect only the price of the stocks in the indexes and do not reflect any dividends or reinvesting
of dividends. Therefore, EIA‘s that use the S&P 500 index will not reflect dividends. At one
time dividends accounted for 2 to 4 % of the stocks annual returns, but it dropped to a little over
1% of the total return after about 1995. Therefore, since dividend yields are lower than they had
been before, it would indicate that they will not have any long-term impact on the market
performance.
It should be fully understood by the marketer and by the consumer, that buying an EIA that is
linked to the S&P 500 is not the same as purchasing stocks in the S&P 500. This does not mean
that the EIA is an ―inferior product,‖ but is just one of the items that the purchaser of an EIA
gives up as a trade-off to eliminate the market risk.
Since there is a separate S&P index that does reflect dividends, there are a handful of EIA
products that have been designed to include dividends. As will be emphasized in this text, there
are only 100 pennies in a dollar, so there will be a trade-off by the EIA having a lower
participation rate as explained later.
GUARANTEED RATE – THE SAFETY CUSHION
All EIA‘s have a guaranteed minimum interest rate, usually 3%. Why so low? Insurance
products are subject to ―non-forfeiture‖ laws, which specify the minimum interest rate that must
be attributed to a policyholder upon the ―forfeiture‖ of the policy, usually annuitization or
surrender. The non-forfeiture provision is a function of state regulations and there may be some
differences, however 3% is considered as the ―standard.‖ Fixed annuities normally apply the
guaranteed minimum interest rate to the entire premium deposit each year. If the insurer declares
a higher interest rate, then that rate would apply, but in no circumstances would it be more than
3%.
At the end of the contract‘s term, the contract holder will receive the greater of: (1) the
guaranteed minimum value of the contract, or (2) the indexed value.
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HOW LONG WILL THE CONTRACT RUN?
The term that is used to define the time length of an EIA is the ―Initial Accumulation Term.‖
This can vary anywhere from one year to 15 years, but the usual period is 5 to 7 years. The
initial accumulation term has two functions:
(1) the length of time that the indexed rate of return is applied to the contract, and
(2) the length of the surrender period during which surrender charges apply.
At the end of the contract period, there is a ―window‖ of (usually) 30 to 45 days for the
annuitant to determine if they want to annuitize (cash-out) the annuity, full or partial withdrawal
of the funds, or renew the contract for another term. If no choice is made, some companies will
automatically transfer the funds into a fixed annuity. Others may simply renew the contract for
another term.
HOW MUCH IS SUBJECT TO INTEREST PARTICIPATION
First, it should be pointed out that premiums for EIA‘s are in most cases, single premiums,
with typical minimum payment of $5,000 or more. However, some companies are allowing
additional premium payments, usually in amounts of $50 to $500. This is important to know as
customers may question as to why, since they have made a large payment, they are initially only
going to receive credit for part of the amount. Secondly, participation rates may differ according
to the date that a payment is made.
Another rather unique design of the EIA is the ―Participation‖ rate. This is simply the
percentage of the premium deposit and annuity value that will be applied (credited) to the
contract. ―Participation‖ comes from the fact that it determines what percent the contract
―participates‖ in the contract‘s indexed return.
In order to determine the actual interest rate applied to the contract, the first step is to
determine the yield of the index used. Then the participation rate (percent) is multiplied by the
participation rate to determine the amount of interest to be credited.
CUSTOMER APPLICATION
Archie purchased an Equity Indexed Annuity a year ago with a participation rate of 90%.
This particular annuity uses the S&P 500 index. The S&P 500 rose 10% during the first contract
year. Therefore the interest rate applied to the contract would be 9% (.10 x .90).
Participation rates can range from 20% to over 100%. One company uses 100% of the
average of the daily closing prices during the year. The participation rate depends upon the
features of the product, i.e. generally if the participation rate is low, the contract has more liberal
features in other areas. Of course it also depends upon the insurer‘s internal indexes and cost
allocations.
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A higher participation rate does not necessarily mean that it will result in higher interest
crediting, as will be explained later. Also, most EIA contracts will use the same participation
rate throughout the contract term, but some contracts will change participation rates annually.
The fact that the EIA collects its premium usually in a rather large lump sum, but the entire
amount immediately ―reduces‖ in value (in most plans) can cause questions in the minds of the
customer (and the marketer, the first time they see this). One of the reasons is that most
insurance regulations allow an insurer to collect a 10% ―load‖ on an annuity for administrative
purposes. While this is factual, it is of little interest to the consumer.
There are two reasons that can be explained to the customer:
1. At the guaranteed rate of 3%, for instance, a $10,000 premium deposit will start exceeding
$10,000 in value after about 3 ½ years. If the ―math‖ is done, over $11,000 will be credited
to the account after 7 years.
2. And most importantly, this product should not be sold to anyone that will have immediate
liquidity needs, or needed on an on-going basis, or will need to surrender the contract prior to
the contract term. It cannot be emphasized enough:
Equity indexed annuities are designed for long-term investing, and should not be sold
to those with immediate or continuing liquidity requirements
An ―alternative‖ to the participation rate is the ―Margin‖ (also known as the ‖spread‖) used
on some contracts. The ―margin‖ is subtracted from the indexed yield (instead of being
multiplied as with the participation rate). For instance, the margin rate on a contract may be 5%.
If the indexed yield is 10%, then the interest rate credited to the EIA would be 5% (.10 - .05).
The question as to, which is best for the client, frequently arises when discussing margins
and participation rates. Mathematically, different assumptions will produce different results
because the two are not mathematically comparable. Basically, when indexed rates are low, then
the participation rates may produce better results, and conversely, when the indexed rates are
high, the margin may produce better results. There may be more technical answers but simply
put, ―it just all depends‖, as one is not comparing apples-to-apples.
Margins may be used for any EIA product, but are most commonly used with annual reset
products.
CAPS – IS THE SKY THE LIMIT?
Some – not all – EIA‘s have a ―CAP‖ or limit on the amount of indexed interest that can be
applied to the contract during a certain period, regardless of how high the indexes may go. As an
example, a contract may have a cap of 12%. If the market-oriented index soars to 15% in one
year, the maximum that will be attributed that year, would be 12%.
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How is this explained? The actual and true reason for the cap is that it protects the insurer
against ―wild fluctuations‖ or very substantial index increases. Therefore the insurer is able to
offer other attractive features, without which they would not be able to do so.
One large broker who sells a substantial amount of EIA‘s, and whose remarks have been
seconded by many other marketers, in a recent survey by Life Insurance Selling‖, stated, in effect
that his chief concern for both buyers and sellers of EIA‘s, is the cap on returns. ―Inferior
products‖ (his terminology) that cap returns have cost annuitants millions in lost gains. This is
particularly noticeable during 1998 for instance, when the indexed rates would have almost
always created returns in excess of 20%. An annuitant at that time would have been losing 6%.
Caps may be applied to any indexing method but they are generally found on annual reset
contracts.
WHAT IF THE INDEX NOSEDIVES? – THE FLOOR
The floor is the minimum amount of indexed interest that will be credited to a contract in any
one year or over several years and applies only to those contracts that determine index interest
annually or multi-year. In most contracts, this amount is –0- (zero), which means that if the
index drops, there will be no interest credited. But this doesn‘t mean that the customer‘s account
value will lose, it will just remain the same as the previous year.
Example: Participation percentage is 80%. The first year the indexed percentage is 10%,
therefore 8% is credited. Second year the index drops to 5%, 4% is credited. The next year
the bottom drops out and the index drops to a minus 15%. In that case –0- would be credited.
The fourth year however, if the index yield increases back up to 5%, 4% would be credited
for that year.
The Floor and the guaranteed minimum interest rate are two different things. The guaranteed
minimum interest rate is what the contract owner will receive at the end of the contract term if
the accumulations of the indexed amount are less than the minimum interest rate. The floor is
the lowest amount that can be credited to the indexed interest in any particular year or years.
EARLY OUT – VESTING AND SURRENDER
There are two provisions that address early withdrawal of funds, either partially or totally.
―Vesting‖ allows for partial withdrawals or surrenders and operates much like a pension
fund‘s ―vesting.‖ A percent each year of the account value at the end of each year is available
from the total contract‘s value. For instance, many EIA‘s that have this feature allow for an
increasing percentage of the cumulative interest credited. If the contract term is 5 years, for
example, the percentages may start at 20% the first year, and increase by 20% increments until
100% of the amount is vested in the 5th year.
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The purpose of this feature is to protect the insurer from early contract surrenders. An
insurance company invests in financial markets that closely approximate the EIA‘s that it
markets. If a number of EIA‘s terminate early, this means that the insurer will have to cash-in
some of its investments to meet the demand for cash because of contract surrenders. An early
termination of investments always is expensive as most financial products have some sort of
protection against early termination, or it could occur when the market was down, resulting in
the sale of investments at a substantial loss.
Mathematically, the beginning year account value is increased by the interest that is credited
to the contract. The vesting percentage is applied to that amount to determine the amount vested.
Surrender charges of EIA‘s differ from surrender charges of other fixed annuities. Usually if
there is a vesting provision, there are no surrender charges. Otherwise, they have a schedule that
declines over the number of years the contract is held.
Early surrender of an EIA can mean that the annuitant loses not only the surrender charge,
but can lose the interest credited to the account that year. For instance, if the policy anniversary
date is June 1, and the contract is surrendered May 1, the amount that is tendered may be based
on the previous year‘s account value. If there had been a substantial increase in the index for the
11 months prior to surrender, this could mean more of a loss than anticipated.
THE END PRODUCT - ANNUITIZATION
The principal purpose of an annuity is to guarantee an income stream after retirement to
supplement other retirement income, such as Social Security, pension plans and other
investments. Through the accumulation of funds, the annuitization of an EIA operates just like
any other annuity. The insurance company assumes an interest rate that considers the annuitant‘s
age, sex and anticipated longevity and whether it is a single or joint annuity.
Once the values are annuitized, the amount of the monthly (or other mode) payments will
remain the same. Some insurance companies are attempting to create a product that will index
the annuity payments and it is anticipated that both immediate and deferred annuities will offer
this feature.
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The comparison of risk of various planning and investment products can be illustrated by the
following:
RELATIONSHIP OF RETURN AND RISK
(High)
Commodities
Options
R Limited Partnerships
Individual Stocks
E Corporate Bonds
Mutual Funds
T Money Market Funds
Variable Life Insurance
U Variable Annuities
Equity Indexed Annuities
Savings Bonds
R Savings Accounts
Life insurance
N Fixed Annuities-(fixed rate)
Government Bonds
Certificates of Deposits
Checking Accounts
(Low)
RISK
The top of this illustration shows those investments normally considered to be ―High Risk.‖
The bottom shows those which are normally considered to be ―Low to No Risk.‖ Following the
point made earlier in this text, this illustrates again that the higher the return, the higher the risk.
The top 3 (Commodities, Options and Limited Partnerships) are considered High Risk, the next
lower 6 investments are considered as Medium risks and the bottom 7 are considered as Low to
No Risk. An attempt is made to ―rank‖ them in order as to the risk, but some may differ as to the
order. For instance, while a Certificate of Deposit is guaranteed by the FDIC for up to $100,000,
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a CD for $250,000 would not be as ―safe.‖ In respect to Government Bonds, this refers to all
―governments‖ that issue bonds, and on occasion a municipality has had to default on its bonds.
So whether a products guaranteed by a ―government‖ is safer than that guaranteed by an
insurance company, may be argued any way.
The idea of this illustration is to show that the EIA as an investment is a secure investment,
but even though it is first and foremost, a Fixed Annuity, with all the safety thereto, it can be
legitimately shown as higher in return and lower in risk than almost any other product. The EIA
―breaks the mold‖ in investment products, as shown in this illustration, and that, of course, is the
attractiveness of the product.
COMPARISONS WITH OTHER ANNUITIES OR MUTUAL FUNDS
ANNUITIES
While there are certain limiting factors with the EIA, the prospect of participating in the
gains of the S&P 500 or other indices, without suffering the losses inherent in the market, is
quite appealing.
How the growth is determined:
With the Fixed-rate Annuity (FRA), the rate is set by the contract.
With the Variable Annuity (VA) the contract holder (or investor, if you will) may select one
or more Mutual Funds.
The EIA increases are tied to the S&P 500, Dow-Jones, or other indices.
Is the rate guaranteed:
The rate is guaranteed by the FRA, but not with the VA or the EIA.
Is there a minimum guarantee:
FRA has a minimum guarantee, as does the EIA. The VA does not.
Is there a loss potential:
While there is no potential loss for the FRA or the EIA, there is for the VA.
Is there, then, the potential for gain:
The FRA has only a slight (or modest) potential for gain, while with the EIA it is very
good. Of course, this is the ―meat‖ of the VA, so the potential for gain is excellent.
How about access to the money:
With the FRA and the VA, access is quite good, but with an EIA, depending upon the
contract, it is somewhere between nearly impossible, to quite good also.
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MUTUAL FUNDS
At least half, if not more, of investors in the U.S. are investing or have invested in Mutual Funds.
This gives them an advantage over the EIA as the EIA is a relatively new product and only a
small fraction of those who invest in Mutual Funds have even heard of the EIA. All mutual
funds are either ―Equity Funds‖ (SF), i.e. invest in stocks, or ―Debt Instrument (Bond) Funds‖
(BF) which invest in bonds and money market instruments.
Using the criteria as above, the following comparisons can be made.
How the growth is determined:
With the SF, growth is based on the stocks in the portfolio. With the BF, of course,
the growth is determined by the growth of the bonds in the portfolio. The EIA is tied
to the increases in the S&P 500 (or other indices).
Is the rate guaranteed:
The rate is not guaranteed by the SF, BF of the EIA.
Is there a minimum guarantee:
There is no minimum guarantee by the SF or BF, but this is the strong point of the
EIA.
Is there a loss potential:
Conversely, there is a potential for losses with either the SF or the BF, but not with
the EIA.
Is there, then, the potential for gain:
The SF has the greatest potential for gain of the three, with BF usually having a
modest potential for gain. The potential for gain with the EIA is excellent (not as
good as the SF, but not bad either).
How about access to the money:
An advantage with Mutual Funds, Stocks or Bond funds, is that there is relatively
easy access to the money. Again, depending upon the EIA, access is either poor to
quite good.
Equity (stock) mutual funds very frequently do not perform as well as the S&P 500. According
to a study by Lipper Analytical Services, the percentage of equity mutual funds that have done
worse than the S&P 500 are shown in the following graph.
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Percent of stocks doing worse
than S&P 500
100
90
80
70
60
50
40
30
20
10
0
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
1980
WHAT HAPPENS NOW?
After a blazing four years of great returns in the EIA, the brakes were starting to be applied
in 2000. The problem is that with the volatility of the market, fixed equity products are bringing
in returns that swing from one end of the spectrum to the other. A good agent that can offer any
protection against the swings of the market will be valuable. In many cases this will be the
difference between keeping and losing a customer.
Throughout the short life of the product, the EIA‘s have had many design changes and
features have been added. But regardless, nearly all – about 85-90% - EIA‘s share one important
feature.
Despite all of these changes, one key element of most EIA‘s available, is the annual reset
and lock-in methodology.
Some of the changes have been in the use of ―Caps‖, the advent of the index/margin fees, and
the differing kinds of averaging. As stated elsewhere in this discussion, very recently there have
been swings away from the Standard & Poor‘s 500, and some use the Dow Jones Industrial
Average, the Russell 2000, the NASDAQ 100 and/or different bond indexing. Recently some
EIA‘s offer the customer a choice, and in some cases, asset re-balancing.
To reiterate – every EIA has an indexed starting point (issue date usually) and is the number
from which all gains or losses are measured, as compared to the index value at the end of the
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indexing term. This is the ―foundation‖ from which the interest is credited to the policy, after the
participating rate, crediting method, margin, and/or the ―cap‖ of the policy are applied. The
annual reset feature as the term would indicate, in fact ―resets‖ the index starting point on each
policy anniversary and the ending index value is the index new starting point for the next index
term, as explained previously.
The gains realized on the policy during the reset period are ―locked-in‖ and is added to the
accumulation value. The beauty of this, when applied properly, is that the gains already realized,
cannot be lost, regardless of how the market fluctuates. The importance of this can best be
understood by the following ―Consumer Application.‖
CONSUMER APPLICATION
Bruce is an agent for Lucard Insurance Company, and in discussions with his client, it has
been determined that the client wants the point-to-point crediting method (an index starting
point, and an index ending point). One of the annuities is an annual reset annuity, with an annual
lock-in – referred to as the ―Reset Protector.‖ The other annuity is a point-to-point, long-term
annuity that measures only the beginning and the ending value of the full index term – referred to
as the ―Original Index Protector.‖ Both plans have a 100% participation rate, no cap or
margin/fee, and a product term of 3 years. For comparison purposes, the proposal shows both
plans purchased on the same day, with $100,000 premium with an annual index starting point of
1,000. For illustration purposes, it is assumed that the fund will be credited with 10% growth.
The Reset Protector (RP) (with an annual reset) grows to an index value of 1,100 at the end
of the first year (accumulation value of $110,000).
The Original Index Protector (OIP) doesn‘t recognize any gains at this point, and continues
its merry way, waiting until the end of the 3rd year to credit any gain.
Oh, Oh. Since the market goes down as well as up, assume that the market has gone down
during the second year, and the index has gone down to 900. However, one of the great
advantages of an EIA is that it does not credit negative movement. Therefore, the RP will credit
a gain of 0% at the end of the second year. But, because of the ―lock-in‖, the account value is
unaffected and remains at $110,000. But, the starting point of the new index term will now be
900.
However, on the OIP, since there is no notice taken of the downturn, the customer will have
to wait until the end of the 3rd year to credit a gain.
The assumption is now that for the 3rd year, the index value has climbed back to 1,000. So,
what does this do?
The RP credits a gain of 11%, because the annual reset feature allows the retracing of the
gain from 900 to 1,000. Guess what? This increased the account‘s value by $12,100 because it
credited growth in two years, even though the index level returned to the same level as it was on
the issue date of the policy. Therefore, the client‘s premium has grown to $122,100!
Now, a look at the OIP. After waiting for three years to see what the fluctuations in the
market produces, the index value at the end is the same as in the beginning, i.e. 1,000.
This ―Consumer Application‖ is simplistic perhaps, and may (or may not) reflect ―real life‖,
but regardless, it cannot be ignored. If the professional agent does not point out to the customer
what can arise in a situation such as this, it would be a good bet that another agent would be
doing so. Besides, the average length of the term of an EIA is 7 to 10 years; this can be a long
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time to wait for results.
At the very least, an agent would want to have an EIA with the annual reset and lock-in
feature in his/her portfolio.
WHAT’S OUT THERE? SUMMARY OF PRESENT PRODUCTS
The following summary of EIA products is a 1999 survey. EIA products change rapidly,
which is typical of any new product of this type. The following summary will at least give a
starting point in understanding the plans available.
TYPES OF PREMIUMS
Single Premium 68%
Flexible Premium 32%
METHODS OF INDEXING
Annual Reset 50%
Point-to-point 33%
High Water Mark 16%
Others 1%
FEATURES AS GAUGED BY USE IN CURRENT PRODUCTS
Participation Rate 65%
Margin only 7%
Margin and Participation Rate 3%
Cap with Participation Rate 25%
Participation &/or Margins that can change 33%
Averaging 60%
Vesting 20%
Specified Surrender Charges 85%
Surrender Charges not specified 15%
INTEREST CALCULATION
Compound 85%
Simple 10%
Not applicable 5%
If Free Withdrawal privileges are available, more than half use a percentage of the indexed
value; about 15% use a percentage of premium; around 15% have no privilege for withdrawal
and the remainder have some other sort of calculation.
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RECENT MARKETING COMMENTS ON EIAS
Several publications, including Life Insurance Selling, early in 2001 have articles about the
EIAs from the viewpoint of those who have had success in marketing this relatively new product.
These comments are abbreviated and are presented here for the unquestionable value of the
viewpoint from those who know the product(s) well and have been successful in marketing EIAs
to the general public.
Prime Candidates for EIAs are those who may have 401(k) plans, pensions, or IRA rollovers
and they wish to reinvest their money without risk. Many clients take required minimum
distributions (RMD)from their IRA at age 70 ½. When compared to equities, the EIA takes the
guesswork out of trying to determine the best time to liquidate shares for the RMD. With the
EIA, gains are credited and become a guaranteed part of the contract, and then most companies
automatically send out the RMD.
As interest rates continue to decrease in the early part of 2001, many predict that more and
more producers will seek alternatives to the traditional fixed annuities and CDs. Clients are not
going to be motivated to tie up their money for several years at a 6% (or below) interest rate.
These EIAs will at least give them a good chance for returns that are higher than the traditional
annuities.
Now that the interest rates have begun to decline, EIA‘s appeal is increasing once again.
From the S&P 500 results, it has been noted that 2000 was the first year to show negative figures
in the market since 1994 and the first double-digit loss since 1977. In the past 25 years, there
have been a total of five negative years of growth.
Because so many people buy when the market is high and do not buy when the market is
low, many people have been ―burned‖ by these fluctuations. EIAs eliminate the risk of being
―burned.‖ Most newer EIAs are annual reset/annual lock-in designs, which eliminates the ―bad
time to buy‖ obstacle. Therefore, many large producers are confident that EIAs will affect
annuity sales significantly next year and in the next few years.
In the area of advice to new producers, it has been pointed out that often producers describe
in minute detail how the crediting methodology works. However, they spend very little time
defining what the client‘s general expectations should be. Just having the client understand how
the crediting method works, does not guarantee that his expectations are reasonable. As one
General Agent put it: ―Many producers get so tied up in describing how the watch is built, that
they forget to tell the client what time it is.‖
Many companies are now offering more than one market index, and one company in
particulars now offers a choice of 5 different index accounts: Dow-Jones Industrial Average
(DJIA), NASDAQ 100, the Russell 2000, the S&P Midcap 400, and the S&P 500.
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Nearly all producers questioned or who have written about EIAs firmly believe that the
market being sub-par in 2000, can be a good thing for EIAs. Many investors had year after year
of outstanding returns, and suddenly they realize that, yes, the market can go down also. Many
investors are, or will be, looking for EIAs to capture some of the substantial market gain that
they have achieved over the past few years and protect them from any future market downturn.
The slowing economy has affected EIAs in several ways. First, as interest rates decrease,
participation rates seem to shrink because of smaller option budgets. Second, some consumers
choose to sit on the sidelines during the times of economic unrest. The reality is that now is the
best time to purchase EIAs as many people would benefit from lower starting points for their
indexing calculations. Several of the large producers emphasized that this is a good time because
of the indexing starting point.
There is one ―downside‖ noted by some. The EIA market seems to be in a ―holding pattern‖,
i.e. many brokers have seen margins increase, or caps and participation rates decrease, in as early
as the second year of the product‘s life. This type of activity has angered clients, which then
causes brokers not to offer the product at all. Some feel that this activity will not change because
more carriers are offering products with fewer guarantees in an effort to become competitive in
the first year. And of course, as stated frequently in this text, this product is not, and was never
intended to be or designed for, a one-year product. Those producers who have noted this
―downside‖ are articulate in demanding a simplification of product.
Increased volatility in the market has had an effect on the kind of EIA products that are
popular. For example, market volatility plays to the strength of the EIAs that use an annual reset
crediting method. Continued volatility also may add to the popularity of flexible premium EIA
products as dollar-cost averaging vehicles. If the volatility persists, say some, it may swell EIA
sales as Variable Annuity policyholders whose surrender periods have run out, are attracted by
the EIAs guaranteed minimum interest rates and security of principal.
Companies are taking a long hard look at their agents, and at least one company now requires
that all of their agents marketing EIA products be ―certified‖ which is offered by the company
and which educates the agent not only in EIAs, but also about the business as a whole.
NOW THAT WE KNOW WHAT THEY ARE, HOW ARE THEY USED?
Remember that an EIA is a form of deferred annuity and therefore it is used as a deferred
annuity, i.e., it is generally used for long-term investments and for long–term accumulation of
funds. Therefore, retirement is an example of what the annuity was designed to do. Funds
accumulate on a tax-deferred basis, which is probably one of the most used feature that is sold in
recommending annuities for financial planning.
Further, an annuity has many options available when the annuity is ―annuitized.‖ If the life
income option is chosen, the income cannot be outlived – guaranteed.
The Equity Indexed Annuity has some further features that recommend it for financial
planning. Because the EIA is an (attractive) alternate to other, much riskier, investments, it
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provides an opportunity to ―beat‖ the rate of inflation and to do so without market risk, while
offering a potential for higher market returns. As most investors know, or are made aware of,
over a period of time, investments in equities out-performs the rate of inflation, and have done so
better than fixed-interest investments such as Treasury bills and Bonds.
Until the EIA was introduced, if an investor wanted to offset the effects of inflation on their
personal retirement savings, there was no vehicle or easy way to do so. Some investors refused
to take the market risk at all, and invested only in guaranteed products. Even though there is no
guarantee as to how the market will perform in the future (or even in the next 15 minutes!), the
EIA offers the customer the potential to receive a rate of return that is higher than the rate of
inflation. A survey of mutual fund investors showed that 27 percent of investors in mutual funds
were very cautious about taking any risk and would avoid any investments that might be
construed as ―risky‖ in any sense.
Some investors, super cautious, believe that they will be better off with their Certificates of
Deposits (CDs). Maybe, but probably not. The Federal Deposit Insurance Corp. (FDIC) insures
any bank CD balances of $100,000. Investors have actually experienced losses where they had
CDs for amounts exceeding $100,000. Conversely, losses on annuities have only had one loss,
and those annuitants did not lose their principal, only the expected return for one year.
In addition, annuities almost always carry higher interest earning rates than CDs, and – this is
of utmost importance – because their earnings are tax deferred, they actually earn even more
because with good planning, their marginal tax rate will be less when they annuitize (so they pay
less taxes) than during the accumulation period.
One note of caution when EIA‘s are used for an IRA. The contract period must coincide
with or be earlier than, the date that the annuitant turns age 70 ½, or severe tax penalties will
occur. This pertains to any IRA, regardless of the type of funding.
When discussing an EIA with a customer, as indicated earlier in this text but should be
repeated again for emphasis, an EIA should never be directly compared to a registered security.
(In those instances where the EIA is a registered product, then this would not apply). Any
attempt to promote the EIA as a ―superior‖ product can have negative implications. Presenting a
nonregistered EIA as if it were a security is a violation of the Securities laws. However, as good
as this sounds and as accurate as the statement is, there will be times when a potential customer
who is familiar with mutual funds &/or other investments, will demand some sort of comparison.
Not to provide a comparison under these circumstances could make it appear that the agent is
―hiding something‖, or he/she is simply not well versed in the product.
How to handle, how to handle?? It is recommended by those with experience in this product,
and by companies who are very sensitive to the dividing line between insurance and securities,
that:
Reinforce how the EIA DIFFERS from a security.
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To reiterate: A registered security product participates fully in both market gains and market
losses. The amount of the investment (principal) is not guaranteed and they can be purchased for
either short-term or long-term investing. EIAs, however, are purchased by consumers primarily
for the purpose of accumulating savings for their retirement
A good way to understand how an EIA may be used (there must be thousands of specific
instances) can be summed up in the following Consumer Application:
CONSUMER APPLICATION
Barbara Whitters is single and is now 55 years old and worrying about what she will do at
retirement. She has a good job making about $75,000 a year and she saves about 30% of her
income. Because of her frugality, she now has a portfolio of over $1 million, all of it invested in
several mutual funds – all of them no-load funds. Barbara is smarter than the usual investor, and
when everyone was riding the crest last year, she started thinking that what goes up, must come
down. Therefore, she took about 40% of her portfolio last year, and converted it to cash. About
60% of the portfolio is qualified money.
Barbara wants to retire in 5 years and move to Hawaii. She will continue to save at her usual
rate until retirement, so she is concerned about getting a lifetime income of about $45,000 a year
and she wants to retain her principal at the same time. She agrees that a 3% inflation factor
should be considered in planning. She has no family so typical estate planning does not enter the
picture.
Barbara invests $400,000 into an EIA now. For the growth over the next five years, she
assumes that 8% would be about right and therefore, the resulting principal when she reaches age
60 should provide a lifetime income of $45,000 per year (no period certain). If she used a fixed
annuity, it would require more capital ―up front‖ because it would be necessary to assume a
lower rate of return. Therefore, by using an EIA there is a higher anticipated return so a smaller
investment can be made to accomplish the goals.
Barbara will fund the annuity out of the qualified money. She will also use some of the
liquid cash, and will convert some mutual funds to cash. There still will be more than $200,000
in qualified mutual funds, plus the non-qualified investments for future income and cash needs,
that will still remain.
Barbara is comfortable using mutual funds as she has been investing in them for years with
good results. Therefore, she is also comfortable with the EIAs. The agent can recommend using
two EIA‘s with different crediting methods, even though the returns over the past few years have
been more than adequate to meet the 8% assumption.
The EIAs should also have an indexed payout feature, which can handle the need for her to
increase her income because of inflation. It can also carry a long-term care benefit, which will
pay anywhere from 30% to 60% additional benefit if she required long-term care.
This plan has allocated 40% of her portfolio to an EIA with a guaranteed benefit. The 60%
will be kept in mutual funds, with annual reviews to make sure that the plan is performing so that
she can meet her goals.
Please refer to the last chapter of this text (Pot-pourri) for a discussion of ―Split Annuities‖
which can accomplish similar goals, using only annuities. The Consumer Application shown
above is a practical approach as if a client who has to work for their money has a $1 million in
mutual funds, they evidently have some confidence in them and they would in all likelihood
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protest if all of the funds were to move immediately to another investment vehicle with which
they are unfamiliar.
WHAT DO THE AGENTS THINK ABOUT EIAS?
Various insurance industry publications, as well as releases from insurance companies and
brokers that specialize in EIAs, have discussed the EIA from the marketing viewpoint. Many of
those that have written articles or contributed to surveys, etc., are professional financial planners
so their opinions are well worth reviewing.
THE MARKET
Generally, the EIA is recommended to those who want to improve their return on
investments, compared with a CD, for example. Some people have done well with other
investments and now want to save their gains for retirement and still ―participate‖ in the market
without the attending risk of other investments. Other interested parties are bondholders,
charities with money in other ―safe‖ investments and those with under-performing annuities, or
those with no surrender charges on their annuities.
One financial planner states, ―The only situation in which I do not recommend the EIA is
when they are looking for a fixed income.‖ The usual purchaser is over 50 and has over
$100,000 to invest. One common characteristic of EIA prospects appears to be those persons
who have identified a part (or all) of their investment portfolio that they do not want to expose
their investments to risk, but still wants an alternative to fixed interest investments.
Many financial planners maintain that ―almost everyone‖ is a potential EIA customer. There
is a new category of ―super-wealthy‖ individuals who do not want to lose their money, but still
wants to participate in the market. In other words, those who believe in long-term gain potential
but still want to lock in past gains. Those people, who have identified ―safe money‖ as part of
their savings plan, are ―naturals‖ for EIA‘s.
Perhaps because so many financial planners are registered representatives, several
professionals have stated that the EIA should not be presented as an alternative to investing in
the market itself. They stress that the EIA is ―different money‖ - it fills different needs, and is in
a classification all of its own or risk-based products and solutions. The consumer, who is
uncomfortable with money invested directly in the stock market and in Variable Annuities and
mutual funds, may be very interested in an EIA.
In some fashion or other, many financial planners classify their clients who can benefit from
an EIA, into one of the following categories:
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Those with money or designated savings or insurance plans that they want to protect with
products that are conservative and use guarantees for both the downside and the upside
fluctuations.
Those that have money gained from the stock market over the past 10-12 years, but are
nervous about the long term and want to move some of their money into guaranteed
products.
Investors who don‘t think that the present bull market will continue and want to move
their 401(k) or 403(b) accounts into EIAs.
Baby-boomers, who have 20 years or more to save for retirement, but want to diversify
their plan with a guaranteed alternative. They may not have much faith that there will be
a Social Security ―floor‖ for their retirement income.
THE DREAM PRODUCT
Of course, those who contribute to industry publications will strongly recommend whatever
their particular organization represents. This is natural, especially since this is a relatively new
product and changes are occurring ―even as we speak.‖ As, for example, when the Universal
Life policy was first introduced, producers made untold recommendations and actuaries worked
overtime in order to ―improve‖ the product. It appears that this may be happening to the EIA
product also.
A comment from a producer that was one of the first to market EIA‘s, and market it for one
of the first company‘s to offer this product, realizes that today, many customers prefer an annual
ratchet type with an averaging feature and a 10% penalty-free withdrawal to allow for some
liquidity. Some are still satisfied with the ―old‖ original point-to-point, S&P 500 indexed, with
the income added each year on the anniversary date. These producers feel that this is the
simplest to explain to their customers and ―if it ain‘t broken, don‘t fix it.‖
One company‘s best seller is an annual reset product, with a 10 year guaranteed 125%
participation rate and a 5-year guaranteed 15% annual cap. They have just introduced a new
version that uses a flexible-premium with annual reset and with a 100% participation rate.
(Remember the discussion on giving up one feature in order to get another?)
The cap on returns has not been well received by the producers. Because of the volatility of
the stock market in today‘s financial climate, many producers are concerned about tying the EIA
only to the S&P 500 index. They believe that if the S&P 500 drops for a meaningful (in the eyes
of the consumers) period of time, that will be the death of the EIA.
The top-ranked product in the eyes of many producers is one that offers a true (read 100%)
participation rate, with no caps, and no spreads without requiring annuitization. Some planners
also prefers those ―that offer more than one premium account (by using ‖ sub-accounts‖ – a
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concept that has not been fully accepted by the industry as yet) or multiple cash value strategies
with multiple indices.‖ (Just for fun – guess what industry or discipline this marketing
organization is in? The ―multiple-cash-value strategies‖ and the ―multiple indices‖ give it away
as a member of the Banking industry. They ―want their cake and eat it too‖ – they don‘t want to
pass up the commissions on the insurance-based product, but then they also would like for the
money to come back to their fold in CD‘s or other bank-related products.)
One large company that markets EIA products says they are presently offering five
participation choices on 3 EIA‘s. All are annual reset, and incorporate daily averaging to
determine the annual indexed interest rate. Replying to the requirements of their customers, their
plans have guaranteed participation rates, and guaranteed caps or margins, for the entire index
period, annual recognition and crediting of index interest and full liquidity of the index account
value at the end of the index period (no forced annuitization).
The High Water Mark design is attractive to many producers also, which allows the customer
to lock in the highest S&P‘s index value on each contract anniversary, because historically, the
S&P 500 has declined about every fourth year. The plan also locks in the participation rate and
has income options including some the customer cannot outlive and protection against index
volatility with monthly averaging.
Another insurance company offers a portfolio of three plans. They are all annual reset
designs, with no caps, spreads or vesting formulas. One of the plans has a 10-year design that
has a monthly averaging provision that will return to their customers a better index participation
during bear markets. (Maybe this is the solution to those who are concerned about the S&P 500
dropping…)
Still another insurance company who has designed their products as a result of customers‘
requests, says that their best seller features a nine-year declining surrender period, full account
value upon death, 10% free withdrawals after the first year, 20% nursing home withdrawals, a
critical illness waiver, annuitization after the first year, and an annual switch option that allows
policyholders to move out of indexed-linked returns and into a guaranteed interest rate product at
each policy anniversary. This company also offers a product that is tied to the S&P 500 and to
the Dow Jones Industrial Average (on a 50/50 basis).
One company offers indexing linked to the above two plus the Russell 5000. This plan,
which allows multiple interest crediting strategies, allows them to transfer funds between the
different strategies without incurring taxes or surrender charges.
SUMMARY
It would be relatively safe to assume that the Equity Indexed Annuity will follow the path of
other products and in a few years (or months) there will be a wide variety of plans and options,
including several indexing sources. A lot of the changes in the EIA will depend upon the
movement of the stock market, since indexing is the most unique feature of this plan.
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In the meantime, the EIA is a new product that fills a particular need in the investment
environment. It is sold primarily by those who are not registered representatives or dually
licensed, however many ―experts‖ in EIA‘s see a trend towards dual licensing as it is difficult to
differentiate the EIA from a securities product in the mind of many investors. In any event, it is
a product that deserves to be seriously considered by the financial planner.
STUDY QUESTIONS
1. How are stock dividends treated in an EIA using the S&P 500 Index?
A. They are sold and the money is sent directly to the annuity owner.
B. They are added to the growth of the stock in calculating the index.
C. The reinvesting of dividends are indicated in the stock average only, not the initial
dividend.
D. The EIA will not reflect dividends.
2. The ―Initial Accumulation Term‖ describes
A. the date from which the indexing is calculated for a particular period.
B. the time length of the EIA.
C. the time between the inforce date and when each premium is due.
D. the time it takes the annuitant to earn enough to pay the premium.
3. When Joe buys an EIA and pays $10,000, only $9,000 is invested for him. The $9,000 is
called the
A. discount.
B. participation rate.
C. collar.
D. investment ratio.
4. The limit on the amount of indexed interest that can be applied to an EIA during a certain
period, regardless of how high the indexes may go, is called
A. illegal as it violates securities laws.
B. a ―cap.‖
C. the participation rate.
D. the ―top hat.‖
5. If an annual reset EIA has a minimum amount of indexed interest that will be credited to it in
any one year, then this minimum is called
A. the ―cap.‖
B. the participation rate.
C. the ―floor.‖
D. the ―cellar.‖
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6. A percent of each year‘s account value at the end of each year, is available from the EIA
without penalty. This is called
A. amortizing.
B. indexing.
C. consolidating.
D. vesting.
7. Which of the following investment vehicles has the higher risk?
A. Commodities.
B. Variable Annuities.
C. Government Bonds.
D. Certificate of Deposit.
8. Which of the following types of annuities has the greatest loss potential?
A. Fixed-rate annuity.
B. Variable Annuity.
C. EIA
D. Fixed rate immediate annuity.
9. According to recent surveys, which indexing method is used in most EIAs?
A. Point-to-point
B. High water mark
C. Annual reset
D. Digital Method.
10. In order to reinforce the non-securities status of the EIA product, the agent should
A. reinforce how the EIA differs from a security.
B. compare the results of a Mutual Fund with the returns on an EIA.
C. represent the EIA as a securities product regulated by the SEC.
D. pick a blue-ribbon well-known stock, and indicate the EIA results will be the same.
ANSWERS TO STUDY QUESTIONS
1D 2B 3B 4B 5C 6D 7A 8B 9C 10A
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CHAPTER EIGHT - DISADVANTAGES OF ANNUITIES
The previous chapters focused on the many advantages of both the fixed rate and Variable
Annuities It might seem self-defeating to show the disadvantages of such a time-honored
product, but one must be aware that nothing is perfect – not even annuities. As a matter of fact,
there are three disadvantages listed by financial planners - and according to some, there are even
more than three. However, the three that seem to have validity are:
(1) there are potential IRS penalties and taxes,
(2) potential insurance company penalties, and
(3) the ongoing expenses of Variable Annuities.
IRS PENALTY
No matter what type of annuity you purchase, it is subject to a 10 percent IRS penalty for
withdrawals of growth of income made prior to age 59 ½. No penalty is imposed on one's
principal, i.e. the money put in by the owner is the owner‘s money.
It makes no difference how old the annuitant (or owner) of the contract is, if they die then
there is no penalty. Also, the Section 72 of the IRS Code states that the penalty is waived if the
annuitant (or owner) is disabled. Generally, it must be the death or disability of the annuitant,
not the contract owner or beneficiary, except where the contract is owner-driven, in which case
all IRS penalties will be waived upon death or disability of the owner.
If the contract is annuitized, it will avoid penalty, but such annuitization must be elected by
the contract owner within one year after investing in the annuity. The age of the owner does not
have to be 59 ½, indeed it is irrelevant.
The final way in which the 10 percent IRS penalty can be avoided is the contract owner
being age 59 1/2 or older.
Because of these penalties, annuities are usually recommended for younger people unless it is
part of a retirement plan such as an IRA or pension plan or profit-sharing plan. Of course, there
is always the exception of the person who has sufficient funds so that they would not have to
touch the funds in case of an emergency. Annuities are ideal candidates for the investor who is
near or past age 591/2.
Unless the contract is ―owner-driven‖, the owner can be any age, from newborn to
centenarian. But even with the penalty, it could still make good sense for a young person(s) but
would depend upon how soon the money is withdrawn and the assumed rate of growth.
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CONSUMER APPLICATION
David inherits $10,000 from an uncle, at age 29. He invests it into a Variable Annuity and
the VA performs admirably, giving him an average annual compound rate of return of 15
percent. At 15%, at the end of five years, his investment will more than double and be worth
$20,113. David is married at the end of the five years, and needs some money for a new car and
$10,113 is about right to let him buy the car, using his old car for the down payment. He
discovers that he can have the money but he will have to pay a 10 percent penalty on the $10,113
growth portion of his annuity ($1,011). That would come out of the proceeds that David
receives, so he would get only $9,102.
Now he finds out that he will have to declare this amount on his income tax, and the taxable
amount would include the penalty, so he will have to show income of the full $10,113.
If David were in the 33% bracket, he would have to pay $3,337 in state and federal income
taxes. So when he finally winds his way through the penalty and taxes, his actual proceeds
would be $15,765 (gross profit less penalties, minus taxes on the growth of the fund, plus the
original investment).
Actually, when he got to thinking about it, he still had his original $10,000, he had an
additional $5,765 in his account and he is driving a new SUV.
ORDINARY INCOME TAXES
Inside an annuity, the contract-holder‘s money will grow and compound tax-deferred, not
tax-free. To say it another way, any and all income tax liability can be postponed indefinitely.
The death of one spouse will not trigger income taxes provided that the beneficiary was the
surviving spouse. What happens when the surviving spouse remarries? The survivor can name
themselves as the beneficiary and can name a new partner as the annuitant. When the last spouse
dies, the beneficiary(s) can postpone taxes for up to an additional five years.
Income taxes are always due in the year in which income or growth of the fund is received.
The return of principal is never taxed, regardless of who receives the money. The amount of
taxes on the growth will be based on the tax bracket of the person receiving the funds.
Unfortunately the taxable portion is always considered as ordinary income, and does not qualify
for capital gains treatment.
As is obvious, taxes will have to be paid at some time or other. This may be considered as a
―negative‖ but perhaps it is not all bad. For instance, the owner of the annuity decides when
withdrawals are to be made. Therefore, one would attempt to take out the money when they are
at the lowest income tax bracket, i.e. their income is the lowest. Frequently this is when the
person retires.
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CONSUMER APPLICATION
Bill is a partner in a business with Ned. They sell their business at a nice profit and after
investing in a new business, they each have $1 million to invest as they had no retirement plan at
their previous business. They are both in a 33% tax bracket. They talk it over and decide that
they should be getting around 12% per year on their investment.
Ned invests his entire $1 million in a growth and income mutual fund as his brother-in-law is
a securities dealer. However, since Bill‘s brother-in-law is an insurance agent, to keep peace in
the family he invests it in a Variable Annuity.
Twenty-four years later they retire at age 65 and they compare notes and find that the mutual
fund and the Variable Annuity both have provided a 15 percent pretax rate of return. However,
Bill now has $16 million in his retirement fund with the annuity, and even after paying taxes of
about $5 million, he still has $11 million.
Ned is not a happy camper when he sees what Bill has done. Since Ned paid income taxes
every year for 24 years, he will net approximately $6,829,000. Ned never speaks to his brother-
in-law again.
If, for instance, Bill had withdrawn some of the funds during the ―lean years‖ when their
business suffered for a variety of reasons and Bill‘s income was lower – putting him into a lower
tax bracket, the overall results would have been even more outstanding.
But that isn‘t all the good news for Bill! Since he and Ned were both over age 65 at
retirement and drawing Social Security benefits, and retirement for them both was the original $1
million investment, the Social Security tax (wherein up to 85 percent of their benefits become
taxable) applies if they have an adjusted gross income of at least $32,000 (both married). This
formula to determine the income level includes all sources of income, including interest from tax
free bonds and Social Security payments except it does not include the deferred growth or
income within an annuity.
Now Ned‘s wife won‘t speak to her brother…
PARTIAL WITHDRAWALS CAN RESULT IN HIGH TAXATION
This ―disadvantage‖ can best be explained by an illustration.
Don is 45 years old, and a year ago he invested $100,000 in a Variable Annuity that now is
worth $120,000. This annuity has a surrender penalty that starts at 8% the first year, and 7%
the second year, etc.
Don wants to take the growth, $20,000, out of the annuity. In this example a substantial
portion of the $20,000 will be needed for taxes and penalties. The penalty the second year is
7%, and Don is in the 33% bracket (ignore state taxes for this illustration).
Withdrawal $20,000. Income taxes @ 33% = $6600.
Penalty 2nd year of 7% of principal = $7,000.
Amount that Don will receive ($20,000 minus $6600 minus $700 equals) - $12,700. (36.5%)
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CONSUMER APPLICATION
Bertha owns a Variable Annuity, recently turned 65, and is receiving Social Security. She
does not want to annuitize the VA at this time, but is concerned about taxation of the growth.
Under the Social Security Tax laws, up to 85% of the Social Security Benefits are taxable if
the adjusted gross income is at least $25,000. Bertha owns her house and her car totally, and the
only debt she has is a small credit card bill that she pays every month. She has children who take
care of many of her other financial needs, so her income is kept at $24,000. However, she knows
that any source of income such as interest from tax-free bonds and Social Security can trigger the
85%. But she is glad to know that the formula that determines the income level does not include
the deferred growth or income within an annuity.
CONSUMER APPLICATION
Johnson is 47 years old. A year ago, he invested $100,000 into a Variable Annuity, and that
annuity is now worth $120,000. The Variable Annuity contract includes an 8 percent declining
surrender-rate penalty schedule (which is now 7 percent since the contract is in its second year).
Johnson wants to get a new SUV and needs $20,000 as he does not want to pay interest on an
auto loan, even though the rate is quite low. His son is an accounting student, and suggests that
his father ―do some math‖ to see if he should take the earnings out of his annuity. So Johnson
starts writing on a legal pad, and is amazed at what he discovers:
Withdrawal from the annuity $20,000
Income taxes, at 40 percent (state and federal combined) $8,000
7 percent back-end load or penalty (year two of the contract) $700
10 percent IRS penalty under age 59 1/2 $2,000
Net remainder $9,300
Whoops! Smart son. Johnson finds an auto loan more acceptable.
ANNUITY AGGREGATION RULE
The annuity aggregation rule may sound complicated, but actually it is quite logical. It
applies to multiple (more than one) annuity contracts established after October 21, 1988, issued
by the same company, to the same policyholder and within 12 months of each other.
If two or more contracts were issued by the same insurer to the same contract owner,
distributions from either contract would be combined for income tax purposes. The result could
be that tax liability could be greater than if the second contract had been purchased from another
insurance company.
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CONSUMER APPLICATION
Benton invests $50,000 in an annuity with Acme Insurance in June 1999. Six months later,
he invests another $50,000 in an annuity with Acme Insurance.
The annuities grow at an annual return of 8%, with the combined value of $171,382 at the
end of the 7th contract year. Benton withdraws $85,671 at the end of the 7th contract year. The
total remaining with Acme is $85,671.
Lamar invests $50,000 with Acme Insurance in July 1999. In October, he invests another
$50,000 with Standard Annuity Company. These annuities both grow at an annual return of 8%,
with a value of $85,671 from Acme and $75,671 from Standard. Lamar also withdraws $85,671
at the end of 7 years from Acme Insurance. In effect, there is no more value in the Acme
annuity, but $85,671 in the Standard annuity.
Assuming the same tax rates (1997 for a single person):
For Benton, the taxable amount is $71,382 with taxes due of $17,131.
For Lamar, the taxable amount is $35,671 with taxes due of $6,789.
Therefore, Lamar is in a better financial position at the end of 7 years, as both have a
remaining balance of $85, 671.
But is this the final word. Hardly.
If Benton is to eliminate the remaining balance, there would be no tax liability as the $85,671
is less than the original $100,000 – and is entitled to a loss for tax purposes of $14,309.
If Lamar eliminates the remaining balance (the same amount as Benton), the tax liability of
Benton would be based on a gain of $35,671 – which is the gain of $85,671 minus $50,000.
Lesson to be learned is that the annuity aggregation rule should be of concern only under
particular withdrawal situations.
TAX DEFERRAL AND STEPPED UP BASIS
While most knowledgeable investors understand tax deferral, frequently they are not aware
of the benefit of the stepped up basis. Basically, most assets will receive a ―step-up‖ in tax basis
to the ―fair market value‖ at the time of death. Annuities and other retirement accounts do not
receive this ―step-up‖ in basis. Actually, the tax deferral on the unrealized (and untaxed)
appreciation becomes tax ―forgiveness.‖ But don‘t get too excited – this stepped-up basis takes
place only when the owner of the asset dies through the act of inheritance.
CONSUMER APPLICATION
Eugene buys a lot in an undeveloped shopping center that later is developed. He paid
$100,000 for the lot and now it is worth $900,000. Eugenr dies, and this property passes to his
son, Harold. Harold will receive this property and for tax purposes, the ―stepped-up‖ value will
be $900,000 – even though his father only paid $100,000 for it.
Harold sells the lot for $950,000 soon after he inherited it. He will owe taxes only on the
$50,000 – not on the $850,000 that the lot has actually appreciated since it was purchased by
Eugene.
If Harold had sold the lot for only $875,000, then there would be a loss of $25,000 that can
be used to offset other gains or a small amount of ordinary income each year.
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The bad news is that annuities, retirement accounts and gifts do not qualify for such a step-up
in basis, regardless of how long the account was held by the deceased or the heir or beneficiary.
It is beyond the scope of this text to go into detail, but suffice it to say that there is a big
difference in taxation because of the step-up basis, and that of holding the asset for a comparable
period of time and then selling it. As an example, a $10,000 investment earning a10% annual
compound interest rate for a period of 20 years would indicate that the step-up basis investment
on an after-tax basis, would be approximately 30% more than the same investment using the tax
deferral of an annuity.
STATE PREMIUM TAX
Many states have state premium taxes, which become due if and when the contract is
annuitized and is based on the value at the time it is annuitized. While states vary, it can be as
high as 3.5% of the contract value and the entire tax is deducted before the first distribution is
submitted. Not all states have this tax, so it behooves the professional to know if it applies and
the rate, and notify the clients of this charge, if any.
PENALTIES IMPOSED BY THE INSURER
If the contract owner takes out more than a certain specified amount, expressed as a
percentage, and within a specified number of years since inception of the policy, most insurance
companies will impose an early-withdrawal penalty. The range of years is from zero (no
penalty) to 10, years with fixed annuities usually being four years and Variable Annuities, eight
years. A very few companies impose a penalty that is not applicable when the contract is
annuitized, or death. The penalty schedule is usually published in the sales literature, and with
some plans, is referred to as a ―contingent deferred sales charge‖ (CDSC), ―back-end load‖, or
surrender charge.
This surrender charge has been discussed elsewhere in this text, but to reiterate, the annuitant
can make annual withdrawals of, usually, 10% to 15% per year, after the contract has been in
force for one year. Company policies vary, as some companies will use a dollar amount that is
based on the principal and all accumulated growth up to the time of withdrawal. Also, as a
general practice, the permitted withdrawal amount does not accumulate, i.e. if nothing is
withdrawn during the first two years the contract is in force, then the amount that can be
withdrawn is still the first year amount. Some plans allow withdrawal of accumulated growth
(not principal) at any time without penalties
This penalty kicks in if the withdrawal is in excess of the free withdrawal privilege. The
insurance company penalty occurs if the withdrawal is for an amount in excess of the free
withdrawal privilege.
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CONSUMER APPLICATION
Harley invests $100,000 into an annuity. Harley is aware that he can withdraw a specified
amount each year without penalty, but after the 7th year, there is no penalty.
Harley decides that he wants to buy a used SUV (those expensive SUV‘s!) and needs
$15,000 after having the annuity for 4 years. He has $9,000 of ―free‖ withdrawal but the $6,000
in addition that he would need to buy the car would be subject to a penalty. The annuity penalty
is stated to be 4% (rather typical), so $240 would be subtracted from the request, and Harley
would get a check for $14,760. He then has to come up with an additional $240 to buy the car.
While some annuities have a penalty period of up to 10 years, most have periods that last for
5 to 8 years, and the penalty will decline each year. An example would be a ―6-5-4-3-2-1-0‖
thereafter." Obviously, this means that the first year excess withdrawal would be subject to 6%,
etc., and after 6 years, there is no penalty. Keep in mind that some companies have no penalty at
all. In addition, remember that the penalty applies to only the excess amount.
Most contracts allow penalty avoidance if any of the following situation arises:
(1) death,
(2) disability,
(3) annuitization,
(4) withdrawals limited to those allowed under the free withdrawal privilege, and
(5) waiting until the penalty period lapses.
The insurance industry reports that over 75% of all the people who invest in an annuity
never take out any money
MORTALITY AND EXPENSE FEE
The guaranteed death benefit is a unique feature of an ―investment vehicle‖, and the insurer
collects a mortality fee to offset the cost of this benefit. This fee is intended to cover the cost of
the death benefit, including commission and administrative cost.
The charges or fees for the death benefit will usually range from less than .5% to nearly 2%,
with the most common being 1.25%. Since it is a ―life insurance‖ vehicle, the fee (or premium
for the death benefit) can never be increased and is shown clearly on all Variable Annuity
contracts. For the purchaser of a Variable Annuity, since it is an investment by law, the
prospectus given to all purchasers and which shows the different sub-accounts, their performance
and charges, will show the fee among other charges required to be shown in the prospectus.
There still is no such thing as a free lunch. There would not be a mortality and maintenance
charge if there is no guaranteed death benefit.
ANNUAL CONTRACT MAINTENANCE CHARGE
The prospectus will also show an annual ―contract maintenance charge‖, generally ranging
from nothing to $50 per year. This amount is used to cover the cost to the insurer of maintaining
the contract, i.e. administrative cost of keeping the policy active every year. It is normally
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waived if the annuity is above a certain minimum amount. This charge does not apply to fixed-
rate annuities (there is no ―annual‖, or more frequent, report to the contractholder required).
STUDY QUESTIONS
1. One of the disadvantages of annuity is
A. the rate of return is fixed and EIA annuities are guaranteed.
B. there are no surrender charges made by the insurance company.
C. there are possible IRS penalties and taxes.
D. the interest earned is tax deferred.
2. If the annuity contract is annuitized
A. there will be no early withdrawal penalty.
B. the withdrawal penalty will still remain.
C. the withdrawal will be penalized, unless the amount is spread over 10 years.
D. the invested amount will be returned immediately to the annuitant, the rest to U.S.
3. Inside an annuity, the contract-holder‘s money will grow and compound
A. tax-free.
B. tax-deferred.
C. taxable each contract year.
D. and estimated taxes must be paid quarterly.
4. Joe annuitizes a $50,000 annuity in 1998, but is going to receive his money in 1999, and is
going to be taxed (income tax) on $30,000. When are his taxes due?
A. Each year at the annual anniversary of the contract.
B. 1998
C 1999
D. Quarterly, starting with the quarter in 1998 when he notified the insurer.
5. If the beneficiary of an annuity is the spouse of a deceased annuitant, and the surviving
spouse remarries, naming the new spouse as the annuitant and herself as the beneficiary.
When are the taxes paid?
A. When the original spouse died.
B. When the original beneficiary dies.
C. When the last spouse dies, the beneficiary can postpone paying taxes for 25 years.
D. When the last spouse dies, the beneficiary can postpone paying taxes for up to 5 years.
6. Bob has an annuity worth $55,000 that he has had for 3 years. If he wants to take money out
of the annuity (early withdrawal) in excess of the allowed amount
A. he can do so by law, with no penalties.
B. he will have to pay income taxes on the income plus the penalty.
C. he will have to pay income taxes on the withdrawn amount, less the penalty.
D. he will have to pay both income taxes and capital gains taxes.
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7. If two or more contracts were issued by the same insurer to the same contract owner,
distributions from either contract would be combined for income tax purposes. This is called
the
A. annuity stepped-up basis.
B. tax-deferred rule.
C. annuity aggregation rule.
D. accumulation ratio.
8. The guaranteed death benefit is unique to annuities. Which is true?
A. There will probably be a fee or mortality charge.
B. The premiums for this death benefit are included in the premiums and it is illegal to
charge another premium.
C. There is a fee for this benefit which will increase every year.
D. There is no additional fee as the premiums are taken out of agents commissions.
9. Most assets receive a ―step-up‖ in the tax basis to the ―fair market value‖ at death.
A. Annuities also receive the step-up basis at death of the annuitant.
B. All retirement accounts except 401(k) plans receive the step-up basis.
C. Annuities and other retirement plans do not receive this ―step-up‖ in basis.
D. Annuities are the only asset that does not receive the step-up basis.
10. When John‘s fixed premium annuity annuitizes,
A. there will never be a state tax on an annuity that annuitizes.
B. he will not have to worry about state taxes as that is illegal.
C. all states have premium taxes that become due when the plan annuitizes.
D. many states have premium taxes that become due when the annuity annuitizes.
ANSWERS TO STUDY QUESTIONS
1C 2A 3B 4C 5D 6B 7C 8A 9C 10D
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CHAPTER NINE - THE FINANCIAL STRENGTH OF INSURERS
A typical consumer has no idea as to how to determine if a particular insurance company will
be around to make its financial commitments when it is needed. They may rely upon the
Department of Insurance, but many people do not even know how to contact them. When a
person is purchasing an annuity, usually there is a considerable amount of cash involved that will
be sent to the insurer with the ―promise‖ that certain amounts will be paid, and/or investments
will be made on behalf of the annuity owner. When an investor uses Certificates of Deposit for
investments, there is the government guarantee of liquidity within certain limits, but with an
insurance company a prospective client (or ―investor‖) would be negligent if they did not inquire
as to the financial standing of the insurance company that has received their hard-earned funds.
They are not comfortable knowing that their funds are going to be co-mingled with assets of
other annuity holders. Variable Annuity funds are not co-mingled with the insurer‘s funds, so
owners of Variable Annuities do not have this concern.
A professional will carry information with them from at least one of the rating services
giving the rating of the annuity carriers that he/she represents. This information is available from
most public libraries, and a professional adviser will maintain the necessary information so if
they do not have them at point of sale, then can supply the client with this very necessary
information immediately thereafter. The client (investor) can also make inquiries of the financial
planner, broker, or agent to find out whether he or she is dealing with a full-time, professional
adviser.
The general areas that can be furnished to the investor by rating services are:
1. company rating,
2. claims-paying ability,
3. annual statements, and
4. the investment portfolio.
COMPANY RATING
Perhaps the best known of the rating services is A.M. Best. Most agents have a copy of Best
Agents Guide to Life Insurance Companies. A.M. Best Company reviews the financial status of
thousands of insurers and rates them on their financial strength and operating performance based
on the norms of the life and health insurance industry. The Best Company has been in business
since 1899 and started rating insurers in 1906. In 1934, Best stopped its alphabetical ratings
(A+, A, etc.) and began a rating system based on general descriptions measuring the performance
of each company in the areas of: competency of underwriting, control of expenses, adequacy of
reserves, soundness of investments, and capital sufficiency.
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The ratings for A.M. Best are:
Rating Description
A++ Superior
A+ Superior
A Excellent
A Excellent
B++ Very good
B+ Very good
B Fair
B Fair
C++ Marginal
C+ Marginal
c Weak
D Poor
E Regulatory supervision
F Liquidation
s Rating suspended
In general, a prudent investor should only consider the top four categories, particularly with
fixed-rate contracts. There are no advantages in dealing with a company that has a B++ or lower
rating. Variable Annuities, on the other hand, do not co-mingle their accounts and some
financial advisors believe that lack of solvency or bankruptcy does not affect the value or
integrity of Variable Annuity investments. However, to be realistic, if an insurance company
goes bankrupt, it is possible that the return on variable contracts might be frozen by a purchaser
of the contracts or by the Department of Insurance. In any event, the ―prudent‖ investor would
want to avoid any such eventualities, even though remote.
A client might want to survey the net yield on invested assets of the insurer. There should be
justified suspicion of a company offering a rate equal to or higher than what they are earning on
the money.
In considering any of the rating services, they are usually published on a quarterly (at best)
basis. Things can change rapidly before the next book is published.
STANDARD & POOR'S
Standard & Poor‘s (S&P) has been well known in the financial rating system of insurance
companies for over 25years but it‘s ratings were not made public before 1983. The company's
reputation in the financial guarantee area, however, has enabled S&P to assume a number two
position in the ―rating‘ field.
S&P evaluates the ability of an insurer to meet its obligations based upon and agreement with
the insurer to provide S&P with information necessary to achieve a final rating. All claims-
paying ability ratings are voluntary with the company‘s cooperation. A rating from S&P costs
anywhere from $15,000 to $30,000 per year, depending on the company's size.
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The information received from the company initially covers about six years of operations and
then subdivided into other areas for evaluation. S&P maintains that an essential part of the rating
methodology is the identification of the company's product lines and distribution systems and
determining its strengths and weaknesses and comparing them to the insurance industry as a
whole.
Some of the areas that S&P investigates are:
The compound growth rate of revenue over the past five to six years.
Revenue distribution by business unit, geography, product, and distribution channel.
The company's market share, both overall and for its individual product lines.
Allocation of the company‘s investments.
The interest rate risk of the company's interest-sensitive portfolios and guaranteed
investment contracts.
Company's credit quality.
The company's asset concentration by industry and issuer.
The current portfolio yield.
The total return on the portfolio.
And many other similar questions are also asked and studied.
After all of the information is studied and discussed S&P deletes the confidential material
and publishes the information in: (1) S&P's Insurance Book, a loose-leaf collection of full, in-
depth reports on each rated insurer, complete with charts and graphs, updated throughout the
year as necessary, (2) S&P Insurance Digest, a quarterly publication containing the company's
letter rating and a rationale for the rating, and (3) S&P's Insurer Ratings List, a monthly listing of
insurers and their letter ratings.
If a company objects to the ratings, they always have the right to deny publication of the
rating and choose to remain unrated.
With this rating system, AAA companies may not be the best for investment contracts as
often they have more capital than needed because they pay a conservative rate of return to the
policyholders. Companies rated AA or A may be willing to take more risks (though not drastic
ones) and they usually pay a better rate of return.
MOODY'S
Moody's Investors Service has been evaluating life insurance companies since the 1970s.
Moody‘s introduced financial strength ratings so as to provide guaranteed investment contract
(GIC) investors with objective and independent credit opinions. Moody‘s changed some
formulae in the early 1990‘s to better reflect all of the changes occurring in the insurance
industry.
Insurance companies will pay about $30,000 for the service, but Moody's considers its real
clients as financial intermediaries such as brokers, pension plan sponsors, structured settlement
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advisers, and agents, with attention particularly to insurers in the group pension and individual
annuity business. Their coverage has significantly expanded from initial focus on companies
selling GICs to annuity providers, universal life writers, and providers of other life products.
Consequently, Moody's rates a number of small companies as well as the giants.
Carriers that contract with Moody's can refuse to have a rating published, but only if they do not
become active in the market that Moody's currently covers (group pension and individual
annuities). If the carrier enters the market later on, or Moody's expands to cover the carrier's
market, Moody's can release the rating.
Moody's ratings are opinions of the relative financial strength or weakness of insurance
companies and are intended to summarize its opinion concerning the likelihood that an insurance
company will be able to meet its future obligations to policyholders. Moody‘s considers
financial strength actually as meaning "claims paying ability."
DUFF & PHELPS
The Duff & Phelps (D&P) insurance company rating process, is a relatively newcomer, first
used in 1986. The companies using this service pays $20,000 for the rating, which, similarly to
other rating companies, is derived from information provided by the insurer, then on-site
meetings, and the rating is provided after considerable consultation with experts in financial
matters. The insurer may either publish the rating, or decide not to.
WEISS RESEARCH, INC.
Weiss has publicly stated that a rating system should "flag potential problems in such a way
that the average consumer will be adequately informed in a timely fashion." The company
employs about 50 people, including analysts, programmers and technicians, clerks, and customer
service counselors, nearly all located in Florida.
Weiss is a little different from other rating services, as it is highly ―computerized‖, and uses a
model they developed that uses some 200 ratios derived from 750 pieces of data to determine an
insurer's rating. The data for these calculations come from the statutory reports insurance
companies submit to the state insurance commissioners, plus supplemental data from the
companies. Weiss is also rather unique inasmuch as it does not interview managers of the
insurance companies. Weiss is very statistical driven and believes that good results come from
good management, and if the experience of the company is otherwise, no amount of discussions
with managers will change the outcome.
The companies are requested to review the results of the analysis and the ratings, and to
examine such data and verify it. Historically, some companies do not respond to these requests,
or they object to it (sometimes quite vociferously). New information is added to the analytical
process and is reported in quarterly updates.
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CLAIMS PAYING ABILITY
Moody‘s and S&P are the primary rating systems that rate the claims paying abilities.
Moody's rating system consists of Aaa (highest quality) down to C (lowest quality) Claims
paying ratings are: Aaa, Aal, Aa2, Aa3, Al, A2, Baal, Baa2, Baa3, Bal, Ba2, Ba3, BI, B2, B3,
Caa, Ca, and C. The numerical qualifiers (1,2,3) indicate whether a company is in the higher(1),
middle(2), or lower(3) end of the category.
Standard & Poor's ratings are similar, with categories ranging from AAA to BBB and speculative
grade ratings from BB down to D. The D rating is used only for an insurance company placed
under a court liquidation order.
ANNUAL STATEMENTS
Annual statements are filed by each insurance company with every state in which the insurer
does business. In Schedule F of this statement, the amount of claims paid out and claims resisted
is listed. The lower the net dollars paid out, the more financially sound the insurer.
A professional should also have the ability to review the annual statement (the ―blue book‖
as they are known to Insurance Departments) and determine other information that can be of
value in discussing the financial stability of the insurer to a prospective investor. One does not
have to be an accountant to garner interesting information from the statement. For instance, if
the insurance company is owned by another company, if the Board of Directors contains a well
known public or wealthy figure, the number of states the company operates in, the Capital and
Surplus of the company, etc., are easily found and recognized.
For a person with accounting background, the Statements can be a little confusing, as
insurance accounting is quite different in some areas, than usual business accounting. If there is
ever a question, specific questions will be addressed by accountants or actuaries at the insurance
company. Actually, if the insurer would hesitate in furnishing any requested financial
information; there could easily be a question whether an annuity should be placed with the
company. Agents have been sued when an insurer that they represent, goes ―down the tubes.‖
The presumption by the client is that the agent should have been aware of any financial
difficulties, etc.
INVESTMENT PORTFOLIO
Insurance companies help keep printers and paper companies in business, it seems, and fixed
rate annuity companies are no slouches in this respect. Most, if not all, offer information on their
investment portfolio in brochures and other marketing material. If further information is needed,
a call to the marketing department of the insurer should bring results. Of courses, other sources
could be the Wall Street journal, Barron's, and materials published by A.M. Best, Moody's, and
Standard & Poor's, as well as other financial newsletters and periodicals. When all else fails, one
can always contact state's Department of Insurance.
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It is not unreasonable, at all, for a potential client to ask for a summary of the insurance
company's investment portfolio to see how its assets are distributed. There is no right or wrong
mix of investments, but there are industry norms that have proven sound through good and bad
times, and most insurance companies tend to follow them. For whatever it is worth, the
American Council of Life Insurance (ACLI), reviews the annual financial statements of nearly
every U.S. insurance company and reports the industry portfolio averages. As expected, the
investments of insurers must be conservative, as indicated by the latest statistics: 43 percent
corporate bonds, 22 percent mortgages, 15 percent government securities, 5 percent policy loans,
5 percent stocks, 3 percent real estate, and 7 percent in other asset categories.
A general consensus of investment advisors say that their clients can feel quite confident if
they only do business with the approximately 25 percent of insurers reviewed by A.M. Best that
get the company's A++ or A+ rating, particularly those that have had that rating consistently for
years. A second rating from a company Standard & Poor's, Moody's Investors Service and Duff
& Phelps, can solidify the confidence. Unfortunately, most insurers, while rated by Best, are not
rated by the debt rating agencies. The debt rating companies, unlike Best, rate only those
insurers that pay to be rated; the largest and those most likely to get a high rating have chosen to
do so.
PAST INSOLVENCY’S
In 1991, Executive Life Insurance Company of California was seized by California
regulators due principally to its having nearly 2/3 of its assets in junk bonds while the industry
average is about 6%. Policyholders of interest-sensitive life insurance policies, approximately
170,000 life insurance policies outstanding, with a face value of $38 billion, and the owners of
their 75,000 fixed-rate annuities with a value of $2.5 billion, as a whole, were not complaining,
as the investment in junk bonds allowed a higher return on their portfolio than that experienced
by other companies. However, the insurance industry is closely regulated, and rightfully so, and
the insurance departments (not only of California) were not comfortable.
Earlier, Baldwin-United, an annuity writer failed in 1983. No investor lost any money
because of their collapse, however, annuity owners had their assets frozen during the period of
time that the insurance departments were shopping for a savior (which eventually became
Metropolitan Life primarily). The contract owners got only 7.5 percent on their money, not the
13.6 percent initially promised. So even though no one ―lost‖ any money, many of the annuity
owners were elderly persons who did not need this type of problem late in their life.
STATE GUARANTY LAWS
Life and Health insurance companies (and other insurers also) belong to Guaranty pools, or
at least protected by some sort of guaranty fund, in their state of domicile. Therefore, while an
annuity may not be backed by government funds, as a CD purchased from a bank does, there is
still considerable financial backing if an insurer becomes insolvent. The guarantee as far as the
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individual annuity owner is concerned, depends entirely upon how the insurer becomes
insolvent, residence of the contract owner, type of annuity, and value of the annuity. Guaranty
laws have been established in 46 states for the purpose of protecting policyholders against
insolvency. Generally, there is a limit of $ 100,000 on cash values of life insurance policies and
up to $300,000 on combined benefits from all life insurance policies. The Guaranty funds are
backed by assessments of solvent insurers when an insurer becomes insolvent. Annuity investors
are protected, with overall coverage limits normally being higher. Coverage for annuities is
typically 80% of the annuity‘s contract, or $100,000, whichever is lower. There are multiple
coverages if there are multiple policies issued to the same person. All annuities are covered by
these guaranty laws with the exception of those contracts owned by corporations or partnerships,
what are referred to in the industry as "unallocated annuities." In the case of an insurance
company's death benefit, protection against an insurer's insolvency is covered for up to $250,000
per policy or 80 percent of the death benefit, whichever is less.
JUDGING RATING SERVICES
Basically, there are two types of rating services, those that charge the companies a fee to be
rated and those that do not. Those that do not, Weiss Reports and Standard & Poor's Insurer
Solvency Review, make their money by selling their reports to investors and brokers.
On the other hand, the companies that charge a fee, Standard & Poor's (in certain instances),
Duff & Phelps, Moody's, and A.M. Best, hope that insurers that do not have any kind of rating
will look worse to agents and annuity purchasers than companies that have a low rating.
Many insurers either do not want to pay a rating fee, or they do not see the necessity of
obtaining a rating from more than one service. There is a certain amount of logic in not getting a
second rating, if the first rating is quite high. They can use the high rating to their distinct
advantage in advertising. Even with a high rating, an investor can be misled, because they still
do not know if the company‘s financials are (and if so, how) affected by excellent, good, or bad
investments. The job of a true professional is to help guide these clients with accurate
information so they can make an intelligent decision.
Finally, it must be stated that rating is rather judgmental, and even the largest and oldest of
the rating company‘s do not always agree. It can be said that the Weiss Reports and Standard &
Poor‘s Insurer Solvency Review are targeted toward the average investor rather than the
sophisticated broker or financial adviser. And while they are quite easily understandable, neither
of them are totally complete. Of course, the same thing can be said about A.M. Best. They often
do not agree. A random sampling of an insurer shows that while Weiss shows the company as
falling into one of their weakest categories. A.M. Best lists it as ―insufficient experience.‖
However, S&P and D&P, both give it an AA rating. These type of discrepancies are not unique.
What to do? An insurer does not have to have the top rating to be safe. Most experienced
insurance experts will agree that it is a mistake to rely too heavily on one rating service. Also,
keep in mind that there are only a few banks that carry the top rating (AAA) – however, again,
the banks are backed by the strength of the U.S. government.
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Perhaps the best advice in this matter came from a very successful financial planner who
knows, understands, and likes annuities. He looks at every client as if they were his grandmother
(or grandfather) and he was responsible for them to invest their money so they would not have to
suffer during retirement. Before he represents some insurers that may not be known as well as
the giants, he has been known to go to the home office and personally review their investment
operations. He does not feel that this is ―overkill‖, but is just an action a true professional would
automatically perform.
We can all wish that all of those who market annuities would have the same commitment to
the profession.
STUDY QUESTIONS
1. Which of the following services to a potential investor cannot be furnished by a rating
service?
A. the investment portfolio
B. claims paying ability
C. policy provisions
d. annual statements
2. An A.M. Best rating of B+ means the company is rated as
A. excellent.
B. very good.
C. fair.
D. great.
3. A rating from Standard & Poor‘s
A. is only good for property and casualty companies.
B. is not considered as a major rating service.
C. can cost the company between $15,000 to $30,000 per year.
D. is always disregarded in sales pieces.
4. Companies rated _______ are probably not the best for investment contracts as they have
more capital than needed for their operations and could conceivably be too conservative with
their investments for their clients.
A. A
B. B
C. BBB
D. AAA
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5. Which of the following rating companies considers its ―real‖ clients as financial
intermediaries?
A. A.M. Best
B. Standard & Poor‘s
C. Moody‘s Investor Services
D. Weiss Research
6. Weiss Research, Inc., believes that if the company is managed well,
A. there is no reason to interview the managers.
B. then the managers should be interviewed to anticipate any difficulties.
C. they do not need to be rated.
D. they will automatically be rated A+.
7. The rating services that are the primary companies to evaluate the claims paying ability of an
insurer, are
A. A.M. Best & Standard & Poor‘s.
B. Weiss Research and Moody‘s Investor Services.
C. Moody‘s Investor Services and Standard & Poor‘s.
D. A.M. Best and Moody‘s.
8. Insurance companies invest mostly in
A. mortgages.
B. real estate.
C. corporate bonds.
D. common stocks.
9. The assets of insurance companies in most states are protected by
A. the Federal Deposit Insurance Corporation.
B. the Securities and Exchange Commission.
C. a guaranty fund.
D. State Bonds.
10. Which of the following would be least interested in knowing the rating of an insurer.
A. The purchaser of a fixed premium deferred annuity.
B. The purchaser of a TSA.
C. The purchaser of an EIA.
D. The purchaser of a Variable Annuity.
ANSWERS TO STUDY QUESTIONS
1C 2B 3C 4D 5C 6A 7C 8C 9C 10D
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CHAPTER TEN - POTPOURRI
No, there is no annuity (that we are aware of) that is called the ―Potpourri.‖ This section is
basically a collection of interesting &/or important items in the Annuity field, that could be of
value to the students of annuities.
“TAXLESS” ANNUITIES
The following information is included as an example of ingenuity by Financial Planners and
agents in marketing annuities, and is not to be construed as a recommendation or suggestion for
the annuity and insurance products described.
In a recent issue of Life Insurance Selling, the problems of non-qualified annuities is
discussed, and a unique way to assist those who inherit those annuities with the income taxes
due. If this may seem like a small market, consider that according to a recent Gallup pole, there
are approximately $1 trillion in annuity assets, and further, many estimate that more than 80% of
these assets are to be part of a parent‘s legacy for their children.
Obviously, as annuity owners continue to accumulate assets in their tax deferred annuities,
the tax liabilities are increasing. The typical solution has been to annuitize the annuities in force,
over a five to seven years, into a life insurance contract with income tax-free death benefits.
Even though this would appear to be a good plan, exceptional sales have not occurred, and
possibly because the clients are trying to avoid income taxes – not accelerate them.
Many times agents will present an annuity plan to a retired person. However, as is so typical,
the children become involved and one of their first questions could be how the taxes will be paid
on the money when they inherit the annuities. Of course, the children will still have a good
amount of money that they possibly would not have otherwise, but this can still be a sticky point
with the children. If the retiree does purchase a deferred annuity and thereby avoids current
income taxes, the alternative would be not to leave a tax liability for the children. In this case it
might just be easier to not purchase the annuity.
If the parents want to leave money to their heirs in an annuity, if they are afraid that there
will be overwhelming taxation when the annuity is distributed, or if they want to avoid paying
taxes in today‘s dollars, then the possibility might be an annuity ―that pays it own taxes.‖ This is
a very new innovation, so new that there is a patent pending on a version of this plan!
This idea started by using an annuity with a term rider equal in amount to 28% of the gain in
the contract. The term insurance provides an increasing death benefit, and a plan with guarantee
issue age up to age 90 was used. The cost of the insurance is taxable to the owner of the annuity
each year, thereby making the death benefit income-tax-free.
At this point, the idea should start forming as to how this works, exactly. For an example,
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assume that a 65 year-old purchases an annuity with a premium of $100,000. After the annuity
has been in force for 10 years, the annuity owner dies and passes $200,000 (his original
―investment‖ into the annuity has doubled) to his children. Assuming the children are in the
28% income tax level, they would have to pay $28,000 income tax on $100,000 in the annuity
gain. (No tax on the amount invested originally)
Using the term-rider concept, it would pay the beneficiaries $28,000 income tax-free to offset
the taxes. Therefore, the children inherit the entire $200,000 (instead of $172,000).
To further illustrate this idea, other scenarios can be used. If the client has an annuity paying
6% interest, with no term-rider, the beneficiaries will pay taxes on that 6% at the 28% rate. In
effect, this is netting 4.32%. If the term rider is used, then the beneficiaries would net the full
6%. When the term rider is added to the annuity, not only does the retiree get the benefits of tax
deferral, but the beneficiaries also are collecting the full 6%.
Another scenario might be a client with a large municipal bond portfolio yielding 6%,
(admittedly a high rate in today's market). Since 6% interest is accumulating tax free, one might
ask what benefit is there to purchase a tax-deferred annuity. If the retiree is drawing Social
Security, the municipal bond interest is added back into the tax-payer's tax return for "taxable
Social Security" purposes. So the result would probably still be that they would be better off
using the annuity + term rider program.
In order for this transaction to be ―legal‖, the contract would specify a separate non-annuity
benefit, for which there is a premium deducted for the cost of insurance. The taxpayer pays
taxes on the cost of insurance.
According to IRS private letter rulings, the IRS classifies a rider sold with a deferred annuity
contract, which provides a term life insurance benefit, as a separate life insurance contract within
the meaning of Section 7702. As a result, the IRS private letter ruling (PLR 200022003)
concludes that the proceeds payable under the rider on the death of the insured are excludable by
the beneficiary under Section 101(a)(1) as life insurance proceeds.
Since this is a new concept, they‘re only a few products available at this time, and there are
two separate types. One group is the type of rider as described above. Another type is the rider
that adds an annuity of 28% or 40% bonus.
This second type incurs an additional taxable gain. Using the example above of the $100,000
annuity with $100,000 gain, after the bonus, the beneficiaries would pay tax on $128,000. If the
beneficiaries were in the 28% bracket, they would receive a net of $92,160. While $92,160 is
better than the $72,000 the beneficiaries would have received with no rider, it still is almost
$8,000 less than they could have received from the tax-free term rider.
Regardless of the ―name‖ of these products, they still remain an annuity with a term rider.
Probably there will be efforts to generate greater benefits to the client using term riders. One
suggestion has been accelerated death benefits, which would provide the client with the ability to
receive part of the term insurance in the event of terminal illness or long-term care needs.
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Another idea would make the beneficiary of the annuity/term-rider a charity. The charity
would receive 100% of the annuity value plus the bonus, thereby creating a significant income or
estate tax deduction.
WHAT IS HAPPENING TO ANNUITIES TODAY?
Please note that the following discussion of annuities ―today‖ was created in the latter part of
2000, when the market was flying high, the Dow Jones was over 10,000 and there seemed to be
no ―tomorrow.‖ Since that time, there has been, at the very least, a ―leveling of the stock
market,‖ with a substantial (and warranted according to most financial analysts) slide in the
NASDAQ. However, indications are that the economy still has a good ―head of steam‖, so this
particular discussion should still be timely.
Annuities play an important part in financial planning, and have been an integral part of this
process for many years. Recently there has been a change in the use and marketability of
annuities, driven by the economy, the low interest rates, and the ―bullish‖ stock market. Surveys
have been made by various publications and organizations in respect to what has happened to the
annuity market and the popularity of annuities in financial planning.
If the economy were different, for instance if inflation was 2%, interest rates on ―risk-free‖
investments such as CD‘s were around 8%, and the stock market would go down as much as
going up, then investment choices would be different. In recent years, this would probably
indicate an excellent market for fixed annuities. But today, this is not the case.
One large brokerage firm that specializes in annuities and has been in the market for several
years, in a Life Insurance Selling article they reported their experience in the changing annuity
market. Their experience parallels those of other annuity brokerage firms and is worth
discussing in this context.
In 1992, the annuity brokerage business was nearly totally the traditional fixed deferred
annuities with one year guaranteed interest rates. In the second half of 1999, these types of
annuities had fallen to where they were only about 25% of their total brokerage annuity
premium.
The reason that the number of fixed annuities have decreased is because interest rates have
been going down since about 1982, and that downward interest rates continued from 1992 to
1998, with a sign of some increase in 1999 and early 2000. As interest rates moved down, bond
prices moved up, and insurance companies were induced to sell their bonds so as to realize the
gains and to invest in other obligations as required by regulatory authorities.
Renewal interest rates on one year guaranteed annuity rates were realigned to reflect new
lower bond interest rates. It was customary for annuities to renew at or near the present (current)
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interest rates, which were consistently lower. Annuitants that had a 9% return on their annuities,
found themselves with 5% returns and were not happy. Some agents were quite unhappy also, as
they had expected that the fixed deferred annuities would at least maintain their original base rate
renewal levels. Where customers expected that returns would not drop to these levels, their
agents found themselves losing business and losing ―face‖ among their customers.
One large brokerage firm has gone from nearly 100% fixed deferred annuities less than 10
years ago, to only 25% one-year guaranteed rate annuities, 30% long-term guaranteed annuities,
8% single-premium immediate annuities, and 37% equity indexed annuities.
The ―long-term guarantee‖ annuities feature interest rate guarantees that run from 5 to 10
years, usually with an option to surrender without penalty at the end of the interest-guarantee
period. This changes the design of the fixed annuity to where it is much more palatable. Since
these 5-10 year rate guarantees are often higher than one-year base rate guarantees, this product
is increasing in market share.
The single premium immediate annuities are becoming more popular, for whatever reason.
While there seems to be nothing totally specific about the attractiveness of this product, it is felt
that the general trend towards fully guaranteed annuities is increasing for a variety of reasons.
(This was discussed early in this text)
The Equity Indexed Annuities has been explored in detail in this text, and the brokers are all
excited about this new product and predict a solid place in financial planning.
WHAT’S OUT THERE IN THE S.P.D.A. MARKET
The Single Premium Deferred Annuity (SPDA) could be considered as the ―traditional‖
annuity, or to draw a parallel with life insurance, one might say that Whole Life is the
―traditional policy.‖ It has been around as long as any other type of annuity, and still finds
substantial use in financial planning.
A survey of 64 Single Premium Deferred Annuities was conducted by Tillinghast/Towers,
Perrin and published in Life Insurance Selling, March 2001. Of course, the entire study is too
lengthy to publish, but an agent interested in an annuity offered by a company, or who represents
several companies, can – and should – contact the insurer for more details. Certain items that
would be important to an agent are not included in this study – such as commissions. Obviously,
with a General Agency system, commissions vary by agency, broker, agent, etc., etc.
A brief review of the various questions asked, and the answers given, show a wide range of
requirements, definitions, benefits, etc. It is not within the scope of this text to go into detail as
to specific companies, but a general overall look at this popular plan in today‘s market should be
of interest.
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Number of Products: While most companies offered less than 5 SPDA plans, one company had
19, another 23, and one company had 46!
Individual or Group Trust: 61 were Individual, one was only Group Trust, one was both, and
one stated that it depended upon the state.
States Available: As could be expected, the states where their plans were sold were in keeping
with the states in which their other insurance lines are sold. Of course, there is always New York
where a company, unless they are domiciled in that state, will not offer their usual products.
Qualified or Non-qualified plans: All companies offer both.
Minimum Premium for Qualified Plan: Runs from $500 to $20,000. Most companies use
either$1,000, $2,000, $5,000 or $10,000. Obviously, with this much variance, an agent with a
client who wants to invest under $10,000 must make sure that the company will accept the small
premiums.
Minimum Premium for Non qualified plan: The same as for Qualified plans with most
companies, with half-dozen exceptions.
Maximum Issue Age: Ranges from 85 to 100+, with most in the 85-90 range. Some offer lower
maximum ages if the plan is a qualified plan.
Maximum Annuitization Age: Some have no maximum, some go up to 110, but most are 90-95.
Current initial interest rate for a $20,000 single premium as of 1/1/01: This runs the gamut –
from 5.25% to over 12%. Most are in the high 5%, 6% and up to 7.5%. This is an area to study
well, as there can even be different rates after the first year.
Bonus included in the interest rate? about 50% of the companies include a bonus; most of them
are 1%. There are some that go higher, one company has 6%.
Initial interest rate guaranteed for: While this is usually one year, some are 2,3,5,6 and even 10
years. The 2nd most common guarantee was 5 years.
Minimum interest guarantee: Nearly half (29) use 3%; 13 offer 4%; 9 offer 3.5%; 6 offer 1%; 1
offers 3.25%; 3offer 5%; and the remainder are graded or subject to a formula.
The interest rate paid on both new policies and those issued in the past 5 years, with $20,000
premium, range all over the map. Most of them hover in the 5 to 6% range.
Free Partial Withdrawal, when are they available, and how many per year: This also varies
widely, with no apparent pattern. Several offer up to 10% after 1 year, but others range from
unlimited, to no limit after 6 months, to 30 days after policy date, and anytime prior to
annuitization, etc. This is another important area that a professional would research before
offering a plan to a client.
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May withdrawals be set up on an automatic monthly basis with annuitization? Only 17% of the
companies (11) would not allow this.
Surrender charge: % of account balance or gross premium: Most of the companies base
surrender charge on account balance. Most range around 7-9% the first year, with 0% at 10
years. Again, there are some surprises with a couple of companies going over 10% the first year.
Circumstances under which surrender charge waived: Most all listed death, almost as many
listed annuitization, and a large number (probably growing number) list nursing home &/or
disability.
The results of this study emphasizes that it is really necessary to contact the insurer on each plan
and there are so many choices.
ROTH IRA
Effective January 1, 1998, most people can now fund a Roth IRA. The maximum
contribution in 2002 is $3,000, as in a regular IRA, but a person cannot establish a Roth IRA if
they show an adjusted gross income (AGI) of $110,000 (single) or $160,000 (married). If a
regular IRA is rolled over into a Roth IRA, that money is not subject to the AGI calculation.
Also, all income must be ―earned income‖, i.e. wages, tips, bonuses, commissions, etc.)
There are certain benefits to a Roth IRA, such as:
Earnings grow and compound tax-free (not tax-deferred).
A person does not have to withdraw at age 70 ½ (there are no limits).
Contributions can continue past age 70 – but it must be earned income.
If the Roth IRA is at least 5 years old and the owner is at least 59 ½, the growth and
earnings are TAX-FREE!
There are exceptions to the 5-year and age 59 ½ rule, such as if the owner becomes
disabled or dies, or a one-time maximum withdrawal of $10,000 is allowed.
Withdrawals of the principal are not taxed, even during the early years.
The proceeds of the Roth IRA will pass tax-free to heirs.
Whether a Roth IRA or a traditional IRA is best for the individual, much depends upon
whether the individual can deduct the contributions of an IRA from their income taxes, and
consideration must be made as to tax bracket, how long the money will be allowed to compound,
etc. There really is not an easy answer, but practically it comes down to whether the individual
(&/or spouse) needs the benefits of a traditional IRA each year when the tax forms are filed – in
other words, the $3,000 per person deductible is important now, and if so, then the traditional
IRA will do the job.
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However, if only the growth for later years is important, then the Roth IRA has substantial
advantages. However, the money each year that goes into the Roth IRA is taxed as ordinary
income that year.
CONVERTING AN IRA TO A ROTH IRA
If one is considering rolling over a traditional IRA into a Roth IRA, they will have to pay
income tax on the traditional IRA, but there is no tax penalty. Whether a person should convert
would depend upon several situations:
The individual‘s tax bracket, as the traditional IRA funds will show as ordinary income
during that year. The conversion will definitely add to the AGI for that year, and a rise to
another bracket can many times ensue.
The expected tax bracket when funds are planned to be removed. The lower the
anticipated tax bracket, the less attractive the Roth IRA becomes.
The time frame for the Roth IRA to grow. The longer the time, the more attractive the
Roth IRA becomes.
How fast the funds grow, as the higher the rate, the better the Roth IRA appears.
ROTH VS ANNUITY
The major advantages of an annuity over a Roth IRA are that is that there is no limit as to
how much can be invested into an annuity each year, and there is no maximum amount that can
be invested.
The advantages of a Roth IRA are:
A Roth IRA can provide more investment opportunities, such as allowing investments
into stocks, bonds, Real Estate Trusts, and, yes, even annuities.
There are no taxes when a withdrawal takes place, either by the owner or an heir.
Remember, with an annuity only the principal can be withdrawn tax-free, and
withdrawals of growth is taxed as ordinary income, and not as capital gains.
There is no ―first time home owner‖ tax exemption with an annuity. A Roth IRA has a
maximum of $10,000.
ANNUITY AND A ROTH?
At this point, it might appear that if a prospective client is leaning towards establishing a
Roth IRA, the annuity salesperson should walk away. WHY? A Roth IRA (or a traditional IRA)
is simply a tax vehicle to encourage people to save. Save in what? What is wrong with an
annuity, for heaven‘s sake? If this is the response, go back and read the chapter EIAs.
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If a person wants to be able to have a guarantee of a minimum interest rate on an investment,
greater than that offered by a Bank‘s CD, then the EIA is a great vehicle for a Roth IRA.
The advantages of using any annuity in a traditional IRA or a Roth IRA are outlined in
various sections of this text. Remember that the IRA and the Roth IRA programs are specifically
designed for those who are savings for retirement. And what is a better savings vehicle than an
annuity?
THE RULE OF 72
The Rule of 72 is rather simple and known by many in the investment community. Basically,
it is an easy method of determining when an investment will double in worth, knowing the
interest rate. No calculators, no pencil-and-paper, no ―mathematical brain.‖
Take the rate of return, (whether it is assumed, projected or guaranteed) and divide it into 72!
That is all there is to it.
For instance: A fund invested at 7%, will double in (72 divided by 7) a little over 10 years
(10.285714 years to be exact – but who wants to be that exact). A fund invested at 6% will
double in 12 years (that one is easy). How about 8.75%. Then you might want a calculator,
but the answer is a little over 8 years (8.22+, or one could say, nearly 8 years and 3 months)
But this rule also shows the effects of inflation. For instance, if a 6% average annual rate of
inflation is forecast, then a dollar will only buy 50 cents worth of goods or services at the end of
12 years. To continue, at the end of another 12 years, the same dollar would only buy 25 cents
worth of goods or services. It can be stated otherwise, at the end of 12 years, it would take 2
dollars to buy what one dollar had purchased originally, or 4 dollars at the end of 24 years.
However, inflation comes and goes, and presently is not significant, but this is still an interesting
exercise.
An interesting display of the dangers of procrastination is shown in the following:
117
CONSUMER APPLICATION
Twins Don and Ron each come into $100,000 to invest as the result of their business doing
well. They both feel that they can get 14% per year from now into the distant future.
Don invests his money right away, as he is afraid that he will spend it otherwise.
Ron decides to wait for 5 years and not take out $100,00 in case the business should suffer
during this period of time – he simply cannot believe his good fortune.
At the end of 20 years, Don has nearly $1,600,000, but Ron only has approximately
$800,000. Ron simply cannot believe this as it would be more logical if he had waited for 10
years, then he could possibly have only half as much as Ron.
The arithmetic is that using the Rule of 72 and 14% interest, the money would double in 5.1
years (72 divided by 14 = 5.14 years). This means that there are four ―doubling periods‖ in 20
years (approximately 5.1 goes into 20 four times). Roughly, at the end of 5 years, Don has
$200,000, and Ron has only the original $100,000. At the end of 10 years, Don has $400,000
and Ron has $200,000 – see where this is going?
The big ―jump‖ occurs during the last doubling period. Don would go from about $800,000
to nearly $1,600,000, while Ron goes from approximately $400,000 to nearly $800,000.
What happens if a ―procrastinator‖ tries to catch up? That is very difficult to do.
CONSUMER APPLICATION
John and Joe, twins age 35, both decide upon a retirement program.
John decides to purchase a Variable Annuity each year for 10 years, investing $5,000 each
year.
Joe does not make any investments for 10 years, as he had ―more important‖ things to do
with his money. But when he reaches age 45, he decides enough is enough, and he had better get
serious about his retirement. So he invests $7,500 each year, and continues to make the
investment for 21 years, with a total of investment of $157,500. Since John had only invested
$50,000 total, Joe feels that surely he has more than made up for not investing the first 10 years.
They did no actual comparing of their retirement funds until they decide to retire at age 65.
They discover that they have both made a 12 percent annual compound rate of growth.
John has $1,061,726.
Joe has $682,269.
Joe cannot believe it. He contributed 50% more money each year, and did so for 11 years
more than his brother, but he has only about 68% of the fund!
When Joe discussed this with his accountant, he discovered that he could have paid $7,500
every year for the foreseeable future, and still never caught up with his brother who had only
invested $50,000 and who would not need to put in another cent. (Assuming the continuing 12%
rate of return)
118
PERFORMANCE OF VARIABLE ANNUITIES VS MUTUAL FUNDS
The following graphs represent the comparative performance of various types of Mutual
Funds with Variable Annuities, and covers the time period from the end of 1987 through 1997, in
increments of 3 years, 5 years and 10 years. Unfortunately the significance of these comparisons
has been diminished somewhat by the booming economy from 1997 through 2000, however it is
believed by many economists that the stock market boom was caused in part by the ―dot-com‖
companies and other incidents that is considered as quite outside of the ―norm.‖ Therefore, the
growths over this previous period indicated in these graphs are proportionately viable and future
growths could easily follow the same patterns.
Since Variable Annuities are invested in sub-accounts, the comparison here is apples-to-
apples, as both the Variable Annuity sub-accounts and the mutual funds should continue to show
comparative appreciation, just the amounts (percentages) of growth would have increased but for
both Variable Annuities and mutual funds.
Remember in the early part of this text, the annuity compared to a Certificate of Deposit, at
8% interest and at 33% tax bracket, showed how the net funds can grow. The following graphs
do not take into consideration the tax deferral feature of the annuity, but is just ―raw data.‖
25
20
15 MUTUAL
AGGRESSIVE FUNDS
GROWTH
VARIABLE
10 ANNTY
5
0
3 YRS. 5YRS. 10 YRS.
The numbers on the side of the charts represent percentage (i.e. 25%, 20%, etc.)
This graph shows the funds invested in ―aggressive‖, which are ―riskier‖ but which can produce
higher yields than the more conservative funds. These funds are quite volatile, and are the most
risky. There are over 200 sub-accounts in this category.
119
30
25
20
MUTUAL
FUNDS
15
VARIABLE
GROWTH ANNTY
10 FUNDS
5
0
3 YRS. 5YRS. 10 YRS.
This graph shows the comparison of mutual funds and Variable Annuities in growth funds. Note
that the growth is nearly identical until the 5th year when mutual funds outperform the Variable
Annuities. Growth funds are those expected to grow at or more than the expected overall
market. Growth (appreciation) of the stock is the primary objective. There are more sub-
accounts what would fit this category, than any other category.
18
16
14
12
MUTUAL
10 FUNDS
BALANCED
8 VARIABLE
ANNTY
6
4
2
0
3 YRS. 5YRS. 10 YRS.
This graph shows comparisons of mutual funds and Variable Annuities in balanced funds.
Balanced funds are as the name implies – ―balanced‖ between aggressive and bond funds.
Mutual funds outperform Variable Annuities but again not drastically until the 5th year.
120
16
14
12
10 MUTUAL
FUNDS
8
CORPORATE BONDS VARIABLE
6 ANNTY
4
2
0
3 YRS. 5YRS. 10 YRS.
According to this graph, Corporate Bonds as an investment in a mutual fund did quite well as
compared to a Variable Annuity investment in these bonds. Corporate bond sub-accounts invest
in fixed-income instruments issued by U.S. companies. They are of high quality and there are a
substantial number of corporate bond sub-accounts.
9
8
7
6
MUTUAL
5 FUNDS
4 VARIABLE
ANNTY
3
GOVERNMENT BOND
2
1
0
3 YRS. 5YRS. 10 YRS.
And lastly, the comparisons using Government Bonds as the investment instrument. The
greatest percentage of Government Bonds used in sub-accounts are principally federal agency
issues, such as GNMA and FNMA. The average maturity is 7 to 8 years. There are fewer sub-
accounts in Government Bonds that in the other types of sub-accounts.
121
SPLIT ANNUITY
A ―Split Annuity‖ is not a product, actually it is a technique that can be used with either a
fixed-premium annuity, or a Variable Annuity. It is designed to allow a certain percentage of the
principal and interest to be withdrawn by the contract owner, while the remaining investment
grows (and compounds) and with the prospect of eventually equaling the original investment
amount.
The concept is simple: The contract owner divides the account into two parts. One part is
completely liquidated, and the other part is used strictly for growth. While either a fixed-
premium annuity, or a Variable Annuity can be used, obviously only the fixed-premium contract
can make the guarantee that the original amount will be completely restored within a pre-
determined period of time.
The purpose of the Split Annuity concept is to maximize income and at the same time, keep
wealth intact. It also has a tax advantage. The way that this would work can best be explained in
the following Consumer Application.
CONSUMER APPLICATION
Bradley has freed up $100,000 because of a market transaction. He wants to have a current
income but he also wants to make sure that after a certain period of time, he still has his
$100,000. And, he wants to do this and still have a tax break.
Bradley invests approximately $60,000 into a fixed-premium annuity, which guarantees a 6%
rate of income over the next eight years. He then takes the remaining money (approximately
$40,000) that is immediately annuitized for the same period of time – 8 years. The insurance
company issuing the annuities furnish the exact amount that can be used to accomplish his
purpose.
According to the interest credited by the insurance company, the approximately $60,000 will
be worth $100,000 (exactly) at the end of the 8 year period. During this 8 years, he will receive
approximately $450 per month (again the insurer will calculate the exact amount).
The tax break develops because 82% of the $450 per month is not subject to income taxes
because of the exclusion ratio.
His goals have been accomplished.
As an alternative, Bradley could invest the $40,000 into a variable account that could take
advantage of the returns of 12% - 13% growth of the stocks (over the past 50 years). If he had
invested 8 years ago, with the recent stock market gains, he would have had substantial growth in
his sub-accounts. Just at $12%, it would have grown to over $90,000.
122
THE AFTER-TAX ADVANTAGES OF AN ANNUITY
It goes without saying that a fund will grow faster if the increase in the fund from interest or
appreciation is tax deferred, as opposed to being taxed as ordinary income each year. However
often this is stated and no matter as to how it is stated, the effect is more startling and easier to
remember if it is ―seen.‖
The following charts show what happens when a single $10,000 investment is made into a
tax deferred vehicle such as an annuity, as opposed to the growth rate in an investment with the
same rate of return but subject to current income taxes. These graphs only show Federal income
tax rates (MAX TAX), but if there are state tax rates also, the difference would even be more
―graphic.‖
The following graphs illustrate this effect over period of 5 – 10 –15- and 20 years, at varying
rates of interest. The numbers at the left side of the graphs are dollar amounts. And, of course,
the higher the interest, the wider the difference.
With the present Administration pushing for a reduction in Federal Taxes, and with the Fed
dropping interest rates at this time, these graphs may be obsolete by the time this text is
published, but regardless, these graphs give a visual indication of the differences in growth when
annuities are used.
These graphs are a simple compilation of (1) determining the maximum tax (―MAX TAX‖)
by taking the $10,000 at the indicated interest rate, and then subtracting the tax each year; and
(2) taking the same $10,000 at the same interest rate, but not taking the taxes out each year.
Therefore, the interest will compound on the full amount each year.
One does not need a mathematical background to produce such a chart, and if the situation
arises where the interest rate is not at an even amount (for instance, 6.75%) then such a
comparison chart is easy to assemble.
123
35000
30000
6% Interest
25000
20000 MAX TAX
15000 TAX DEFF
10000
5000
0
5 YEARS 10 YEARS 15 YEARS 20 YEARS
50000
45000
40000 8 % Interest
35000
30000 MAX TAX
25000
20000 DEFF TAX
15000
10000
5000
0
5 10 15 20
YEARS YEARS YEARS YEARS
124
70000
60000
10% Interest
50000
40000 MAX TAX
30000 DEFF TAX
20000
10000
0
5 10 15 20
YEARS YEARS YEARS YEARS
140000
120000
14% Interest
100000
80000 MAX TAX
60000 DEFF TAX
40000
20000
0
5 10 15 20
YEARS YEARS YEARS YEARS
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SAMPLE FIXED ANNUITY FORM
The following is an example of a Joint and Last Survivor Immediate Fixed annuity. This
particular policy form is relatively simple and straightforward and the format is that used by
most of the insurers. This particular form is chosen for use as an example as a Variable product
and the Equity Indexed Annuities are, by their very nature, quite complicated
ANNUITY POLICY FORM
POLICY NUMBER XXXX DATE OF FIRST PAYMENT APRIL 08, 1995
ANNUITANT JOHN H. DOE SEX MALE AGE 65 3/12
JOINT ANNUITANT JANE R. DOE SEX FEMALE AGE 63 4/12
SINGLE PREMIUM $50,000
OWNER: THE JOINT ANNUITANTS
JOINT LIFE ANNUITY: Payments will be made to the annuitants while either is living.
Payments are to begin April 08, 1995. If both annuitants die before the total sum of the annuity is
paid, the difference will be paid to the estate of the second annuitant to die as a benefit at death.
JOINT ANNUITY PAYMENT WHILE BOTH ANNUITANTS ARE LIVING:
$409.08 EACH MONTH
SURVIVOR ANNUITY PAYMENT UPON THE DEATH OF THE FIRST ANNUITANT TO
DIE
$205.04 EACH MONTH
AJAX INSURANCE COMPANY (the ―Company‖) will pay the above periodic payment to the
Annuitants, while both living or one is living, at its Home Office in Podunk, Texas, subject to the
provisions of this Policy. The Date of the First Payment is shown above. The payments will be
payable according to the Annuity Plan shown above.
This Policy is issued in consideration of the application and receipt of the Single Premium by the
Company. This Policy is a legal contract between the Owner and Ajax Insurance Company.
READ YOUR POLICY CAREFULLY.
NOTICE OF 10 DAY RIGHT TO CANCEL POLICY. The Owner may cancel this Policy not
later than ten days after the date it is delivered. The Owner must request in writing that this
Policy be cancelled, and this Policy must be returned to the Company‘s Home Office. The
Owner may also return this Policy along with the written cancellation request to an agency office
of the Company or to the agent through whom this Policy was bought. The Company will refund
the premium paid not later than ten days after receipt of the notice to cancel and this Policy. If
the Owner cancels this Policy, it will be completely void and not obligate the Company in any
way.
(Signed by an Officer of the Company at the Home Office of the Company, on the Date of Issue)
126
(The Second page of the Annuity is a copy of the Application, asking following questions:)
Name, Sex, Date of Birth, Age and Social Security Number of the Annuitant
Name, Sex, Date of Birth, Age and Social Security Number of the Joint Annuitant
Address of Annuitant:
Owner if other than Annuitant: Name, Relationship to Annuitant, Address, Owners Social
Security No.
Send Premium Notices to ( ) Owner ( ) Annuitant If other, give name and address.
Beneficiary: Relationship to Annuitant Date of Birth
Type of annuity: (check one)
Flexible Premium Deferred
Single Premium Deferred
Tax Qualified Non-tax Qualified
Age at Maturity: (not to exceed 70 ½ for tax qualification)
Annuity Certain for ______ years
SINGLE PREMIUM IMMEDIATE ANNUITY
Date of First Annuity Income Payment __________
Premium Mode: Annual Semi-annual Quarterly Monthly Single Premium
Premium Method: Direct Pre-authorized pay Government Allotment Salary Deduct.
Premium Amount: Amount paid with Application $ _____
Amount to be billed on above mode $ _____
Annuity Income Options: (Defaults to 10 year C & L if option is not selected
10 yr C&L Life No Refund Life Installment Refund 20 year C&L
Life Cash Refund Joint & Survivor (______% to Survivor)
Frequency of Annuity Income Payments: Annually Semi-ann. Quarterly Monthly
If intended to be tax-qualified, policy is to be issued as part of the following type of plan:
Pension or Profit Sharing
Tax Sheltered Annuity Plan
I.R.A.
I.R.A. Rollover
Other
Will the Annuity be applied for replace or use cash values of any existing insurance or annuity
policy issued by any company? (yes or no) If ―yes‖ give details.
Each of the undersign declared for themselves, and for all other interested parties, that all of the
answers in this application and any supplements to it are full, complete and true to the best of
their knowledge and belief. They also agree that (1) these answers as written; (i) were given to
induce the Company to issue an Annuity Policy; and (ii) shall form the basis for and become a
part of any Annuity Policy issued on this application; (2) the Company may issue an Annuity
Policy different than that specified in this application; no change in: (i) type of Annuity; (ii)
Premium Mode; (iii) Premium Amount; (iv) Annuity Income Option; or; (v) issue age, will be
effective unless agreed to by the owner in writing; and (3) only an authorized Officer of the
Company has the authority to waive any of the Company rights or requirements or to waive any
of the provisions of (i) this application; or (ii) any Annuity Policy issued on this application.
Signed by the Annuitant and dated. -Witnessed by Soliciting Agent or Owner
127
SECTION 1 NONPARTICIPATING POLICY
This policy is nonparticipating; it does not share in the Company‘s profits or surplus.
SECTION 2 OWNERSHIP
The Owner is named on the Front Page. The Owner may exercise all rights of ownership as long
as the Company continues to make Annuity Payments under this Policy.
The Owner‘s rights are subject to the rights of any assignee of record.
TRANSFER OF OWNERSHIP. If the Owner is other than the Joint Annuitants named on the
Data Page, ownership will pass to the Owner‘s estate upon death.
If the Owner is named on the Data Page as being the Joint Annuitants, then upon the death of the
first annuitant to die, ownership will pass to the surviving annuitant unless otherwise specified.
SECTION 3 GENERAL PROVISIONS
ENTIRE CONTRACT. This Policy and the application, if attached on the date of issue, form
the entire contract.
POWER TO MODIFY. Only the Company‘s President, a Vice President, or Secretary has the
power to:
(1) change the Policy; or
(2) waive any Policy provisions.
Any change in the Policy will be by endorsement signed by one of the above-named officers.
EFFECTIVE DATE. The Policy takes effect on the Date of Issue shown on the Front Page
upon payment of the Singe Premium on or before the Date of Issue.
INCONTESTABILITY. This Policy will be incontestable from its Date of Issue.
MISSTATEMENT OF AGE OR SEX. If age or sex were misstated, any future benefits or
amounts payable will be changed to what the premium would have bought for the correct age
and sex. An adjustment will be made for any prior underpayments or overpayments. Amounts
will be based on the Company‘s rates on the Issue Date. As used in this Policy, ―age‖ means age
last birthday.
ASSIGNMENT. No assignment will bind the Company until recorded at the Home Office. The
Company is not obliged to see that an assignment is valid or sufficient. Any claim by an
assignee is subject to proof of the validity and extent of the assignee‘s interest in the Policy.
CONTRACT SETTLEMENT. All amounts due under this Policy are payable at the Home
Office. The Company may require proof that an Annuitant is living.
128
STUDY QUESTIONS
1. A major concern that a parent has who has large annuities for the benefit of heirs is
A. the company won‘t be around when they money is to be paid.
B. there can be overwhelming taxes when the annuity funds are paid to the children.
C. inflation.
D. scam artists.
2. The ―Taxless Annuity‖ is simply put,
A. an EIA and a deferred fixed annuity.
B. a Variable Annuity.
C. a deferred annuity with a term life rider.
D. a Variable Annuity and a fixed premium deferred annuity.
3. The reason that sales of fixed annuities has decreased over the past few years is
A. interest climbing skyward.
B. annuities have been outlawed in some of the major states.
C. the number of agents marketing annuities, and few companies offering annuities.
D. interest rates have been going down.
4. In trying to determine which IRA is best for a client, much will depend upon
A. whether the individual can deduct the contributions of an IRA from their income taxes.
B. the stability of all of the assets outside of the proposed IRA.
C. the age of the owner of the IRA.
D. the commissions that are paid to the agent.
5. The earnings from a Roth IRA are tax-free if the IRA is at least _____ years old, and the
owner is at least ______ years old.
A. 10 - 70 ½
B. 10 - 59 ½
C. 5 - 59 ½
D. 5 - 70 ½
6. The advantages of a Roth IRA over an annuity, include
A. the fact that there are no taxes when a withdrawal takes place, either by the owner or heir.
B. the conservative requirements as to what a Roth IRA can be invested in.
C. investments in a Roth IRA must only be from certain ―blue-ribbon‖ stocks.
D. guaranteed return on the Roth investment, regardless of investment vehicle.
7. The Rule of 72 is a method to determine
A. what the interest rate is going to be at a future date.
B. when an investment will double in worth.
C. the present value of future investments.
D. the amount of taxes due at annuitizaton.
129
8. A major advantage of an annuity over a Roth IRA is
A. with the annuity there are no income taxes paid upon withdraw.
B. there is no limit as to how much can be invested into an annuity.
C. principal and interest can be withdrawn from the annuity tax-free.
D. interest withdrawn is taxed as capital gains
9. When an investor withdraws funds from an annuity, but leaves enough invested so that it will
eventually equal the original investment amount, this is called
A. a deferred annuity.
B. impossible.
C. a Split Annuity.
D. vesting.
10. A fund will grow faster if the increases in the fund
A. are taxed as ordinary income each year.
B. is tax deferred.
C. are taxed as capital gains each year.
D. are tied to the consumer priced indexed.
ANSWERS TO STUDY QUESTIONS
1B 2C 3D 4A 5C 6A 7B 8B 9C 10B
130
BIBLIOGRAPHY
BOOKS, REFERENCE AND TEXT
The Handbook of Estate Planning
Robert Esperti & Renno Peterson
McGraw Hill Book Co., NY
Principles of Insurance Production
Peter Kasicky, et al
Insurance Institute of America, 1986
Black‘s Law Dictionary
West Publishing Company
Annuities
Continuing Education Insurance School
Private Printing 1998
Life, Health and Contracts
Noble Continuing Education
Private Printing 1996
Dictionary of Insurance Terms
Harvey W. Rubin, Ph.D., CLU, CPCU
Barron‘s Educational Series, 1995
Financial and Estate Planning with Life Insurance Products
James C. Munch, Jr.
Little Brown & Co. 1990
Legal Aspects of Life Insurance
Edward Graves and Dan McGill
American College 1997
Life Insurance
Kenneth Black & Harold Skipper
Prentice Hall 1993
Getting Started in Annuities
Gordon K. Williamson
John Wiley & Sons 1999
131
Ernst & Young‘s Personal Financial Planning Guide
Robert Garner, Robert Coplan, Martin Nissenbaum, Barbara Raasch, Charles
Ratner
John Wiley & Sons, Inc. 1999
Financial Planning Process Course
Pictorial Publications
Pictorial 1997
Equity Indexed Annuities
Thomas F Streiff, CFP, CLU, ChFC, CFS, Chythia DiBiase, CFS
Dearborn Financial Publishing 1999
PERIODICALS, NEWSPAPERS AND MAGAZINES
Life Insurance Selling
Oct., Nov., 1998; Jan., Feb., April., Sept., Oct., 1999, Jan, Feb, 2000, March 2001, April
2001
Health Insurance Underwriters
Publications of 1997, 1998, 1999 and 2000.
National Underwriter
April, May 1998, Feb, April, June, Oct., 1999, Feb. 2000
Specializing in Section 401(k) Plans Can Pay Off
Jeff Van Strien, ChFC, CMFC, CRPS
Life Insurance Selling Jan. 2000
Sell Case Management Benefits
Brian D. Hayes, CEBS
Life Insurance Selling Nov. 1999
Enhanced Immediate Annuities
Shawn McConnell
Life Insurance Selling Nov. 1999
An Agent‘s Guide to Variable Annuities
Life Insurance Selling Nov. 1999
EIA‘s: How to Get The Best Deal
Ronald K. Wright, CLU
Life Insurance Selling Feb 2000
132
How To Perform Due Care
Richard M. Weber, CLU
Life Insurance Selling Feb 2000
Reaching Deeper into the EIA Market
David O‘Neill
Life Insurance Selling April 2000
Young Seniors Need a SIMPLE Retirement Guide
Wayne Gardner RHU, CLU, ChFC
Life Insurance Selling May 2000
Universal Life Fits Five Stages of Economic Life
Roger Loewenheim, CLU
Life Insurance Selling May 2000
Explaining Annuities to Prospects
Susan M Miller
Life Insurance Selling, May 2000
An Agent‘s Guide to Single Premium Deferred Annuities 2000
Life Insurance Selling March 2000
Learning the rules of the Roth, and non-Roth, IRA‘s
Helen Huntley
Tampa Tribune Feb 20, 2000
Annuities and Life Insurance: The Pillars of Security
Richard Dobson Jr.
Life Insurance Selling March 2000
EIAs: Balancing Risk & Reward
Allison Woodworth
Life Insurance Selling April 2001
The Annuity That Pays Its Own Taxes
Kathran J. Martin & Jack L. Martin
Life Insurance Selling March 2001
The Evolution Of The Variable Annuity
Geri Rhoades & David VerMuelen
Life Insurance Selling March 2001
A Producers Guide to Single-Premium Deferred Annuities - 2001
Life Insurance Selling March 2001
133
Answering the Bells & Whistles,
Thomas Oliphant & Scott Dunn, CLU,
Life Insurance Selling March 2000.
INTERNET ARTICLES
401 (k) – Single Premium Life Insurance
http://wwww-e.analytics.com/fp17.htm
Variable & Fixed Annuities
http://www.e-analytics.com/fp30.htm
Keogh Plans
http://www.e-analytics.com/fp33.htm
Tax Treatment of Variable Annuities
http://www.variableannuityonline.com/free/vatal.cfm
Estate Planning, MFS Fund Distributors. mfs.com 8/14/99
Changes in Federal Gift & Estate Tax. wmop@mindspring.com
Several excellent articles from Recer Estate Services. Recer.com
Roth IRA. rothirainc.com
How the Stock market Affect Annuities
insure.com/life/annuity/stock market.html
Variable Life
variableannuityonline.com/vlife/vlwhat.cfm
Financial Planning – GE Center for Financial Learning
financiallearning,com/financial_life_events/building_basics.html
Insure.com‘s Retirement Roundtable
insure.com/life/roundtable99/index.html
Morningstar Fund Selector
screen.morningstar.com/FundResults.html
Equity-indexed Annuities, The best thing since sliced bread?
insure.com/life/annuity/eiamain.html
134
How Much Money Will You Need When You Retire
e-analytics.com
Roth Conversion IRA Retirement Plan
roth-ira-conversion.com/
401(k) and 403(b) Retirement Plans
financialplan.about.com/finance/financialplan/msub401k.htm
OTHER REFERENCES
Sources
Variable Annuity Research and Data Service (VARDS) Total Reference, Third Quarter 1999
Sales & Asset; Morningstar Variable Annuity Performance Report, December 1999.
VARDS Profilers, Third Quarter1999
VARDS Total Reference, December 31, 1999
Monthly Performance; Morningstar Variable Annuity Performance Report, January 2000.
135