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					                            California 8 Hour Annuity Course
                                      TABLE OF CONTENTS
CHAPTER ONE - WHAT ARE ANNUITIES .............................................................................. 1
   THE ORIGINAL “ANNUITY” - TONTINES ....................................................................... 1
   EARLY LIFE INSURERS ISSUING ANNUITIES .............................................................. 1
   MARKET OVERVIEW ......................................................................................................... 3
 CAST OF CHARACTERS:........................................................................................................ 6
   OWNERSHIP OF AN ANNUITY ......................................................................................... 6
   THE ANNUITANT ................................................................................................................ 6
   AGE OF ANNUITANT .......................................................................................................... 7
   THE BENEFICIARY ............................................................................................................. 7
   MULTIPLE TITLES .............................................................................................................. 8
   HOW THE CONTRACT IS "DRIVEN" ................................................................................ 8
   WHEN DO BENEFITS BEGIN? ........................................................................................... 8
   IMMEDIATE ANNUITY –START PAYING NOW ............................................................ 8
   DEFERRED ANNUITY-START PAYING LATER ............................................................. 8
   HOW ARE ANNUITIES PURCHASED? ............................................................................. 9
     MARKETING..................................................................................................................... 9
     A TYPICAL ANNUITY OWNER ..................................................................................... 9
     PREMIUM PAYMENTS ................................................................................................... 9
   COLLECTING PREMIUMS IN ADVANCE ...................................................................... 10
     HOW ARE ANNUITY PREMIUMS PAID? ................................................................... 10
   MAXIMUM PREMIUM ALLOWED TO BE COLLECTED ............................................. 11
   HOW LONG WILL BENEFIT PAYMENTS CONTINUE? ............................................... 11
     ANNUITY CERTAIN (PERIOD CERTAIN).................................................................. 11
     LIFE ANNUITIES (STRAIGHT LIFE ANNUITIES)..................................................... 12
     LIFE INCOME WITH PERIOD CERTAIN .................................................................... 12
     LIFE INCOME WITH REFUND ANNUITY .................................................................. 12
     TEMPORARY LIFE ANNUITY ..................................................................................... 13
   JOINT AND SURVIVOR ANNUITIES .............................................................................. 13
   C0MPOUNDING (RULE OF 72) ........................................................................................ 13
   DOUBLING POWER ........................................................................................................... 13
   COMPARISON OF ANNUITY vs CD NET RETURNS .................................................... 14
   TAX DEFERRAL IN THE SALES PROCESS ................................................................... 14
     TAX DEFERRAL VS LACK OF STEPPED-UP BASIS AT DEATH ........................... 15
 WITHDRAWAL OPTIONS ..................................................................................................... 15
 ANNUITIZATION ................................................................................................................... 16
   MORTALITY & ANNUITY TABLES................................................................................ 16
   APPLICATION OF MORTALITY TABLES IN RATE MAKING ................................... 18
     ANNUITY RESERVES ................................................................................................... 19
     DEFERRED ANNUITY RESERVES.............................................................................. 19
   RESERVING ........................................................................................................................ 20
     RESERVES FOR INDIVIDUAL DEFERRED ANNUITIES ......................................... 20
   REGULATIONS REGARDING FUNDING AGREEMENTS ........................................... 20


                                                                   i
   MINIMUM GUARANTEED INTEREST RATES ............................................................. 21
     THE EFFECT OF LOW INTEREST RATES.................................................................. 22
   ANNUITY NONFORFEITURE VALUES .......................................................................... 22
   RECORD CONTRACT DISCLOSURE .............................................................................. 24
   THE POSITION OF THE SEC ON FIXED ANNUITIES .................................................. 25
   STATE SECURITIES REGULATIONS OF ANNUITY CONTRACTS ........................... 26
CHAPTER TWO - HOW ANNUITIES ARE USED................................................................... 28
 SOME BASIC CONSIDERATIONS ....................................................................................... 28
   ISSUE AGES ........................................................................................................................ 28
   LONG-TERM INVESTMENT STRATEGIES ................................................................... 29
   INTEREST RATE STRATEGIES ....................................................................................... 29
   SURRENDER CHARGES ................................................................................................... 30
   QUALIFIED AND NON QUALIFIED ANNUITIES ......................................................... 33
   INDIVIDUAL RETIREMENT ACCOUNT (IRA) ANNUITIES ....................................... 34
     ELIGIBILITY AND MAXIMUM CONTRIBUTION ..................................................... 34
   IS IT DEDUCTIBLE? .......................................................................................................... 34
   SIMPLIFIED EMPLOYEE PENSION PLANS (SEP) ........................................................ 35
   DEEMED IRA ...................................................................................................................... 36
 ROTH IRA ................................................................................................................................ 36
   CONVERTING AN IRA TO A ROTH IRA ........................................................................ 37
   ROTH vs ANNUITY ............................................................................................................ 37
   ANNUITY AND A ROTH? ................................................................................................. 37
 NON QUALIFIED INDIVIDUAL ANNUITIES .................................................................... 38
 SPLIT ANNUITY ..................................................................................................................... 38
   ANNUITIES FOR SENIOR AGE GROUPS ....................................................................... 39
 FUNDING RETIREMENT WITH THE USE OF RESIDENCE & ANNUITY ..................... 39
   REVIEWING ANNUITY CONTRACTS ............................................................................ 40
   SINGLE PREMIUM DEFERRED ANNUITIES ................................................................. 41
   VARIABLE ANNUITIES .................................................................................................... 42
   EQUITY INDEX ANNUITIES ............................................................................................ 43
 SALES PRACTICES ................................................................................................................ 44
   ADVERTISING .................................................................................................................... 44
     SEMINARS, CLASSES, INFORMATIONAL MEETINGS ........................................... 45
   ADVERTISING TO THE SENIOR MARKET ................................................................... 45
   PENALTIES FOR VIOLATION OF THE REGULATIONS ............................................. 46
   EXEMPTIONS FROM ADVERTISING REGULATIONS ................................................ 46
   CAUSE FOR LICENSE SUSPENSION AND/OR REVOCATION ................................... 48
   LOANS ................................................................................................................................. 48
   AGENT BENEFICIARIES .................................................................................................. 48
   AGENT TRUSTEE .............................................................................................................. 48
   AGENT HOLDING POWER OF ATTORNEY .................................................................. 49
   PENALTIES FOR VIOLATION CIC ARTICLE 6.3 (SENIORS)...................................... 49
CHAPTER THREE - GROUP/BUSINESS-OWNED ANNUITIES ........................................... 51
 INSURED PENSION CONTRACTS....................................................................................... 51
 KEOGH PLANS ....................................................................................................................... 52
 DEFINED BENEFIT PLAN..................................................................................................... 52



                                                                     ii
   DEFINED CONTRIBUTION PLAN ................................................................................... 53
 CORPORATE PENSION AND PROFIT SHARING PLANS ................................................ 53
   GROUP DEFERRED ANNUITY ........................................................................................ 53
 SINGLE-PREMIUM ANNUITY CONTRACTS .................................................................... 53
   LEVEL-PREMIUM ANNUITY CONTRACTS .................................................................. 54
 SINGLE-PREMIUM DEFERRED ANNUITIES .................................................................... 54
   GROUP DEPOSIT ADMINISTRATION CONTRACT ..................................................... 55
 IMMEDIATE PARTICIPATION GUARANTEE CONTRACTS .......................................... 56
 401(K) PLANS ......................................................................................................................... 56
CHAPTER FOUR - TAXATION OF ANNUITIES .................................................................... 59
   DEDUCTIBILITY OF PREMIUM PAYMENTS................................................................ 59
   CURRENT INCOME TAXATION ..................................................................................... 59
   STATE PREMIUM TAXES................................................................................................. 59
   TAX DEFERRAL OF INTEREST ACCUMULATIONS ................................................... 60
   DISTRIBUTIONS OF QUALIFIED PLANS ...................................................................... 60
     INSTALLMENT PAYMENTS OF QUALIFIED PLAN DISTRIBUTIONS ................. 61
       REQUIREMENTS FOR LUMP SUM DISTRIBUTIONS .......................................... 61
   TAXATION OF PARTIAL WITHDRAWAL ..................................................................... 62
   CASH VALUE ACCRUAL ................................................................................................. 62
       CONTRACTS ISSUED 01/01/04 AND PRIOR TO 01/01/06 .................................... 62
       CONTRACTS ISSUED AFTER 01/01/04 ................................................................... 63
 AGGREGATION RULE .......................................................................................................... 64
   TAX RELIEF ACT 1986 ...................................................................................................... 65
 ROLLOVERS (1035 EXCHANGES) ...................................................................................... 65
   INCOME TAX AND THE INTEREST-OUT-FIRST RULE .............................................. 66
   WITHDRAWALS, LOANS AND SURRENDERS ............................................................ 66
 PENALTY TAX ....................................................................................................................... 66
   LOANS ................................................................................................................................. 67
   ANNUITY LIQUIDATION PAYMENTS........................................................................... 67
 EXCLUSION RATIO ............................................................................................................... 67
 TAXATION OF DEATH BENEFITS...................................................................................... 68
   DEATH PRIOR TO LIQUIDATION PHASE ..................................................................... 68
 DEATH BENEFIT UNDER A NONQUALIFIED ANNUITY ............................................... 69
   IRS REQUIREMENTS FOR DEATH BENEFITS ............................................................. 69
   TAX-RELIEF ON INHERITED ANNUITY ....................................................................... 70
   FEDERAL ESTATE TAXES ............................................................................................... 72
   STEP-UP BASIS – 1997 TAX CHANGES ......................................................................... 72
 GIFT TAX ................................................................................................................................ 73
   TRANSFER OF OWNERSHIP OF NQ-ANNUITY AT DEATH OF OWNER................. 73
   ANNUITY INCLUDED IN DECEASED OWNER’S ESTATE FOR FEDERAL TAX .... 74
   MORE ABOUT TAXES ...................................................................................................... 74
CHAPTER FIVE - TAX SHELTERED ANNUITIES................................................................. 76
 TAXATION OF TSA’s ............................................................................................................ 77
 CONTRIBUTIONS (ACCUMULATION PERIOD) ............................................................... 77
 DISTRIBUTION....................................................................................................................... 77
 FUNDING................................................................................................................................. 78



                                                                     iii
   OPTIONS UPON RETIREMENT ....................................................................................... 78
 LOANS ..................................................................................................................................... 79
 DEATH BENEFITS TSA CONTRACTS ................................................................................ 80
 INSURER EXPENSES ............................................................................................................. 80
     EXCLUSION RATIO AS IT PERTAINS TO DEATH BENEFITS ............................... 80
CHAPTER SIX - VARIABLE ANNUITIES ............................................................................... 83
   DOLLAR COST AVERAGING .......................................................................................... 83
     Parameters ......................................................................................................................... 83
     Return ................................................................................................................................ 84
     Criticism............................................................................................................................ 84
     Confusion .......................................................................................................................... 84
   PRIMARY BENEFITS OF VARIABLE ANNUITIES ....................................................... 85
 THE SEPARATE ACCOUNT THAT VARIES ...................................................................... 85
 SECURITIES AND INSURANCE REGULATION................................................................ 85
 THE VALUE OF THE FUND: ACCUMULATION UNITS ................................................. 86
 LOADING AND OTHER CHARGES..................................................................................... 87
 IMMEDIATE VARIABLE ANNUITIES ................................................................................ 88
   VARIABLE ANNUITIES EXCLUSION RATIO ............................................................... 88
   COMPANY MANAGED VS. SELF DIRECTED ACCOUNTS ........................................ 89
   OPTIONS AVAILABLE AT DEATH ................................................................................. 89
     RATCHETED OR STEP-UP DEATH BENEFIT ........................................................... 89
     DEATH BENEFIT ADJUSTMENT ................................................................................ 90
     ANNUALLY INCREASING DEATH BENEFIT ........................................................... 90
 FIXED AND VARIABLE PAYOUTS .................................................................................... 90
 FIXED PAYMENTS ................................................................................................................ 90
 VARIABLE PAYMENTS ........................................................................................................ 91
   VARIABLE ANNUITY UNITS AT LIQUIDATION ......................................................... 91
   HOW MUCH RISK? ............................................................................................................ 92
   EARNINGS, GUARANTEED OR NOT ............................................................................. 92
 LIQUIDITY .............................................................................................................................. 92
 DETERMINING THE RIGHT PRODUCT ............................................................................. 93
   EXTRA-CREDIT ANNUITIES ........................................................................................... 93
   SPECIAL DISCLOSURE OBLIGATIONS WITH BONUS PROGRAMS ........................ 95
   DIRECT-MARKETED ANNUITIES .................................................................................. 95
   LIVING BENEFITS ............................................................................................................. 96
     IMPORTANCE OF THE DEATH BENEFIT .................................................................. 96
     COST OF LIVING/DEATH BENEFITS ......................................................................... 97
 TAXATION OF VARIABLE ANNUITIES ............................................................................ 97
     INCOME FROM VARIABLE ANNUITY TAXED AT ORDINARY INCOME RATES
     ........................................................................................................................................... 97
   USING A VARIABLE ANNUITY FOR ESTATE & FINANCIAL PLANNING ............. 98
   SEC REGULATION OF UNDERLYING FUNDS ............................................................. 99
CHAPTER SEVEN - EQUITY INDEXED ANNUITIES ......................................................... 102
 BACKGROUND .................................................................................................................... 102
 WHAT IS AN EIA? ................................................................................................................ 102
   THE ORIGINATION OF THE EIA ................................................................................... 103



                                                                        iv
 PURPOSE OF INDEXING?................................................................................................... 104
   “TRUST ME” ..................................................................................................................... 105
   METHODS OF MARKETING EIAS ................................................................................ 105
 EXEMPTION FROM SEC REGULATIONS ........................................................................ 106
   MARKETING RESTRICTIONS ON EIAS ....................................................................... 107
 PROVISIONS OF EQUITY INDEXED ANNUITIES .......................................................... 107
 CALCULATION OF YIELD ................................................................................................. 108
   HOW THE INTEREST RATE IS DETERMINED ........................................................... 109
   THE SIMPLE POINT-TO-POINT INDEXING METHOD .............................................. 109
   THE HIGH WATER MARK INDEXING METHOD ....................................................... 110
   THE RATCHETING (ANNUAL RESET) INDEXING METHOD .................................. 110
   END POINT OR LOW WATER MARK INDEXING METHOD .................................... 111
   THE LIGHT SWITCH (DIGITAL) INDEXING METHOD ............................................. 111
   THE MULTI-YEAR RESET INDEXING METHOD ....................................................... 112
   AVERAGING ..................................................................................................................... 112
CHAPTER EIGHT – FUNCTIONS AND USES OF EIA’S ..................................................... 115
   DIVIDENDS ....................................................................................................................... 115
   GUARANTEED RATE – THE SAFETY CUSHION ....................................................... 115
   LENGTH OF THE CONTRACT ....................................................................................... 115
   INTEREST PARTICIPATION .......................................................................................... 116
   RESTRICTING INCOME BY USING “CAPS” ............................................................... 117
   CONVERSELY, THE FLOOR .......................................................................................... 118
   EARLY OUT – VESTING AND SURRENDER .............................................................. 118
     ASSET FEES .................................................................................................................. 119
   COMPARISONS WITH OTHER ANNUITIES OR MUTUAL FUNDS ......................... 119
     ANNUITIES ................................................................................................................... 119
     MUTUAL FUNDS ......................................................................................................... 120
 THE BENEFITS OF USING EIAS ........................................................................................ 122
 SPLIT ANNUITY ................................................................................................................... 124
CHAPTER NINE - DISADVANTAGES OF ANNUITIES ...................................................... 127
 IRS PENALTY ....................................................................................................................... 127
   ORDINARY INCOME TAXES ......................................................................................... 128
     PARTIAL WITHDRAWALS CAN RESULT IN HIGH TAXATION ......................... 129
   ANNUITY AGGREGATION RULE ................................................................................. 130
     TAX DEFERRAL AND STEPPED UP BASIS ............................................................. 131
     STATE PREMIUM TAX ............................................................................................... 132
     PENALTIES IMPOSED BY THE INSURER ............................................................... 132
   MORTALITY AND EXPENSE FEE ................................................................................. 133
     ANNUAL CONTRACT MAINTENANCE CHARGE ................................................. 133
   COMPARISON WITH OTHER INVESTMENTS ............................................................ 133
 SUMMARY -ADVANTAGES AND DISADVANTAGES OF ANNUITIES ..................... 136
   ANNUITIES-ANNUITIES IN GENERAL ........................................................................ 136
   Variable Annuities .............................................................................................................. 137
     Pros of Variable Annuities .............................................................................................. 137
     Cons of Variable Annuities ............................................................................................. 137
   Pros and Cons of Equity Index Annuities ........................................................................... 138



                                                                   v
        Benefits ....................................................................................................................... 138
        Disadvantages ............................................................................................................. 138
   Pros and Cons of Immediate Annuities .............................................................................. 139
   Pros and Cons of Fixed Annuities ...................................................................................... 140
 RECENT COMPARISONS OF ANNUITIES AND OTHER INVESTMENTS .................. 140
   STRUCTURED SETTLEMENT ANNUITIES ................................................................. 142
CHAPTER TEN – PROVIDING ANNUITIES TO THE SENIOR MARKET ......................... 144
   DEFINITION OF SENIOR/ELDERLY ............................................................................. 144
   HISTORY OF THE SENIOR MARKET ........................................................................... 147
 SPECIAL SENIOR DIFFICULTIES ..................................................................................... 148
     CONTRACT RECISSION ............................................................................................. 148
   FINANCIAL CONCERNS OF THE ELDERLY .............................................................. 148
   SHORT-TERM MEMORY LOSS INDICATORS ............................................................ 149
   CLIENT SUITABILITY .................................................................................................... 150
   HEALTH CONCERNS OF THE SENIORS ...................................................................... 151
     Health Insurance ............................................................................................................. 151
   Long Term Care Insurance ................................................................................................. 152
   LONG TERM CARE BENEFITS RIDERS ....................................................................... 152
     Estate Planning................................................................................................................ 155
   AGENT’S ADVICE AT TIME OF SALE OF ANNUITY TO SENIORS ........................ 155
   POLICY DETAILS AND NOTIFICATION FOR SENIOR CITIZEN ANNUITIES ...... 155
   ILLUSTRATIONS OF NON-GUARANTEED VALUES ................................................ 157
     ANNUAL STATEMENT ............................................................................................... 157
   MARKETING BY SEMINARS ......................................................................................... 157
 WAIVERS OF SURRENDER CHARGES ............................................................................ 158
   VARIOUS WAIVERS AVAILABLE ................................................................................ 158
   Death benefit waiver (aka Life Insurance Rider with some plans) .............................. 159
   Nursing home waiver ........................................................................................................ 159
   Terminal illness waiver..................................................................................................... 159
   LIVING TRUST MILLS .................................................................................................... 159
   CAUSE FOR SUSPENSION ............................................................................................. 160
   PRETEXT INTERVIEW .................................................................................................... 161
   CONTACT FROM LEADS ............................................................................................... 161
 MISLEADING MATERIALS ................................................................................................ 162
   SALES IN THE HOME OF THE ELDERLY ................................................................... 162
 USE OF ANNUITIES FOR MEDICAID (MEDI-CAL) ELIGIBILITY ............................... 164
 SETTLEMENT OPTIONS AVAILABLE TO BENEFICIARIES ........................................ 164
   ELIGIBILITY REQUIREMENTS ..................................................................................... 164
 DISCLOSURES FOR MEDI-CAL ELIGIBILITY ................................................................ 164
     REAL AND PERSONAL PROPERTY EXEMPTIONS ............................................... 165
     PERSONAL PROPERTY AND OTHER EXEMPT ASSETS ...................................... 165
     REAL AND PROPERTY EXEMPTIONS ..................................................................... 166
   LOOK-BACK PERIOD...................................................................................................... 166
     SPIA USED AS EXEMPTIONS FOR MEDI-CAL....................................................... 166
   HARDSHIP EXCEPTION ................................................................................................. 167
   WELFARE AND INSTITUTIONS CODE , HOME & FACILITY CARE ...................... 168



                                                                    vi
    MEDI-CAL REQUIREMENTS RE: ANNUITIES, BENEFICIARIES, ETC. ................. 168
    SHARING COMMISSIONS .............................................................................................. 168
  REPLACEMENT OF ANNUITIES ....................................................................................... 169
    (TWISTING versus REPLACEMENT) ............................................................................. 169
    REPLACEMENT ............................................................................................................... 170
    ILLUSTRATION – not PRE-PRINTED APPLICATION ................................................. 170
       UNNECESSARY REPLACEMENT ............................................................................. 171
    REPLACEMENT OF ANNUITIES SOLD TO SENIORS................................................ 172
       Presumption of Intention to Replace............................................................................... 175
       PENALTIES ................................................................................................................... 175
    MISREPRESENTATION OF POLICY ............................................................................. 175
       PENALTIES FOR VIOLATION OF CODE ................................................................. 176
    LIQUIDATION OF ASSETS IN PURCHASING AN ANNUITY ................................... 177
    MISREPRESENTATION OF ASSET TREATMENT FOR MEDI-CAL......................... 177
  DISCLOSURES FOR MEDI-CAL ELIGIBILITY ................................................................ 177
       REAL AND PERSONAL PROPERTY EXEMPTIONS ............................................... 178
       PERSONAL PROPERTY AND OTHER EXEMPT ASSETS ...................................... 178
CHAPTER ELEVEN - THE FINANCIAL STRENGTH OF INSURERS ................................ 181
    INSURANCE RATING SERVICES .................................................................................. 181
    OTHER FACTORS IN THE REPLACEMENT SITUATION .......................................... 183
  CLAIMS PAYING ABILITY ................................................................................................ 183
  ANNUAL STATEMENTS..................................................................................................... 183
  INVESTMENT PORTFOLIO ................................................................................................ 183
    PAST INSOLVENCY’S ..................................................................................................... 184
  JUDGING RATING SERVICES ........................................................................................... 184
  LIFE AND HEALTH INSURANCE GUARANTEE ASSOCIATION ................................ 185
    COVERED PARTIES ........................................................................................................ 185
    COVERAGE ....................................................................................................................... 186
  TEXT REFERENCES ............................................................................................................ 189
BIBLIOGRAPHY ....................................................................................................................... 192
    BOOKS, REFERENCE AND TEXT ................................................................................. 192
    PERIODICALS, NEWSPAPERS AND MAGAZINES .................................................... 194
    INTERNET ARTICLES ..................................................................................................... 197
  ATTACHMENT I................................................................................................................... 199
  ATTACHMENT II ................................................................................................................. 205
    ATTACHMENT III – STRUCTURED SETTLEMENT ANNUITIES ............................. 214
  Structured Settlements in the United States ............................................................................ 214
    Definitions........................................................................................................................... 214
    Legal Structure .................................................................................................................... 215




                                                                     vii
viii
                     CHAPTER ONE - WHAT ARE ANNUITIES

(NOTE: The use of the male gender, i.e. “he”, “his”, “him” etc., is used to designate a person of
either sex for simplicity purposes, as having to refer to “he/she”, “him/her”, is rather clumsy.)
DEFINITION
    An annuity may be defined as the liquidation of a principal sum to be distributed on a
periodic payment basis to commence at a specific time and to continue throughout a specified
period of time or for the duration of a designated life or lives.
    A similar definition: 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.
                          THE ORIGINAL “ANNUITY” - TONTINES
    The right to receive rent from land and to transfer this right to others was well established
before Roman times. A landowner, for a consideration, could transfer the rent or income from a
designed farm or landholding to a beneficiary, who might receive this rent in money or in kind
for life or for a specified time. It was but a short step from life rents based upon the grantor’s
solvency. Governments, as well as monasteries and other religious organizations, used the sale
of annuities as fund-raising devices. The religious prohibition against usury made the annuity a
favored device for borrowing large sums.
    Louis XIV of France, in 1689, used an annuity scheme devised by Lorenzo Tonti—from
hence comes the term “tontine”—to raise needed funds for the state. An annuity may be defined
as the liquidation of a principal sum to be distributed on a periodic payment basis to commence
at a specific time and to continue throughout a specified period of time or for the duration of a
designated life or lives.
      Other governments and private promoters continued this scheme almost into the twentieth
century, when it was outlawed. (Life and Health Insurance, 13th Ed.)
                        EARLY LIFE INSURERS ISSUING ANNUITIES
    The first stock insurer in the US was the Insurance Company of North America, which was
chartered in Pennsylvania on April 14, 1794. It was originally organized to sell annuities, but
changed its plans. It only sold six policies in five years, so it went out of business in 1804.
    The Pennsylvania Company for the Insurance on Lives and Granting Annuities was chartered
in 1812 and was the first North American insurer to be organized for the sole purpose of life
insurance and annuities to the general public. It went out of the insurance business in 1872.
Followed by the Massachusetts Hospital Life Insurance Company, which was the first to market
insurance through agents, and the New York Life and Trust in 1930—all three companies went
out of the insurance business and continued as banks or trust companies.
    The Girard Life Insurance, Annuity, and Trust Company of Philadelphia, started in 1836,


                                                 1
was the first company to grant policyholder dividends (for policies in force 3 or more years).
Then along came the Prudential (1875), John Hancock and the Metropolitan, both (obviously)
still in business. They marketed annuities, but their principal market originally was industrial
life insurance.
     As the United States grew and industrialized, there became a need for a wider variety of
annuities, particularly since retirement from the larger industries became a reality and annuities
were a method of funding retirement plans, whether funded by insurance companies, or by
private annuities underwritten by the employer.
     The following chart shows the various types of annuities by classification1:




     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).



                                                 2
    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.


                                      MARKET OVERVIEW
    This period of time could be the worse time in the history of the United States to attempt
to foresee or forecast the market for annuities, primarily because so much depends upon the
political scene. If the country continues its course of growing government, that will decrease
tremendously the market for annuities for retirement purposes, as the government will, in
effect, provide annuities guaranteed by the government and paid for by taxes. If the course
swings in the other direction, then there would, probably, be more prospective purchasers of
annuities for retirement purposes.
    Further, if there is a recession as many leading economists have so stated, insurers would
suffer greatly with their investments (which would be reflected in their annuity interests)
because their investments are, by law, invested only in solid “blue-chip” investments which
would not reflect the rapidity of the interest growth rate. This would further restrict insurers
from offering annuities with interest rates competitive in such market.
    At the present time, it would appear that the present market in annuities is concentrated in
defined benefit annuities (used for investments) and specialty annuities, such as those used in
court settlements (such as Structured Settlement Annuities—see Attachment III). The Equity
Indexed Annuities (EIA) appear to be holding steady and may have the best chance of
surviving politically-inspired investment income swings. As mentioned elsewhere in the text,
the EIA presently pays a higher commission than for other annuities.
    Also, at this particular time, the Congress seemingly has “passed” on changing the sunset
of the tax legislation, known as the “Bush” tax cuts, at least for the time being. Of interest in
annuities is the outcome of whether estate taxes will be reinstated, or partially reinstated.
Those with substantial investments would look more favorably upon purchasing annuities
where the returns are spread over a period of time. There are those who are convinced just
the opposite, so time will tell. (By the time this text is available for study, this should be well
settled.)
    At least there seems to be market activity primarily in the defined benefit pension field
where annuities are generally used. The defined benefit (DB) pension buyout market has
traditionally existed to serve the trustees of schemes being wound up, allowing them to
transfer their members to an insurance company when the sponsoring employer has become
insolvent. Over the last 12 months, this market has fundamentally changed as both
established and new insurance providers have entered, and companies increasingly seek to
contain their DB pension liabilities, allowing them to concentrate on their core businesses.


                                                  3
(Note: Particularly so because business is having an extremely difficult time in borrowing
money that was usually available to them, so they are having to operate more conservatively
on their own cash flow….another reason for high unemployment?)
     A number of drivers, namely changes in pension regulation, increased life expectancy
predictions and disclosure requirements, have caused many corporate directors, company
owners and scheme trustees to take longer, deeper and most intelligent choices in this field,
all of which can be favorable to annuities.
    The Federal Government sponsored the selecting of a 401(k) investment program which
will requires an insurance company to document that they requested information on six key
financial factors. That's the word from the DOL (Dept. of Labor) in Advisory Opinion 2002-
14A. These factors were confirmed by the DOL in a request from an insurance company on
how to comply with fiduciary requirements when annuities are purchased by defined
contribution plans.
    In Interpretive Bulletin (IB) 95-1, the DOL addresses the fiduciary requirements for the
purchase of annuities by a defined benefit pension plan for the purpose of making
distributions, such as when the plan is terminated. A purchase of annuities by the defined
benefit plan results from transferring the plan's liability for the payment of benefits to an
insurance company. IB 95-1 directs plan fiduciaries to make that purchase according to hard
and fast rules (and confusing, as expected).
    Selecting an annuity provider begins with evaluating the ability of potential providers to
meet the ERISA fiduciary standards for procedural prudence as outlined by the Fifth Circuit,
and not the minimum standards of DOL Interpretive Bulletin 95-1. It is the process, not the
result that counts. What this really means is for the Insurance Company legal staff to figure
out…
    However, what it says is that the failures of major life insurers during the early 1990s
placed plan trustees in a quandary when shopping for closeout annuities to preserve pension
benefits for plan participants, as there was little published guidance on selecting an annuity
provider. The failures of Executive Life and Mutual Benefit were widely known; both
companies had been rated AAA by Standard & Poor's (S&P's) rating agency and A+ by A.M.
Best & Co. (A.M. Best). After receiving a number of inquiries, the Department of Labor
(DOL) issued Interpretive Bulletin the aforementioned bulletin.
    For general information, the bulletin develops several guidelines to be considered by a
plan fiduciary when selecting an annuity provider:
   1. The quality and diversification of the insurer's investment portfolio;
   2. The size of the insurer relative to the proposed annuity contract;
   3. The level of the insurer's capital and surplus;
   4. The lines of business of the insurer and other indications of an insurer's exposure to
      liability;
   5. The structure of the annuity contract and guarantees supporting the annuities, such as
      the use of separate accounts; and
   6. The availability of additional protection through state guaranty associations and the
      extent of the guarantees.



                                                 4
   The bulletin encourages fiduciaries to apply these guidelines to meet the "safest available
annuity" standard.
    Annuities continue to be used for 401(k) plans, but there are some developments. As
many employees continue to underutilize their 401(k) plans, companies are becoming
increasingly concerned that their employees aren't up to the challenge of assuming
responsibility for their own retirement savings, according to a new survey by Hewitt
Associates, a global human resources services firm. To address these concerns, employers
are stepping up their efforts in 2005 to educate and make it easier for employees to effectively
participate in their 401(k) plans.
    Hewitt's survey of nearly 200 large companies reveals that only 18 percent feel confident
that their employees will retire with sufficient retirement assets. Even less (12 percent) feel
confident that their employees even understand their retirement benefits and are taking …
   Insurers may have an opportunity to sell more immediate annuities to defined
contribution plans, thanks to a pending safe harbor rule.
    The rule, expected to take effect in the first quarter of 2008 will clarify fiduciary standards
for the selection of annuity providers by plan sponsors and fiduciaries of individual account
plans, IT IS HOPED. The DOL's "safest available annuity" standard for the selection of an
annuity carrier currently prevents many plan sponsors from using annuities as an income
distribution vehicle for plan participants. However, the Pension Protection Act required the
DOL to clarify exactly what the "safest available annuity" actually is.
     Although retired Baby Boomers will control over $13 trillion and spend about $300
billion a year, many financial industry executives remained unconvinced that a retirement
income bonanza awaits them, according to a recent study by Financial Research Corp.
    Executives tend to fall into one of three camps, FRC found: those who are fired up about
the Boomer opportunity, those who think it's a marketing fad, and those who want more proof
that it's real.
    If you think of the retirement income market as a championship football game, a new
survey shows that the annuity industry is beginning to put on its shoulder pads and lace up its
cleats.
    But recent studies indicate that most Baby Boomers still don't know that the income game
is on their schedule. Responses from variable annuity providers showed that the retirement
income market is ripening but still immature.
   "The industry is beginning to focus on the retirement income issue, but most people
would acknowledge that there's a long way to go.”
    Sales of immediate variable annuities (IVAs) have been down, but carriers are
increasingly devoting resources to promoting retirement income prior to the economy crash.
   Simply put, from many and various published sources, annuity sales and marketing plans
appear to be in a holding pattern.




                                                  5
                                 CAST OF CHARACTERS:
                                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,
and can give the contract to anyone, or will give part or the entire 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. However, 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. 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 annuitant, by itself, cannot make withdrawals or deposits, change the names of
the parties to the agreement, or terminate the contract.
    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.2
    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 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.


                                                  6
   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.
                                     AGE OF ANNUITANT
     Regulations are rather detailed as to who can purchase an annuity and for whose benefit,
keeping in mind the contract law that a contract entered into by a minor can be voided by such
minor.
      California regulations state that (a) a minor under age 18 may enter into a valid contract for
life or disability insurance, or annuities, (b) those under age 16 can purchase life or disability
insurance or annuities with the written consent of their parent or guardian. In respect to
benefits, a minor under the age of 18 may give valid instructions as to any money that has
accrued or payable under the terms of the contract, but only with the written consent of a parent
or guardian. The regulations also state that any contract that is made by a minor under age 18
that can result in the personal liability for assessment may only be issued with the written
assumption of such liability by a parent or guardian. 12B
     In actual practice, annuities are generally issued with maximum ages of 85 and annuitization
at age 90 or 95, with some offering maximum annuitization age of 100. Age 85 is also often
used for both purposes as that is the law in Pennsylvania. For non-qualified products the
youngest issue age is usually -0-, but the minimum age usually is only mentioned for Equity
Index Annuities.41,46,49
                                       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 annuitant 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. They 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.


                                                 7
    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 annuities state that certain provision can come into being if the
owner, co-owner, or annuitant dies, reaches the age of annuitization, or becomes 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 and deferred.
                      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 purchaser of a Deferred Annuity is permitted to alter the date that payments are



                                                  8
scheduled to begin but within certain conditions that are plainly stated in the annuity.
                            HOW ARE ANNUITIES PURCHASED?
                                           MARKETING
    Prior to the 1970s, annuities were marketed by traditional insurance agents, most of whom
were career agents. During the 19970s and early 1980s, stockbrokers increased their distribution
of annuities, followed by growth in brokerage general agency distribution, followed by growth
by banks marketing annuities. In today’s market, all marketing and distribution systems are
doing well.
                                 A TYPICAL ANNUITY OWNER
    The Gallup Organization surveyed over 1,000 nonqualified annuity owners in 2004 for the
Committee of Annuity Insurers – an organization of life insurance companies that issue
annuities. Gallup identified the nonqualified annuity-owners by several characteristics3:
                   Interestingly, the average of these annuity owners was 65.
                   52% of these annuity owners were male, 48% female.
                   63% of annuity owners of these contracts were married, 20% were
                     widowed.
                   Of owners of nonqualified annuities, 56% were retired, 38% were employed
                     (either full-time or part-time).
                   55% of owners had “moderate” household income, described as between
                     $20,000 and $74,999. 62% had total annual household incomes under
                     $75,000.
                   85% of the owners purchased that first annuity when they were less than 65
                     years old. Average age at which owners purchased their first annuity was
                     50.
                                     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 returns 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 is required by the insurer
to pay all claims and satisfy their stockholders.



                                                 9
     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 $74.26 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.
                          COLLECTING PREMIUMS IN ADVANCE
    (California Insurance Code #10540.) An incorporated life insurer issuing life insurance
policies on the reserve basis may collect premiums in advance. Such insurers may also accept
moneys for the payment of future premiums related to any policies issued by it. No such insurer
may accept such moneys in an amount to exceed (1) the sum of future unpaid premiums on any
such policy or (2) the sum of 10 such future unpaid annual premiums on any such policy if such
sum is less than the sum of future unpaid premiums on any such policy. This section shall not
limit the right of such insurers to accept funds under an agreement which provides for an
accumulation of such funds for the purpose of purchasing annuities at future dates.

                          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.


                                                10
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 are 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, fruit-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.


                  MAXIMUM PREMIUM ALLOWED TO BE COLLECTED
    Insurance companies that issue annuities are restricted as to the amount of premiums paid in
advance that they are allowed to collect. This is important inasmuch as Variable Annuities, and
to some extent, Equity Indexed Annuities, allows other than fixed payments. Obviously, in order
for the insurance system to work, an insurer may accept such funds, but the funds may not
exceed the sum of future unpaid premiums on any policy or the sum of 10 such future unpaid
annual premiums if such sum is less than the sum of future unpaid premiums. These regulations
do not disallow the rights of an insurer to accept funds when there is an agreement that such
accumulation of funds will be used for purchasing annuities at a future date.3A
                  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.

    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


                                                11
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 has 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.” 4
                        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.

                           LIFE INCOME WITH REFUND ANNUITY
    The Life Income with Refund type of Annuity states that in 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


                                                12
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 insured, 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.
                               C0MPOUNDING (RULE OF 72)
    Often those who are investing, or considering investing, are curious as to when their invest
ment will double. There is a simple arithmetic exercise, called the Rule of 72.
    In order to determine when the funds will double, use the expected interest return on the
investment—assumed, projected, actual, guesstimate, or stipulated—and divide that number into
72. For instance, if the interest rate were 10% (don’t we wish!), divide 10 into 72, which would
show that the investment would double in 7.2 years. If 7% is used, then the investment would
double in 10.2 years. At today’s CD rates of 2%, it will take forever (you do the math).
                                     DOUBLING POWER
    The Rule of 72 shows the effect of inflation—which may be right around the corner,
depending upon who is doing the forecasting—so a good practical rule can be interpolated here.
A primary goal of every investor should be to have the growth portion of the investment
portfolio double before a certain event occurs—death, retirement, college costs, divorce, etc.
Equally important, the money must be in investments that have an acceptable risk level.
    There can be no better “secure” investment than annuities.



                                                13
                    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.5




    From this bar chart, it is obvious that greater growth is recognized by putting assets into
annuities, instead of CD’s, and the longer the period of time that funds remain in annuities, the
better performance.
                          TAX DEFERRAL IN THE SALES PROCESS
    There is little doubt that tax deferral is an important selling point for annuities. A Gallup
Organization study showed that tax deferral is one of several important reasons that individuals
buy nonqualified annuities.
    74% 0f the owners of non-qualified annuity contracts believe that the government should
give tax incentives to encourage people to save. Those under age 64 are more likely than those
who are older to believe that the government should give incentives to encourage people to safe -
81% of those under age 64, compared to 69% if those older than age 64.



                                                14
    82% of the owners of non-qualified (NQ) annuities report that they have saved more money
than they would have if the tax advantage of an annuity were not available. 88% report that they
try not to withdraw any money from their annuity before they retire because they would have to
pay tax on the money withdrawn – this percentage of people that are trying not to withdraw has
decreased by 5% since 1999.6
             TAX DEFERRAL VS LACK OF STEPPED-UP BASIS AT DEATH
    One of the disadvantages of tax deferral on earnings is that deferred annuity income will be
taxed at death. However, if taxes can be deferred long enough – such as 5 years or more – that
would usually offset the lack of step-up at death. It should always be remembered that annuities
are being used to ultimately provide retirement income, with payments taken periodically over a
number of years. This is discussed in more detail in Chapter Four.
                                 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. Note that withdrawal options may be different for those
over age 65 as discussed later in this text.
    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
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.
    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. Paul would receive a check for $1,000.



                                                15
                                      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
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.
                              MORTALITY & ANNUITY TABLES
    Those in the life insurance industry are familiar with mortality tables, at least in concept.
Basically, a mortality table represents a record of the number of persons dying and those
surviving at each age out of a composite of a large number of lives. In other words, a mortality
table is a chart that shows the rate of death at each age in terms of number of deaths per
thousand. It shows a hypothetical group of individuals beginning at a certain age and traces the
history of the entire group year by year until all have died.7

   The mortality tables based on life insurance experience are not suitable for use in the
development of rates for annuities for several reasons:
      Generally, annuities are purchased by persons in poor health.
      Especially with single premium immediate annuities, the rates of mortality among
        annuitants are generally lower than those insured covered by life insurance policies.
        Therefore, a life insurance table would overstate expected mortality rates.
      While the continual improvement in mortality rates, even though offset occasionally by
        unanticipated developments (such as AIDs), creates a gradually increasing margin of
        safety for life insurance companies, it has just the reverse effect on annuities.
   Therefore, an annuity table must show the lower rates of mortality that can be expected in the


                                                16
future instead of a table showing rates that have been experienced in the past. Technically, these
are called “Tables with Projection.” as opposed to “static” tables used for life insurance which
did not provide for changes in rates depending upon the calendar year to which they were
applied.
    While life insurance has reaped the benefit of improving mortality, in annuity policies the
improving mortality has led to smaller margins as the “postponement” of death means more
annuity payments and annuity tables in use today usually contain projection factors that make
allowance for future reductions in mortality rates. The need for such calculations is particularly
important in variable annuities because this portion of the annuity business is growing and there
is no interest margin to help offset mortality losses that develop.
    To further complicate this discussion, there are annuity tables that are used for different
purposes. For instance, the 1949 Annuity Table was developed to reflect steady improvement in
mortality; the 1955 Annuity Table was developed to help determine the proper rates for annual-
premium deferred annuities and life income settlement options. In 1971 the Group Annuity table
was developed for the (at that time) time field of group annuities. Presently, the 2000 Annuity
Basic Mortality Table has been endorsed by the Society of Actuaries to be used for individual
annuities written in the U.S. but it is an extension of the 1983 Individual Annuity Mortality
Table.
    For educational and information purposes, the 1983 Table for ages 61 to age 85 is reproduced
below. The complete tables start at age 5 with 10,000,000 lives at the beginning of the year and
run to 115 years when it is assumed that everyone has passed on.9




                                               17
   Age (x) at             Number Living at         Number Dying       Yearly Probability   Yearly Probability
Beginning of Year    Beginning of Year (lx)   during Year (d x)   of Dying (qx)            of Surviving (p x)
61                   8,938,628                80,296              0.008983                     0.991017
62                   8,858,332                86,280              0.009740                     0.990260
63                   8,772,052                93,247              0.010630                     0.989370
64                   8,678,805                101,230             0.011664                     0.988336
65                   8,577,575                110,230             0.012851                     0.987149
66                   8,467,345                120,228             0.014199                     0.985801
67                   8,347,117                131,192             0.015717                     0.984283
68                   8,215,925                143,072             0.017414                     0.982586
69                   8,072,853                155,774             0.019296                     0.980704
70                   7,917,079                169,196             0.021371                     0.978629
71                   7,747,883                183,214             0.023647                     0.976353
72                   7,564,669                197,672             0.026131                     0.973869
73                   7,366,997                212,427             0.028835                     0.971165
74                   7,154,570                227,472             0.031794                     0.968206
75                   6,927,098                242,767             0.035046                     0.964954
76                   6,684,331                258,222             0.038631                     0.961369
77                   6,426,109                273,669             0.042587                     0.957413
78                   6,152,440                288,863             0.046951                     0.953049
79                   5,863,577                303,469             0.051755                     0.948245
80                   5,560,108                317,071             0.057026                     0.942974
81                   5,243,037                329,216             0.062791                     0.937209
82                   4,913,821                339,452             0.069081                     0.930919
83                   4,574,369                347,231             0.075908                     0.924092
84                   4,227,138                351,825             0.083230                     0.916770
85                   3,875,313                352,603             0.090987                     0.909013


                    APPLICATION OF MORTALITY TABLES IN RATE MAKING


     Actuarial computations and calculations as to how rates (premiums) are determined in detail
are outside the scope of this discussion. However, the basic concept of how annuity premiums
are determined should be known by those who represent annuity insurers – even an auto
salesman needs to have some understanding what happens within the block of steel in the front
part of the car.
     The mortality tables show the probability of a person living or dying at certain ages at certain
periods of time. Using this table (above), in order to determine what the gross premiums for a
life insurance policy payable in 5 years for a man age 61, there are 8,938,628 men living at age
68, and 80,296 dying before the end of that year. Therefore, the probability of death at that age
is 80296 divided by 8938628 or .008983 for the first year. To determine how many are “left
standing” 5 years hence, this arithmetic is repeated for the next five years by adding the number
of persons dying each year (471283) and dividing by 8938628 which give the probability factor
of .0527243.10



                                                        18
    For an annuity, the process is just reversed inasmuch as probabilities of survival or chance of
living for at least one year following issue age will be a fraction, the denominator of which is the
number living at age 61 and the numerator of which is the number that have lived one year
following the specified age (i.e., to age 62). This would be 8938628 divided by 8858332, thus
probability of surviving would be 1.0090644.
    To an actuary, this is just a start of premium calculation as the interest that the company will
receive on premiums received over the period of the policy/annuity, and expenses that will occur
in both issue and maintenance in addition to the survival probability must be calculated. In
addition, there must be some profit for the company calculated plus a margin for contingencies.
All of these are factored in with the age and sex of the annuitant. Now you see why actuaries get
the “big bucks.”

                                     ANNUITY RESERVES
   One of the primary functions of actuaries is the calculation of “reserves.” The best way to
explain this complicated subject is to use the method used for Deferred Annuities.

                               DEFERRED ANNUITY RESERVES
    Deferred annuities are usually paid for by flexible, periodic premiums, or sometimes by fixed
and periodic premiums. Even though the premiums may be flexible, the contract holder may
choose to pay a level amount into the annuity so as to build to a larger sum at annuitization
and/or retirement. Theoretically, premiums may continue through the entire period of deferment.
The level annual premium is paid only while the insured is still alive.
    If, for example, the deferred annuity issued at age 40 starts the payment of $100 a month at
age 70, and if the net single premium (the amount needed to deposit immediately to create the
payment at age 70) for this is $239.36, the annual premium on this policy may be paid until one
year prior to the annuitization of the payment of the benefits (in this situation, the contract holder
would be age 69). Therefore, the series of annual payments is a temporary annuity due for a
term of 30 years (age 40 to age 69 inclusive). The amount of this net annual premium would be
found by dividing the net single premium by the present value of an annuity due of “1”
computed for the 30 year period.
    The present value (as calculated by the actuaries from existing tables) of the 30 year annuity
just happens to be 16.141 (actually, it is 15.141 plus 1 – if that helps) or to put it in another way,
the present expected value or an annual level premium of “1” paid over the same term as the
premiums on the deferred annuity. This figure, divided into the net single premium for the
annuity, gives a net annual level premium of
                                $239.36
                                 16.141        which equals $14.83

    Now that we know how a net annual premium is created, obviously there has to be funds held
by the insurance company to pay for any such obligations. Therefore, they are “reserves.11”




                                                 19
                                           RESERVING
    The reserves of an insurance company basically reflect its obligations to its customers.
Policy reserves are liabilities that represent in respect to business in-force, the amount that, with
future premiums and interest earned, is expected to be needed to pay future benefits. Another
explanation is simply that reserves are the present value of future benefits. Reserve calculations
require the use of mortality tables and an interest rate. If an insurer underestimates its policy
reserves, or fails to maintain sufficient assets to back its reserves, it may find itself in the
untenable situation of not being able to pay claims.
    Incidentally, there are other reserves, such as Reserves for Substandard Policies; Reserves for
Special Benefits, Reserves for Premiums Paid in Advance, Reserves for Claims Not Reported,
etc., but the Policy Reserves are the most important – far and away!
                    RESERVES FOR INDIVIDUAL DEFERRED ANNUITIES
    As stated, there are 3 basic forms of annuities – flexible or fixed-premium deferred annuities,
single-premium deferred annuities, and single-premium immediate annuities. The policy reserve
for the majority of the annuities is equal to the present value of future benefits because most
annuities in today’s market are either flexible-premium deferred annuities (FPDAs) or single-
premium immediate annuities.
    For the FPDAs, insurance companies cannot know for sure what premiums the contract
holder may make in the future. Therefore, the policy reserve must be calculated on the premise
that the contract owner will pay no future premiums. This, then, makes the policy reserve equal
to the present value of future benefits for both single-premium and flexible-premium policies.
    Then, when an annuity starts paying benefits, the reserves are based on a (legally recognized)
mortality table and interest rate according to the annuitant’s attained age and monthly income –
taking into consideration any minimum benefit guarantees. The assumed mortality is calculated
conservatively – meaning lower mortality rates.
    FPDAs are simply policies where the owner pays annual premiums during the period of
accumulation, until the owner starts receiving benefits in the form of income. When the benefits
start, the annuitant receives the monthly income based on the cash value of the policy at that time
and an annuity factor for the attained age of the annuitant.
    Contracts in which there are no further payments are reserved as net single premiums (the
present value of future benefits), including single-premium life and endowment contracts,
immediate life annuities, and paid up life and endowment contracts and supplementary contracts
used in lieu of lump-sum payments.


                  REGULATIONS REGARDING FUNDING AGREEMENTS
    When an insurer accepts funds to provide for an accumulation of funds for the purpose of
making payments in future dates in “amounts that are not based on mortality or morbidity
contingencies,12A” this is called a “funding agreement.” The regulations state that “no amounts
shall be guaranteed or credited under any funding agreement except upon reasonable
assumptions as to investment income and expenses and on a basis equitable to all holder of
funding agreements of a given class.




                                                 20
                        MINIMUM GUARANTEED INTEREST RATES


(The following is from the California Insurance Code 10168.25 as redacted.)
    The minimum values … of any paid-up annuity, cash surrender, or death benefits available
under an annuity contract shall be based upon minimum nonforfeiture amounts as defined in this
Code.
    (1) The minimum nonforfeiture amount at any time at or prior to the commencement of any
annuity payments shall be equal to an accumulation up to that time, at the rates of interest
indicated in subdivision (d), of the net considerations (as hereafter defined) paid prior to that
time, decreased by the sum of all of the following:
      (A) Any prior withdrawals from or partial surrenders of the contract, accumulated at the
rates of interest indicated in (these regulations).
      (B) An annual contract charge of fifty dollars ($50), accumulated at the rates of interest
indicated in (these regulations).
      (C) Any state premium tax paid by the company for the contract, accumulated at the rates
of interest indicated in (these regulations).
    However, the minimum nonforfeiture amount may not be decreased by this amount if the
premium tax is subsequently credited back to the company.
      (D) The amount of any indebtedness to the company on the contract, including interest due
and accrued.
    The net considerations for a given contract year used to define the minimum nonforfeiture
amount shall be an amount equal to 87.5 percent of the gross considerations credited to the
contract during that contract year.
    The interest rate used in determining minimum nonforfeiture amounts shall be an annual rate
of interest determined as the lesser of 3 percent per annum and the following, which shall be
specified in the contract if the interest rate will be reset:
      (1) The five-year Constant Maturity Treasury Rate reported by the Federal Reserve as of a
           date, or averaged over a period, rounded to the nearest one-twentieth of 1 percent,
           specified in the contract no longer than 15 months prior to the contract issue date or
           redetermination date under paragraph (2), reduced by 125 basis points, where the
           resulting rate is not less than 1 percent.
      (2) The interest rate shall apply for an initial period and may be predetermined for
           additional periods. The redetermination date, basis, and period, if any, shall be stated in
           the contract. The basis is the date, or average over a specified period that produces the
           value of the five-year Constant Maturity Treasury Rate to be used at each
           redetermination date.
    During the period or term that a contract provides substantive participation in an equity
indexed benefit, it may increase the reduction described in paragraph (1) of subdivision (d) by up
to an additional 100 basis points to reflect the value of the equity index benefit. The present
value at the contract issue date, and at each redetermination date thereafter, of the additional
reduction shall not exceed the market value of the benefit. The commissioner may require a
demonstration that the present value of the additional reduction does not exceed the market value



                                                 21
of the benefit. Lacking a demonstration that is acceptable to the commissioner, the commissioner
may disallow or limit the additional reduction.
    The commissioner may adopt regulations to implement the provisions of subdivision (e) and
to provide for further adjustments to the calculation of minimum nonforfeiture amounts for
contracts that provide substantive participation in an equity index benefit and for other contracts
with respect to which the commissioner determines adjustments are justified.
                           THE EFFECT OF LOW INTEREST RATES
    The impact of reserves of a change in the interest assumption can be understood as if the rate
of interest assumed in the reserve calculation is decreased, then it follows that there will be an
increase in reserves. The rule, simply put, is that the smaller anticipated earnings must be offset
by a larger reserve at any point in time. Remember, in calculating the present value of $X, the
higher the interest rate assumed, the lower the present value of $X will be, all things taken into
consideration.
    What does this have to do with anything? If the interest rate – which undoubtedly will go no
lower than it was during the first part of 2004 (no such thing as a negative interest rate) is what
the insurer is getting on its investments – which consist primarily of the premiums received –
then at time of claim since it did not make as much money on investing of the premiums as
assumed in the premium and reserve calculations, the insurer would not be able to meet its
financial projections, etc. Fortunately, interest assumptions on new business drops as the interest
the company receives on its investments drops. Unfortunately, the company still has to pay the
income promised under the policy, regardless of what their interest income had been during the
accumulation period.
    This simply means that an annuitant that took out a deferred annuity would still collect – as
an example - $100 for every annual payment (premium) of $14 and change which was promised
when the annuity was purchased some time back when interest rates were high. For another new
annuitant, the premium for $100 for comparative coverage might be as high as $18. The offset,
of course, is that the annuitant cannot put the same money into another investment and receive a
much higher interest than what is received by the insurance company, who has the advantage of
large portfolios professionally managed and therefore can get higher interest than Joe
Lunchbucket.
    Interestingly, the nation’s life and health insurers had a 310.8% jump in net income last year,
earning $30 billion compared to $7.3 billion in 2002.12 The rebound in the equity market was
responsible for the increase in earnings as insurance companies saw improvement on the sale of
invested assets. Insurers had a $4.6 billion capital loss in 2003, compared to a $15.5 billion
capital loss just a year earlier. Capital and surplus of the insurers had its largest increase in
profits since 1997.
    “The equity markets were much kinder to the industry in 2003, and we expect to see positive
gains as 2004 progresses. Insurers didn’t need to dip into capital as much to absorb the higher
losses and maintain reserves.” 13 So, things are looking up!


                            ANNUITY NONFORFEITURE VALUES
   Nonforfeiture values are understood by most as a life insurance policy function but it also
applies in slightly different ways for an annuity. Basically, in life insurance it is a provision that



                                                  22
the insured may receive the equity in some form, even if the policy is cancelled. For annuities, it
is described as the vested benefit usually to a retirement plan participant and is enforceable
against the plan.

    It is of importance as the National Association of Insurance Commissioners (NAIC)
promulgates “Model” legislation for the regulation of the insurance industry in the various states,
and that is usually adopted by most, if not all, of the state insurance departments. Changes to the
annuity nonforfeiture law were made in 2002 to address the reduction in interest rates in and
after 2002, and a standard nonforfeiture law for deferred annuities was proposed by the NAIC.
The change, which is temporary, would be from 3 percent to 1.5 percent to the minimum interest
rate in the annuity nonforfeiture law, and which would be effective for 2 to 3 years (by state
determination). When such provision “sunsets”, which would be sometime between July 2004
and July 2005, the minimum rate will be returned to 3 percent. (This may have happened at the
time of the writing of this text, so it may have already expired in some states where it was
enacted.)

    The NAIC Model Standard Nonforfeiture Law for Individual Deferred Annuities proposes 6
principal changes14:
       1. (For deferred annuities) a minimum interest rate indexed to the five-year Constant
            Maturity Treasurer (CMT) rate, minus 1.25 percent. For equity-indexed plans, the
            minimum rate could be reduced by an additional 1 percent, but subject to guaranteed
            equity-indexed benefits of at least as great as the rate reduction.
       2. The minimum interest rate will be the lesser of 3 percent or the rate determined by the
            5-year CMT index, but it may never be less than 1 percent.
       3. The interest rate can be redetermined at specific contract dates; the reset rate can be
            as of a single date or averaged over the most recent 15 months.
       4. An annual charge of $50 can be recognized. No collection charge is allowed.
       5. The net considerations are 87.5% for all products.
       6. Premium tax can be reflected in the nonforfeiture law.

Every annuity issued must contain certain provisions15 :
         When annuity premiums cease or when the annuity owner requests, the insurer must
          provide a paid-up annuity benefit.
         If the annuity provides for lump-sum settlement when it matures – or at any other
          time – a cash surrender benefit may be paid in lieu of a paid-up annuity benefit.
          Payment may be deferred for no longer than 6 months with the permission of the
          Insurance Department.
         The annuity must contain a statement of the mortality table and interest rates that are
          used in calculating minimum paid-up annuity benefits, cash surrender, or death
          benefits that are available under the annuity and any other information necessary to
          calculate these benefits.
         The annuity must state that these benefits are equal to or more than the minimum
          benefits required by the state in which the annuity is delivered.


                                                23
     Regardless of these requirements, any deferred annuity may provide that if there have been
no consideration received for a period of two years, and the present value of the annuity is less
than $20 monthly, the present value of the annuity is determined according to the Code, and may
be paid in cash.
     For annuities issued before 1/1/04 and prior to 1/1/06, the California Insurance Code16
provides for minimum nonforfeiture values. For flexible contracts, the amount is specified by
formula which assigns an interest rate of 3% for accumulations less withdrawals, indebtedness to
the insurer plus additional amounts assigned by the insurer. The percentage of net consideration
must be 65% for the first year and 87.5% for later years.
     For fixed premium contracts, the portion of the net consideration is the same as for flexible
contracts (65% and 87.5%). For single premium contracts, the minimum nonforfeiture amounts
shall be defined as those with flexible considerations except the minimum nonforfeiture amount
shall be equal to 90% and the contract charge shall be $75.
     For contracts issued on and after 1/1/0617, the determination of the nonforfeiture values
resembles the calculations shown above, but with annual contract charge of $50 (instead of $30)
and the interest rate used in determining the nonforfeiture values will be 3% per annum. If the
interest rate is offset, then the code requires a Constant Maturity Treasury Rate to be used for
each redetermination date.
     For equity indexed plans, provisions for determining the nonforfeiture values is stated in the
Code. Each revaluation must show that each redetermination the additional reduction shall not
exceed the market value of the benefit.
     For a paid-up annuity18, the benefit available under the annuity shall be the present value on
annuitization which must be at least equal to minimum nonforfeiture on that date.
     For a paid-up annuity which provides cash surrender benefits, the Code19 provides a (145
word) sentence outlining the cash surrender benefits available. Simply (very simply) put, the
present value of future benefits less payments made on the annuity, would be the non-forfeiture
amount, but the cash surrender benefit may not be less than the minimum nonforfeiture amount
at that time. The death benefit must be at least equal to the cash surrender benefit.
     For annuities that do not provide cash surrender values20, the nonforfeiture amount shall not
be less than the present value of the maturity value of the paid up benefit, adjusted by payments
and obligations.
     Not all annuities provide for cash surrender benefits or death benefits, and those plans must
so state in a “prominent” place on the contact.21
     If a contract provides – by rider or otherwise - annuity benefits and life insurance benefits or
a return of premium or gross considerations with interest, the minimum nonforfeiture values of
the annuity portion will be calculated individually and then combined.22
                              RECORD CONTRACT DISCLOSURE
(From CIC Section 10168.70)
 Any contract which does not provide cash surrender benefits or does not provide death benefits
at least equal to the minimum nonforfeiture amount prior to the commencement of any annuity
payments shall include a statement in a prominent place in the contract that such benefits are not
provided.


                                                 24
                    THE POSITION OF THE SEC ON FIXED ANNUITIES
    For those who first approach fixed annuities on a marketing basis, it is obvious that the fixed
annuity has been exempted from Securities and Exchange Commission regulations regarding
securities. Such exemption was first granted in 1986 under Rule 151 and such annuities are
exempt (Under Section 3(a)(8)). Rule 151 is a “safe harbor” act – which means that annuities
that annuities falling under the rule are entitled to rely upon the exemption. This does not mean
however, that an annuity that does not fall within the scope of the rule may not still be excluded
according to the Section 3(a)(8) exemption.23

   For an annuity to be exempt under Rule 151, there are two basic tests:
      1. The insurer must assume the investment risk under the contract as defined in the rule,
          and
      2. The contract must not be marketed primarily as an investment.
   These tests will be discussed elsewhere in this text in more detail.
   There are four “prongs” to the investment risk test, and each must be satisfied.

       1. The value of the contract must not vary according to the investment experience of a
          separate account. (This is discussed later as a major reason the Equity Indexed
          Annuity is exempt);
       2. The contract must guarantee the principal amount of premiums and all interest
          credited to it for its entire duration, less any deduction for sales, administrative or
          other expenses or charges;
       3. The contract must (again for its full duration) guarantee that the net premiums and the
          interest credited to it thereto, will be credited with a specified rate of interest at least
          equal to the minimum rate required to be credited by the relevant nonforfeiture law in
          the jurisdiction in which the contract is issued; and
       4. The insurer must guarantee that the rate of any discretionary excess interest to be
          credited to the contract will not be modified more frequently than once a year.

   There is also a marketing test, but it is far from explicit – however the SEC in the release of
Rule 151 indicated some pertinent points that they would take into consideration. Basically, they
require that there be
                no undue emphasis based on current rates of interest;
                the products should be presented as a relatively safe and secure retirement
                 savings vehicle; the insurance and other retirement features (such as payout
                 options, death benefits, etc.) should enjoy at least equal emphasis with the current
                 interest rate feature.

    There are other, highly technical, considerations that the SEC will take into consideration in
determining whether a particular product falls within the exemption.



                                                 25
             STATE SECURITIES REGULATIONS OF ANNUITY CONTRACTS
    The question may arise whether state securities regulations apply to annuity contracts, and if
so, do they duplicate SEC regulations. The National Securities Markets Improvement Act
(NSMIA) of 1996 preempted certain duplicative state securities regulations of registered variable
annuities, and other annuities exempt under federal securities laws. The NSMIA preempts state
securities review and registration of all securities subject to SEC registration, which includes
Variable Annuity contracts, underlying mutual funds, and securities exempt from registration
because of federal regulations.
    However, a state may require a “notice” filing of securities that are sold in that state, which
includes documents filed with the SEC, the sales of the securities, and consents to service of
process. They may continue to collect fees for certain securities. And, of course, states continue
to have the authority to regulate annuities under state insurance laws.



   STUDY QUESTIONS

1. An annuity is like life insurance in many ways, including
   A. premiums may be paid by several modes, other than just monthly.
   B. the fact that annuities are usually sold by life insurance companies.
   C. both require physical examinations to qualify.
   D. the fact that both can be set up to provide coverage for the life of the insured.


2. The owner of an annuity may not be
   A. an individual.
   B. a trust.
   C. a corporation.
   D. a minor.

3. The person that purchases an annuity is
   A. the owner.
   B. the beneficiary.
   C. the annuitant.
   D. a non-legal entity.

4. An annuitant can benefit from an annuity only
   A. if someone else purchases the annuity.
   B. if the annuitant is a corporation.
   C. when it annuitizes.
   D. when the contract owner dies.




                                                26
5. The beneficiary of an annuity has “no status” until
   A. the death of the beneficiary.
   B. a loan has been made on the annuity.
   C. the death of the annuitant.
   D. the beneficiary becomes age 21.


6. If the annuitant reaches a certain age, dies, or becomes disabled, certain provisions of an
    annuity would govern, therefore these annuities are considered as
    A. owner-driven.
    B. insurer-driven.
    C. beneficiary driven.
    D. annuitant driven.

7. With a deferred annuity, if death occurs before the annuitization period stated in the contract,
   A. the contract becomes null and void.
   B. the annuitization period would then start and the payments would be sent to the state.
   C. the cash value paid to the beneficiary would equal the amount of premiums paid in.
   D. the annuity is automatically converted to a whole life insurance policy.

8. When an annuity specifies the number of benefits payment of a set amount, it is
   A. an equity indexed annuity.
   B. an annuity certain.
   C. a Variable Annuity.
   D. an immediate annuity.

9. The maximum income per dollar of outlay is provided by
   A. the straight life annuity.
   B. life income with period certain annuity.
   C. life income with refund annuity.
   D. temporary life annuity.

10. The even distribution of both principal and interest, or growth of the annuity, over a
    specified period of time is
    A. the death benefit.
    B. annuitization.
    C. collateralization.
    D. escrowing.

ANSWERS TO STUDY QUESTIONS
1C   2D   3A   4C   5C   6D   7C   8B   9A   10B




                                                   27
                 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.


                                           ISSUE AGES
    (The following information is derived and redacted from CIC 10112.)
    Subject to the appropriate sections of the Probate Code, in respect to life or disability
insurance, or annuity contracts issued to or upon the life of any person not of the full age of 18
years for the benefit of such minor or for the benefit of the father, mother, husband, wife, child,
brother, or sister, of such minor, or issued to such minor, subject to written consent of a parent or
guardian, upon the life of any person in whom such minor has an insurable interest for the
benefit of himself or such minor's father, mother, husband, wife, child, brother or sister, such
minor shall not, by reason only of such minority, be deemed incompetent to contract for such
insurance or annuity, or for the surrender thereof, or to exercise contractual rights thereunder, or,
subject to approval of a parent or guardian, to give a valid discharge for any benefit accruing or
for any money payable thereunder; provided, that all such contracts made by a minor under the
age of 16 years, as determined by the nearest birthday, shall have the written consent of a parent
or guardian, and that the exercise of all contractual rights under such contracts, or the surrender
thereof, or the giving of a valid discharge for any benefit accruing or money payable thereunder,
in the case of a minor under the age of 16 years, as determined by the nearest birthday, shall have
the written consent of a parent or guardian.
  All such contracts made by a minor not of the full age of 18 years which may result in any
personal liability for assessment shall have the written assumption of any such liability by a
parent or guardian in consideration of the issuance of the contract. Such assumption shall be in a
form approved by the commissioner, reasonably designed to inform the parent or guardian of the
liability thus assumed.
  Such assumption of liability may be made a part of and included with any written consent of
such parent or guardian required under other provisions of this section and it may be provided
therein that such assumption shall cover only up to the anniversary date of the policy nearest to
the member's birthday at which he or she attains age 18.




                                                 28
                          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. Also, as discussed elsewhere, it must
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 or
immediate financial needs are able to access their annuity funds to some extent.24
    In particular, Variable Annuities are best perceived as long-term investments. When the
stock market is a “bull” market, then 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.


                                INTEREST RATE STRATEGIES
    The annuity insurer will usually and periodically determine a first-year interest rate and a
renewal year interest rate, based upon the interest rates realized by the insurer and the general
economy. The annuity will have a “guaranteed” rate which will remain static throughout the life
of the annuity, but it will also have a “current” rate which is the one that changes, generally upon
the decisions of the Board of Directors of the insurer.
    As with all insurance products, “first-year” interest rate is the rate that is applied when the
annuity is first purchased. “Renewal” interest rates will apply to later years and may or may not
be the same as the first-year rate. Sometimes insurers will have a higher first-year rate so that it
may attract new business (so-called “teaser” rates).
    Interest rates for annuities may be either annual or multi-year. As one would expect, annual
interest rates are the interest rates guaranteed for one year, whereas multi-year rates can extend
over a period of several years. Some multi-year annuities guarantee interest rates for two years,
others for period of 3 to 10 years. The multi-year guarantee annuities were designed specifically
to compete with certificate of deposit which can change their interest earnings periodically.




                                                29
                                    SURRENDER CHARGES
   (This section is derived from CIC 10127.10, 10127.11 and 10127.12 redacted)

    Every policy of individual life insurance and every individual annuity contract that is initially
delivered or issued for delivery to a senior citizen in this state on and after July 1, 2004, shall
have printed thereon or attached thereto a notice stating that, after receipt of the policy by the
owner, the policy may be returned by the owner for cancellation by delivering it or mailing it to
the insurer or agent from whom it was purchased.
    The period of time set forth by the insurer for return of the policy by the owner shall be
clearly stated on the notice and this period shall be not less than 30 days. The owner may return
the policy to the insurer by mail or otherwise at any time during the period specified in the
notice. During the 30-day cancellation period, the premium for a variable annuity may be
invested only in fixed-income investments and money-market funds, unless the investor
specifically directs that the premium be invested in the mutual funds underlying the variable
annuity contract. Return of the policy within the 30-day cancellation period shall have one of the
following effects:
       (1) In the case of individual life insurance policies and variable annuity contracts for which
the owner has not directed that the premium be invested in the mutual funds underlying the
contract during the cancellation period, return of the policy during the cancellation period shall
have the effect of voiding the policy from the beginning, and the parties shall be in the same
position as if no policy had been issued. All premiums paid and any policy fee paid for the policy
shall be refunded by the insurer to the owner within 30 days from the date that the insurer is
notified that the owner has canceled the policy. The premium and policy fee shall be refunded by
the insurer to the owner within 30 days from the date that the insurer is notified that the owner
has canceled the policy.
       (2) In the case of a variable annuity for which the owner has directed that the premium be
invested in the mutual funds underlying the contract during the 30-day cancellation period,
cancellation shall entitle the owner to a refund of the account value. The account value shall be
refunded by the insurer to the owner within 30 days from the date that the insurer is notified that
the owner has canceled the contract.
    This section applies to all individual policies issued or delivered to senior citizens in this
state on or after January 1, 2004. All policies subject to this section which are in effect on
January 1, 2003, shall be construed to be in compliance with this section, and any provision in
any policy which is in conflict with this section shall be of no force or effect.
    Every individual life insurance policy and every individual annuity contract, other than
variable contracts and modified guaranteed contracts, subject to this section, that is delivered or
issued for delivery in this state shall have the following notice either printed on the cover page or
policy jacket in 12-point bold print with one inch of space on all sides or printed on a sticker that
is affixed to the cover page or policy jacket: (10127.13.) All individual life insurance policies
and individual annuity contracts for senior citizens that contain a surrender charge period shall
either disclose the surrender period and all associated penalties in 12-point bold print on the
cover sheet of the policy or disclose the location of the surrender information in bold 12-point
print on the cover page of the policy, or printed on a sticker that is affixed to the cover page or to



                                                 30
the policy jacket. The notice required by this section may appear on a cover sheet that also
contains the disclosure required.



                  "IMPORTANT
    YOU HAVE PURCHASED A LIFE INSURANCE POLICY OR ANNUITY CONTRACT.
   CAREFULLY REVIEW IT FOR LIMITATIONS.

    THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU
   RECEIVED IT FOR A FULL REFUND BY RETURNING IT TO THE INSURANCE
   COMPANY OR AGENT WHO SOLD YOU THIS POLICY. AFTER 30 DAYS,
   CANCELLATION MAY RESULT IN A SUBSTANTIAL PENALTY, KNOWN AS A
   SURRENDER CHARGE."



    The phrase "after 30 days, cancellation may result in a substantial penalty, known as a
surrender charge" may be deleted if the policy does not contain those charges or penalties.
    Every individual variable annuity contract, variable life insurance contract, or modified
guaranteed contract subject to this section, that is delivered or issued for delivery in this state,
shall have the following notice either printed on the cover page or policy jacket in 12-point bold
print with one inch of space on all sides or printed on a sticker that is affixed to the cover page or
policy jacket:
                                   "IMPORTANT
     YOU HAVE PURCHASED A VARIABLE ANNUITY CONTRACT (VARIABLE LIFE
   INSURANCE CONTRACT, OR MODIFIED GUARANTEED CONTRACT). CAREFULLY
   REVIEW IT FOR LIMITATIONS.
     THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU
   RECEIVED IT. DURING THAT 30-DAY PERIOD, YOUR MONEY WILL BE PLACED IN
   A FIXED ACCOUNT OR MONEY-MARKET FUND, UNLESS YOU DIRECT THAT THE
   PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO UNDERLYING THE
   CONTRACT DURING THE 30-DAY PERIOD. IF YOU DO NOT DIRECT THAT THE
   PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO, AND IF YOU RETURN
   THE POLICY WITHIN THE 30-DAY PERIOD, YOU WILL BE ENTITLED TO A REFUND
   OF THE PREMIUM AND POLICY FEES. IF YOU DIRECT THAT THE PREMIUM BE
   INVESTED IN A STOCK OR BOND PORTFOLIO DURING THE 30-DAY PERIOD, AND
   IF YOU RETURN THE POLICY DURING THAT PERIOD, YOU WILL BE ENTITLED TO
   A REFUND OF THE POLICY'S ACCOUNT VALUE ON THE DAY THE POLICY IS
   RECEIVED BY THE INSURANCE COMPANY OR AGENT WHO SOLD YOU THIS POLICY,
   WHICH COULD BE LESS THAN THE PREMIUM YOU PAID FOR THE POLICY. A
   RETURN OF THE POLICY AFTER 30 DAYS MAY RESULT IN A SUBSTANTIAL
   PENALTY, KNOWN AS A SURRENDER CHARGE."



                                                 31
    The words "known as a surrender charge" may be deleted if the contract does not contain
those charges.
    This section does not apply to life insurance policies issued in connection with a credit
transaction or issued under a contractual policy-change or conversion privilege provision
contained in a policy. Additionally, this section shall not apply to contributory and
noncontributory employer group life insurance, contributory and noncontributory employer
group annuity contracts, and group term life insurance, with the exception of the following:
    When an insurer, its agent, group master policyowner, or association collects more than one
month's premium from a senior citizen at the time of application or at the time of delivery of a
group term life insurance policy or certificate, the insurer must provide the senior citizen a
prorated refund of the premium if the senior citizen delivers a cancellation request to the insurer
during the first 30 days of the policy period.
    For purposes of this chapter, a senior citizen means an individual who is 60 years of age or
older on the date of purchase of the policy.
    Every insurer and life agent offering for sale individual life insurance policies or individual
annuity contracts that are initially delivered or issued for delivery to senior citizens in this state
on and after January 1, 1995, with the use of nonpreprinted illustrations of nonguaranteed values
shall disclose on those illustrations or on an attached cover sheet, in bold or underlined
capitalized print, or in the form of a contrasting color sticker, bright highlighter pen, or in any
manner that makes it more prominent than the surrounding material, with at least one-half inch
space on all four sides, the following statement:

  "THIS IS AN ILLUSTRATION ONLY. AN ILLUSTRATION IS NOT INTENDED TO
PREDICT ACTUAL PERFORMANCE. INTEREST RATES, DIVIDENDS, OR VALUES
THAT ARE SET FORTH IN THE ILLUSTRATION ARE NOT GUARANTEED, EXCEPT
FOR THOSE ITEMS CLEARLY LABELED AS GUARANTEED."

     All preprinted policy illustrations shall contain this notice in 12-point bold print with at least one-half
inch space on all four sides and shall be printed on the illustration form itself or on an attached cover
sheet, or in the form of a contrasting color sticker placed on the front of the illustration. All preprinted
illustrations containing nonguaranteed values shall show the columns of guaranteed values in bold print.
All other columns used in the illustration shall be in standard print. "Values" as used here includes cash
value, surrender value, and death benefit.
     All individual life insurance policies and individual annuity contracts for senior citizens that
contain a surrender charge period shall either disclose the surrender period and all associated
penalties in 12-point bold print on the cover sheet of the policy or disclose the location of the
surrender information in bold 12-point print on the cover page of the policy, or printed on a
sticker that is affixed to the cover page or to the policy jacket. The notice required by this section
may appear on a cover sheet that also contains the disclosure required by (these regulations).
     Multi-year guarantee annuities do not provide the liquidity of annual guarantee annuities and
surrender charges are usually imposed if the annuity is surrendered prior to the end of the present
guarantee period. Most annuities allow that for a specified period of time, usually 30 days, the
multi-year guarantee contract can be surrendered without being penalized by surrender charges.
If the annuity owner has not surrendered the annuity, it is then renewed for a multi-year period if


                                                      32
is the same as the original period, but the annuity owner may select a different renewal period.
     Surrender charges for a multi-year guarantee annuity usually do not apply if withdrawals are
of an amount that is less than the credited interest or if the annuity owner elects to receive
periodic income payments (annuitizes). Of course, if the death of the owner of the annuity
occurs then death benefits are paid with no surrender charge.
     In some multi-year guarantee annuities, an insurer may offer a “bonus” annuity by crediting
additional interest in the first year of the multi-year guarantee period. (See discussion of the
bonus effect in SPDAs in Chapter 2, and “Disclosure Obligations of Bonus Programs” in Chap.
6.)
     Multi-year guarantee annuities may resemble bonds in some fashion as they have a market
value adjustment, which, in “bond lingo” refers to a bond which pays interest depending upon
what investors can receive in other markets. In some cases the adjustment may increase, in
others it would decrease – interestingly to those who are not familiar with the bond market, if the
prevailing interest rates go up, the bond holder is stuck with a lower interest rate, and so the
bondholder will lose when he sells at the market value. Conversely, if the market drops, then the
bond becomes more valuable and the bondholder would make a profit if he sold at the market
value. This dissertation on market value adjustment has a bearing on multi-year guarantee
annuities.
     If the annuity owner surrenders the annuity before the end of its term, the market value
adjustment normally would be applied in addition to any other surrender charge or “premature
distribution” tax penalty. Therefore, if the prevailing interest rates have increased, then the
market value adjustment would be negative – just like in a bond and the surrender charge could
become expensive.
     Conversely, if the interest rates have dropped, then the market value adjustment would be
positive, therefore offsetting some of the surrender charge.
     In actual practice, surrenders of annuities primarily occur during riding interest rates where
the annuity owners are chasing higher interest investments, therefore the market value
adjustment is generally costly to the annuity owner.
                      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
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



                                                33
certain uses, such as for IRAs or for 403(b) organizations.
                 INDIVIDUAL RETIREMENT ACCOUNT (IRA) ANNUITIES
    Individual Retirement Account (IRAs) annuities 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 annuity 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.25)
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.
Individual retirement arrangements (IRAs) are often established in connection with workplace
retirement plant, such as SEPs and SIMPLEs. (IRC 408(k). Because Congress tinkers with
IRAs every few years, the regulations and limitations change from time to time. 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. However,
when annuity premiums are deductible in such a case, it is because of the annuity’s inclusion in
the plan rather than the fact that it is, indeed, an annuity.
                        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
$2,000 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 $2,001 or more per year may contribute only the $2,000 maximum rather than 100% of
earnings. In addition, the wage earner may make an additional contribution on behalf of a non-
employed spouse, in which case the wage earner may contribute up to $4,000 a year or 100% of
earnings.
     The maximum age for participating in an IRA is 70 ½, at which age there must be
withdrawals which are specified in the government regulations and which can be taken in a lump
sum or spread out over a number of years.
                                      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.



                                                34
    The entire amount of the contribution is deductible for a single taxpayer whose adjusted
gross income (AGI) is less than $25,000 annually and for married taxpayers filing jointly whose
AGI is less than $40,000 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 $35,000, or
for joint filers when their AGI reaches $50,000. But remember, the tax deferral on interest
continues even though the contribution is not tax deductible.
    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 all 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.
                      SIMPLIFIED EMPLOYEE PENSION PLANS (SEP)
    Whether a person is self-employed or receives income from consulting or part-time work,
they should consider setting up a Simplified Employee Pension Plan (SEP). This allows an
employer to make contributions to an employee's retirement without becoming involved in more
complex plans, and further, a self-employed person can contribute to his own SEP.
    An employer or self-employed person, may make a deductible contribution each year of up
to $40,000, or 25% of compensation, whichever is less. Some low-middle class employees may
receive an additional tax credit of 10% to 50%.
    Annuities are used in all types of tax-favored retirement plans maintained by employers for
the benefit of their employees. IRAs are also established with workplace retirement plans, such
as SEPs and SIMPLEs.


                                                35
    Federal information returns must be filed by companies that issue contracts with designated
distributions may be made. IRS Code 408(i) states that the issuer of an IA including an SEP or
SIMPLE PLAN, is required to report annually the contributions to such accounts of small
employers and the fair market value of the contract is determined. In general, the issuer of the
annuity contract is responsible for any federal tax reporting applicable with respect to the annuity
contract it issues. This is another advantage of using annuities for such retirement vehicles,
particularly is the person is self-employed as insurance companies are familiar with such
reporting requirements and it is extremely rare, if ever, where there would be an error.


                                          DEEMED IRA
    Starting in 2002, tax-favored retirement plans (401(a), 401(k), 403(a), 457 plans) and Section
403(b) annuities are allowed to include an IRA account/annuity within the plan. These plans can
accept voluntary employee contributions if (1) the contributions are held in a separate
account/annuity that is established under the tax-qualified arrangement; and (2) the
account/annuity meets the requirements for either a traditional or Roth IRA. These
annuities/accounts will be treated as an IRA for tax purposes (hence the name, deemed IRA).
They are subject to the contribution limit – such as $3,000 for 2003 – and distribution rules, IRA
early withdrawal tax exemptions and reporting requirements.26

    Some other features of the deemed IRA are that the voluntary contributions and earnings are
not subject to any qualified plan limits and do not affect the applicability of the limits or other
rules to amounts held by the individual held under a qualifying (or other) plan. This plan allows
IRA and qualified plan funds to be commingled for investment purposes if the deemed IRA
assets are held in a trust or annuity separate from other plan assets.


                                           ROTH IRA
    Effective January 1, 1998, most people can fund a Roth IRA. The maximum contribution is
$2,000, 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.


                                                36
    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 $2,000 per person deductible is important now, and if so, then the traditional
IRA will do the job.

    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 the individual’s tax bracket as in some cases it could trigger a rise to another
tax bracket. Questions of this sort should be referred to a tax attorney or accountant.


                                     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 are 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, refer to the chapter on EIAs.

    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.


                                                37
    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?


                     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.
                                      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.27
    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.

    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 work $100,000 (exactly) at the end of the 8 year period. During these 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.


                                               38
   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.
                          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 ages 55
and higher — although the products may be purchased by younger people as well.
    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 any time 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.”

   NOTE: Chapter 10 of this text discusses in detail, the marketing of annuities to seniors
   and regulations pertaining to this particular area.

    FUNDING RETIREMENT WITH THE USE OF RESIDENCE & ANNUITY
    Many elderly persons are retired and strapped for cash, and many have been made aware of
various methods of obtaining income from their residence that in many cases are mortgage-free
or has considerable equity. “Reverse mortgages” are often used to use the residence as a source
of retirement income. The homeowner may be able to borrow considerable funds with a home-
equity conversion mortgage, the most popular type of reverse mortgage27A.
    These mortgages are better for the individual in many cases, as if they simply refinanced and
took out a new mortgage, they would still be faced with mortgage payments – provided they


                                                39
could even find a lender willing to refinance as in many cases the owner would be facing larger
monthly mortgage payments than they could afford. The advantages of a regular mortgage are
that the up-front costs are lower, and the interest charged is usually tax-deductible. But even if
you took the money from refinancing and invested it in bonds, particularly at today’s low interest
rates, many times the homeowner would still be out of pocket as the interest income would not
make the mortgage payment.
     The next best thing, as argued by many financial analysts, is to obtain a line of credit that
would allow the homeowner to tap into the equity. However, if problems arise in the future in
respect to needing more money, then it would be necessary to go to a longer-term solution.
     Another option involves annuities (yes, we are talking about annuities eventually…). The
homeowner takes out a mortgage for most of the value of the home, and then uses the proceeds
to buy an immediate-fixed annuity that would pay lifetime income. Usually, at the older ages,
the monthly payment would easily cover the mortgage payment – the only drawback being that
some portion of the annuity check would be taxable.
     Then, since there is a conventional mortgage, the debt will shrink, so the longer one lives, the
more attractive this arrangement becomes. One drawback, as with any annuity, you want to live
for a period of time because if the homeowners buys an annuity and then dies shortly thereafter,
it’s a financial disaster because the annuity investment is gone and the homeowner received very
little income from the annuity.
     If the person is healthy and their family has usually lived for a long time, and all health
indications are good, then this is a possible alternative to the reverse-mortgage.

    CONSUMER APPLICATION
    Bill Jensen has just turned 75 and has most of his retirement in Certificate of Deposit and
Money Market funds; with the result that he feels it is necessary to increase his retirement
income. In looking around at what he has, he realizes that his home (that he paid off 10 years
ago) is now worth $250,000.
    Bill takes out a 6.3 percent mortgage for 80% of his home’s $250,000 value. He uses the
proceeds to purchase a fixed annuity that pays $1,809 a month. His mortgage payment is $1,238,
so even paying income tax on some of the annuity payment; he would increase his monthly
income by $571 per month.


                             REVIEWING ANNUITY CONTRACTS
   It cannot be stressed enough –

   Annuity agents are not “one-size-fits-all” salespersons. Each applicant is unique
  therefore, the annuity products must be determined as the best product for their needs.

    Believe it or not, there are a multitude of annuities available in today’s market. If an agent is
not familiar with many of the products, they are not going to be able to professionally
recommend a particular product to fit each situation. Obviously, it is not possible to dissect
every annuity available so as to differentiate between them, but there are certain areas that apply



                                                 40
to every annuity of that particular type.
    Throughout this text there are discussions on different points of the various types of
annuities. For illustration, three types of annuities – Single Premium Deferred Annuities,
Variable Annuities and Equity Index Annuities – are discussed. While there are some
similarities between all annuities – such as the financial strengths of the issuing company – there
are also important differences.


                        SINGLE PREMIUM DEFERRED ANNUITIES
   Some of the major items that must be known in order to recommend a particular SPDA:
        Issuing Company. As with all policies, the rating of the issuing company must be
         taken into consideration. If an agent recommends a policy from a particular company
         that eventually is taken over by a regulatory agency because of financial difficulties,
         at the very least the professional reputation of the agent will be hurt, perhaps
         irreparable.
        How Many SPDAs Does the Company Offer? If the company has several types of
         SPDAs, it certainly behooves the agent to find out what the difference is between the
         products. It may be possible to offer the applicant a wider choice with the same
         insurer – which may be the best or most financial secure company.
        Minimum Premium for the Plan. This can range from $5,000 upwards to $50,000,
         most being in the $5,000 to $10,000 range. One would not be wise to offer an
         annuity with a minimum premium of $25,000 when the applicant only has $10,000 to
         invest in an annuity.
        Maximum Issue Age and Maximum Annuitization Age. This can range from 80 to
         95 issue age, and age 85 to 99 to indefinite for Annuitization age. For an elderly
         (very) person, this can be very important. Remember that many elderly applicants for
         SPDAs that can afford a sizeable premium, probably also have excellent attorneys in
         case the annuity does not perform as expected.
        Current Interest Rate. The current interest rate jumps all over the place – in early
         2004, for example, among the largest writers of SPDAs, the current rates ranged from
         4.25% to 10.48%. The highest interest rate may not be the only criteria that matters,
         but it certainly is important. Clients usually want the “biggest bang for the buck” or
         why they don’t have it.
        Bonus Included in the Interest Rate? Again, this ranges from 0% to 7%. One
         might surmise that the companies with the highest bonus would have the lowest
         interest rate – but that is not necessarily true. For instance, a company with the
         10.48% current interest rate has a bonus of 7%. Proves again, the agent must be
         familiar with the contract.
        Minimum Interest Guarantee. Ranges from 1.5% to 4.7%. Some may ask if that
         has any relation to the Bonus or Current interest rate. Maybe, the company offering
         the 10.48% current interest rate and bonus of 7% has a minimum guarantee of 1.5%.
        Initial Rate SPDA Paid on New Policies and Interest Rate Credited to SPDAs
         Over the Past Five Years. This information is important because the prospective
         annuity purchaser may want to know exactly what had others gotten in recent years.


                                                41
           The agent must be prepared for this, as everyone knows that interest rates have
           plummeted recently and it is so very difficult to predict what interest rates will do in
           the future. Really not apropos to anything, but interestingly, the initial rate over the
           past 5 years have run from “Not Applicable” (obviously) to as high as 8.25%.
           Interest rate credited ranged from 3% to 5% (including some ‘proprietary
           information” – in other words, none of our business.) An agent should be aware of
           what interest has been credited on the annuities if they are licensed with the company.
          Fees and Surrender Charges. Most companies have no fees, only surrender
           charges. This has been addressed in this text and can be different for the senior
           citizen than for other annuitants.
          Free Partial Withdrawal, When Available and How Many a Year? Very
           important. The agent must know this “cold.” At this time there is only one company
           reporting that they do not have a partial withdrawal. The other companies make such
           withdrawal available from immediately, to after the first contract year (most
           prevalent) and most allow one per year. Some allow the amount by percentage, such
           as one company allows immediate withdrawal with 10% free corridor. Another point
           that must be known. Cold! Clients nearly always want to know how they can get
           their premium (investment) back if something happens.
          Condition to Qualify for Free Partial Withdrawal. If free withdrawal is allowed,
           then what does the client have to do to qualify for a “free” withdrawal. Some
           companies limit it to a percentage after certain time has expired, to several other
           conditions. These vary widely, so again, it must be known.
          Surrender Charges. This is not partial withdrawal, obviously, but is the penalty if
           the annuity is surrendered. Generally companies have a surrender charge of 8-9-10%
           the first year, graded down each year until it is zero or no charge, which usually
           occurs at or about the 10th year. Pretty standard, but a good agent would never take
           this for granted – one company, for instance, has charges of (from first year to year of
           no charge) 6-6-6-5-4-3-2-0%. Another has 7-7-7-7-6-5-4-3-2-1%.
          Situations When Surrender Fees are Waived. Death and annuitization universally.
           Others offer nursing home, terminal illness or hospital confinement. One company
           adds natural disaster (if this sounds far-fetched, think Hurricane Charley!).
           Sometimes if death is waived, it is waived only if an optional death benefit is chosen.
           If this were missed and death of an annuitant occurred, someone would have a hard
           time explaining to the heirs that an option was not chosen that just happens to be
           covered under nearly all other annuities. Some also waiver unemployment, disability,
           and chargers and fees under certain conditions.


                                    VARIABLE ANNUITIES
   Of course Variable Annuities share many of the same provisions as SPDAs and other
annuities, but there are some provisions that are unique to the VAs that should be known to the
agent.

          Fixed Account? It is about half “Yes” and half “No.” Of course this is of prime



                                                42
    importance to the marketer of Variable Annuities.
   Current Credited Interest Rate. Most credit 3%, but one company credits 4%,
    another 0%.
   Minimum Guaranteed Interest Rate. Most are at 3%, but some are only 1.5%.
   Market Value Adjustment? This ranges from “None” to 3-5-7-10 year.
   Investment Option – Fund Management Firm. This separates the “men from the
    boys” and is at the heart of the Variable Annuity. Each of the Options should be
    broken down into
        Annualized Rate of Return
        Investment Advisory Fee
        Fund Operating Expense
        12b-1 Fees.
   Total Number of Funds Offered. 21 to 63 funds offered.
   Mortality and Risk Charge.         .9% to 1.6% Apply this is a sample premium of
    $20,000 and notice the difference - $180 to $320.
   Asset Based Administrative Charge (if separate from M&E). .15% to .2 %
   Guaranteed Minimum Death Benefit (GMDB). Most are reset up only, annually,
    with accumulated benefit of 5%. There are some that have Return of Premium, and
    reset benefit every 6 years.
   Policy Fee. Ranges from zero to $30 that is waived at $50,000. Has there ever been
    an agent who hasn’t lost a sale because they “forgot” the policy fee, small though it
    may be?
   GMDB Cap, Max. age, Additional Cost (if Rider). This also varies greatly by
    company and by product and policy form. The agent must become proficient in
    interpreting accumulation benefit, ratchet & ratchet rider, annual step-up, contract
    value for return of premium, etc., as they are all used by various policy forms.
   Annuitization Options. Variable Annuities generally allow variable annuitization
    option and/or fixed annuitization option.


                          EQUITY INDEX ANNUITIES
   EIAs have a lot of similarity to Variable Annuities in respect to important provisions,
    but with some differences.
   Index Values Available for Free Partial Withdrawals. A unique feature of an
    EIA. Most companies allow this, but some do not.
   Method for Determining Surrender Values. Nearly always the contract can be
    surrendered during index term. The amount varies widely and each annuity contract
    must be studied carefully in this respect.
   Waivers. Waivers range from after year one and confinement in a nursing home over
    a minimum of 5 years, to nursing home and/or terminal illness which will allow for
    more than 10% to be withdrawn but with penalty fee. This varies so widely also that
    each contract needs to be carefully reviewed.


                                        43
          Index to Which Product is Tied. Usually this is S&P 500, but some companies
           specify Dow Jones Averages, or some companies give a choice of 3-4 indexes.
          Indexing Method. The indexing methods will be discussed in the Chapter on EIAs.
           Most companies at this time use the annual ratchet method or annual point-to-point.
           Some companies offer a wide choice of methods with different plans.
          Caps on Annual Earnings &/or Cap on Total Return Over Contract Term.
           Some annuities do not have a cap; others have caps on annual earnings and total
           return. These caps are based upon various options, so these caps, MUST be known
           and reviewed periodically in case there are changes in new products.
          Current Participation Rate. Extreme important. As discussed later in the text, this
           is the percentage of premiums that will be invested from the premiums paid and can
           range from 100% to 55%, usually depending upon the indexing method.
          Participation Rates for the Past 12 Months. This is another “MUST” and can be
           quite informative as it can range from 100% each month, down to range of around
           55% each previous month.
          Value at Death or Annuitization. For those not familiar with this product, it is
           rather interesting to see the varying death and annuitization benefits. Most pay full
           index value at death, but some do not. The professional agent must pay attention to
           this also.

   While there are many other items that the agent must pay particular attention to prior to
making a presentation to a prospect or discussing an annuity with a client, these are probably the
most important items.
                                      SALES PRACTICES
    It would be nice if there were no such thing as an “unethical” agent, but unfortunately this is
not the case. Therefore, regulations are in force to correct the practices that cause irreparable
harm to our industry and to our profession. The most often targeted of our population by these
miscreants are the elderly for a variety of reasons. Fortunately the Departments of Insurance and
legislatures – locally, state and federal – have created special types of regulation protection these
citizens, and this is true in the field of annuity sales. There is a chapter of this text dedicated to
the problems of the senior citizens with discussions of appropriate regulations and penalties for
those who ignore or disregard these regulations. This section discusses the sales practices of
agents marketing annuities to anyone regardless of age, recognizing that some of this will be
repeated in the later discussion of marketing to the seniors.
                                          ADVERTISING
    For the purpose of this discussion and regulations, “advertising” applies not only to “ads”
(which actually is an abbreviation for advertisement) brochures, newspaper and other media
articles, television and radio advertising – but primarily printed material. Envelopes, stationery,
business cards and any other material that is used by an agent or insurer that are designed to
describe the insurance product and to attempt to encourage a purchase of the insurance product –
annuity for this discussion.
    Simply put, the regulations89 are intended to insure that the insurers and agents treat their
clients honestly and openly. Therefore, any advertising must not mislead those who read it and


                                                 44
act upon the information contained in the material (with special obligations to seniors, discussed
later).
    Advertising is also the material that is used to generate leads through reader response,
generally followed by an agent calling. It can advertise a meeting or seminar at which
information is provided (also covered in detail in a separate section), or simply advertising the
product of the insurer. If the advertisement is directed towards those aged 65 or older, if the
advertisement is used for leads, the advertiser must disclose in the advertisement that an agent
may contact the person – if this is intended.
    If the name of the prospect is obtained from a lead source, the source must be disclosed to
those over age 65.
    Even though it is in nearly all agents’ contracts, it does not hurt to point out that the
insurance company must give an agent permission in writing before the agent can advertise the
product.
    The regulations explicitly state “Any advertisement or other device designed to produce
leads based on a response from a potential insured which is directed towards persons age 65 or
older shall prominently disclose that an agent may contact the applicant if that is the fact. In
addition, an agent who makes contact with a person as a result of acquiring that person's name
from a lead generating device shall disclose that fact in the initial contact with the person.”

                   SEMINARS, CLASSES, INFORMATIONAL MEETINGS
    Agents and others, who market financial products, attempt to obtain new clients by holding
seminars, classes or information meetings. This is particular applicable in the senior market, and
is so discussed later in the text. Basically, the regulations require that for such a meeting to be
advertised (to any age) that the advertiser must disclose their intention by adding “and
insurance sales presentation” immediately following the words “seminar,” “class,” or
“informational meeting.”
                          ADVERTISING TO THE SENIOR MARKET
    (SEE CHAPTER TEN) Marketing of annuities to those over age 65 have strict prohibitions
as follows, however the rest of the regulations are also quite strict and consumer oriented:
         Any advertisement or other device designed to produce leads based on a response from
        a potential insured which is directed towards persons age 65 or older shall prominently
        disclose that an agent may contact the applicant if that is the fact. In addition, an agent
        who makes contact with a person as a result of acquiring that person's name from a lead
        generating device shall disclose that fact in the initial contact with the person.
         No insurer, agent, broker, solicitor, or other person or other entity shall solicit persons
        age 65 and older in this state for the purchase of disability insurance, life insurance, or
        annuities through the use of a true or fictitious name which is deceptive or misleading
        with regard to the status, character, or proprietary or representative capacity of the entity
        or person, or to the true purpose of the advertisement.
         For the purposes of this section, an advertisement includes envelopes, stationery,
        business cards, or other materials designed to describe and encourage the purchase of a
        policy or certificate of disability insurance, life insurance, or an annuity.
         Advertisements shall not employ words, letters, initials, symbols, or other devices
        which are so similar to those used by governmental agencies, a nonprofit or charitable


                                                 45
       institution, senior organization, or other insurer that they could have the capacity or
       tendency to mislead the public. Examples of misleading materials, include, but are not
       limited to, those which imply any of the following:
                             The advertised coverages are somehow provided by or are endorsed
                              by any governmental agencies, nonprofit or charitable institution or
                              senior organizations.
                             The advertiser is the same as, is connected with, or is endorsed by
                              governmental agencies, nonprofit or charitable institutions or senior
                              organizations.
        No advertisement may use the name of a state or political subdivision thereof in a
       policy name or description.
        No advertisement may use any name, service mark, slogan, symbol, or any device in
       any manner that implies that the insurer, or the policy or certificate advertised, or that any
       agency who may call upon the consumer in response to the advertisement, is connected
       with a governmental agency, such as the Social Security Administration.
        No advertisement may imply that the reader may lose a right, or privilege, or benefits
       under federal, state, or local law if he or she fails to respond to the advertisement.
        An insurer, agent, broker, or other entity may not use an address so as to mislead or
       deceive as to the true identity, location, or licensing status of the insurer, agent, broker, or
       other entity.
        No insurer may use, in the trade name of its insurance policy or certificate, any
       terminology or words so similar to the name of a governmental agency or governmental
       program as to have the capacity or the tendency to confuse, deceive, or mislead a
       prospective purchaser.
        All advertisements used by agents, producers, brokers, solicitors, or other persons for a
       policy of an insurer shall have written approval of the insurer before they may be used.
        No insurer, agent, broker, or other entity may solicit a particular class by use of
       advertisements which state or imply that the occupational or other status as members of
       the class entitles them to reduced rates on a group or other basis when, in fact, the policy
       or certificate being advertised is sold on an individual basis at regular rates.
        In addition to any other prohibition on untrue, deceptive, or misleading advertisements,
       no advertisement for an event where insurance products will be offered for sale may use
       the terms "seminar," "class," "informational meeting," or substantially equivalent terms
       to characterize the purpose of the public gathering or event unless it adds the words "and
       insurance sales presentation" immediately following those terms in the same type size
       and font as those terms.


                   PENALTIES FOR VIOLATION OF THE REGULATIONS
    Any person or business in violation of the advertising regulations is subject to a stiff fine
levied by the Insurance Commissioner. The fine for the first offense is $200, for the second
offense it goes to $500, and for the third and later offenses, $1,000. The maximum fine for any
one violation is $1,000. And if you are interested, the money goes into the Insurance Fund.63C
                   EXEMPTIONS FROM ADVERTISING REGULATIONS
   While the regulations are quite specific in respect to requiring that every licensee shall


                                                 46
prominently affix, print or type on business cards, price quotes or advertisements, its license
number, address or fax number, and the word, “Insurance” must be displayed (as stated above)
on the printed matter. However, there are certain exceptions to these rules:63D

          Separate penalty shall not be imposed on each piece of printed material that fails to
           conform to the regulations.
          If a person is unable to abide by the regulations by circumstances beyond his control,
           the Insurance Commissioner may relieve the licensee of any penalty after the licensee
           files documents with the Department setting forth the facts.
          These regulations do not apply to any person or business that is not licensed by the
           Department or is otherwise exempted from the regulation.
          Motor Clubs that that list insurance products as one of several services offered
           without details of the insurance products, is exempt.
          Life insurance policy projections and illustrations, or to life insurance cost indexes as
           required by other regulations, are exempt, but they must comply with other
           appropriate regulations.

  (a) No insurer, agent, broker, solicitor, or other person or other entity shall solicit persons age
65 and older in this state for the purchase of disability insurance, life insurance, or annuities
through the use of a true or fictitious name which is deceptive or misleading with regard to the
status, character, or proprietary or representative capacity of the entity or person, or to the true
purpose of the advertisement.
  (b) For the purposes of this section, an advertisement includes envelopes, stationery, business
cards, or other materials designed to describe and encourage the purchase of a policy or
certificate of disability insurance, life insurance, or an annuity.
  (c) Advertisements shall not employ words, letters, initials, symbols, or other devices which
are so similar to those used by governmental agencies, a nonprofit or charitable institution, senior
organization, or other insurer that they could have the capacity or tendency to mislead the public.
Examples of misleading materials, include, but are not limited to, those which imply any of the
following:
  (1) The advertised coverages are somehow provided by or are endorsed by any governmental
agencies, nonprofit or charitable institution or senior organizations.
  (2) The advertiser is the same as, is connected with, or is endorsed by governmental agencies,
nonprofit or charitable institutions or senior organizations.
  (d) No advertisement may use the name of a state or political subdivision thereof in a policy
name or description.
  (e) No advertisement may use any name, service mark, slogan, symbol, or any device in any
manner that implies that the insurer, or the policy or certificate advertised, or that any agency
who may call upon the consumer in response to the advertisement, is connected with a
governmental agency, such as the Social Security Administration.
  (f) No advertisement may imply that the reader may lose a right, or privilege, or benefits under
federal, state, or local law if he or she fails to respond to the advertisement.
  (g) An insurer, agent, broker, or other entity may not use an address so as to mislead or deceive
as to the true identity, location, or licensing status of the insurer, agent, broker, or other entity.



                                                 47
  (h) No insurer may use, in the trade name of its insurance policy or certificate, any terminology
or words so similar to the name of a governmental agency or governmental program as to have
the capacity or the tendency to confuse, deceive, or mislead a prospective purchaser.
  (i) All advertisements used by agents, producers, brokers, solicitors, or other persons for a
policy of an insurer shall have written approval of the insurer before they may be used.
  (j) No insurer, agent, broker, or other entity may solicit a particular class by use of
advertisements which state or imply that the occupational or other status as members of the class
entitles them to reduced rates on a group or other basis when, in fact, the policy or certificate
being advertised is sold on an individual basis at regular rates.
  (k) In addition to any other prohibition on untrue, deceptive, or misleading advertisements, no
advertisement for an event where insurance products will be offered for sale may use the terms
"seminar," "class," "informational meeting," or substantially equivalent terms to characterize the
purpose of the public gathering or event unless it adds the words "and insurance sales
presentation" immediately following those terms in the same type size and font as those terms.


               CAUSE FOR LICENSE SUSPENSION AND/OR REVOCATION
    Regulations differentiate between Fine and Penalties for violation of regulations, and license
suspension and/or revocation.91 These acts assume that the agent has used his relationship with
the client to take advantage of her/him.
                                               LOANS
     If an agent persuades or causes a client to cosign or make a loan, investment or gift, or
provide a future benefit through a right of survivorship for the benefit of
          the agent,
          a person with a relationship to the agent by birth, marriage or adoption,
          a friend or business acquaintance of the agent, or
          a domestic partner of the agent –
         the agent’s license may be suspended or revoked.
         This does not apply if the client is related to the agent by birth, adoption or marriage, nor
is a domestic partner of the agent.
                                     AGENT BENEFICIARIES
    The agent’s license may be suspended or revoked if an agent persuades or causes a client to
designate as a trust beneficiary or beneficiary or owner of a life insurance policy or annuity for
the benefit of the agent, a person with a relationship to the agent by birth, marriage or adoption, a
friend or business acquaintance of the agent, or a domestic partner of the agent. This does not
apply if the client is related to the agent by birth, adoption or marriage, nor is a domestic partner
of the agent.
                                         AGENT TRUSTEE
    The agent’s license may be suspended or revoked is the agent persuades or causes a client to
designate as a trustee under a trust, the agent, etc., as listed above. There is an exception where
the agent is designated as a trust of a testamentary or inter vivos trust if the agent is also an


                                                  48
attorney in any state and the agent is not a seller of insurance to the Trustor of the fund.
                          AGENT HOLDING POWER OF ATTORNEY
     An agent’s license may be suspended or revoked if an agent has a power of attorney for a
client and has sold the client an insurance product for which the agent has received a
commission. Further, the license may be suspended or revoked if the agent has used the power
of attorney to purchase an insurance product on behalf of the client and for which the agent has
received a commission.
     This rule does not apply if the client is related to the agent by birth, adoption or marriage, nor
is a domestic partner of the agent.
                 PENALTIES FOR VIOLATION CIC ARTICLE 6.3 (SENIORS)
   For misrepresentations the penalties are usually punishable by fine of up to $1,500 and 6
months in jail. Penalties are much harsher for insurance code violations involving older citizens.
These penalties are detailed in a later Chapter.

   STUDY QUESTIONS

1. Except for an immediate annuity, annuities should be considered
   A. as part of a long-term investment strategy.
   B. as part of a short-term liquid savings accountant.
   C. as just another type of life insurance policy.
   D. as the best type of investment for those who need immediate access to their funds.

2. When variable annuities are used as a long-term investment, the key for profitability is
   A. to avoid the temptation to withdraw during temporary market downturns.
   B. to put more into the annuities than the contract holder can afford.
   C. to purchase the annuity from a low-rated company that will promise more returns.
   D. to purchase the annuity through a bank or S&L.

3. With a qualified annuity,
   A. it is paid for with after-tax dollars, so contributions are not tax deductible.
   B. the agent must be licensed with the SEC.
   C. no current income tax is required on the portion of income used to pay the premium.
   D. it may be issued only with a company with an A+ or higher rating.

4. An IRA is always
   A. a fixed premium immediate annuity.
   B. a Variable Annuity.
   C. a flexible premium deferred annuity.
   D. a single premium immediate annuity.




                                                  49
5. If an IRA holder is going to roll over the IRA into another plan, in order to avoid penalties
    A. the new plan must be written with an off-shore or foreign insurer.
    B. corporate plan proceeds must be paid from the former employer’s plan directly into an
        other instrument.
    C. all funds must remain with the former employer.
    D. the funds must be held for 60 days before being paid to the new plan.

6. Unless an individual annuity is used to fund an IRA,
   A. it is qualified.
   B. it is an equity indexed annuity.
   C. it is nonqualified.
   D. it may not be used for any other purpose.

7. When an individual annuity is used to fund an IRA, one of the major advantages is
   A. the nonqualified annuity is not subject to the contribution limitations of an IRA.
   B. that it is exactly like any other IRA so the IRS will allow it without question.
   C. funds are guaranteed by the Federal Deposit Insurance Corporation (FDIC).
   D. there are no commissions paid on an individual annuity.

8. When a contract owner divides an annuity account into two parts and liquidates one part,
   using the other part strictly for growth, this is called
   A. a dual annuity.
   B. a last survivor annuity.
   C. delving an annuity.
   D. a split annuity.

9. When annuities are specially designed for the senior market, they typically may have
   A. higher withdrawal penalties than with traditional annuities.
   B. must higher premiums because the average age would be older.
   C. free withdrawal privileges and provision to annuitize at any time without charges.
   D. tougher underwriting requirements.

10. For annuities designed for the senior market, interest rates
    A. would be the same as with any other annuities.
    B. are stipulated by regulation to not exceed 3% per annum.
    C. may be graded downward at the upper age range.
    D. will automatically be 3 percent above the consumer index rates.

ANSWERS TO STUDY QUESTIONS
1A   2A   3C   4C   5B   6C   7A   8D   9C   10C




                                                   50
        CHAPTER THREE - 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 are known as 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.


                             INSURED PENSION CONTRACTS
    A life insurance company offers a business considerable flexibility in tailoring a funding
vehicle to meet the needs of the various employers. While in this text names are assigned to
various types of insured pension arrangements, it is important to also realize that these contracts
may be modified to fit particular requirements.
    Life insurance companies accept risks – indeed, that is their business – so they can
underwrite various types of risks associated with pension plane, and to underwrite them also by
degree, depending upon the desires and the needs of the employer. These risks include, but are
not limited to the following:
               Longevity – in determining the proper rates it is quite possible that more
                individuals may live long enough to retire than what was contemplated by the
                actuarial tables used. Mortality as a whole has increased with time and mortality
                tables must be changed periodically to reflect this improvement. Generally, the
                insurer does not have the luxury of changing an existing annuity or pension plan
                to reflect such changes on insured individuals.
               Retired Lives – those persons who have already retired may live longer than
                anticipated by the mortality tables that were used. The “senior citizens” is the
                fastest growing segment of our society, due to improvements in health care and
                environment.
               Interest Rates – in determining the appropriate premium for an annuity product,
                the rate of interest that the insurer earns on the investments may fall below the
                expected levels. In today’s financial atmosphere of low investment income,
                insurers have suffered as they anticipated a much higher rate of return on their
                investments used in their pricing of products, particularly those that have
                premiums that cannot be changed as investment income changes.
               Selling Investments at a Loss – in the same vein, because of the lower-than-
                anticipated interest rates on their investments, insurers have had to sell particular
                investments at a loss and even in some cases; there have been defaults in their
                investment portfolio.
               Expenses – the cost of doing business has increased continually and the expenses
                associated with some plans have proven to be much higher than anticipated.
                While the actual administrative and issue costs of many insurance products have
                decreased because of technological advances, by the same token it has been
                necessary to acquire more sophisticated and more advanced equipment.



                                                 51
     Interestingly, if one considers these factors and how they “intertwine” it becomes obvious
that a well-designed benefit plan – whether the plan is designed by an insurance company or
consultants or pension specialists in pension services – that provides death, disability and
retirement benefits with values that are at least reasonably comparable, the actual (and actuarial)
experience will not vary much if more (or less) employees become disabled, more employees
become disabled, or more simply live and retire. This is because the adverse experience under
one plan can result in better results under another plan.
     Consider that if a plan has higher mortality under the death benefit plan than anticipated, then
they may have more favorable mortality under the retirement plan which results in lower benefit
amounts being paid.
                                        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



                                                 52
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
    Annuities may also be used to fund corporate pension and profit sharing plans. While Keoghs
are designed for self-employed, corporate and profit-sharing 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
(Group) 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.
                      SINGLE-PREMIUM ANNUITY CONTRACTS
    There is a rather unusual situation in respect to group annuities whereby the employer
determines the benefit that will ultimately payable to each employee, and the employer then
makes a single payment to guarantee that these benefits will be paid as they become due.
    This arrangement is generally used for a situation where there is a large body of employees
who have already retired and where an uninsured trusted arrangement is terminated for whatever
reason, with the funds available from the trust used to purchase either immediate or deferred
annuities for the employees that are covered by the plan. The employer usually then enjoys a



                                                53
favorable accounting treatment of retired-lives obligations. It is rarely used for employees who
are still working and are then covered by an ongoing plan.
                          LEVEL-PREMIUM ANNUITY CONTRACTS
     Often an employer will estimate the pension that will be payable when each of the employees
reach their normal retirement age and will then ask an insurance company to quote a level
payment that is guaranteed to provide the pension amount that has been estimated. The insurer
will then guarantee to pay the indicated amount of benefit if the established premium is paid each
year until the employee retires.
     If this is an individual policy pension trust, the benefits are funded by individual policies that
are issued on the lives of the employees but the policies are usually issued to and held by a
trustee.
     Under a group permanent contract, a level-premium group annuity contract, or a level-
premium contract with lifetime guarantees, the benefits are funded through a master group
annuity contract that is issued to the employer with certificates (of coverage) given to the
employees.
     Under either of these situations, a life insurance feature is usually provided prior to
retirement. Also under these types of arrangements, the insurance company assumes all of the
risk and provides all of the services and guarantees the pricing.
                      SINGLE-PREMIUM DEFERRED ANNUITIES
     Under the Group Deferred Annuity programs, the employer contributes sufficient funds so as
to purchase single premium deferred annuities for those employees, based on the amount of
annuity benefits that is accrued by each employee each year. Each employee’s pension is broken
into sections which are associated with the number of years that the employee has been
employed by the employer. For example, for every year of employment, the employee could be
entitled to an annual pension of a percentage of salary (such as 2%), or, a flat monthly amount
for each year of employment ($50 for example). Each year the employer purchases this single
premium deferred annuity that annuitizes upon the retirement age of the employee. The amount
of pension for each employee then becomes the sum total of all of the units that is purchased for
him/her.
     It should be noted that even though the company’s risk in respect to any one employee, may
extend to a lengthy period, even as long as 60 years, in respect to the premium that it has
received, but the insurer does not guarantee the premium it will charge for additional units to be
purchased in the future. As a general rule, insurers will guarantee their rates for the first five
contract years.
     These arrangements make it possible to inform each employee that a benefit has been
purchased for him/her and the insurance company guarantees that it will be paid. The employer
is then aware that it is not burdening future management with the problem of inadequate funding
for the benefits promised to the employees. This also alleviates the problem of further
management having to solve an inadequate funding problem by reducing benefits.
     Simply put,

    money is set aside to provide pensions for all employees who are qualified to receive
                                       such pension benefits.


                                                  54
    However, it is a fact of life that many employees will not stay with the employer until their
pensions have been vested, therefore oftentimes employers will discount those payments in
advance because of the fact that many will not stick around long enough to become vested.
Because of this problem, the level-premium and the single-premium deferred annuities are not
nearly as popular as in the past, so the insurance industry – never the ones to allow profits to fly
out the windows – developed the deposit administration concept.
                     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.
Therefore, the life insurance company takes all of the risks and provides all of the services, but
only with respect to those employees who have retired.
    For those employees who have not reached retirement, the insurance company does not
directly guarantee the employer contributions, except that pensions will be provided according to
the money available at the time of retirement of the employee. An actuary supplies the employer
with the estimates of the amount of the funds that should be set aside each year to create
sufficient funds to purchase the annuities for individuals at their time of retirement. The money
is held by the insurance company (for both safekeeping and for investment). The insurer will,
therefore, guarantee the employer that there will be no decrease in this capital and it will also
guarantee to the employer that there will be at least a specified minimum amount of interest
earned at that fund. The insurer will also guarantee a price structure to purchase annuities for the
employees as they retire.
    The deposit administration contract contains a schedule of annuity purchase rates and rates of
interest applicable to these funds and guaranteed, usually, for the first five years. Needless to
say, these rates are quite conservative. The minimum rate of interest at the rate schedules in
force when money is paid to the insurer will apply to these funds - regardless of when these
funds are withdrawn from the fund to provide an annuity. Some companies will guarantee
purchase rates for 5 (or 10) years of retirement, but with the right to change the annuity purchase
basis for new retirees after that period of time.
    This may not sound like much of a “guarantee” but because of volatility of the investment
portfolios, many companies now avoid long-term guarantees.




                                                 55
            IMMEDIATE PARTICIPATION GUARANTEE CONTRACTS
    The immediate participation guarantee contract (IPG) is similar to the deposit administration
contract described above, as the contributions of the employer are kept in an unallocated fund,
but the insurance company will guarantee that the annuities for retired employees will be paid (in
full). The principal difference is the extent to which the insurance company assumes the
mortality, the investment income, and the expenses in respect to retired lives, and the timing of
these assumptions.
    The “active” period of the IPG continues just as long as the employer contributes sufficient
funds which will keep the fund amount above the insurer’s price to provide guaranteed annuities
for retired employees. If the fund amount falls below this level, it is considered as then being in
the “critical” area.
    Without being too technical, basically the initial (and sufficient) fund is charged with the
contract’s share of the expenses of the life insurance company and all retired benefits that are
being paid; the fund is also credited with its share of investment fund – minus a small risk
charge. The fund is also credited or debited with its share of the insurer’s capital gains and loss,
and investment and expense experience of the retired employees.
    If, however, the employer allows the fund to become insufficient and then fall into the
“critical” area, then the fund amount is used to provide fully guaranteed annuities for all of the
benefits under the contract, and the fund ceases to exist.
    As long as the employer’s contributions are sufficient to maintain the contract, then the
insurance company does not have to maintain the risk of investment, mortality and investment in
regards to active employees and the mortality risk for retired employees. If, however,
contributions are not adequate (the critical area), then the fund amount is used to purchase fully
guaranteed annuities for all benefits required under the plan – and the fund no longer exists.
    In recent years, some IPG contracts have changed so as to eliminate the guaranteed annuity
rates but provide an agreement that the non-guaranteed payments will be made until the fund is
completely exhausted under an “investment only” type of contract. Then the employer is
responsible for the adequacy of funding and the employees cannot look to the insurer for benefit
payments to continue until their death.
                                        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


                                                56
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.

STUDY QUESTIONS

1. When lower-than-anticipated interest rates affect an insurer’s investment portfolio,
   A. the insurer then lowers the premiums.
   B. insurers have had to sell particular investments at a loss, sometimes defaults occur.
   C. it has no effect on the insurance company because they are all so large.
   D. the Department of Insurance takes control of the insurer.

2. People who are self-employed, may establish a retirement plan for themselves under a
   A. Dashle plan.
   B. 401(k) plan.
   C. 1040 plan.
   D. Keogh or HR-10 plan.

3. A benefit plan that specifies or defines the amount of the benefit paid at retirement is
   A. a group deferred annuity.
   B. a defined benefit plan.
   C. a defined contribution plan.
   D. a Keogh plan.

4. A benefit plan that specifies a formula for the amount of the contribution that will be made, is
   A. a group deferred annuity.
   B. a defined benefit plan.
   C. a defined contribution plan.
   D. a Keogh plan

5. An employer establishes a pension plan for employees by contributing to the purchase of an
   annuity for each of his employees. The funding annuity would be
   A. a non-guaranteed plan.
   B. a self-administered plan where the insurer does none of the administration.
   C. illegal in most states as it is not allowed under ERISA.


                                                 57
     D. a group single premium deferred annuity for each employee.



6. If an employer purchases another company that has a large body of retired employees and an
    uninsured trusted arrangement is terminated, to continue providing benefits for the retired
    employees and also to enjoy a favorable accounting treatment of the retired-lives obligations,
    A. the employer could use the funds freed-up from the retired lives trust to purchase a single
        premium annuity for the retired employees.
    B. the employer would just simply mix the retired employees benefits with active benefits.
    C. the retired employees would have to be spun off to a fictitious corporation.
    D. the employer would have to contribute stock to the fund, or sell stock to fund it.

7. When funds are deposited with the insurer that are not allocated for individual annuities, but
   instead, provide a pool that the insurer invests as a whole, this type of retirement program is
   A. a group deposit administration contract.
   B. a Keogh plan.
   C. a non-funded retirement ensemble.
   D. an immediate participation guarantee contract.

8. When contributions of an employer are kept in an unallocated fund, but the insurer guarantees
   that the annuities for retired employees will be paid in full, this is called
   A. a group deposit administration contract.
   B. an immediate participation guarantee contract.
   C. a 401(k) plan.
   D. a Keogh plan.

9. Under a 401(k) plan, employee participation
   A. is not allowed.
   B. is mandatory.
   C. must be optional.
   D. may be optional for some employees, mandatory for others.

10. One of the primary advantages of a 401(k) plan from the employer’s point of view is
    A. the employer may take tax credit for the amount contributed by the employee also.
    B. when the employee terminates employment, all plan funds are returned to the employer.
    C. the IRS will not audit firms that have a 401(k) plan installed.
    D. that the contribution is essentially made with the employee’s money.

ANSWERS TO STUDY QUESTIONS
1B   2D   3B   4C   5D M 6A   7A   8B   9C   10D




                                                   58
                 CHAPTER FOUR - 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.
                        DEDUCTIBILITY OF 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 who 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.


                                               59
                     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 individual’s age 59½. These tax consequences include current income
taxation and an additional penalty tax.
                           DISTRIBUTIONS OF QUALIFIED PLANS
     In general 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 are
“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.
     The IRS addresses “roll-overs” as “a distribution that is paid into another tax-favored plan in
accordance with the applicable rules; it may be a direct rollover or a traditional rollover.”29
     An employee of spousal distributee may elect to have an eligible rollover distribution paid


                                                 60
directly to an IRA or another qualified plan, or Section 403(b) annuity, for governmental 457
plan in a direct rollover. A qualified plan, Section 40-3(b) annuity, or governmental 457 plan is
required to allow a distributee of all eligible rollover distribution to make a direct rollover to an
IRA or any defined contribution plan, Section 403(b) annuity, or governmental 457 that accepts
rollovers.29 The qualified plan, Section 403(b) annuity or governmental 457 plan may, however,
require that an employee’s aggregate eligible rollover distributions for a year exceed $200 (and
may impose a minimum of $500 for partial rollovers) before the employee may elect a direct
rollover.30
    If the rollover is not made under the direct rollover rules, the rollover is a traditional rollover.
Such a rollover generally must be made within 60 days (subject to possible exception for
hardship) of the distributee’s receipt of the distribution, and in the case of a qualified plan,
Section 403(b) annuity or governmental 457 plan distribution, must meet the other requirements
for eligible rollover distributions.31
    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
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


                                                  61
be 100% of the employee’s account balance/accrued benefit, and further, the entire distribution
must be made in one taxable year!
                          TAXATION OF PARTIAL WITHDRAWAL
    When a partial withdrawal is taken from an annuity contact before the annuity starting date,
the amount that is received is usually includible in income to the extent of any income on the
contract. “Income on the contract” is defined by the IRS as the excess of the cash value of the
contract, ignoring any surrender charge, immediately before the amount is received over the
investment in the contract at that time.
    When income on the contract is determine in respect of a partial withdrawal, the entire cash
value of the annuity and the entire investment in the contract must be taken into consideration,
even if the partial withdrawal was made from a particular subaccount under a Variable Annuity.
    If the amount of the partial withdrawal exceeds the income on the contract, the excess
amount is considered as a return on the investment in the contract and is not included in income.
The net effect of these rules is on a partial withdrawal, the last-in, first-out (LIFO) basis is
created.
    The IRS has maintained that in certain situations partial withdrawals that are taken in the
form of “systematic” withdrawals—such as in the case of a death benefit payment—can be
considered as amounts received as an annuity and can be taxed as annuity payments.
                                    CASH VALUE ACCRUAL
(This section is derived from California Insurance Code 10168.2 and has been redacted)
                   CONTRACTS ISSUED 01/01/04 AND PRIOR TO 01/01/06
    This particular section shall apply to contracts issued before January 1, 2004, and may be
applied by a company, on a contract-form-by-contract-form basis, to any contract issued
on or after January 1, 2004, and before January 1, 2006. This section shall not apply to any
contract issued on or after January 1, 2006—which are covered in the next section.
  (b) The minimum values as specified in CIC Sections of any paid-up annuity, cash surrender or
death benefits available under an annuity contract shall be based upon minimum nonforfeiture
amounts as defined in this section.
  (c) With respect to contracts providing for flexible considerations, the minimum nonforfeiture
amount at any time at or prior to the commencement of any annuity payments shall be equal to
an accumulation up to that time at a rate of interest of 3 percent per annum of percentages of the
net considerations (as hereinafter defined) paid prior to that time, decreased by the sum of (i) any
prior withdrawals from or partial surrenders of the contract accumulated at a rate of interest of 3
percent per annum and (ii) the amount of any indebtedness to the company on the contract,
including interest due and accrued, and increased by any existing additional amounts credited by
the company to the contract.
  The net considerations for a given contract year used to define the minimum nonforfeiture
amount shall be an amount not less than zero and shall be equal to the corresponding gross
considerations credited to the contract during that contract year less an annual contract charge of
thirty dollars ($30) and less a collection charge of one dollar and twenty-five cents ($1.25) per
consideration credited to the contract during that contract year. The percentages of net




                                                62
considerations shall be 65 percent of the net consideration for the first contract year and 87 1/2
percent of the net considerations for the second and later contract years.
Notwithstanding the provisions of the preceding sentence, the percentage shall be 65 percent of
the portion of the total net consideration for any renewal contract year which exceeds by not
more than two times the sum of those portions of the net considerations in all prior contract years
for which the percentage was 65 percent.
  (d) With respect to contracts providing for fixed scheduled considerations, minimum
nonforfeiture amounts shall be calculated on the assumption that considerations are paid annually
in advance and shall be defined as for contracts with flexible considerations which are paid
annually with two exceptions:
  (1) The portion of the net consideration for the first contract year to be accumulated shall be
the sum of 65 percent of the net consideration for the first contract year plus 22 1/2 percent of the
excess of the net consideration for the first contract year over the lesser of the net considerations
for the second and third contract years.
  (2) The annual contract charge shall be the lesser of thirty dollars ($30) or 10 percent of the
gross annual consideration.
  (e) With respect to contracts providing for a single consideration, minimum nonforfeiture
amounts shall be defined as for contracts with flexible considerations except that the percentage
of net consideration used to determine the minimum nonforfeiture amount shall be equal to 90
percent and the net consideration shall be the gross consideration less a contract charge of
seventy-five dollars ($75).
                              CONTRACTS ISSUED AFTER 01/01/04
The following regulations (CIC 10168.25) pertains only to contracts issued on and after
January 1, 2006, and may be applied by a company, on a contract-form-by-contract-form
basis, to any contract issued on or after January 1, 2004, and before January 1, 2006.
  (b) The minimum values (as specified in various CIC appropriate Sections) of any paid-up
annuity, cash surrender, or death benefits available under an annuity contract shall be based upon
minimum nonforfeiture amounts as defined in this section.
  (c) (1) The minimum nonforfeiture amount at any time at or prior to the commencement of any
annuity payments shall be equal to an accumulation up to that time, at the rates of interest
indicated in subdivision (d), of the net considerations (as hereafter defined) paid prior to that
time, decreased by the sum of all of the following:
  (A) Any prior withdrawals from or partial surrenders of the contract, accumulated at prescribed
rates of interest.
  (B) An annual contract charge of fifty dollars ($50), accumulated at prescribed rates of interest.
  (C) Any state premium tax paid by the company for the contract, accumulated at prescribed
rates of interest.
However, the minimum nonforfeiture amount may not be decreased by this amount if the
premium tax is subsequently credited back to the company.
  (D) The amount of any indebtedness to the company on the contract, including interest due and
accrued.




                                                 63
  (2) The net considerations for a given contract year used to define the minimum nonforfeiture
amount shall be an amount equal to 87.5 percent of the gross considerations credited to the
contract during that contract year.
  (d) The interest rate used in determining minimum nonforfeiture amounts shall be an annual
rate of interest determined as the littlest of 3 percent per annum and the following, which shall be
specified in the contract if the interest rate will be reset:
  (1) The five-year Constant Maturity Treasury Rate reported by the Federal Reserve as of a
date, or averaged over a period, rounded to the nearest one-twentieth of 1 percent, specified in
the contract no longer than 15 months prior to the contract issue date or redetermination date
under paragraph (2), reduced by 125 basis points, where the resulting rate is not less than 1
percent.
  (2) The interest rate shall apply for an initial period and may be redetermined for additional
periods. The redetermination date, basis, and period, if any, shall be stated in the contract. The
basis is the date, or average over a specified period, that produces the value of the five-year
Constant Maturity Treasury Rate to be used at each redetermination date.
  (e) During the period or term that a contract provides substantive participation in an equity
indexed benefit, it may increase the reduction described in paragraph (1) of subdivision (d) by up
to an additional 100 basis points to reflect the value of the equity index benefit. The present
value at the contract issue date, and at each redetermination date thereafter, of the additional
reduction shall not exceed the market value of the benefit. The commissioner may require a
demonstration that the present value of the additional reduction does not exceed the market value
of the benefit. Lacking a demonstration that is acceptable to the commissioner, the commissioner
may disallow or limit the additional reduction.
  (f) The commissioner may adopt regulations to implement the provisions of subdivision (e) and
to provide for further adjustments to the calculation of minimum nonforfeiture amounts for
contracts that provide substantive participation in an equity index benefit and for other contracts
with respect to which the commissioner determines adjustments are justified.


                                    AGGREGATION RULE
    The “aggregation rule” is used for the purpose of measuring the amounts includible in gross
income32 –when an annuity is surrendered or a partial withdrawal is made, then all annuities
issued by the same insurance company to the same policyholder during any calendar year are to
be considered as a single contract. It also states that all affiliated insurers will be treated as one
company for such purpose. There still are some questions not completely satisfied regarding the
application of this rule in connection with annuitization and following a tax-free exchange.
    There is another aggregation rule that provides that two or more annuity obligations or
elements that are acquired for a single consideration - which could be paid by more than one
person and in more than one sum – will be treated as a single annuity. The purpose of this rule
(which was issued in 1956) was to combine annuity obligations under qualified plans that by
doing so, would simplify their income tax treatment.
    Also, the IRS has ruled that 2 deferred annuities issued in a tax-free exchange – replacing
one deferred annuity – are treated as a single, aggregated contract, therefore under the rule
amounts distributed from one contract to pay required premiums under the other contract are not
treated as distributions taxable under the IRS Code.


                                                  64
                                     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.
    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 is 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 are 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 immediately (according to recent action by the IRS, although within 60 days is still in
the regulations – but why take a chance?). Current taxation on the qualified distribution can be
avoided if it is rolled over into a regular IRA.
    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
ordinary income, and any annuity distributions will be taxed as previously discussed.



                                                 65
    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.
    For exchanging a nonqualified annuity for another annuity tax free if:
                  The same person must be the obligee or obligees (insureds) under both
                   contracts.84
                  Exchange must be a “like kind” transfer of one contract for another contract, so
                   exchange proceeds are transferred directly between the issuers or the old and
                   new contracts. If proceeds are received by contract owner in cash, the
                   transaction will be treated as a taxable surrender of existing contract, and will
                   probably be treated as a taxable surrender followed by purchase of new
                   contract.85
    The IRS has held that the direct transfer of an entire annuity contract into another preexisting
annuity contract qualifies as a tax-free exchange under Code Section 1035.86


                   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.


    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 individual’s age 59½. These tax consequences include current income
taxation and an additional penalty tax.
                                        PENALTY TAX
    Under IRS Code Section 72(q) there is a 10 percent penalty tax on the taxable portion of
distributions from nonqualified annuities.




                                                 66
   The 10% penalty tax is imposed in addition to the income tax otherwise due.

    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.
    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.”


                                      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



                                                67
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.

   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.
                             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


                                                68
     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.
              DEATH BENEFIT UNDER A NONQUALIFIED ANNUITY
     A death benefit under an annuity may be paid to fulfill a requirement imposed by the Code,
or as a pure annuitant death benefit, defined as a benefit triggered by annuitant’s death under the
annuity and not required by the tax law. If death benefits are paid in a lump sum, the distribution
is taxed in the same manner as a full surrender. If a death benefit is paid according to an annuity
option, then the distribution is taxed as an amount received as an annuity. However, if periodic
payments are made in full discharge of the obligation of the insurer under the annuity, the FIFO
(First In – First Out) rule applies.
     Death benefit payments under an annuity are not eligible for exclusion from gross income.
This includes death benefits that exceed the contract’s cash surrender value at death, including
“enhanced death benefits” payable under variable annuities. Also, as discussed elsewhere, even
though the death benefit is paid upon the death of the owner of the contract, the “investment in
the contract” is not “stepped-up” as contrasted with the treatment of the tax basis of other kinds
and forms of property passed on to heirs at death.
     Conversely, a death benefit paid under a term life insurance rider issued in conjunction with
an annuity, may be eligible for the tax exclusion from gross income. In order to qualify for this,
the death benefit must be paid under a rider that is economically independent of the annuity and
separately constitutes life insurance under IRS rules. Further, since the rider is considered as
separate from the annuity, any amount that is taken from the annuity’s value to pay for the life
insurance rider would be includible in income in the same manner as a partial withdrawal.
     The recipient of a death benefit payment or payments from an annuity may be eligible for an
income tax deduction related to the inclusion of the value of the annuity in the decedent’s estate
for federal estate tax purposes.33
                        IRS REQUIREMENTS FOR DEATH BENEFITS
    The IRS Code Section 72(s) provides that a contract will not be treated as an annuity contract
for federal tax purposes unless (with certain designated exceptions) it provides for certain
distributions in the event that the holder of the contract dies. This means that if the 72(s)
requirements are not met, the deferral of income tax that usually applies to an annuity will not be
available and there will be current taxation of the inside buildup in the contract. While these
regulations apply more to the insurance company, it is wise to be acquainted with these
provisions and could prove helpful in discussions regarding that taxation of annuities.
    These requirements are rather extensive, but basically they are as follows:

   Post-annuitization. The contract must provide that if any holder dies on or after the starting
   date of the annuity and prior to the time that the entire interest in the contract has been
   distributed, the remaining portion of such may be accelerated but may not slow down - such



                                                69
   as extending the period of which payments may be made, or change in the pattern of
   payments.

    During Deferral Stage. The annuity must provide that if any holder dies before the annuity
    starting date, the entire interest in the contract will be distributed within 5 years after the
    holder’s death. There are certain exceptions to this:
         If the designated beneficiary is the surviving spouse of the deceased holder, the
            contract may be written so that it continues after the holder’s death (such as survivor
            plans).
         If the beneficiary so designated is an individual, Code Section 72(s) will be met as to
            the portion of the contract that is payable to such person if it is distributed, starting
            within one year of the holder’s death, over the life of the beneficiary that is so
            designated or over a period of time not extending behind the life expectancy of the
            beneficiary.
         If the designated beneficiary is a grantor trust, an individual who is treated as owning
            the assets of the grantor trust is considered the designated beneficiary of contracts
            held by the trust.
         A designated beneficiary will satisfy 72(s) if he/she receives a portion of the balance
            payable under the contract as a series of payments in accordance with this Code, with
            the remaining balance distributed to the beneficiary within five years of the date of
            death.
         Acceleration of payments scheduled under the 5-year rule of 72(s) will not violate the
            Code.
    This Code goes deeper into various definitions for the purpose of the Code but is not really
pertinent to this discussion.


                           TAX-RELIEF ON INHERITED ANNUITY
    According to a recent Gallup poll, there are approximately $1 trillion in annuity assets, and
further, many estimates indicate 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 year period, 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.
    Often retired persons will purchase a deferred annuity in order to avoid current income taxes
but the end result is passing the taxes on to their heirs. While the heirs may have more money as
an inheritance, many times they will have tax problems of their own. Practically speaking, those
individuals who have tax concerns and use an annuity to transfer tax risk are usually wealthier
individuals, but generally their heirs are also well-off. 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


                                                 70
taxes in today’s dollars, then the possibility might be an annuity “that pays its own taxes.” This
is a very new innovation, so new that there is a patent pending on a version of this plan!

    This is a relatively new concept and simply put, it is usually 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 can be used. The cost of the
insurance is taxable to the owner of the annuity each year, thereby making the death benefit
income-tax-free.
    This can best be explained by example. 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, the rider 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, 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 to pass the test of legality, 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 an IRS private letter ruling33A, 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 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, there 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


                                                 71
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.

   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.
                                   FEDERAL ESTATE TAXES
    New Federal Tax legislation and the generation skipping transfer tax are phased out
gradually starting in 2002 and will be totally eliminated by 2010 – provided politics does not
interfere. This law will expire in 2010 unless repealed prior to that date.
    NOTE: At this time (October 2010) Federal taxation, particularly income taxation, may be
determined at the next mid-term elections in November, as the outcome of the election will
determine whether what has been called the “Bush” tax cut, will continue for a specified time
into the future (such as through 2011); will be totally eliminated; will remain basically the same
except for “capping” out those “wealthy” persons who will find an increase in their taxes; will
remain exactly the same with no time line; or some other arrangement that will depend upon
politics. The information contained below is effective until such new changes are determined.
    Presently, 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.
                           STEP-UP BASIS – 1997 TAX CHANGES
     The 1997 tax laws reduced capital gains taxes to a maximum of 20% which was welcomed
by most investors, however for those who were considering investing in annuities, this made it a
little more difficult. Again, this will be determined after the November elections in all
probability. The following is in effect in October 2010.
     One of the difficulties of annuity taxation has always been that any withdrawal except for
principal are subject to ordinary income taxation. As indicated in this text, the only way(s) to
avoid this is to annuitize the contract when a portion of each payment is considered principal and
is tax-free for that portion; “wait it out” on the hopes that tax brackets may drop or the person
may be in a lower tax bracket at annuitization; bequeath the annuity to a spouse who would
probably be in a lower tax bracket; or let the kids suffer by not taking any withdrawals and leave
it all up to the kids to receive the funds and have to pay taxes on them.
     Still, since nearly all of the investments that are not annuities have their interest taxed each
year, and fully, (except for municipal bond interest or sheltered by depreciation), annuities have
a distinct advantage in that respect. Growth from any of these “non-annuities” is taxed only if


                                                 72
the investment is sold at a profit, and unlike an annuity, the sale of the investment is never
required. An annuity must be liquidated completely within 5 years after the death of the contract
owner’s surviving spouse (or the owner’s death if he/she is single at death). This is the problem
with annuities in this regard – there is no step-up in basis upon death.
     “Step-up” may be best explained by illustration. If John dies, most of his assets get a “step-
up” in basis, meaning that heirs receive the assets, for purposes of income tax, as if John’s heirs
had purchased the assets on the day that John died for the “fair-market value” as of that date.
Therefore, if one of John’s heirs sold any asset, any gain or loss would be based on the inherited
value and not the price that John paid for the investment when he was alive.
     To reiterate, certain assets do not get a step-up in basis upon death, and that includes
annuities, Certificates of Deposit, money market funds & qualified retirement plans. The heir
must pay taxes on an ordinary income basis when the funds are liquidated. The taxable portion
is the difference between the selling price and the purchase price (or purchase price plus
dividends, capital gains, and/or interest that had been automatically invested each year) – except
for qualified retirement accounts where everything is taxable when withdrawn except for the
money that was contributed on an after-tax basis, i.e., not deductible when invested.
                                           GIFT TAX
     The subject of Gift Taxation may or may not be decided in the November 2010 election, so
the following information is effective as of October 2010.
     The question may arise as to whether the gift of a nonqualified annuity contract or annuity
payments, subject to federal gift tax. The answer is “yes.” The gift of a nonqualified annuity or
annuity payments is subject to the federal gift tax if the gift is complete.34 When a donor makes
a complete gift of an annuity contract, the donor gives up all of his rights in the contract.
Conversely, the complete gift of an annuity payment or payments may allow the donor to retain
an interest in the contract, such as a death benefit payment or future annuity payments.
Therefore, the gift tax may apply when a donor gifts (1) an entire annuity contract, or (2) a
series of annuity payments, or (3) a single annuity payment.
     If the gift is complete, gift tax rules will apply as they generally do to other forms of
property. A taxpayer may gift up to $11,000 or $22,000 for married couple (in 2002) to each of
an unlimited number of donees without attracting gift tax to the donor or tax income to the
donee.35 If a gift is made in excess of the exclusion amount, the donor must either pay gift tax
on the excess or decrease the amount of the unified credit available to the donor under the estate
tax.
        TRANSFER OF OWNERSHIP OF NQ-ANNUITY AT DEATH OF OWNER
    If ownership rights in a nonqualified annuity contract are transferred at death, the value of
such contract ownership - which includes any annuity payment continuing after death – are
includible in the deceased owner’s estate for federal estate tax purposes.37
    Any amounts so included will be taxable under the applicable estate tax rate to the extent that
such amounts exceed the level offset by the unified estate tax credit.
    Under the unified credit, each taxpayer may exclude a statutorily prescribed amount, such as
$1.5 million for 2004 and 2005, from the taxpayer’s taxable estate. The unified credit will be
increased in gradual increments until it reaches $3.5 million in 2009.37A [IRC 2010(c)]



                                                73
      ANNUITY INCLUDED IN DECEASED OWNER’S ESTATE FOR FEDERAL TAX
    If a nonqualified annuity is included in a deceased owner’s estate for federal estate tax
purposes, the person who inherits the annuity does not receive a stepped-up basis. Instead, that
person’s basis is the same as the basis of the deceased owner.38 There are special rules involved
as to the taxation of amounts payable after the owner’s


                                    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

1. The premiums that an individual pays for a nonqualified annuity
   A. are not tax deductible for federal income tax purposes.
   B. are tax deductible for federal income tax purposes.
   C. are subject to gift taxes.
   D. only subject to state premium taxes, and occasionally, sales taxes.

2. During the accumulation period, qualified or non-qualified annuity values
   A. are taxed every year as ordinary income.
   B. are taxed on a capital gains basis.
   C. build on a tax-deferred basis.
   D. build on a tax-free (forever) basis.

3. Distributions that are made in installments are
   A. never taxed.
   B. taxed as ordinary income in the year they are received.
   C. cumulatively taxed each 2 years.
   D. taxed at a capital gains rate.

4. When an annuity is surrendered or a partial withdrawal is made, then all annuities issued by
   the same insurance company to the same policyholder during any calendar year, are to be
   considered as a single contract. This is called
   A. the Annuitization Rule.
   B. a voidable transaction.
   C. the Aggregation Rule.
   D. subrogation.

5. An annuity distributed from a qualified plan can have income tax postponed by converting the
   annuity into a nontransferable annuity immediately. This is called
   A. a 401(k) rollover.


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     B. an ERISA rollover.
     C. a 1035 Exchange.
     D. the substitution rule.




6. Under the IRS guidelines, there is a penalty for early withdrawals, which means
   A. there is an added tax on annuity distributions prior to age 75.
   B. there is an added tax on annuity distributions prior to age 59 ½.
   C. no benefits may be withdrawn tax free at any time.
   D. that it is imposed in addition to the income tax otherwise due.

7. For tax purposes, a loan from an annuity (which is rare) is treated
   A. as a tax-free exchange.
   B. as total annuitization so taxes are due on the entire annuity values.
   C. as the receipt of current income.
   D. as a hardship disbursement, so it is not taxed until the annuity annuitizes.

8. The proportion of an annuitized payment that is considered as a return of capital and is not
   taxed, is
   A. the Accumulation rule.
   B. the Exclusion Ratio.
   C. partial annuitization.
   D. an illegal attempt to avoid taxes.

9. 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
    A. for the above (question 8) to be used.
    B. and the entire amount of the payment is taxed as ordinary income to the beneficiary.
    C. there are no taxes due at any time for the beneficiary to pay.
    D. and the annuity value is doubled if the death is accidental.

10. IRS Code Section 72(s) provides that a contract will not be treated as an annuity contract for
   federal tax purposes unless it provides for certain distributions in the event that the holder of
   the contract dies. This means that if this Code is not met
   A. the income tax deferral of an annuity will not apply.
   B. the income tax deferral of an annuity will apply just the same.
   C. the contract will be considered void ab initio and the insurer must return all premiums.
   D. the IRS will abscond with the annuity values.

ANSWERS TO STUDY QUESTIONS
1A   2C   3B   4C   5C   6D   7C   8B   9A   10A




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                CHAPTER FIVE - 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) or simply, 403(b) plans. 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 differences between individual and group TSA’s, are flexibility & portability.
    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 differences are flexibility and 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.


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    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.
                                    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 (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 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



                                                77
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 they 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 regulations regarding the maximum amount
that may be set aside each year are rather complicated, but basically, the maximum contribution
may equal 20% of the employee’s current year’s total compensation after salary reductions,
times the total employment time of employment with the employer (expressed in years and
fraction of years); less the sum of any previous contributions and other specified tax-deferred
employer contributions made on behalf of the employee. Maximum amount was $10,000 (in
1999, indexed for inflation). 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.
    Employees of certain other public bodies, such as states, counties, municipalities and tax-
exempt organizations, are eligible for a (governmental) Section 457 deferred compensation
arrangement wherein the employer and employee agree as to an amount of reduction in
compensation with investment of this amount into an investment outlet – including, of course,
annuities. The amounts that are deferred, plus the investment earnings, are distributed to the
employee on his/her death, retirement or other stated termination of employment. Deferred
annuities, either fixed or variable, are quite popular in deferred compensation plans.
                               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.


                                                78
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, all withdrawal costs must be spelled out.

     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 remains 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. As with loans on life insurance policies, many
clients cannot understand why the insurance company charges interest on money that belongs to


                                                 79
the contract holder and has been contributed or paid out in their name. Additionally, there is a
special provision in the TSA contract allowing insurance companies to charge interest on the
amount of the outstanding loan. The answer is the same as that of the life insurance company
who charges interest on a loan on the cash value. 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 and this must be thoroughly understood by the employee.
                          DEATH BENEFITS TSA CONTRACTS

    With almost all annuity contracts, there are no fees or penalties for 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.
                                    INSURER 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


                                                80
as the deceased or faster, in order for the exclusion ratio to be used.




STUDY QUESTIONS

1. The retirement plan that provides benefits to teachers, doctors , nurses, school personnel
   hospital employees and members of nonprofit organizations, is
   A. the 401(k) plan.
   B. the nonprofit Keogh Plan.
   C. TSA, Code Section 403(b).
   D. the Medical and Educational Retirement Act (MERA).

2. The biggest difference(s) between an individual TSA and a Group TSA is
   A. portability & flexibility.
   B. no tax advantages for an individual TSA.
   C. no tax advantages for a group TSA.
   D. that anyone can qualify for an individual TSA.

3. Tax Sheltered Annuities’ funds may be released
   A. only at retirement.
   B. only at death of the annuitant.
   C. in cases of financial hardship, death, disability or termination of employment.
   D. only in cases of termination of employment.

4. With a TSA, there may be withdrawal fees if
   A. it is an individual annuity.
   B. it is a group annuity that is being moved to escape IRS taxes or penalties.
   C. the benefits of 20% of the employees exceeds a pre-determined limit.
   D. the annuitant leaves the profession.

5. One of the tax advantages of the TSA is
   A. any contributions reduce the taxable income of the participant, dollar for dollar.
   B. the plan is taxed annually so there are no tax surprises at retirement.
   C. that the IRS has agreed not to audit any person who has a TSA.
   D. that the TSA annuitant automatically falls into the 25% tax bracket.

6. Contributions to a TSA are made
   A. every two years.
   B. with pre-tax dollars.
   C. only annually.
   D. only by the employer.

7. With a TSA, the method used to determine the current interest rate to be credited to the
   employees’ accounts is where all employees’ contributions are treated as one amount and


                                                  81
     each account is credited with the actual yield that the deposits actually earned. This is called
     A. portfolio averaging.
     B. variable investing.
     C. fair market value approximating.
     D. the banding method.

8. With a TSA, there are several options upon retirement, such as
   A. transfer of ownership of the funds to a near relative.
   B. assigning of values to creditors at any time for any portion thereof.
   C. never paying any taxes at all on the accumulated funds.
   D. leaving the money where it is an let it grow.

9. If a loan against a TSA exceeds the total of the employee’s account, of $10,000, whichever is
    less, and if the account is less than or equal to $120,000,
    A. then there may not be any loan made against the TSA.
    B. the employer must countersign the loan.
    C. then the loan is taxable.
    D. then the loan is not taxable.

10. When an insurance company charges expenses against a TSA and are so stated in the
    contract, these are called
    A. explicit fees.
    B. implicit fees.
    C. management penalties.
    D. extraneous charges.

ANSWERS TO STUDY QUESTIONS
1C   2A   3C   4B   5A   6B   7D   8D   9C   10A




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                      CHAPTER SIX - 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 a recent Life Insurance and 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 soon after introduction of
the product, to approximately 665 companies offering nearly 400 products.39
    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.
                                 DOLLAR COST AVERAGING
     There are proponents and opponents to dollar-cost averaging and it is not restricted to
Variable annuities, but can be (and often is) used with most types of investment vehicles.
     Dollar cost averaging (DCA) is an investment strategy, that may be used with any currency.
It takes the form of investing equal monetary amounts regularly and periodically over specific
time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more
shares are purchased when prices are low and fewer shares are purchased when prices are high.
The point of this is to lower the total average cost per share of the investment, giving the
investor a lower overall cost for the shares purchased over time.
     Dollar cost averaging is also called the constant dollar plan (in the US), pound-cost averaging
(in the UK), and, irrespective of currency, as unit cost averaging or the cost average effect.
                                            PARAMETERS
     In dollar cost averaging, the investor decides on three parameters: the fixed amount of money
invested each time, the investment frequency, and the time horizon over which all of the
investments are made. With a shorter time horizon, the strategy behaves more like lump sum
investing. One study has found that the best time periods when investing in the stock market in
terms of balancing return and risk, have been 6 or 12 months. One key component to maximizing
profits is to include the strategy of buying during a down-trending market, using a scaled formula
to buy more as the price falls. Then, as the trend shifts to a higher priced market, use a scaled



                                                83
plan to sell. Using this strategy, one can profit from the relationship between the value of a
currency and a commodity or stock.
                                               RETURN
    Assuming that the same amount of money is invested each time, the return from dollar cost
averaging on the total money invested is



where pF is the final price of the investment and         is the harmonic mean of the purchase
prices. If the time between purchases is small compared to the investment period, then       can be
estimated by the harmonic mean of all the prices within the purchase period.
                                              CRITICISM
     While some financial advisors claim that DCA reduces exposure to certain forms of
Financial risk associated with making a single large purchase, others claim DCA is nothing more
than a marketing gimmick and not a sound investment strategy—by claiming that DCA is a way
to gradually ease worried investors into a market, investing more over time than they might
otherwise be willing to do all at once. Others supporting the strategy suggest the aim of DCA is
to invest a set amount; the same amount you would have had you invested a lump sum.
     Analysis supporting dollar cost averaging has been criticized because it often ignores
transaction fees which can be substantial. Numerous studies of real market performance,
models, and theoretical analysis of the strategy have shown that in addition to having the
admitted lower overall returns, DCA does not meaningfully reduce risk when compared to other
strategies, including a completely random investment strategy.
                                             CONFUSION
     Discussions of the problems with DCA can do a disservice to investors who confuse DCA
with continuous, automatic investing. Unfortunately this confusion of terms is perpetuated by
many sources discussing automatic investing. The weakness of DCA arises in the context of
having the option to invest a lump sum, but choosing to use DCA instead. Because the market
trends upwards over time, DCA always faces a statistical headwind: the investor is choosing to
invest tomorrow rather than today, even though on average tomorrow's prices will be higher.
DCA generally does not overcome this headwind. But most individual investors, especially in
the context of retirement investing, never face a choice between lump sum investing and DCA
investing with a significant amount of money. The disservice arises when these investors take
the criticisms of DCA to mean that timing the market is better than continuously and
automatically investing a portion of their income as they earn it. For example, stopping one's
retirement investment contributions during a declining market on account of the (valid) statistical
arguments against DCA would indicate a misunderstanding of those arguments. The
demonstrable statistical weaknesses of DCA do not arise because attempts at timing the market
tend to be effective, but because investing in the market today tends to be better than waiting
until tomorrow. Applying that knowledge to the average retirement investor's situation would
actually support - rather than contest - a policy of continuous, automatic investing without regard
to market direction.92




                                                84
                      PRIMARY BENEFITS OF VARIABLE ANNUITIES
   The primary benefits of variable annuities are:
       death benefit;
       living benefits;
       tax deferral;
       liquidity;
       tax-free transfers;
       performance;
       probate avoidance;
       potential for a guaranteed lifetime income.

   The benefits, as discussed in detail in this text, are legitimate benefits and should be
emphasized by an agent.
                       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.
   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


                                                 85
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 + $5 = 200)
    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
$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


                                                86
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
contribute to the investment value of the Variable Annuity.


   NOTE: For Senior Citizens – those age 65 or older – there is a 30 day cancellation
period by law, during which the annuitant or insured may rescind the policy with full
refund of all premiums. For variable annuities the premiums may be invested only in fixed-
income investments and money-market funds, unless the investor specifically designates that the
premium be invested in the mutual funds underlying the Variable Annuity contract. If this
occurs, then cancellation shall entitle the owner to a refund of the account value.40

    NOTE: The ability to return the annuity without penalty for full refund of all premiums is
discussed in various places in this text as “Surrender Charges.”
    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.41




                                                 87
                          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
has 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.
    The success of this type of annuities has not been as forecast when the product was first
offered for a variety of reasons, including the roller-coasting of the stock market. Another
reason was because these 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 options can be quite
overwhelming at times.
                         VARIABLE ANNUITIES EXCLUSION RATIO
    The “Exclusion Ratio” was discussed earlier, but Variable Annuities have their own
situations and rules. 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
premiums 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.



                                                88
                 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.
    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 following is derived from California Insurance Code 10168.4, and is redacted.)
   For contracts which provide cash surrender benefits, such cash surrender benefits available
prior to maturity shall not be less than the present value as of the date of surrender of that portion
of the maturity value of the paid-up annuity benefit which would be provided under the contract
at maturity arising from considerations paid prior to the time of cash surrender reduced by the
amount appropriate to reflect any prior withdrawals from or partial surrenders of the contract,
such present value being calculated on the basis of an interest rate not more than 1 percent higher
than the interest rate specified in the contract for accumulating the net considerations to
determine such maturity value, decreased by the amount of any indebtedness to the company on
the contract, including interest due and accrued, and increased by any existing additional
amounts credited by the company to the contract. In no event shall any cash surrender benefit be
less than the minimum nonforfeiture amount at that time. The death benefit under such contracts
shall be at least equal to the cash surrender benefit.
    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


                                                 89
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 will
increase each year (e.g. by 5% of the years 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.
    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.



                                                90
                                  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.
                      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.




                                               91
                                      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:


                        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.
    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
   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


                                                 92
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
    Many are the agents who have lost an existing annuity case by way of a Section 1035
exchange to another annuity (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 seen to appear every month and even
more companies are offering annuities. While it may be 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, keeping
in mind that annuities for those over age 60-65 have severe restrictions, particularly in
replacement of existing annuities. 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 (can anyone spell SUV?). 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.
                                  EXTRA-CREDIT ANNUITIES
   More than 10 companies offer “Extra-credit” annuities, and they have become quite popular.
These Variable Annuities (VA) credit investors’ payments with an additional payment, generally


                                                 93
ranging from 3% to 5%. One of the most frequent usages 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.
    In reviewing six of the most popular of these contracts, it is 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.

    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.




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           SPECIAL DISCLOSURE OBLIGATIONS WITH BONUS PROGRAMS
     The SEC (Securities & Exchange Commission) has no particular disclosure forms for
Variable Annuity exchange transfers, other than generalities to the effect that there should be a
rather detailed disclosure of the transaction which would aid the contract owners in determining
whether it is in their best interests to exchange.
     Be this as it may, the SEC has recently given considerable attention to any exchange offer
that involves the “bonus” credit program and it has stated concerns about any higher surrender
charges and fees associated with the bonus programs. It has required insurance companies to
keep records concerning the exchange activity and how is related to the total number of contract
owners that are eligible to exchange, the persistency of the new contracts and number, types, and
details of complaints made about such exchanges. These records must be made available to the
SEC during examination.
     The SEC recently produced an educational brochure, “Variable Annuities – What You
Should Know,” available on its Web site for investors, and within that brochure, they address the
bonus credit plans and caution investors to carefully “take a hard look at bonus credits” before
entering into an exchange.42
     Brokers-Dealers who are involved in such exchange situations – including supervisory and
suitability requirements – should be aware that the NASD has taken a leaf from the SEC’s book
and issued an “Investor Alert” cautioning investors who are considering an exchange and in
particular, those with a bonus credit plan, to only make the exchange “when you determine…that
it (the exchange) is better for you and not just better for the person who is trying to sell the new
contract to you.”43
                               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 Marketing
and Expense 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.44 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.
     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.


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    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 that limits the account’s growth potential. 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.
     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.

                           IMPORTANCE OF THE DEATH BENEFIT
   The death benefit can be very important when marketing variable annuities. The death
benefit actually assures the buyer that his/her investment is protected in a falling market if the


                                                 96
buyer were to die. The living benefit guarantees the client of a certain amount of income or
value in a falling market. This assurance can be quite meaningful when the buyer is looking for
retirement security or looking for protection for a spouse or other heirs.
                              COST OF LIVING/DEATH BENEFITS
     Since there is a mortality and expense charge by the insurer in a Variable Annuity, the
question arises whether the expense and mortality charge affect the overall performance of a
Variable Annuity. This question may come up when dealing with a particular astute investor.
The cost can range from 0.5 percent per year to 2 percent per year, depending upon the specific
benefit of combination of benefits desired. This, obviously, reduces the investment earnings, so
it is subject to criticisms on occasion. While this is true, the cost must be weighed against the
risk protection that a purchaser of an annuity derives from the fact that the annuity has living and
death benefit guarantees.
                         TAXATION OF VARIABLE ANNUITIES

    Variable Annuities are generally tax-favored investment products 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 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 was
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.) 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.
      INCOME FROM VARIABLE ANNUITY TAXED AT ORDINARY INCOME RATES
     In contrast to mutual funds where income is taxed at capital gains rates, the taxation of all
income from a Variable Annuity is at ordinary income rates, and this should be considered when
variable annuities are marketed. One should be aware, however, that that difference may not be
as significant for many investors as most think.



                                                 97
    One method of analyzing the effects of capital gains rates is to calculate the “break-even
holding period” which is the number of years of accumulation at which time the after-tax return
from a Variable Annuity becomes equal to that of a mutual fund investment of comparable
values. A second way to compare the performance of a Variable Annuity with that of a mutual
fund is to calculate the total after-tax pay-out that can be funded by a Variable Annuity and
compare that to the total after-tax pay-out that can be funded by each after a particular
accumulation period.
        USING A VARIABLE ANNUITY FOR ESTATE & FINANCIAL PLANNING
    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 their 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 and 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.

    Loren is 42 years old and inherited $25,000. He did not really need the money at this time so
he purchased 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, 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, 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.


                                               98
    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, the market should probably also go up again before he annuitizes.


     Chris and Bertha are in their 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.


                        SEC REGULATION OF UNDERLYING FUNDS
    Under federal regulation, the SEC must provide prior approval for substitution of underlying
securities of a unit investment trust and, “(i)t shall be unlawful for any depositor or trustee of a
registered unit investment trust holding the security of a single insurer to substitute another
security for such security unless the Commission shall issue an order approving such
substitution.”45 The SEC views this as applying to substitutions initiated by insurers as well as to
substitution taken by insurers in response to actions taken by an underlying fund or its sponsor,
such as the liquidation of a fund portfolio.
    The number of substitutions filed by insurers has increased considerably because of
competition and the introduction of a wide array of investment options, plus the reduction of the
number of fund groups available in the Variable Annuity product. Also, insurance companies
have more often switched to affiliated underlying funds due to increasing number of insurers
becoming part of financial conglomerates, etc. The insurers have appreciated increasing revenue


                                                99
by including funds that will pay the insurer for performing administrative services on behalf of
the funds, and insurers do like an additional source of income.
    The SEC does not approve all substitution applications, and in recent months have
concentrated on certain areas in determining whether they should grant an application.
    Generally speaking, the SEC will not approve a substitution unless the new fund’s expenses
are capped at the old fund expense levels for a period of time following the substitution. If the
insurer finds this difficult to do, then the SEC can require them to lower the separate account or
contract level fees to provide such a cap on the new fund and subaccount expenses that are
absorbed by the contract owners.
    Sometimes, making it tougher, the SEC may require that the insurer will not receive,
immediately and up to 3 years in the future, after the date of substitution, any direct or indirect
benefit greater than the insurer would have received from the old fund.
    The SEC has expressed concern that the new fund would have a greater amount of (what they
call) “fundamental risk” than the old fund.
    In certain situations, such has when the new fund has a higher investment advisory fee, the
SEC may require that the insurer obtain the contract owner’s permission for the substitution.

STUDY QUESTIONS

1. The Variable Annuity was introduced as it offered a potential for a greater rate of return if
   A. the agent is willing to sell it with no commission.
   B. the annuity owner is willing to pay 150% of the premium of a fixed annuity.
   C. the annuity owner is in a very low tax bracket.
   D. the annuity owner is willing to accept a greater investment risk.

2. Agents who sell Variable Annuities
   A. must be licensed as securities salespeople and registered brokers with the NASD.
   B. need only an insurance agent’s license.
   C. may not market or participate in the marketing of any other product.
   D. must hold both a life/health license and a property/casualty license.

3. Funds invested in a Variable Annuity separate account are referred to as
   A. exclusion ratios.
   B. indigenous accounts.
   C. accumulation units.
   D. accumulation accounts.

4. An addition to the pure cost of insurance that reflects agent’s commissions, premium taxes,
   administrative costs of acquiring business and other contingencies, is called
   A. loading.
   B. accumulated charges.
   C. P&E.
   D. extraneous charges.




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5. With a Variable Annuity, if the value of the investments has increased, an increase in the
   guaranteed floor for the death benefits is called
   A. the adjusted death benefit.
   B. a sub-limital death benefit.
   C. a ratcheted death benefit.
   D. the exclusion ratio.

6. With the new generation of Variable Annuity, at the liquidation phase the only remaining
   “variable” is
   A. the premium.
   B. the amount of income payment.
   C. the commissions paid the agent.
   D. the interest rate, or earnings, paid on the remaining principal.

7. In considering the risk of a Variable Annuity as compared to a fixed annuity, a basic premise
    that should always be remembered is
    A. the higher the risk, the greater the reward.
    B. the lower the risk, the greater the reward.
    C. the greater the risk, the lower the income.
    D. a “variable” product always increases in value more than a mutual fund.

8. Not only have annuity interest rates become competitive with other investment products,
   A. but annuities have no deferral of income taxes on earnings.
   B. but annuities also have deferral of income taxes on earnings.
   C. but now all annuities of any time, variable or fixed, are under the control of the SEC.
   D. but the majority of investors now invest in variable and fixed annuities for all purposes.

9. A Variable Annuity that credits investor’s payments with an additional payment is called
   A. an “extra-credit” or “bonus” annuity.
   B. an equity-indexed annuity.
   C. an add-on annuity.
   D. a 1035 annuity.

10. When a Variable Annuity is purchased as part of a qualified retirement plan, such as an IRA
    or 401(k),
    A. they are then tax-free for the life of the annuitant.
    B. they are taxed as ordinary income each taxable year.
    C. they are taxed under the special tax provisions governing that qualified retirement plan.
    D. income taxes on the portion contributed by the employee is due each quarter.

ANSWERS TO STUDY QUESTIONS
1D   2A   3B   4A   5C   6D   7A   8B   9A   10C




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              CHAPTER SEVEN - EQUITY INDEXED ANNUITIES

                                         BACKGROUND
    The Equity Indexed Annuity (EIA) is not only a newer product; it is a somewhat complicated
product that is extremely unusual and useful. 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.
    Traditionally with 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,


                                                 102
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!
    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.
                               THE ORIGINATION OF THE EIA
    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.46
    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.
    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.




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    Although rarely discussed publicly, there has been 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. The recent court decisions and
guidelines by the SEC and the IRS have pretty well put the subject to bed – at least for the time
being, as discussed elsewhere in detail in this text.
    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.
                                 PURPOSE OF 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.
     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 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 comprises 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.


                                               104
    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).
                               METHODS OF MARKETING EIAS
    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


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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.
                        EXEMPTION FROM SEC REGULATIONS
    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.
    The exemptions of indexed annuities from SEC regulation is detailed below, but basically in
order not to be classified as a security, the annuity 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.
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 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.
    When Rule 151 (the “safe harbor” rule) was first proposed by the SEC (wherein fixed
annuities were not regulated by the SEC provided the insurer assumes the investment risk and
the contract must not be marketed as an investment), that credited interest on the basis of an
external index was not considered. The annuity companies maintained that by externalizing the
excess interest rate, the insurer therefore shifted the investment risk, including fluctuations, to the
purchaser. The SEC allows an indexed annuity to fall within the rule, provided that it meets
investment restrictions and is not marketed primarily as an investment. Subject to such rules, the
rate of indexed interest cannot be modified more frequently than once a year and the indexed
annuity contracts must be guaranteed prospectively for the next 12 month (or longer) period.



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The SEC feels that indexed annuity contracts that adjust the rate more often than once a year, in
actuality operate less like a traditional annuity and more like a security and it shifts to the
purchaser, all of the investment risk regarding fluctuations in the rate.
    In order to fall within the SEC exemption47 depends upon all of the facts, particularly the
annuity design should guarantee principal and therefore, any negative movement in the index
should never result in taking away more than previously credited interest. Products where the
principal may be invaded must be registered as a security product.
    A district court found that an equity indexed annuity was entitled to this exemption for the
definition of a security and the annuity was within the “safe harbor” rule (Rule 151). The court
took into consideration whether an equity-indexed annuity for which the insurer guaranteed that
the annuitant would receive all (100%) percent return of premium plus 3% interest annually,
depending upon the performance of the S&P 500, was a security and not entitled to the
exemption. The court found that the insurer was obligated to return the premium plus 3% annual
interest, regardless of how poorly the market performed, and therefore the insurer had assumed
sufficient investment risk. The only investor situation assumed by the investor with this plan,
was whether she would receive interest more than 3% a year on her premium payment. The
court stated that there was no direct correlation between the benefit payments and the
performance of the investments made with the contract owner’s money.48
                            MARKETING RESTRICTIONS ON EIAS
    In order for the EIA to maintain its “non-security” status, one of the principal criteria by both
the courts and the SEC, is that the product must not be marketed as an investment. Care must
be taken that the method of crediting interest be accurately and thoroughly described. The index
feature may be described as providing a potential for higher rates over the long run. It MUST
NOT be described as providing a means of investing in the stock market with protection against
a declining interest rate or stock market. The usual annuity retirement features, such as income
options, death benefits, etc., should be emphasized in addition to the interest-crediting method.


                   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.


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         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, so
each company’s “influence” on its performance is directly proportional to its market value.
    A recent survey of the best-selling EIA products of 15 insurers indicated that 12 used S&P as
the index to which their product is tied.49
                                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 is 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.
    The S&P 500 index is reported daily in the Wall Street Journal, USA Today and many other
newspapers. The index reports 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


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value.
    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 index annuities. With mutual funds the fund itself purchases stocks 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.

    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 59%. 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.
    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


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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 should
be noted, however, that most plans using the high-water mark method, use the contract-year-end
results, so even if the index has climbed to record highs during the year, and then dropped
somewhat at the end of the contract year, the interest will be credited according to the year-end
index.
    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.
                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 (2004) 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.


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    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.
    A recent survey of the most popular EIAs of 15 insurers indicated that 8 of these policies use
the annual ratchet method, 9 used point-to-point, but more policies used only the annual ratchet
method than any other method.50 When one remembers the volatility of the market over the past
few years, it is easy to understand the popularity of the ratchet method.


 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.
               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


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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.


                       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.
                                           AVERAGING
   Some persons believe that “averaging” (not to be confused with “dollar averaging”) is a
method of calculating indexed returns. Not true. Averaging is incorporated into many indexing


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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.
    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. An Equity Indexed Annuity is
   A. a form of a Mutual Fund, when all is said and done.
   B. a fixed deferred annuity.
   C. a security.
   D. just another type of Variable Annuity

2. The conservation of the principal of the Equity Indexed Annuity (EIA) is
   A. determined by the amount of the premium.
   B. probable.
   C. guaranteed.
   D. a fluctuation device.

3. For an investor, “indexing” is popular because
   A. there is always a guaranteed increase in income.
   B. an indexed product, insurance or security, is a tax-avoidance mechanism.
   C. the investor knows that the “best” stocks in the market comprises the portfolio of which
       he is part manager.
   D. there never is an acquisition expense or commission paid on an indexed product.


4. The majority of the EIAs marketed today


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   A.   are security products and are registered and sold by NASD licensed agents.
   B.   are not considered as security products.
   C.   are sold as securities but are not considered as securities by the agents.
   D.   are not issued by insurance companies, but by banks.

5. In order for the EIA to maintain its position as a “non-security,” one of the principal criteria is
    that
    A. the product not be marketed as an investment.
    B. the EIA must be described and sold as an investment vehicle.
    C. the sale of an EIA is restricted to those over age 65.
    D. by law, the index must be the Dow Jones averages.

6. Standard and Poor’s 500 index is generally used because
   A. they only charge 1% of the value to allow the use of their index.
   B. S&P is owned by an insurance company.
   C. it is widely quoted and understood and is an excellent indicator of the stock market
       movements.
   D. they are the only rating service that rates EIAs.

7. The simplest indexing method is the
   A. high-water mark indexing method.
   B. the point-to-point indexing method.
   C. the Dow Jones indexing method.
   D. generally accepted accounting method.

8. One method of indexing is where the experience of each year stands on its own with a new
   calculation at the end of each year. This is called
   A. the high-water mark indexing method.
   B. the ratcheting or annual reset indexing method.
   C. the renewal year indexing method.
   D. contra-indexing.

9. Another method of indexing simply credits a particular rate of return every year that the index
   is positive, and another type of return if the index is zero. This is called
   A. the low-water mark indexing method.
   B. the fluctuating indexing method.
   C. negative indexing.
   D. the digital indexing method.

10. “Averaging” is used within many indexing methods because
    A. the term, itself, is ambiguous so the annuity holder will not understand it.
    B. that way the contract owner will feel that they are not getting a better or a worse “deal.”
    C. that way the experience of a single day cannot be used as the starting or ending point.
    D. agents are paid on the “averaging” of the premiums for the first 5 years.

ANSWERS TO STUDY QUESTIONS


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1B   2C   3C   4B   5A   6C   7B   8B   9D   10C




               CHAPTER EIGHT – FUNCTIONS AND USES OF EIA’S

                                                   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.
                                        LENGTH OF THE CONTRACT
     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.


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    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.
                                   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.

   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 .09).

    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.
    As an example, a recent survey of the most popular plans of the 15 major writers of EIAs,
showed that about half has 100% participation limit, most with no annual adjustments. Others
range from 60% or 70% to 100%, and daily average of 55% with annual participation of 60%;
daily average of 60% with annual participation of 70%; and others that range all over the
spectrum, with 20% at the low end to 65% at the high end.51 The point is that each plan must be
carefully studied in respect to the participation limits.
    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


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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. 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.
     A recent survey of the most popular EIAs of 15 insurers indicates that the current
participation rate is generally 100% guaranteed with 8 of the plans, most indicate it has never
been adjusted. Other plans range from 60% first year with 50% base; to 70%; to 60% daily
averaging and 70% point-to-point; to a rather complicated rate of 20% first year with 10% cap, 5
yr. 25%, etc52.
                          RESTRICTING INCOME BY USING “CAPS”
   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%. The EIAs recently surveyed
showed many companies adjust their CAP annually. Nearly all had both cap on total earnings,
and cap on annual earnings.
   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


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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.
                                 CONVERSELY, 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. However, 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.
    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


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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. For instance, one popular plan has annual
surrender charges of (percent) 12,12,12,10,8,6,4,0 – applies from date of policy only.

    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.
    A surrender charge value is determined by some, for instance, as being equal to accumulation
value multiplied by the interest adjustment less surrender charges (which vary by length of time
the plan has been in force).
                                            ASSET FEES
    Many of the EIAs on the market today have “Asset Fees” or other additional charges. Asset
fees are a percentage of the assets of the contract. For instance, one company has a 3.50%
administrative charge annual equity strategy, 2.50% convertible and investment grade bond
strategies. For the most popular EIAs sold by 15 of the leading EIA providers, only two of the
plans have such an asset fee.49
            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
     Half or 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 these criteria, 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 or 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.
     Throughout the short life of the product, the EIA’s have had many design changes and
features have been added. However, 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 a few changing from the Standard & Poor’s 500, using instead Dow Jones Industrial
Average, the Russell 2000, the NASDAQ 100 and/or different bond indexing – still S&P 500 is
the most used. 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 is 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”.

    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 which 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 marking 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. However, because of the “lock-in”, the account value
is unaffected and remains at $110,000. However, 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”,


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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
time to wait for results.
    At the very least, it would be desirable for an agent to have an EIA with the annual reset and
lock-in feature in his/her portfolio.
                             THE BENEFITS OF USING EIAS
    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 features that are 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
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 because of failure of the
issuing insurers has only occurred once, 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.


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    When discussing an EIA with a customer (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.
    Again, 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:

     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


                                               123
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.

    The Consumer Application shown above is a practical approach as if a client who has to
work for his money has a $1 million in mutual funds, he evidently has some confidence in
mutual funds and he would in all likelihood protest if all of the funds were to move immediately
to another investment vehicle with which he is unfamiliar.


                                       SPLIT ANNUITY
    Another way to accomplish basically the same thing as in the Consumer Application above,
but using annuities a little differently, would be by using a “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.

    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 can 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.




                                                124
    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.



STUDY QUESTIONS
1. A consumer purchasing an EIA that is linked to the S&P 500 index
   A. is just the same as buying stock that is listed in the index.
   B. is not the same as buying stock because an EIA helps to eliminate the market risk.
   C. will get a much, much lower return than one that is linked to the Dow Jones index.
   D. will not be able to withdraw any money from the EIA under any circumstances.

2. At the end of the term of an EIA, the contract holder will receive
   A. the lesser of the guaranteed minimum value of the contract, or the indexed value.
   B. the greater of the guaranteed minimum value of the contract or the indexed value.
   C. an additional bonus of anywhere from 5 to 7% of the minimum value of the contract.
   D. a return of premium only.

3. The “Initial Accumulation Term” is
   A. the time length of an EIA.
   B. the interest rate that is guaranteed at issue of an EIA.
   C. the first 5-year period of an EIA.
   D. the first 60 days when the purchaser can cancel and get a full refund.

4. The percentage of the premium deposit and annuity value that will be applied to the contract
   is called
   A. the participation rate.
   B. the accumulation gross amount.
   C. the accumulation net amount.
   D. an accumulation unit.

5. Equity indexed annuities are designed
   A. for the super-rich investor.
   B. for pre-funding nursing home care.
   C. for long-term investing.
   D. so that banks and S&Ls can enter the insurance business.

6. Some EIAs have a provision that there will be a maximum interest rate that can be applied to
   a contract during a certain period, regardless of how high the indexes may soar. This is
   called
   A. a floor.
   B. a cap.
   C. a deal-breaker.
   D. a minimum.



                                              125
7. For EIAs that determine index interest annually or multi-year, the minimum amount of
   interest that will be credited to a contract in any one year or over several years is called
   A. a cap.
   B. a floor.
   C. a maintenance fee.
   D. the tunnel.

8. “Vesting” of an EIA allows for partial withdrawals or surrenders where a percent each year of
    the account value is available from the total value of the contract. The purpose of this is
    A. to protect the agent’s commission from chargeback’s.
    B. to differentiate the EIA from other securities products.
    C. protect the insurer from early contract surrenders as the insurer invests in financial mar-
        kets and otherwise they would have to cash in some of their securities.
    D. to keep consumer organizations happy.

9. When an EIA is used for an IRA,
   A. pre-notification must be given to the IRS.
   B. penalties for partial withdrawals or surrenders must be removed by law.
   C. the IRS will question the return every year as the value fluctuates.
   D. the contract period must coincide with or be earlier than, the date the annuitant turns age
      70 ½ or severe tax penalties will occur.

10. EIAs are purchased by consumers primarily
    A. because of the high commissions, agents push them hard.
    B. because the consumer is guaranteed that he will beat the stock market results.
      C. since the funds are guaranteed by the state insurance department, they are so safe.
    D. for the purpose of accumulating savings for their retirement.

ANSWERS TO STUDY QUESTIONS
1B   2B   3A   4A   5C   6B   7B   8C   9D   10D




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             CHAPTER NINE - 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, and there “ain’t no easy way” to avoid
it. No penalty is imposed on one's principal, i.e. the money put in by the owner is the owner’s
money.
     Didn’t say that there was NO way to avoid this penalty prior to the age of 59 ½. There just
happens to be 3 ways to avoid it:
1. The annuitant (or contract owner) must be dead.
2. The contract owner must be disabled.
3. Of course, the contract can be annuitized.
     It makes no difference how old the annuitant (or owner) of the contract is, if they die then
there is no penalty. Also, the IRS Code52 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 59 1/2.
     Unless the contract is “owner-driven”, the owner can be any age, from new born 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.


                                                127
    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 is 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 has his original $10,000 and he has an
additional $5,765 in his account.


                                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.




                                              128
     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.

    CONSUMER APPLICATION
    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 2d year of 7% of principal = $700.
    Amount that Don will receive ($20,000 minus $6600 minus $700 equals) - $12,700. (36.5%)




                                               129
    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 86% 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.



    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
    This was introduced in Chapter Four but it bears further discussion here also. 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 are 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.




                                               130

     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 $85,691 from Acme and $75,691 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 $35,691 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, 691.
     But is this the final word? Hardly.
     If Benton is to eliminate the remaining balance, there would be no tax liability as the $85,691
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 $35,691 – which is the gain of $85,691 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
    This was discussed earlier, but let’s look at it in another way. 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.
    NOTE: This is another area of taxation that had been tossed around by political
parties and politicians, and the future of deferrals and “stepped-up basis” is questionable
at this time.




                                                131
    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. Joe 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.

     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 withdraws 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.




                                                132
     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
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 contract holder required).
                        COMPARISON WITH OTHER INVESTMENTS
   When comparing an annuity with other types of investments, there are advantages and


                                                 133
disadvantages, basically depending upon how Uncle Sam treats the investment at tax time, how
easily and rapidly can the investor get at his funds, whether there is an actual credit risk or risk
on the market, i.e. how stable is the investment when the market fluctuates, etc., and lastly but
not leastly, what guarantee is available to the investor that the funds will be there when needed.
    The following investment “types” pretty well tell the story. Of course not all investment
types are listed as there are all kinds of options on the market, dot.com investments (e.g.
Google), investments in the brother-in-laws business, etc. Mutual Funds have been discussed
earlier in this text.
    NOTE: Be aware that taxation will probably change one way or the other, because of
political reasons and because of the state of the economy. There are at least three probable
situations that may arise: tax treatment can remain the same; investment vehicles (or any
transaction that vaguely resembles investments) will be heavily taxed; or investments can
be protected more against further taxation. Maybe something else or a combination will
emerge…
    Please note that the tax treatment of the investment product does not take into consideration
such investment being used for a tax-deferred program, particularly IRAs, Keogh plans, SEP
plans, TSAs, etc.
            Certificate of Deposit: This is probably the number one competitor of annuities for
             investment – although depending upon the market, other investments may approach it
             for amount invested. All interest income is taxable as earned (except when used as
             stated above). Liquidity is not of the best – penalties will arise. There is no market or
             credit risk as each CD has an established interest rate until the CD matures, but length
             of time until maturity can differ between CDs and with different interest rates
             credited. Strength of CDs is the fact that they are insured by the Federal Deposit
             Insurance Corp. (FDIC) up to a certain amount for each CD.
            Passbook Savings: Much like CDs – interest income is taxable, but the liquidity is
             much higher than CDs – this form of savings is usually used when liquidity is needed.
             Also insured by FDIC.
            Money Market Funds: Another bank product, taxable, with high liquidity but the
             amount may fluctuate with the market. Actually, very little risk as funds can be
             changed with little penalties in most cases, but the funds are NOT insured by the
             FDIC.
            Stocks: This does not apply to necessarily to “stock funds” which have mostly the
             attributes of a mutual fund. Dividends are taxable but the tax on the growth of the
             stock is deferred and, in most cases, the growth is taxed at capital-gains rates.
             Liquidity is “moderate” (for lack of a better word). Stock and Stock Options can be
             used for various purposes, some of which is more flexible than others, and then there
             is Preferred Stock where the stockholder is credited with growth before the Common
             Stockholders. Many rules and there is a high market risk. If the economy is
             “Bullish,” stocks will usually rise – if the economy is “bearish,” stocks will drop,
             generally speaking. Of course there are all kinds of reasons for ups and downs –
             think Martha Stewart. There is no guarantee of the security of the invested funds
             however there is one point often overlooked that partially compensates for this. If a
             stockholder suffers a capital loss, the capital loss can be shown on the individual tax
             return at a specified maximum each year until the entire capital loss has been used


                                                 134
    deducted. This may not mean much to those in particularly tax brackets, but it can be
    a substantial item for an individual “amateur” or one-time investor.
   Bonds: There are Government Bonds which are not taxed, but commercial bonds
    are. Liquidity is also moderate and the risk will range from very little (U.S.
    Government Bonds, for instance) to high risk – such as “junk bonds.” No guarantees
    except for the financial standing of the organization behind the bond. There would be
    no security of principal for bonds so that Joe’s Buggy Whip Corp. can expand its
    business into New Guinea but there would be substantial security for U.S.
    Government Bonds (or we will all be in trouble).
   Options and Commodities: These are used in the stock market and will fluctuate
    with the market, both up and down. The earnings are taxable, there is little, if any,
    liquidity, and the market risk is HIGH. Fortunes have been made and lost in these
    markets and there are no guarantees. These are not for the faint-of-heart and the
    light-of-pocketbook.
   Limited Partnerships and Promissory Notes: Lumped together as they are taxable,
    very low liquidity, with a high amount of risk and with no guarantees.
   Real Estate Investment Trusts (REIT): At one time, the “darlings” of the
    investment community, but in recent years has lost some of its glitter in some places –
    but not all. Income from an REIT is tax deferred, and liquidity is high – shares of
    REITs are traded all the time. It does combine the traditional growth of real estate
    without the risk of individual foreclosure and other financial risks as each participant
    owns shares of a bunch of property. The risk can range from moderate to very high,
    depending upon the portfolio. No guarantees.
   Viatical Settlements: A relatively new area of investment. At the present time, the
    income is taxable. Liquidity cannot be considered in the traditional sense, as since
    this investment is based upon life insurance policies, if the policies are sold to a
    Viatical company, the liquidity is high. Once the policy has been bought by the
    Viatical company, then the liquidity is low. There are no market or credit risks, and
    there are no guarantees except for the insurance company assets which will pay the
    claim at time of death, but since the investors pay for the policies, there is no
    guarantee that the principal invested will always be available as the buyers accept
    premium responsibility.
   Annuities: This text is all about annuities, so suffice it to say that the earnings are
    tax deferred. Liquidity of all annuities is “moderate” because of surrender charges,
    etc. There is no market risk, except for Variable Annuities and to some degree,
    Equity Index Annuities, and these risks are limited. Variable Annuities cannot
    guarantee the income principal – EIAs can. The owners and beneficiaries of annuities
    have guarantees by the California Life and Health Guarantee Association up to 80%
    of the contractual obligations for each contract or $100,000 in present value of
    annuity benefits.




                                        135
      SUMMARY -ADVANTAGES AND DISADVANTAGES OF ANNUITIES

                          ANNUITIES-ANNUITIES IN GENERAL
Tax Deferral: Like an IRA, annuity earnings are tax deferred which makes them more
appealing than CDs, money market funds, or other safe investments.
Safety of Capital: Money is safe in annuities. Insurance companies are required to
keep cash reserves to ensure this. Most states also have a guarantee fund up to
$100,000 per annuity for additional security. (See last chapter for discussion of
Guarantee fund.)
Liquidity: Money is accessible. Most contracts have an annual withdrawal clause that
will allow the annuity owner to take 10-15% of the account value each year without
incurring penalty.
Rate of Return: Annuities offer higher rates of return than other safe investments.
Currently, annuities are yielding an average of 4% tax deferred in comparison to only
2% taxable with CDs. As economic markets stabilize, annuity yields should increase
accordingly. Annuity rates of return offer more stability in fluctuating markets.
Income stream: Fixed annuities that provide an income stream has been found to be
one of the best retirement income vehicles according to a study done by New York Life
and the Wharton Business School. After the first annuity contract year, most annuities
can provide monthly income payments for lifetime. Likewise, immediate annuities
provide monthly income payments for lifetime, but they start immediately.
Conversely, the wrong annuity product can have negative effects
Short Term Money: If there is a chance that the annuity applicant may need all of their
money returned to them in the short-term, (i.e. 2-4 years) an annuity would not be the
proper vehicle. It is best to only invest funds not needed for at least the next five years.
Surrender Schedule: Because annuity contracts have surrender charges for
withdrawing money before the contract matures in lieu of issue sales charges, the
annuity owner will be obligated to the terms of the contract. Some surrender schedules
can be as long as ten years.
Sales Commissions: As with any purchase, the sales agent will earn a sales
commission. Unfortunately an unethical sales agent may not have the applicant’s best
interests at heart.
Liquidity: While liquidity can be a “pro,” it can also be a negative” as the annuity
applicant may not realistically know how much money they may need to access and
when. Without knowing these answers in advance, , liquidity can easily turn into a
negative.




                                            136
                                 VARIABLE ANNUITIES
No other Annuity product creates as much controversy as Variable Annuities. Like a lot
of things in life, there are times when they work great and others when they are
completely inappropriate.
                                 PROS OF VARIABLE ANNUITIES
Guaranteed Benefits:
   Death Benefit- This allows the heirs of the contract to inherit the full principal
   balance in the event that the contract owner passes away while the contract is in
   force and the account has lost value.
   Income- This allows the contract owner to lock in a predetermined level of future
   income regardless of account performance.
 Principal- This allows the contract owner to recover the principal investment or the
 highest contract value achieved regardless of the account value at time of surrender.

Tax Deferral: Taxes are deferred on the growth of assets inside an annuity giving the
contract owner the added benefit of greater compounding. Many critics suggest that
excessive fees mitigate tax deferral benefits. If tax deferral is the sole focus of
purchasing an annuity, expensive optional riders can be waived so that total fees will
run no higher than the average mutual fund.

Unlimited Contributions: Retirement plans have contribution limits. If the annuity
owner ever comes into a larger sum of money, much of it will not be eligible for
allocation in a 401K, IRA, etc. Annuities have no contribution limits.
                              CONS OF VARIABLE ANNUITIES
   High Fees: Many annuities have optional riders that push the overall fees to 3% or
   more. Plenty, but not all, of products allow an investor to elect out of the options. If
   anyone is purchasing an annuity with high fees, there must be compelling reasons to
   do so.
   Limited Investment Choices: Asset allocation options are limited within an annuity.
   Some contracts have predetermined portfolio balances and others will list a limited
   number of available mutual funds.
   Surrender Charges: As with all annuities, variable products have surrender charges
   so your money is tied up for a specified period of time except for the usual 10%
   annual free withdrawal. The annuity purchaser must be positive that the surrender
   schedule works with his investment time horizon.
   Immobility: The combination of investment limitations and surrender charges means
   that his money is much less mobile than it would be in an equivalent securities
   account.




                                           137
                   PROS AND CONS OF EQUITY INDEX ANNUITIES
Equity Indexed Annuities are most complicated type of annuity and should always
require the services of expert advisor. One of the biggest reported problems recently
has been the “pushing” of this product by agents as some companies are paying very
high commissions on this particular product.
Equity index annuities offer principle guarantees with potential growth tied to a major
stock market index. The annuity owner will get his money back in the worst-case
scenario and in addition, he may profit nicely if things go well.

                                         BENEFITS
Principle and Growth Guarantee- The initial investment is secure and guaranteed to
grow at a relatively low rate. The contract will state the minimum amount they can
expect to receive at the end of the surrender period.
Tax Deferral- Like all annuities, money increases on a tax-deferred basis.
Account Step Ups- In most cases, a new base contract value can be locked in when
the index performs well. This gives you the benefit of locking in a new guaranteed basis
when the market works the way we all want it to.

                                          DISADVANTAGES
Capitalization Rates- All contracts state the maximum amount of interest that will be
credited to the account. This can be calculated in a variety of ways such as on a
monthly or annual basis. With an annual cap rate of 9%, the market index may return
20% but the account will only be credited with the maximum cap of 9%.
Participation Rates- All contract also stipulate the percentage of the index gain that will
be credited to the account. This will range from 60%-100%. If the index gains 10% and
the contract has a 60% participation rate, the account will be credited with 6% interest.
This is also subject to the Capitalization Rate where applicable.
Long Surrender Periods- These contracts often have very long surrender periods.
One reason for this is the fact that you have a better chance for favorable index
performance over a longer period of time. Even so, if you have a time horizon of more
than 10 years, the principle guarantee may not be as important. As a general rule there
does not seem to be good equity indexed annuities with long surrender periods. A very
popular EIA has a five-year surrender period whereby if the annuitant or owner happens
to really like it after five years, then they can buy it again and make it a ten-year
strategy. Conversely, if it doesn’t work that well then the money is available much
sooner.
Crediting Methods- This determines how the index return is credited to the account
balance and it can have a dramatic effect on the performance of the annuity. Two
common methods used are monthly averaging and point-to-point (various methods
available are shown in the text, doubtful if any annuity writer offers all methods). The
averaging method will credit the monthly index average to the account. The point-to-
point method will compare the starting and ending values of the index, on a monthly or
annual basis, to determine the total return to the annuity account. Also, for additional
fees, a high-water mark feature can be added to point-to-point option so they can look
back over the period and take the highest value for crediting purposes. All crediting
method options are subject to participation and cap rates.


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                    PROS AND CONS OF IMMEDIATE ANNUITIES

Immediate Annuities are the most traditional annuity product available. In simple terms,
one gives an insurance company his money and in return he will receive income
payments for either a specified period of time or the remainder of his your life; the
decision is his. Note that the benefits are all on the income side.

Lifetime Income- With an immediate annuity the annuitant will receive a higher level of
guaranteed income than available with any other product.

Income Adjustments- If a cost of living adjustment (COLA) is added, or if the
payments are tied to the consumer price index (CPI); then the annuitant will receive
guaranteed income that rises over the years to meet the increases in living expenses.

Flexible Payment Terms- The contract can be structured to pay at the owner’s
discretion be paid. Single life payment options are available for individuals and joint
options for couples. Also, income can be guaranteed for a specific number of years or
until the original principle is repaid, even if the payments are made to heirs. However,
the disadvantages can be avoided with proper planning.
Locked Contract- Once a contract is purchased it is set in stone unless they decide to
sell the payment stream, which should only be considered in dire circumstances. A
thorough financial analysis is necessary before final purchase. As a rule, they should
allocate just enough money in an immediate annuity to generate a comfortable level of
income and reserve the remainder of their assets for other investments.

Surrender of Principle- Simply put, the company gets the money and they pay the
annuitant. When the annuitant dies, the payments stop and the company keeps the
remainder balance, if any. If they can outlive expectations then they win big because
the company must pay for life. The purchaser of the annuity should be familiar with the
flexible payment terms available to ensure that the spouse or heirs are protected with
continued income or return of principle. This may cost a little more, but usually it is the
correct action to take if there are survivors to be considered.




                                            139
                         PROS AND CONS OF FIXED ANNUITIES

Fixed Annuities are the easiest of all annuity products to understand. Simply (very
simply) the purchaser invests money with the insurance company and they pay him
interest. When the investment term has expired, he has the option to either have his
account balance paid out as a stream of income or he can take the entire lump sum and
go elsewhere.
The benefits of fixed annuities are quite clear…
Guaranteed Interest-
He can lock his interest rate for the life of the contract with a CD-type annuity or he may
choose a floating rate that moves up or down according to normal interest rate
fluctuations. Either way, the interest is guaranteed to not go below a certain level as
specified by the contract.
Tax Deferral- Accumulation within the contract happens on a tax-deferred basis so he
has the benefit of additional compounding that gives an effective yield that outpaces
other safe cash investments.
Free Withdrawals- Every contract comes with a provision that allows him to take an
amount, ranging from 10% to 15% of the account balance annually without penalty. This
can be used to meet minimum distribution requirements in retirement accounts or for
discretionary expenses.
Ultimate Safety- Insurance companies are much more conservatively capitalized than
banks so the guarantees are considered by many to mean more. The insurance
industry has a much lower default rate than the banking industry and all states have an
insurance guaranty fund that matches, and in some states, exceeds insurance provided
to banks via the FDIC.
The disadvantages of fixed annuities are equally as clear…
Surrender Periods- Fixed annuity contracts require the person to keep his money
invested for a specified period of time. In exchange for this commitment, there is no up-
front sales charge. The investment term is known as the surrender period and there is a
“back-end” charge if the annuity owner fails to live up to the contract. The surrender
period must work within the time horizon of the purchaser. If he needs more money than
is available via free withdrawal before the end of the contract, as they (reportedly) say in
New York, “fogeddaboudit.” Look for another place to invest money.
Conservative Growth- Fixed annuities will never make anyone rich. They are meant
for asset preservation and safe appreciation. These products work just before or during
retirement because of safety—at the sacrifice of rapid growth. An analogy would be a
putter in your golf bag—you only use it when it is appropriate to do so.




    RECENT COMPARISONS OF ANNUITIES AND OTHER INVESTMENTS
A recent article in American Bankers publication, emphasizes the attraction to investors who are
concerned with the safety of their investment, compares Annuities with other investments, and
discloses what other investment vehicles are “in the mill” to counteract the attractiveness of


                                              140
annuities, particularly with the influx of Baby Boomers (which not specially mentioned in the
article, obliquely voices concern about this large number of future investors,
Investment managers are developing lower-cost alternatives to annuities to help customers —
and advisors — spend their savings after retirement. Fidelity Investments and Vanguard Group
have both rolled out products designed to manage retirement savings and parcel them out in
monthly increments, and Brinker Capital is working on one. Advisors have focused on asset
accumulation for decades, and executives and analysts said that shifting their attention to
products geared toward spending will help them retain clients after they retire.
"Annuities are good products, but some clients just don't like them," (said a principal at a large
investment firm)."
Analysts said retirement income planning remains a hot topic, but the focus has been squarely on
annuities, despite their drawbacks. Fixed annuities lock up principal and do not offset inflation;
the costs associated with variable annuities usually exceed those of mutual funds, and monthly
payouts can be meager.
"There has got to be a better strategy for investors than annuities," said (an expert in financial
research). "The guarantees that annuities offer and the different features have proven insufficient,
improper and expensive. There needs to be an alternative that can properly facilitate distribution
while protecting principal better."
(Another expert researcher) … said that these new products will appeal to a certain segment of
investors but that conservative bank investors will continue to invest in annuities and certificates
of deposit. "My sense is, in the bank channel, guarantees are king, and that is why annuities will
continue to really sell in banks."
(One large investment house) began offering 11 income replacement funds in 2007. (Another
firm) introduced three managed payout funds in May 2008. The funds use three-year averages to
make distributions that are paid monthly. The funds have collected about $320 million in
assets…
Though these products do not offer the guarantees of annuities, … the payout funds are attractive
to investors because they are less expensive than the typical annuity, which costs 100 basis
points, compared with a payout fund, which costs 60 basis points. "The biggest advantages (of
the new products) are its flexibility and liquidity," he said. "With an investment solution, you
have more options if you want to get out. That wouldn't be the case with an insurance product
where there are stiff surrender charges."[NOTE: These “experts” should take another look at
surrender charges as insurers continue to be more flexible in that area.)
(One investment firm) … is developing products that will provide customers with "paychecks"
from their retirement savings. The company said Tuesday it expects to introduce its personalized
distribution strategy, which gives clients a cash liquidity reserve and an investment portfolio, by
the end of the quarter. The cash liquidity reserve consists of 18 months of cash, from which the
client can begin drawing immediately.
As the cash balance is reduced, (this plan) sweeps in cash from investments in dividend- and
income-producing funds. A stop-loss of six months of cash will be maintained so, regardless of
market conditions, the cash reserve will be replenished. "We want to help people to get their
money that they have saved throughout their life to work for them in retirement, … "Most
advisers have spent their lives thinking about accumulation, not distribution. We need to turn the
tables now."



                                                141
It appears that some product of this type is being researched, but as one person said, “… many
advisors are providing similar services, "but it is difficult because they are doing a lot of it on the
back of an envelope.” (The goal seems to be to provide the tools so they can provide (such a
plan) in a more systematized way.
Still, few are abandoning annuities. (One of the larger firms) offers a variable annuity, and
(another firm allows) advisors (to) use (the) product with an annuity.
(Experts) say the industry still has a long way to go … as advisors focused on asset accumulation
could lose customers. Financial services companies need to educate and train advisors about the
role they need to play as customers head toward retirement. "Sales reps have to become more
consultative than transactional. It is hard to be transactional when you have a 67-year-old
client that needs these assets to live on. Companies have to be willing to change their
approach." (our emphasis)




                           STRUCTURED SETTLEMENT ANNUITIES
The very highly specialized field of Structured Settlement annuities is discussed in detail in
ATTACHMENT III. (At the end of the text)

STUDY QUESTIONS

1. One of the disadvantages of annuities often quoted by financial planners is
   A. there are potential IRS penalties and taxes.
   B. Mutual Funds can grow at a better rate because of their taxation advantages.
   C. there is no tax advantage in any respect in an annuity.
   D. only NASD licensed personnel can sell them & they all change jobs too often.

2. If an annuity contract is owner-driven, then at death of the owner
    A. all IRS penalties will be waived.
    B. no IRS penalties will be waived.
    C. IRS penalties will be waived if the owner is older than 59 ½.
    D. all value reverts to the state.

3. The taxable portion of an annuity benefit is
   A. taxed at capital gains rates.
   B. not taxed at distribution.
   C. the total of contributions and internal growth.
   D. taxed as ordinary income.

4. Partial withdrawals
   A. can result in high taxation.
   B. can be tax sheltered for the life of the annuitant plus 8 years.
   C. are never taxed, even at annuitization.
   D. are repayable at 1% interest.


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5. The Annuity Aggregation rule
   A. does not allow an annuitant to own more than 2 annuities.
   B. does not allow a TSA participant to own other types of annuities.
   C. requires insurers to pool the premium income of all annuities.
   D. applies to multiple annuity contracts issued by the same company to the same
       contract owner within 12 months of each other.

6. A “stepped-up” basis for taxation
   A. applies to all annuity benefits at time of death of the contract owner.
   B. does not apply to annuities and takes place only when the owner of the asset dies.
   C. is required for every Variable Annuity, including EIAs.
   D. is the upper tax bracket into which an annuitant falls at annuitization.

7. A withdrawal penalty for early withdrawal from an annuity kicks in
   A. only when the withdrawal is in excess of the free withdrawal privilege.
   B. upon the death of the contract owner.
   C. upon the death of the annuitant and the beneficiary.
   D. upon the retirement or disability of the contract owner.

8. Most contracts allow early withdrawal penalties upon
   A. withdrawals to purchase a first home.
   B. withdrawal to pay for college education debts.
   C. death, disability or annuitization.
   D. a period of three years in a row of excess interest accumulation.

9. The guaranteed death benefit is a unique feature of an “investment vehicle” and
   A. there is no extra charge or fee for this feature.
   B. it is always sold as a rider for a sometime exorbitant fee.
   C. the insurer collects a mortality fee to offset the cost of this benefit.
   D. all funeral expenses are also paid, at no extra cost to the annuity owner.

10. If an annuity has an annual contract maintenance charge, then the annuity is not
   A. a fixed-rate annuity.
   B. an EIA.
   C. a Variable Annuity.
   D. a small amount annuity.

ANSWERS TO STUDY QUESTIONS
1A   2A   3D   4A   5D   6B   7A   8C   9C   10A




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CHAPTER TEN – PROVIDING ANNUITIES TO THE SENIOR MARKET

                              DEFINITION OF SENIOR/ELDERLY
    When reviewing the California Insurance Code (CIC) and other appropriate statutes, laws
and regulations, at first blush there may seem to be an anomaly in determining just what is
considered as “Senior” and/or “Elderly.” The Code governing annuities generally treats those
over age 65 as “elderly” or “Seniors.”
    “CIC 789.10” primarily concerned with marketing of life insurance, including annuities,
states in 789.10(g) “For purposes of this chapter, a senior citizen means an individual who is 60
years of age or older on the date of purchase of the policy.” Further, in 10127.19, (referring to
right of cancellation by annuity owner, etc.) the identical clause appears.

    Additionally, the following Code 789.10 (redacted) would apply:
    This applies to the sale, offering for sale, or generation of leads for the sale of life insurance,
including annuities, to senior insureds or prospective insureds by any person.
    Any person who meets with a senior in the senior's home is required to deliver a notice in
writing to the senior no less than 24 hours prior to that individual's initial meeting in the senior's
home. If the senior has an existing insurance relationship with an agent and requests a meeting
with the agent in the senior's home the same day, a notice shall be delivered to the senior prior to
the meeting. The notice shall be in substantially the following form, with the appropriate
information inserted, in 14-point type:
      "(1) During this visit or a follow-up visit, you will be given a sales presentation on the
    following [indicate all that apply]:
      ( ) Life insurance, including annuities
      ( ) Other insurance products [specify]: _________________.
      (2) You have the right to have other persons present at the meeting, including family
    members, financial advisors or attorneys.
      (3) You have the right to end the meeting at any time.
      (4) You have the right to contact the Department of Insurance for information, or to file a
    complaint. [The notice shall include the consumer assistance telephone numbers at the
    department]
      (5) The following individuals will be coming to your home: [list all attendees, and
    insurance license information, if applicable]"
    Upon contacting the senior in the senior's home, the person shall, before making any
statement other than a greeting, or asking the senior any other questions, state that the purpose of
the contact is to talk about insurance, or to gather information for a follow-up visit to sell
insurance, if that is the case, and shall state the name and titles of all persons arriving at the
senior's home and name of the insurer represented by the person. In addition, each person
attending a meeting with a senior shall provide the senior with a business card or other written
identification stating the person's name, business address, telephone number, and any insurance
license number.
    The persons attending a meeting with a senior shall end all discussions and leave the home of
the senior immediately after being asked to leave by the senior.


                                                 144
    A person may not solicit a sale or order for the sale of an annuity or life insurance policy at
the residence of a senior, in person or by telephone, by using any plan, scheme, or ruse that
misrepresents the true status or mission of the contact.
  (g) For purposes of this chapter, a senior citizen means an individual who is 60 years of
age or older on the date of purchase of the policy.


     (The other provision where Age 60 is used is in 10127.10. )
     Every policy of individual life insurance and every individual annuity contract that is initially
delivered or issued for delivery to a senior citizen shall have printed thereon or attached thereto a
notice stating that, after receipt of the policy by the owner, the policy may be returned by the
owner for cancellation by delivering it or mailing it to the insurer or agent from whom it was
purchased. The period of time set forth by the insurer for return of the policy by the owner shall
be clearly stated on the notice and this period shall be not less than 30 days. The owner may
return the policy to the insurer by mail or otherwise at any time during the period specified in the
notice.
     During the 30-day cancellation period, the premium for a variable annuity may be invested
only in fixed-income investments and money-market funds, unless the investor specifically
directs that the premium be invested in the mutual funds underlying the variable14009 annuity
contract. Return of the policy within the 30-day cancellation period shall have one of the
following effects:
     For variable annuity contracts for which the owner has not directed that the premium be
invested in the mutual funds underlying the contract during the cancellation period, return of the
policy during the cancellation period shall have the effect of voiding the policy from the
beginning, and the parties shall be in the same position as if no policy had been issued. (void ab
initio) All premiums paid and any policy fee paid for the policy shall be refunded by the insurer
to the owner within 30 days from the date that the insurer is notified that the owner has canceled
the policy. The premium and policy fee shall be refunded by the insurer to the owner within 30
days from the date that the insurer is notified that the owner has canceled the policy.
     In the case of a variable annuity for which the owner has directed that the premium be
invested in the mutual funds, underlying the contract during the 30-day cancellation period,
cancellation shall entitle the owner to a refund of the account value. The account value shall be
refunded by the insurer to the owner within 30 days from the date that the insurer is notified that
the owner has canceled the contract.
     Every individual life insurance policy and every individual annuity contract, other than
variable contracts and modified guaranteed contracts, subject to this section, that is delivered or
issued for delivery in this state shall have the following notice either printed on the cover page or
policy jacket in 12-point bold print with one inch of space on all sides or printed on a sticker
affixed to the cover page or policy jacket:

               "IMPORTANT
 YOU HAVE PURCHASED A LIFE INSURANCE POLICY OR ANNUITY CONTRACT.
CAREFULLY REVIEW IT FOR LIMITATIONS.

 THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU
RECEIVED IT FOR A FULL REFUND BY RETURNING IT TO THE INSURANCE



                                                 145
COMPANY OR AGENT WHO SOLD YOU THIS POLICY. AFTER 30 DAYS,
CANCELLATION MAY RESULT IN A SUBSTANTIAL PENALTY, KNOWN AS A
SURRENDER CHARGE."

    The phrase "after 30 days, cancellation may result in a substantial penalty, known as a
surrender charge" may be deleted if the policy does not contain those charges or penalties.
    Every individual variable annuity contract, variable life insurance contract, or modified
guaranteed contract subject to this section, that is delivered or issued for delivery in this state,
shall have the following notice either printed on the cover page or policy jacket in 12-point bold
print with one inch of space on all sides or printed on a sticker that is affixed to the cover page or
policy jacket:
                           "IMPORTANT
  YOU HAVE PURCHASED A VARIABLE ANNUITY CONTRACT (VARIABLE LIFE
INSURANCE CONTRACT, OR MODIFIED GUARANTEED CONTRACT). CAREFULLY
REVIEW IT FOR LIMITATIONS.

  THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU
RECEIVED IT. DURING THAT 30-DAY PERIOD, YOUR MONEY WILL BE PLACED IN
A FIXED ACCOUNT OR MONEY-MARKET FUND, UNLESS YOU DIRECT THAT THE
PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO UNDERLYING THE
CONTRACT DURING THE 30-DAY PERIOD. IF YOU DO NOT DIRECT THAT THE
PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO, AND IF YOU RETURN
THE POLICY WITHIN THE 30-DAY PERIOD, YOU WILL BE ENTITLED TO A REFUND
OF THE PREMIUM AND POLICY FEES. IF YOU DIRECT THAT THE PREMIUM BE
INVESTED IN A STOCK OR BOND PORTFOLIO DURING THE 30-DAY PERIOD, AND
IF YOU RETURN THE POLICY DURING THAT PERIOD, YOU WILL BE ENTITLED TO
A REFUND OF THE POLICY'S ACCOUNT VALUE ON THE DAY THE POLICY IS
RECEIVED BY THE INSURANCE COMPANY OR AGENT WHO SOLD YOU THIS
POLICY,
WHICH COULD BE LESS THAN THE PREMIUM YOU PAID FOR THE POLICY. A
RETURN OF THE POLICY AFTER 30 DAYS MAY RESULT IN A SUBSTANTIAL
PENALTY, KNOWN AS A SURRENDER CHARGE."

    The words "known as a surrender charge" may be deleted if the contract does not contain
those charges.
    This section does not apply to life insurance policies issued in connection with a credit
transaction or issued under a contractual policy-change or conversion privilege provision
contained in a policy. Additionally, this section shall not apply to contributory and
noncontributory employer group life insurance, contributory and noncontributory employer
group annuity contracts, and group term life insurance, with the exception of subdivision (f).
    When an insurer, its agent, group master policyowner, or association collects more than one
month's premium from a senior citizen at the time of application or at the time of delivery of a
group term life insurance policy or certificate, the insurer must provide the senior citizen a
prorated refund of the premium if the senior citizen delivers a cancellation request to the insurer
during the first 30 days of the policy period.




                                                 146
                            HISTORY OF THE SENIOR MARKET
    With the continual improvement in mortality primarily due to advances in the medical field,
the “senior” market continues to grow as a percentage of the population. People are living
longer and they constitute a very important and financially influential portion of our society.
When Medicare was introduced in 1965, no one really had any idea as to the influence it would
have, besides providing health services to all persons over 65 and certain disabled persons under
65. With the growth of medical technology, the growth of the costs of medical care advanced
even more rapidly. Since the older, mostly retired, citizens now have affordable health
insurance; this allows them to keep more of their money to enjoy over a longer period of time.
    The “senior market” for insurers is generally considered to be Medicare Supplemental
policies, Long Term Care (including Home Health Care) Insurance, and Annuities.
Unfortunately, the senior citizens proved to be a market for unscrupulous salespeople as this
generation of seniors are usually very trusting, often uneducated in many financial matters and
more importantly, quite well off. Historically, the husband was the breadwinner of that
generation and handled most, if not all, of the financial matters. This created a large number of
widows who were “comfortable”, some more comfortable than others and many of them with no
experience in handling of financial matters.
    Those who were in the insurance business in the 1970’s and 80’s, remember insurance
“portfolios” consisting of several Medical Supplemental policies, often more-than-one Nursing
Home or Long Term Care insurance policies, along with burial policies, small amount graded-
death benefit insurance policies and “cancer” policies. When those who preyed on the elderly
sold them all of the insurance that they possibly could, they turned to other ways to access more
of their finances. An annuity provided another opportunity.
    Annuities are not well understood by the general public, and with the introduction of
Variable and Equity Indexed Annuities, voila!, the “perfect” investment product for the elderly.
As indicated in this text, many annuities were designed for pre-retirement planning, therefore
upon retirement it was possible that the retiree already had at least a nodding acquaintance with
annuities. Since their pension plans in many cases were funded by annuities, the retiree then
moved to annuitization.
    One of the major concerns of the elderly is that of outliving their resources. Annuities solve
this problem perfectly. Since the return on the “investment” of an annuity is guaranteed by the
assets of the insurance companies, it is nearly impossible for an annuity to provide the income
that other investment vehicles can, such as Mutual Funds. People have a tendency to forget the
stock market losses and remember the high stock market gains at certain times. Therefore, there
seemed to be a “need” to inform and educate the elderly investor of the need to invest in
annuities.




                                               147
                             SPECIAL SENIOR DIFFICULTIES

    The senior citizens have special difficulties in the purchase of insurance, annuities and other
financial matters. Perhaps the most critical problem they have is the simple fact that short-term
memory loss is typical as one grows older. Therefore this important part of our society must
have special protection against those who would take advantage of these conditions suffered by
our seniors. In California, Civil Code Section 38-41 along with other Insurance Codes, assists in
the marketing of insurance and other financial (and non-financial) products to the elder citizens.
                                     CONTRACT RECISSION
    A person without understanding has no power to make a contract of any kind, however, the
person is liable for the reasonable value of things furnished to the person necessary for the
support of the person or his/her family. (CC Code Section 38)
    CC Code Section 39 is in two parts: (1) A contract or other conveyance of a person of
“unsound mind” but with some understanding, that was made prior to the incapacity of the
person has been determined by the courts, is subject to rescission. Further (2) there will be a
rebuttable presumption that affects the burden of proof that a person is of unsound mind if they
are substantially unable to manage his/her own financial resources, and also be able to “resist
fraud or undue influence.” Substantial inability cannot be proven only by an isolated incident of
negligence or “improvidence.”
    CC Code Section 40 , referring to the appropriate Probate Court and the Welfare and
Institutions Code, states that after his/her incapacity has been officially determined by a court, a
person of unsound mind may make no conveyance or other contract, delegate power or waive
any right, until they have been fully restored “to capacity.”
    Further, the establishment of a conservatorship (under the proper Probate Code) must be
determined by the courts of the incapacity of the “conservatee.”
    CC Code Section 41 states that a person of unsound mind, regardless of what degree, is still
civilly liable for a wrong that they commit, but is not liable in exemplary damages unless at the
time of the act, the person was incapable of knowing that the act was wrongful.


                         FINANCIAL CONCERNS OF THE ELDERLY
    Earlier approached in general terms, but specifically, the financial concerns of the elderly are
generally that they are afraid that they will run out of money. One of the biggest concerns in this
respect is the effect of inflation. Even with today’s low inflation rate, with the low returns from
investments which seems to accompany low inflation, retirees are looking backwards with fond
memories of the times when they were getting 7% or more on their investments – even though
inflation was higher. Social Security benefits have been adjusted to reflect inflation (until 2009
and 2010), and that has helped those who rely mostly upon Social Security benefits to survive.
    One of the major problems of Social Security is that the number of employed persons that
support each Social Security recipient has diminished so that the very base of the program has
been weakened. Washington has made moves to move back the retirement age at which a
recipient can receive full benefits – which only makes sense as people are living longer. Not
politically expedient, of course, but makes sense. Unfortunately, in recent elections, some
politicians were able to convince the elderly citizens that Social Security is sacrosanct and is


                                                148
“locked away in a box” so that nothing can happen to it. Now, getting politicians to vote for any
change, whether it is good or not, is for them to “walk on red-hot coals” by bringing up Social
Security reform. It appears at this time that the only change that might be approved soon might
be to move the age of eligibility up to age 70 or so.
    In respect to other investments, the principal concern of senior citizens is that once they have
spent their funds (they may or may not look upon it as “investing”) for retirement purposes, if
something should happen to it, they will not, in most cases, be in a position to replenish the
funds. One of the problems is that at a certain age (70 ½ for IRAs, for instance) they are
required to take the funds out of their retirement plan, and usually the amount that they must take
out (or suffer heavy tax penalties) must be equal to the required minimum distribution amount.
There have been steps taken recently to reduce the amounts that are required to be released, and
consideration is being given to delay the point that the distribution must begin.
    One of the most recent steps, part of the 2002 tax law, the percentage of qualified plan assets
that must be distributed is reduced, and the distribution age of 70 ½ can be postponed until the
person retires.
    Investing these funds is of primary concern to many of the elderly. Many have never had to
make financial decisions before (their late husband always handled the money, etc.) so they are
property concerned about assuming the risks of investing. To help them make the right
decisions, and to help put their minds at ease, there are some steps that can be taken:
           As any profession who works in the senior market can attest, the best thing an agent
            can do is to involve other family members or trusted advisors in the decision making
            process.
           Regulations are very strict and explicit that everything must be out in the open, from
            proper identification of the agent and others that may accompany him, to details of
            each product explained in proper and concise detail, with complete disclosure.
           Inform them that they may want to have an independent advisor in on the discussions,
            such as an attorney or accountant. This is required by regulations also.
           “Ferme la bouche” (A little French lingo there…) “Keep your mouth shut.” When
            working with the elderly, their financial matters must be kept very confidential. They
            do not like for their financial matters to be discussed with others. Neither does the
            Department of Insurance…
    The elderly people are elderly – this means that there may be impairments of some sort or
other that could impede their understanding of what is happening. An agent must be aware of
these situations if for no other reason than the contract may be void if the applicant does not
understand completely what they are signing!
                       SHORT-TERM MEMORY LOSS INDICATORS
    “Cognitive impairments”, or short-term memory loss, is rather difficult to ascertain unless
one plays particular attention and is aware of how this situation manifests itself. More often than
not, seniors have problems with forgetting things that they never used to forget, they may find
themselves having to wear a hearing aid, and the greatest majority of seniors must wear glasses –
which they may have changed once in a while when they just can’t see any longer.
    It is so very, very important that an agent be aware of any impairments, physical or cognitive,
so that they are comfortable that the senior can make a reasoned and informed decision.


                                                149
     The first rule is that not all elderly are impaired. The second rule is that the older you get, the
more you forget – even for a genius. There is actually a 75-year old tour guide at a state park
who has been known to talk steadily for 2 hours during the tour, discussing the flora and the
fauna and the history of the place, without an error or missing a beat – and forget to bring his
lunch. Happens.
     The ability to make an informed decision can be reduced by hearing or eyesight difficulties,
although today they have remarkable appliances and glasses to help. One should watch for
mobility problems but this may or may not signify any lack of understanding – just because a
person uses a walker is no sign that their brain is in park.
     Cognitive impairments are difficult to detect, but one of the ways that it may be spotted is to
listen to the person talk. A professional always gets the applicant to talking, as that way he may
have a clue as to how their brain works, and if they understand what is being said. Step two in
this process, is to review the process during and at the end of the interview, to see if anything out
of the ordinary slipped through the cracks – one could not expect that anyone could remember all
of the information provided to them in these situations, but they should at least basically
understand what is happening. Remember, according to the California Code88 a contract with a
person of unsound mind which is made before the capacity is determined by a court, is subject to
rescission and if the person is completely without understanding the contract is void.
     If it is apparent that the client has difficulty in performing normal everyday tasks, or is
unable to express himself or understand simple concepts, then there is a problem. Of course, if a
person has “mood swings” and forgets appointments and misplaces important items, then these
would be indications of cognitive impairments, but rarely will an agent be with an individual
enough to notice these aberrations of normal activity.
                                       CLIENT SUITABILITY
    Selling annuities to a senior is a financial product sale, and an effort must be made to make
sure that the client and product suit each other. It is extremely important that details financial
records be kept of all transaction with the seniors as typically some of the material discussed will
be forgotten otherwise. And before financial discussions can be meaningful, it is necessary for
the senior client to have detailed financial records of his assets and liabilities.
    The tax situation of the client is important as that is one of the most important benefits of an
annuity, however, if the client really has little of no income tax liability and none is anticipated,
then serious consideration must be given as to whether (a) this is the proper product for the
client, and (b) if the client can afford the financial strain of investing in an annuity.
    In the same vein, since annuities are not designed to be effective short-term investments, if
the client does not have sufficient liquidity to maintain a decent life style after purchasing an
annuity, then it could be entirely possible that an annuity is not suitable. If it appears that the
client may need or want the funds that are invested in the annuity, in the near future, then other
types of investments or products should be used, not an annuity. The surrender charges and
taxation penalties for short-term investing in annuities must be fully explained so that the client
understands that if he purchases the annuity for short-term needs, it can be quite costly.
    In discussing financial needs, the client will probably have some investments already in a
401(k) or 403(b) plans, Keogh plans, or some other such retirement plan, unless he has already
distributed these funds because of age. If the client still qualified for any of these plans that offer
favorable tax benefits, then that is where his money should go at this time. If, on the other hand,


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an annuity is purchased for the purpose of funding a 401(k) or similar account, then the tax
benefits of an annuity is unnecessary and the annuity should be used in a tax-qualified account
only in those situations where the tax–deferral is important.
    If a senior is thinking of buying a Variable Annuity, then one must look at the investment
sophistication of the client as this is a rather complex product. Sometimes the concept of
variable subaccounts is beyond the contemplation of the senior, in particular. Unless the client is
so wealthy that he would not notice how the market fared because the money was immaterial,
then an agent is not performing a professional service if the client does not fully understand how
the plan works.
    If the client cannot understand fully the ramifications of the annuity purchase, there will not
be the type of situation that makes for a happy relationship. If the client does not provide enough
information so that a proper determination as to the suitability of the product can be made, then
that is also not a good situation. If the client makes a decision that is against the
recommendation of the agent or insurer’s recommendations, the consequences of such an action
must be fully understood by the client – but it is his decision to make and a professional will
provide as much assistance as possible so that his decision would not cause too much damage, if
any.
    If these recommendations are suitable, the insurer (and the agent) must maintain adequate
records so that in the future at any time, after the fact, it can be determined if the
recommendations were suitable for that client.
                           HEALTH CONCERNS OF THE SENIORS
     Besides the financial concerns of the seniors but closely tied to financial matters, are health
concerns of this important segment of our society. Indeed, anyone who has spent any time with
a number of senior citizens will rapidly realize that not only is their health of their primary
concern, but it overshadows any other concern for most seniors. Medicare was introduced in
1965, basically because the insurance industry was not able or did not care to, insure citizenry as
they became older so the government had to do it. This still applies presently in respect to
prescription drugs – both a health and a financial concern.
                                         HEALTH INSURANCE
     Many annuities are sold as a result of the efforts of agents who specialize in the Senior
market and who market Social Security Supplemental policies and Long Term Care insurance.
Medicare is the provider of health care for nearly all senior citizens, and to the surprise of many,
it serves its purpose rather well, with frequent adjustments and tweaks, etc., but at a cost that
would have not been believed when it was introduced. Regardless, it is here and it will stay.
     Medicare provides hospital and doctors medical care, with deductibles and coinsurance
applicable, some of which can be covered by Medicare Supplemental insurance. A wise – and
most seniors are wise in this matter – will make sure that the doctors and hospitals will accept
Medicare and their Medicare Supplement as payment in full for their services.
     There are some medical conditions that are not covered by Medicare and if these situations
arise, the medical bills can be enormous. Generally, these uncovered medical bills would be for
certain plastic surgery which is performed for physical enhancement, certain medical procedures
which are either experimental or are not approved by Medicare because a suitable alternate
procedure is available. Incidentally, many seniors are not aware that if Medicare does not pay
for a medical procedure or cost, then their Medicare Supplemental policy will not cover it also.


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                                LONG TERM CARE INSURANCE
     Another point not understood by many seniors, is that nursing home care is not covered by
Medicare for custodial care. This is an area in which more seniors should be concerned, but
unfortunately so many of them have the attitude that the “government will take care of them” if
they become incapacitated or have to go to a nursing home. Medicare provides some care but
not for custodial care, and only for a limited period.
     Long-term care is normally custodial care because an individual cannot perform certain
“Activities of Daily Living (ADLs) such as bathing, dressing, eating toileting, continence, and
transferring. There are Long Term Care Insurance (LTCI) policies available that will provide
help for ADLs either in a nursing home, assisted living facility or home health care. The
possibilities of a senior citizen needing long term care is substantial, and outside the purview of
this discussion, but suffice it to say, very few senior citizens are aware of the possibilities until a
family member or a close friend has to go to a nursing home.
     Custodial care is not cheap – indeed it is quite expensive. The majority of the persons in the
nursing home are Medicare patients. Since they are Medicare (Medi-Cal in California) patients,
they must pay their own way if they have the assets, or otherwise be subject to only the basic
income as described elsewhere in this text. Otherwise, a decent nursing home near any
metropolitan area will run $200 a day and upwards.
     There have been ways to “beat the system” introduced so that a person can receive long term
care paid for by Medi-Cal and they would still be able to keep all of their assets, and one of the
ways this has been attempted is by using annuities – covered in detail later in this text as this is
not allowed.
     Why do not more seniors purchase LTCI? Interestingly, even though more people have
become aware of this coverage since it is now sold on a group basis and many purchasers are
younger, the sales of LTCI has fallen rather drastically. Therefore the studies that show why
people do not buy LTCI from 2000 surveys, which indicated that the cost was considered as too
high by the greatest majority (85%), confusing to 45%, or they wanted a better policy, or they
felt that the services would not be needed – are immaterial today. Many LTCI experts now agree
that the “government will take care of me” attitude is the most prevalent, even though it has not
been expressed so much.
     It is fair to say that when working with seniors, any agent should make sure that their client is
at least aware of the availability of LTCI. There has been at least two successful lawsuits where
heirs have sued an insurance company because the agent (accountant in one case) did not make
the client aware of this coverage. Therefore, when the principle was confined to a nursing home
and which then proceeded to spend most of their inheritance, they did not like that, and sued –
and won. This is a good reason to make the client aware of the Long Term Care Rider on an
annuity. Some financial planners are looking seriously at this as a more reasonable replacement
for the LTCI policy that never was bought.
                            LONG TERM CARE BENEFITS RIDERS
    The Pension Protection Act of 2006 included some key provisions that addressed for the first
time the taxation of combination annuity plans featuring long-term care insurance (LTCI). The
rules apply only to nonqualified annuities coupled with tax-qualified long-term care riders. The


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Act clarified that, effective Jan. 1, 2010, long-term care insurance benefits paid out of these plans
(even if a portion of those serves to reduce account values in the underlying annuity) are paid as
tax-free long-term care insurance benefits. This is unprecedented in the annuity world; prior to
that date there was no mechanism that allowed for gains in a contract to be paid out on a tax-free
basis. In addition, the law also allows for 1035 exchanges into combination plans. This is
noteworthy in light of the many trillions of dollars deposited in existing annuities.
    Given this new tax advantage, and the compelling need for long-term care insurance that is
not being sufficiently met by standalone products, we are seeing significant activity by carriers
who are developing combination annuities for introduction on or after Jan. 1, 2010. Carriers also
see the opportunity to enhance persistency to levels much higher than those seen with standalone
annuities, which is expected to boost profitability on new combo business as well for any
existing annuity contracts to which long-term care benefits are added.
     Early indications are that many consumers are intrigued by the concept of an insurance
vehicle that can provide protection against the risk of long-term care, but that can also provide
cash values even in the event that no long-term care services are ever needed. This overcomes
one of the major concerns of consumers regarding standalone LTCI, the fear of a "use-it-or-lose-
it" proposition.
    Only a few companies have introduced such products to date. Actual sales results have been
ramping up gradually by some accounts, although 2008 first-year premium on combination plans
has been estimated at $650 million (primarily single premium), exceeding first-year standalone
LTCI premium (primarily annual premium) of roughly $600 million. We believe that the
industry will address the challenges of rolling out these cutting-edge products over the next few
years.
   Clearing potential hurdles
    To date, there are several key obstacles to success. Simplifying the underwriting process to
protect the company, yet not burden the producer, is one challenge. Agent training and licensing
issues need to be addressed to enable the sales process. Sufficient compensation needs to be
provided to incent producers to market these products. In addition, there is agent confusion
regarding the fact that properly structured plans that were sold prior to Jan. 1, 2010, will receive
the same favorable tax treatment as plans sold after Jan. 1, 2010, once that date has passed. That
problem goes away at the end of 2009.
    Solutions are on the way. Education of producers will be a critical issue, and companies as
well as wholesalers are targeting these products and markets and preparing for that effort.
Underwriting standards are evolving and tele-underwriting techniques are being developed to
reduce the burden on annuity producers or financial planners not familiar with LTCI
underwriting. Commission structures are being developed to reward producers for their efforts
in selling these plans, not only at issue but in some cases through trail commissions that can be
lucrative over time because of the long-term persistency expected on these plans.
   Unique product design
    The benefit payout structure under these plans is typically defined as an accelerated benefit,
whereby LTCI benefit payments are made from the annuity account value while waiving
surrender charges. This is usually combined with some form of tail benefit payable after account


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values are depleted. The benefit is paid monthly and is usually expressed as a percent of the
annuity account value at the time of initial claim. For example, 1/24 of the lifetime LTC benefit
limit may be payable for 24 or more months from the account value, with a 12-, 24-, or 48-month
extension of benefit "tail" as selected by the client. This creates the opportunity to convert what
would have been partially taxable account values from the annuity into tax-free payouts that
range from 150% to 300% of the account value as LTCI benefits.
    There are several alternative structures, all of which combine accelerated benefits and
independent benefits, but under different configurations. We think certain segments of the
market will find these new designs even more interesting than the tail design described above.
There are also various ways to provide protection against the risk of LTC cost inflation. Those
designs that tie LTC benefit amounts to account values inherently provide a form of inflation
protection, in that account value growth would naturally occur within the annuity.
    Consider a 60-year-old annuity purchaser depositing $100,000 ($100K), who at age 80 needs
24 months of accelerated LTC benefits and another 24 months of tail benefits. Assuming an
annuity purchase without the LTC rider, she cashes out $219K (4% annual growth) and pays
$36K of taxes on gain (assuming a 30% tax rate), with a net of $183K after tax. In contrast, with
an LTC rider attached that pays out up to 200% of account value, with a cost of 65 basis points
per year assessed against the account value, the annuity grows to $193K, so the contract pays out
$386K tax-free. Note that this ignores potential tax benefits of itemized deductions for
unreimbursed LTC medical expenses, which might dampen some of the differentials above for
many insureds.
    Next, consider a second scenario, where the same client eventually needs six years of care
after the purchase of a more expensive 24 month accelerated benefit plus 48-month extension of
benefit tail, effectively creating a total potential benefit of three times the account value. With
the LTC rider featuring a cost of 90 basis points per year, the annuity funded with $100K grows
to $184K, so the contract pays out $552K tax-free, versus the $183K without the rider.
     These examples highlight the combination of tax benefits and insurance benefits that can
leverage accumulation values within annuities. Admittedly, not all consumers will actually
utilize long-term care services. However, the risk of long-term care utilization is sufficiently
high (50% or more at ages 65 and above), and the cost versus potential benefits sufficiently
compelling, that we expect producers and companies will appreciate the power of these
combination plans.
   Getting combo products in the hands of consumers
    In terms of distribution outlets, interest levels are expected to grow among LTCI producers
who are familiar with LTCI underwriting and who are seeking lower-cost products to address the
long-term care insurance need. Banks and annuity producers are close to customers with funds
available, and repositioning of these assets into these new tax-effective protection plans is
expected. Financial planners are yet another likely source of this business. Perhaps the most
effective distribution mechanisms will evolve from a collaborative effort between different types
of distribution systems.
    With the new tax law reforms coming into place in 2010, this is a story that will be brought
to the market. It should be fascinating over the next few years to see which product designs,



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which distribution mechanisms, and which companies most effectively address the needs of the
consumer with these new products.
                                          ESTATE PLANNING
     Annuities are an integral part of a proper estate plan. The transferring of assets to designated
recipients at death is a profession practiced by attorneys, accountants and insurance
professionals. Until recently, many thought that estate planning was only for those with huge
estates - $1 million or more and then were surprised when the heirs discovered that the family
home and business was at ¾ of that amount and they had to pay a debilitating tax to the federal
and state governments. The Economic Growth and Tax Relief Reconciliation Act of 2001
changed all that, exempting estates of $1 in 2001, increasing each year until it soon reaches zero.
Gift taxes are also an important part of an estate plan, and these taxes have been reduced in some
areas.
     There are two things to remember. First, the way the law is written, it will “sunset” in 2011
unless legislation keeps it alive. Secondly, there are many other items other than taxes that are
reasons for estate planning – probate, wills, trusts, etc. – that still exist. Therefore, annuities will
still play a big role in estate planning and estate planning is still alive and well, thank you!
             AGENT’S ADVICE AT TIME OF SALE OF ANNUITY TO SENIORS
    Regulations54 in respect to sales of annuities to Seniors states that if an (life) agent offers to
sell an “elder” any life insurance or annuity product, the agent must advise the elder or the
elder’s agent that the sale or liquidation of any stock, bond, IRA, Certificate of deposit, mutual
fund, annuity, or other asset to fund the purchase of this product may have tax consequences,
early withdrawal penalties, or other costs or penalties as a result of the sale or liquidation.
Further, the agent must advise his client that he/she or elder’s agent, may want to consult an
independent legal or financial advisor before selling any assets or before selling or liquidating
any annuity product being sold, offered for sale or even being solicited.
    As discussed later in this text, a more detailed discussion of selling a financial product on the
basis of the product’s treatment under the Med-Cal program as it may pertain to the
determination of the elder’s eligibility for any program of public assistance. Basically, an agent
is prohibited from negligently misrepresenting the treatment of any asset under the Medi-Cal
rules.
       POLICY DETAILS AND NOTIFICATION FOR SENIOR CITIZEN ANNUITIES
    The California Insurance Code55 has detailed and strict instructions in respect to the annuity
product that is being sold after July 2004 to Seniors in the state. All policies of the type detailed
in this Section that are in force as of January 1, 2003, will be considered to be in compliance
with this Section.
    The regulations require that every annuity that is sold, delivered or issued for delivery to a
Senior Citizen (over age 60) must have a notice which (plainly) states that after he has received
the annuity it may be returned to the insurer for cancellation simply by mailing or delivering it to
the company or to the agent from whom it was purchased. The annuity owner may return the
annuity within 30 days by mail or otherwise during this period. For a Variable Annuity (as
stated elsewhere in this text), the premium may be invested only in fixed-income investments




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and money-market funds, unless the investor specifically directs that the premium be invested in
the mutual funds underlying the Variable Annuity contract.
    If the Variable Annuity is returned within the 30-day cancellation period and if the owner has
not directed that the premium for Variable Annuity contracts be invested in the mutual funds
underlying the contract during the cancellation period, then this will have the effect of voiding
the policy – which means that the parties shall be in the same position as if there had been no
policy issued and all premiums paid and any policy fee paid for the policy shall be refunded by
the insurer to the owner within 30 days from the date that the insurer is notified that the owner
has canceled the policy.
    Conversely, if the owner of a Variable Annuity has directed that the premium be invested in
the mutual funds underlying the contract during the 30-day cancellation period, then cancellation
shall entitle the owner to a refund of the account value which will be refunded within 30 days
from the date that the insurer is notified that the owner has canceled the contract.
    Further, every individual annuity contract, other than variable contracts and modified
guaranteed contracts that are subject to this particular regulation(s), that is delivered or issued for
delivery California state shall have the following notice either printed on the cover page or
policy jacket in 12-point bold print with one inch of space on all sides or printed on a sticker that
is affixed to the cover page or policy jacket:

                                          "IMPORTANT
    YOU HAVE PURCHASED A LIFE INSURANCE POLICY OR ANNUITY
CONTRACT. CAREFULLY REVIEW IT FOR LIMITATIONS.
    THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU
RECEIVED IT FOR A FULL REFUND BY RETURNING IT TO THE INSURANCE
COMPANY OR AGENT WHO SOLD YOU THIS POLICY.
    AFTER 30 DAYS, CANCELLATION MAY RESULT IN A SUBSTANTIAL
PENALTY, KNOWN AS A SURRENDER CHARGE."
    The phrase "after 30 days, cancellation may result in a substantial penalty, known as a
surrender charge" may be deleted if the policy does not contain those charges or penalties.
    In addition, every individual Variable Annuity contract, variable life insurance contract, or
modified guaranteed contract subject to this regulation, that is delivered or issued for delivery in
this state, shall have the following notice either printed on the cover page or policy jacket in 12-
point bold print with one inch of space on all sides or printed on a sticker that is affixed to the
cover page or policy jacket:

                             "IMPORTANT
   YOU HAVE PURCHASED A VARIABLE ANNUITY CONTRACT (VARIABLE LIFE
INSURANCE CONTRACT, OR MODIFIED GUARANTEED CONTRACT). CAREFULLY
REVIEW IT FOR LIMITATIONS.
   THIS POLICY MAY BE RETURNED WITHIN 30 DAYS FROM THE DATE YOU
RECEIVED IT. DURING THAT 30-DAY PERIOD, YOUR MONEY WILL BE PLACED IN
A FIXED ACCOUNT OR MONEY-MARKET FUND, UNLESS YOU DIRECT THAT THE
PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO UNDERLYING THE


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CONTRACT DURING THE 30-DAY PERIOD. IF YOU DO NOT DIRECT THAT THE
PREMIUM BE INVESTED IN A STOCK OR BOND PORTFOLIO, AND IF YOU RETURN
THE POLICY WITHIN THE 30-DAY PERIOD, YOU WILL BE ENTITLED TO A REFUND
OF THE PREMIUM AND POLICY FEES. IF YOU DIRECT THAT THE PREMIUM BE
INVESTED IN A STOCK OR BOND PORTFOLIO DURING THE 30-DAY PERIOD, AND IF
YOU RETURN THE POLICY DURING THAT PERIOD, YOU WILL BE ENTITLED TO A
REFUND OF THE POLICY'S ACCOUNT VALUE ON THE DAY THE POLICY IS
RECEIVED BY THE INSURANCE COMPANY OR AGENT WHO SOLD YOU THIS
POLICY, WHICH COULD BE LESS THAN THE PREMIUM YOU PAID FOR THE POLICY.
A RETURN OF THE POLICY AFTER 30 DAYS MAY RESULT IN A SUBSTANTIAL
PENALTY, KNOWN AS A SURRENDER CHARGE."
    The words "known as a surrender charge" may be deleted if the contract does not
contain those charges.
    Excluded from this provision are credit life insurance policies, some forms of group life
insurance, and noncontributory employer group annuity contracts. (There are additional
requirements for group life insurance sold to a Senior.)


                     ILLUSTRATIONS OF NON-GUARANTEED VALUES
    When non-preprinted illustrations of non-guaranteed values on annuity contracts that are
delivered or issued for delivery to senior citizens after 1/1/95, shall disclose on those sheets, in
bold or underlined capitalized print, or in the form of a contrasting color sticker, bright
highlighter pen, or in any manner that makes it more prominent than the surrounding material,
with at least one-half inch space on all four sides, the following statement:
  "THIS IS AN ILLUSTRATION ONLY. AN ILLUSTRATION IS NOT INTENDED TO
PREDICT ACTUAL PERFORMANCE. INTEREST RATES, DIVIDENDS, OR VALUES
THAT ARE SET FORTH IN THE ILLUSTRATION ARE NOT GUARANTEED, EXCEPT
FOR THOSE ITEMS CLEARLY LABELED AS GUARANTEED."
    All preprinted illustrations containing nonguaranteed values must show the columns of
guaranteed values in bold print. All other columns used in the illustration shall be in standard
print. "Values" are defined as including cash value, surrender value, and death benefit.56
                                     ANNUAL STATEMENT
    Whenever an insurer provides an annual statement to a senior policyowner of an individual
annuity contract issued after January 1, 1995, the insurer must also provide the current
accumulation value and the current cash surrender value.57
                                  MARKETING BY SEMINARS
    The “seminar” approach to selling is addressed in this discussion of marketing annuities, as if
one lives in a retirement community and if they are over age 55, they will be deluged with
invitations to attend an “educational seminar,” often at one of the trendiest luncheon spots in the
city, for the purpose of discussing “estate planning,” “investment strategy” or “Long Term Care
Planning” or such.
    So, what is wrong with this? Sometimes, not a thing. The speakers may be professionals in
their field and include attorneys specializing in elder law, tax accountants or attorneys


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specializing in taxation, but in every case someone is trying to sell something (somebody has to
pay for the meal or hall rental). The problem generally is that the person who is selling
something often misrepresents him (or her) –self as an “expert” in the field, and/or they do not
advertise that the sole purpose of the “seminar” is to sell insurance or annuities (or mutual funds,
etc.).
    This can be a violation of the insurance code58 on untrue, deceptive or misleading
advertisements as no advertisement (even an engraved personalized invitation is still an
“advertisement) for an event where insurance products will be offered for sale, may use the terms
“Seminar,” “Class,” “Informational Meeting,” or similar term to characterize the purpose of the
event unless it adds the words, “and insurance sales presentation” immediately following those
terms in the same type size, etc. Such meetings are obviously not illegal per se, unless they are
used to sell insurance products without prior notification.


                         WAIVERS OF SURRENDER CHARGES
    Surrender charges has been discussed and is a problem with those who purchased an annuity
and for-whatever-reason finds that they need to take the money out of the annuity. Until
recently, the only way an annuity owner could take out the money without paying a penalty -
often substantial – was at death and, of course, at annuitization. Now, however, surrender
charges are waived on most annuity policies if the owner is confined to a nursing home.
    Some policies go a little further and will also allow surrender without penalty in cases of
terminal illness or hospital confinements, disability, even “disaster” in some annuities (often
referred to as “crisis waivers).
    The waiver of surrender charges may be accomplished either by waiver or by rider. The
distinctions between “waiver” and “rider” are often blurred, but basically the waiver is the
voluntary relinquishment of a legal right, and a rider is an attachment or endorsement to a policy
that modifies clauses or provisions of a policy.59 Even when used interchangeably, usually the
waiver is instigated by the insurance company and often no extra charge is accessed against the
policyholder, whereas a rider is instigated by the insured and there often is an added charge.
                              VARIOUS WAIVERS AVAILABLE

Many companies now offer a variety of waivers , such as if the annuitant becomes disabled or
needs to go to a nursing home before retirement, the annuity may contain a waiver that triggers
payments that are not subject to the usual surrender fees.
An annuity tracking service (Bacon Research) discovered that the percentage of annuities with
waivers has increased dramatically in the last decade. In a recent analysis of several hundred
fixed annuities in they found that 99 percent contain some type of waiver for surrender fees.
Most fixed annuities, 92 percent, have a death waiver, 85 percent have a nursing waiver, 60
percent contain a terminal illness waiver, 55 percent have a waiver for extended hospital stays of
several months or more, 20 percent contain a disability waiver, and 12 percent have a waiver for
unemployment. More than half of fixed annuities, 61 percent, have a waiver for annuitization –
converting a deferred annuity into an immediate annuity.




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Meanwhile, all of the 10 top-selling variable annuities have a death waiver —nine have a
terminal illness waiver, eight have a nursing home waiver, five have hospitalization waivers, two
have disability waivers, and one has a waiver for unemployment.
Situations that trigger the waiver and allows for early annuity withdrawals vary from company to
company. For instance, one insurer might require a 90-day nursing home confinement before r
benefits are activated, while another might call for 60 days. Furthers, one company may
consider a person disabled if unable to work in any occupation, while another may require only
that the person is unable to work in his current occupation.

Death benefit waiver (aka Life Insurance Rider with some plans)
This waiver passes on your annuity to the beneficiary if the annuitant dies before annuitizing.

Nursing home waiver
Typically, when the annuitant needs nursing home care, he will not be charged surrender fees
and he will be allowed access to some, or all, of the annuity if confined to a nursing facility. A
written confirmation from the nursing facility and attending physician will be necessary.

Terminal illness waiver
The annuity might contain a provision that waives surrender charges if the annuitant becomes
terminally ill, thus allowing you access to their money when needed most. While the definition
of terminally ill may vary slightly from company to company, it's generally a condition that will
result in death within six months to a year.
As with the nursing home waiver, an insurance company will want certification from the doctor
(and perhaps from their doctor as well) that life expectancy is indeed a matter of months.

Disability waiver
Even though the risk of disability is greater than the risk of death at all ages between 20 and 65,
Unfortunately, only 20 percent of fixed annuities and only two of the 10 top-selling variable
annuities offer a disability waiver.


                                     LIVING TRUST MILLS
    For purposes of this discussion, a “Living Trust Mill (LTM)” is an unlawful marketing
scheme used to sell annuities to senior citizens.60 While there actually are several types of
LTMs, they are all are created by misrepresentation of identity and purpose as each “mill”
misrepresents the actual business of the sales representative and hides the true purpose of the
solicitation. Often the first approach to seniors is the “seminar” approach, as discussed above,
but instead of presenting the product of service that they advertise, the meeting is supposedly
designed to educate those attending about the benefit of living trusts (and other estate planning
devices). Seniors are invited through mass mailing, telemarketing, or any other method to “get
the word out” including informal announcements at senior functions.




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     Once the crowd has gathered, the salespeople misrepresent themselves as experts in financial
and/or estate planning. Their services are either very inexpensive or “free” as a public service,
but in any event, the goal is to get the trust of the seniors and they find out the assets of the
seniors by determining whether the senior could benefit from a living trust.
     Persons so engaged in these “mills” may be licensed or unlicensed insurance persons and
they may work in conjunction with attorneys, thereby giving a “legalistic” atmosphere to the
meeting. After the living trust and other estate planning documents have been sold, then a
licensed agent – who in most cases does not represent himself/herself to be an “insurance agent”
– tries to sell the senior on the benefits of an annuity as part of the estate planning process.
Actually, clients often will consider the agent as their legal advisor or estate planner and not an
insurance agent.
     Besides being actionable under the Business and Professional Code61 , such violations are
administratively actionable under the Insurance Information and Privacy Protection Act61A (CIC
Section 791 and sequential portions) and may result in cease and desist orders, financial penalties
and suspension or revocation of certificates of authority and/or insurance licenses.
Section 6125 of the Business and Professions Code state that: No person shall practice law in
California unless the person is an active member of the State Bar.
                                   CAUSE FOR SUSPENSION
    California Insurance Code (1668.1) states that (in addition to the grounds set forth in the
previous Section), the following acts shall constitute cause to suspend or revoke any permanent
license issued pursuant to this chapter:
         The licensee has induced a client, whether directly or indirectly, to cosign or make a
          loan, make an investment, make a gift, including a testamentary gift, or provide any
          future benefit through a right of survivorship to the licensee, or to any of the persons
          listed in subdivision (e).
         The licensee has induced a client, whether directly or indirectly, to make the licensee or
          any of the persons listed in subdivision (e) a beneficiary under the terms of any
          intervivos or testamentary trust or the owner or beneficiary of a life insurance policy or
          an annuity policy.
         The licensee has induced a client, whether directly or indirectly, to make the licensee,
          or a person who is registered as a domestic partner of the licensee, or is related to the
          licensee by birth, marriage, or adoption, a trustee under the terms of any intervivos or
          testamentary trust. However, if the licensee is also licensed as an attorney in any state,
          the licensee may be made a trustee under the terms of any intervivos or testamentary
          trust, provided that the licensee is not a seller of insurance to the Trustor of the trust.
         The licensee, who has a power of attorney for a client has sold to the client or has used
          the power of attorney to purchase an insurance product on behalf of the client for which
          the licensee has received a commission.
         The first two Subdivisions above shall also apply if the licensee induces the client to
          provide the benefits in those subdivisions to the following people:
                             A person who is related to the licensee by birth, marriage, or
                               adoption.
                             A person who is a friend or business acquaintance of the licensee.
                             A person who is registered as a domestic partner of the licensee.



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        This section shall not apply to situations in which the client is either a person related to
        the licensee by birth, marriage, or adoption; of a person who is registered as a domestic
        partner of the licensee.

                                       PRETEXT INTERVIEW
    The Code62 states that “no insurance institution, agent or insurance support organization”
(defined as persons engaged in business of collecting information about persons for the primary
purpose of providing the information to an insurance institute or agent for an insurance
transaction…) shall perform a pretext interview.

    “Pretext interview” is defined as an “interview whereby a person, in an attempt to obtain
information about a natural person, performs one or more of the following acts:
             Pretends to be someone he or she is not.
             Pretends to represent a person he or she is not in fact representing,
             Misrepresents the true purpose of the interview.
             Refuses to identify him or her upon request.
    The first three of the above “acts” are typical and common in a trust mill so any agent or
insurance company that uses or authorizes the use of these practices, will be sanctioned under the
Insurance Information and Privacy Protection Act.
    Further, the Commissioner has requested that all agents and insurers review their marketing
programs to determine if they are involved with such an operation, with particular attention to
any program for annuity sales in which the insurance agent or insurer states or infers that they
have particular expertise in the areas of law, finance or financial planning. The Commissioner
instructs that such programs should be corrected immediately and remedial action taken,
including allowing purchasers that were so unlawfully solicited, to rescind their contracts.
                                     CONTACT FROM LEADS
    Contacting a senior citizen for the purpose of selling insurance or annuities as the result of a
“lead system” is not illegal as such, provided that there is no misrepresentation, of course. Any
such advertisement or any other lead method that is directed towards those age 65 or older, shall
prominently disclose that an agent may contact the applicant (if that is the case). And further,
the agent who contacts that person as a result of the lead MUST disclose that fact to the
prospective purchaser during the initial contact.63
    It is also illegal for an agent or broker or solicitor, etc., to solicit a person age 65 or older for
the purpose of marketing annuities (or life insurance or disability insurance) by using a business
name, whether true or fictitious, which is deceptive or misleading in respect to the status,
character, or proprietary representative capacity of the entity or person, (and here is the
“kicker:”) or to the true purpose of the advertisement.63(A) This portion of the insurance code
also defines as an advertisement as envelopes, stationery, business cards, or other materials
designed to encourage…(an) annuity. For instance, the business card or other price quotes or
advertisements must contain the agent’s license number and word “Insurance.” 63B




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                                  MISLEADING MATERIALS
     Defined as “misleading” materials are specific advertisements insinuating that the materials
are from or associated or affiliated with a governmental agency or nonprofit or charitable
organization or a senior organization. No advertisement can infer or imply that the party can
lose a right or privilege or public benefits if they do not respond to the advertisement. To help
enforce these regulations, all advertisements by agents or producers, etc., must have the approval
of the insurer.
There are certain prohibitions that apply to any advertising directed at the age 65 and older
market. Pursuant to these prohibitions, an advertiser may not engage in any of the following in
its advertising:
     1. An insurer may not use a name that is misleading or deceptive with respect to the status,
         character or capacity of the person or concerning the true purpose of the advertisement;
     2. An advertisement must not use words, letters, initials, symbols, or other devices that are
         so similar to those used by governmental agencies, nonprofit or charitable institutions,
         senior organizations, or other insurers that they could have the tendency to mislead;
     3. An advertisement must not use the name of a state or political subdivision (city, county,
         etc.) in the name of a policy or in its description;
     4. An advertisement must not use any slogan, name, symbol, service mark or other device in
         any way that implies that the insurer, its products or its agents who may call upon the
         consumer in response to the advertisement are connected with a government agency, such
         as Social Security;
     5. An advertisement may not imply that the reader will lose any rights, privileges, or
         benefits, etc. under the law by failing to respond to the advertisement.
     In addition, as described earlier, an advertisement used by an agent must have been approved
     by the insurance company. Also, in case of a Seminar, etc., “and insurance presentation”
     must follow the terms of seminars, etc.
     In addition to the above requirements, agents and insurers may not
            use an address for the purpose of misleading or deceiving others as to the true
             identity, location or licensing status of the insurance company or its agents;
            use language in the name of the insurance policy or certificate that is too similar to
             the name of a government agency or program that it could be construed as confusing
             or misleading a prospective purchaser; and
            solicit a particular class through the use of advertising that states or implies that their
             occupational or other status entitles them to a reduction in premium, if the policies are
             actually being sold on an individual basis at no premium discount.
     Penalties for the violation of these regulations are, as stated elsewhere in this text but needs
reiteration - $250 for the first offense, $500 for the second and $1,000 for third and later offense.
In addition, there is always the possibility that the license or certificate of authority could be
lifted.
                            SALES IN THE HOME OF THE ELDERLY
    It should be no surprise that the majority of insurance sales to the elderly are conducted in
their homes. While the elderly prospects may feel that they are “safer” in their home, experience


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has shown that just the reverse may be true. Even though they may feel safe, they are now also a
“host” and as such are more inclined to make the “visitor” comfortable and often may feel much
more comfortable making a decision in their home. The elderly generation often feels that
nothing bad can happen to them in their home. Unfortunately, this has not always been the case.

    So that the elderly prospects may be protected from being entirely at the mercy of such
persons, the Insurance Code demands that for the sale, offering for sale, or for lead generation
for the selling of annuities to senior insureds or prospective insureds by any person, certain
procedures must be followed.

       Any person who meets with a senior in the senior’s home for these purposes must
deliver a notice in writing to the senior no less than 24 hours prior to that person’s
individual meeting with the senior.

    If the senior has an existing relationship with the agent and requests that the agent come to
their home on the same day, a notice must be delivered to the senior’s home prior to the meeting.
The notice must be state substantially the following (in 14 pt. type):


       During the visit or a follow-up visit, you will be given a sales presentation
   on life insurance, including annuities, or other (specified insurance product).
       You have the right to have other persons present at the meeting, including
   family members, financial advisors or attorneys.
       You have the right to end the meeting at any time.
       You have the right to contact the Department of Insurance for information or
   to file a complaint (with consumer assistance telephone number provided).
       The following individuals will be coming to your home: (All attendees and
   insurance license information, if applicable).

    Prior to contacting the senior in their home, the agent shall first, prior to asking any
questions, state that the purpose of the meeting is to talk about insurance or to gather information
for a follow-up visit to sell insurance (if that is the purpose). The agent must also state
         The names and title of all persons arriving at the senior’s home.
         Each person attending such meeting shall provide the senior with a business card or
            other written identification stating the person’s name, business address, telephone
            number, and any insurance license number.
         The persons attending such meeting will immediately end all discussions and leave
            the home of the senior after being asked to leave by the senior.
         A person may not solicit a sales or order for the sale of an annuity or life insurance
            policy at the residence of a senior, in person or by telephone, by using any plan,
            scheme, or ruse that misrepresents the true status or mission of the contact.



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         USE OF ANNUITIES FOR MEDICAID (MEDI-CAL) ELIGIBILITY
           SETTLEMENT OPTIONS AVAILABLE TO BENEFICIARIES

  (The following discussion is based on Senate Bill 483 which outlines the rights and options
available to beneficiaries, and is part of SEC. 7. Section 14009.7 and which has been redacted.)
  This Section pertains to Medi-Cal primarily, and added to the Welfare and Institutions Code,
to read:
  If an annuity is considered part or all of the community spouse resource allowance allowed
(under subdivision (c) of Section 14006), the state shall only become a remainder beneficiary of
that portion of the annuity that is not a part of that community spouse resource allowance.
  The state shall not become a remainder beneficiary of an annuity that is any of the following:
         (1) Purchased by a community spouse with resources of the community spouse during
         the continuous period in which the individual is receiving medical assistance for home
         and facility care and after the month in which the individual is determined eligible for
         these benefits.
         (2) Contained in a retirement plan qualified under Title 26 of the United States Code,
         established by an employer or an individual, including, but not limited to, an Individual
         Retirement Annuity or Account (IRA), Roth IRA, or Keogh fund.
         (3) An annuity that is all of the following:
              (A) The annuity is irrevocable and nonassignable.
              (B) The annuity is actuarially sound.
              (C) The annuity provides for payments in equal amounts during the term of the
                  annuity, with no deferral and no balloon payments made from the annuity.
  The individual or the community spouse, or both, shall bear the burden of demonstrating that
the requirements of this section that limit the state’s right to become a remainder beneficiary, as
described in Section 14009.6, are met.
  This section shall be implemented pursuant to the requirements of [Title XIX of the federal
Social Security Act] and any regulations adopted pursuant to that act, and only to the extent that
federal financial participation is available.
  Definitions: For the purposes of this Bill, the following are defined:
  (a) “Annuity” means a contract that names an annuitant and gives a person or entity the right to
receive periodic payments of a fixed or variable sum for a described period of time, which may
include a lump-sum payment or periodic payments upon the death of the annuitant.
  (b) “Community spouse” means the spouse of an institutionalized spouse.


                                ELIGIBILITY REQUIREMENTS

                     DISCLOSURES FOR MEDI-CAL ELIGIBILITY
        Notice Regarding Standards for Medi-Cal Eligibility. The elder or spouse, if
         contemplating purchasing a financial product because of its Medi-Cal treatment, do
         not have to use all of their savings.



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          Unmarried Resident. An unmarried resident may be eligible for Medi-Cal if they
            have less than the amount allowed at that time for qualification. The Medi-Cal
            recipient is allowed to keep monthly income a personal allowance and the amount of
            health insurance premiums paid, with the remainder paid to the nursing facility.
          Married Resident. There is a Community Spouse Resource Allowance that provides
            that if one spouse lives in a nursing facility and the other does not, Medi-Cal will pay
            some or all of the nursing home allowance, provided that the couple does not have
            more than a specified amount of community countable assets. In addition, there is a
            Minimum Monthly Maintenance Needs Allowance which allows the spouse living at
            home to keep a monthly amount with specified maximum.
          Fair Hearing and Court Orders. Under certain circumstances, the at-home spouse
            may be allowed to keep additional resources by the order of an administrative judge.
                      REAL AND PERSONAL PROPERTY EXEMPTIONS
          One Principal Residence. The home is usually exempt if the applicant intends to
            return to it someday and if the spouse and/or dependent relative continues to live in it.
            If the home is sold, they have 6 months to apply the funds from the sale to the
            purchase of a new home.
          Real Property Used in a Business or Trade. Real estate used in a business or trade is
            exempt regardless of its equity value or whether it produces income.
                   PERSONAL PROPERTY AND OTHER EXEMPT ASSETS
        IRAs, KEOGHs, and Other Work-related Pension Plans. These funds are exempt if
         the family member who owns the plan benefits does not want Medi-Cal, otherwise if
         payments are being received, the balance is considered unavailable is not counted. It is
         not necessary to annuitize, convert to an annuity, or otherwise change the form of the
         assets in order for them to be unavailable.
        Personal Property Used in a Trade or Business.
        One Motor Vehicle.
        Irrevocable Burial Trusts or Irrevocable Prepaid Burial Contracts.
        There May be Other Assets That May be Exempt.

   Advice is also given in this Disclosure that the applicant may want to call the County welfare
Department, and are advised to contact an independent attorney.
    Financial planners have often been asked by their elderly clients for assistance through the
overlapping federal and state regulations about Medicaid (Medi-Cal in California) and its
participation in funding long-term care and how annuities could be used in these situations.
Many have avoided the questions and recommended that the client involve the services of a local
elder law attorney.
    Taking into consideration the requirements for participation in Medicaid, there still are
technical and numerous questions that may be raised as to eligibility for long term care. In
California – and in most of the other states as Medicaid is a joint program between the federal
government and the states, this program - which incidentally is a welfare program not intended to
fund long term care for those who can afford it – has eligibility requirements as stated above. A
resident of the state qualifies for Medicaid if he/she has less than $2,000 in countable resources,


                                                 165
and for an unmarried person, they are allowed to keep a monthly income of $35 (personal
allowance) plus any health insurance premiums paid. The remainder of the monthly income is
then paid to the nursing facility as a method of sharing the monthly cost.
     For a married person, there is a community spouse resource allowance when one spouse is in
a nursing facility and the other spouse lives at home, the Medicaid (Medi-Cal) program will pay
nursing facility costs as long as the couple combined do not have assets worth more than $92,760
(for 2004) plus the $2,000. The minimum monthly maintenance needs allowance when a spouse
is eligible for nursing home facilities, the other spouse living at home is allowed to keep a
monthly income of at least his or her individual monthly income or $2319 (2004), whichever is
greater. In some situations, a court may allow the couple to retain more than $92,760 + $2,000
in countable resources, and/or allow the at-home spouse to retain more than $2319 (2004) in
monthly income.
                             REAL AND PROPERTY EXEMPTIONS
     Property exemptions to the above rules include one principal residence that is used as a home
and will remain exempt if the applicant intends to return to it in the future and/or the spouse or
dependent relative continue to live in it. If the home is sold, the money from the sale can be
exempt if the money is used to purchase another home.
     One motor vehicle is allowed, value not specified. It is not unusual for a person of modest
means to purchase a Mercedes or Jaguar as that is one, legal, way of sheltering assets,
particularly if the automobile keeps it value.
     Irrevocable burial trusts or irrevocable prepaid burial contracts are exempt.
     Now for the “annuity-related” part, IRAs, KEOGHs and other work-related pension plans
are exempt if the family member in whose name the pension is attributed does not participate in
Medicaid. If it is held in the name of a person who wants to participate in Medicaid (Medi-Cal)
and payments of principal and interest are being received, the balance is unavailable and is not
counted. The California Assembly Bill 210764 states that it is not necessary to annuitize, convert
to an annuity, or otherwise change the form of the assets in order for them to be unavailable.

                                     LOOK-BACK PERIOD
   Under the Welfare and Institutions Code, it shall be presumed that assets transferred by the
applicant or beneficiary prior to the (presently five year) look-back period established by the
department preceding the date of initial application were not transferred to establish eligibility or
reduce the share of cost. These assets shall not be considered in determining eligibility.

                        SPIA USED AS EXEMPTIONS FOR MEDI-CAL
     Prior to the passage of this legislation and insurance code in California, and still allowed in
most states, non-countable inclusions are home and land and one car with no value limits; term
life insurance up to $2,500 death benefit or face value; most qualified funds; the $2,000 cash or
cash equivalent, and income producing property or an annuity in the payout phase.
     Too many agents, this cried for relief in the form of an immediate annuity, preferably a single
premium immediate annuity (SPIA), thereby allowing the customer to shield a large amount of
assets and receive income from the assets in the form of annuity payouts, and still allow the
customer to be eligible for Medicaid/Medi-Cal. The purpose was to slow down the income


                                                166
stream and the erosion of income for a Medicaid candidate.
    This was done by converting countable assets to non-countable assets using the SPIA by
remaining under the countable asset cap. The SPIA often used for this purpose had a balloon
provision, is irrevocable and non-assignable, and commutable only to the beneficiaries. The
income stream from the annuity should be held as minimum and thereby protecting most of the
principal (if not all). Further, the income period would be equal to or less than the life
expectancy of the individual annuitant. The “implied” benefit is that the balloon payment would,
in most cases, be made to a surviving spouse or heir of the institutionalized senior without the
otherwise-necessary erosion of assets due to the long-term care provided. Some states do not
allow the balloon payment annuities, but do offer a period certain SPIA option.



    CONSUMER APPLICATION
    A large insurer offered an 80-year old male that wanted to shield $100,000 before entering a
nursing home, a single premium immediate annuity. The benefit for this amount was $256.63
per month with a final payment of $99,170 at the end of 6 years and 11 months. This would have
brought in a total benefit of $120,470. For a 90-year old male with $100,000 to invest, with the
same monthly benefit, at the end of 3 years and 10 months, the “balloon” payment would be
$99,540.

    Keeping in mind that Medicaid/Medi-Cal is a welfare program, funded by taxes and was
designed to be provided for the poor and indigent who require nursing home care. A assets of
those on the program and which are not exempt under the program are used to reimburse
Medicaid for the expenses involved in the nursing home care. There are laws prohibiting the
transfer of property for several (usually 5) years prior to entering a nursing home in order to
avoid the reimbursement. Therefore, it should be obvious to any reasonable person or
institution, that avoiding payment part or all of the nursing home costs when assets are otherwise
available, is like “stealing from the taxpayers.”
                                    HARDSHIP EXCEPTION
    The state of California65 has taken immediate action to stop this unintended use of annuities
to avoid Medi-Cal reimbursement. An annuity shall not be sold to a senior if the senior’s
purpose in purchasing the annuity is to affect Medi-Cal eligibility and either of the following is
true:
    1. If assets are equal to or less than community spouse resource allowance.
    2. The senior would otherwise qualify for Medi-Cal,
    3. The senior’s purpose in purchasing the annuity is to affect Med-Cal eligibility and, after
       the purchase of the annuity, the senior (or the senior’s spouse) would not qualify for
       Medi-Cal.

    In the event that a fixed annuity specified in this code is issued to a senior, the issuer shall
rescind the contract and refund to the purchaser all premiums, fees, any interest earned under the
terms of the contract, and costs paid for the annuity. This remedy shall be in addition to any


                                                167
other remedy that may be available.
            WELFARE AND INSTITUTIONS CODE , HOME & FACILITY CARE
    An undue hardship shall be found to exist under any of the following circumstances:
  (1) The individual has been determined eligible for medical assistance for home and facility
care based on an application filed on or after January 1, 2006, and before the date that
regulations adopted pursuant or relating to this section have been certified with the Secretary of
State.
  (2) The deprivation of medical assistance for home and facility care would cause an
endangerment to the life or health of the individual.
  (3) The denial of medical assistance for home and facility care would result in the eviction of
the individual from a nursing home.
  (4) The individual is otherwise eligible for the Medi-Cal program and unable to obtain home
and facility care without Medi-Cal.
  (5) The denial of medical assistance for home and facility care would cause the individual to be
unable to remain at home or in the community and would hasten or cause the individual's entry
into a medical or long-term care institution.
  (6) The individual would be deprived of food, clothing, shelter, or other necessities of life.
          MEDI-CAL REQUIREMENTS RE: ANNUITIES, BENEFICIARIES, ETC.
Under Welfare & Institutions Code 14006.15:
     For the purposes of this section, "equity interest" means the lesser of the following:
  (1) The assessed value of the principal residence determined under the most recent tax
      assessment, less any encumbrances of record.
  (2) The appraised value of the principal residence determined by a qualified real estate
      appraiser who has been retained by the applicant or beneficiary, less any encumbrances of
      record.
Under Welfare & Institutions Code 14006.41:
     To be eligible for medical assistance for home and facility care, an individual shall disclose
at the time of the individual's application or redetermination a description of any interest that he
or she or his or her spouse has in an annuity, which is known to the individual or his or her
spouse, regardless of whether the annuity is irrevocable or is treated as income or as a resource.
  (b) At the time of the individual's application or redetermination, the department shall inform
the individual and his or her spouse that, by virtue of its provision of medical assistance for home
and facility care to the individual, the state will, by operation of law, become a remainder
beneficiary of certain annuities, as described above.
                                  SHARING COMMISSIONS
    In marketing annuities to the elderly, it is not only wise, it may also be necessary, to involve
a member of the legal profession, usually one practicing Elder Law. Many times an attorney is
brought into the picture in estate or financial planning of an elderly client, for many reasons,
generally very legitimately, by an insurance agent – particularly where the agent has represented
an elderly person for several years and has gained their trust. In such a case, the attorney will be
paid by the elderly person. In addition, financial planners and estate planners often work closely
with attorneys, and properly so. Commercial insurance of various types often require the advice
of the legal &/or accounting profession. Often, the influence of the attorney is such that the


                                                168
agent makes a sale that they might not have otherwise made. Regardless of how grateful the
agent is, they may not share their commission or any other fees with an active member of the bar
(particularly in California)66.
    An agent, broker, or solicitor who is not an active member of the State Bar of California may
not share a commission or other compensation with an active member of the State Bar of
California. “Commission or other compensation” means pecuniary or no pecuniary
compensation of any kind relating to the sale of renewal of an insurance policy to certificate of
an annuity, including, but limited to, a bonus, gift, price, award, or finder’s fee.
                             REPLACEMENT OF ANNUITIES
                            (TWISTING VERSUS REPLACEMENT)
    Agents who specialize in the senior market in particular, often find themselves in a situation
where an insured wishes to replace an existing insurance plan with another policy or plan. It is
important to differentiate between “replacing” a plan (which is legal) and “twisting” (which is
not legal). “Twisting” is where an agent or broker attempts to persuade a policyholder through
misrepresentation to cancel one policy and purchase another one. Replacement is the
substitution of one insurance policy for a policy of like kind and value (no misrepresentation
involved). State laws universally protect policyholders from “twisting” and replacing usually
requires notification of the existing insurer of a replacement of one of their policies, often giving
them time to respond.
    Replacement can be a “good thing,” such as when the first interest-sensitive life insurance
policies were introduced. Millions of policyholders had life insurance policies where their cash
value was credited at 3% (or similar amounts), during a time when anyone could walk into a
bank and get a much higher rate of return on any investment. Legitimate, honest replacement
possibly saved the life insurance industry from the “buy term and invest the difference”
syndrome – or at least it had a very positive effect.
    Regardless, replacement is always under the microscope because when a policy is replaced,
the replacing agent is receiving a new commission. While companies may restrict the
commission paid on their own business being replaced with another product of theirs, most
agents today are multi-company licensed and are aware of new products. Therefore many are
capable of providing an important service in “upgrading” policies because of lower mortality
assumptions, lower expense assumptions, or higher interest income on their investments.
Unfortunately, without strict regulation, many agents would be tempted to misrepresent benefits
of one policy over an existing policy in order to receive a new commission.
    This raises concerns from within the industry and from regulators. Replacing hurts
persistency, and a higher-than-anticipated lapse ratio hurts the profits of the company,
particularly since in many insurance products, it is not possible to raise premiums to compensate
for the poor persistency. It should be known to those in the insurance industry that the first year
expenses are higher than at any other time in the life of a life or annuity product – and other
insurance products as well – because of not only the cost of issuing and underwriting a policy,
but also because agent’s commissions are traditionally much higher the first year. Insurers must
be protective of their persistency at all times, so they must be aware of any replacement. Even if
the insurer is the recipient of the new policies, if there is a trend of replacement by an agency or
by a product, the company then is aware that the same thing could happen to them in the near
future.


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                                        REPLACEMENT
According to state regulations67 Annuity “Replacement” means that a new annuity is going to be
purchased and such annuity is known or should be known to the proposing agent or insurer that
the annuity is or has been:
     “Lapsed, forfeited, surrendered or otherwise terminated.”
     Converted or reduced in value by the use of nonforfeiture provisions or other means.
     “Amended so as to effect either a reduction in benefits or in the term for which coverage
       would otherwise remain in force or for which benefits would be paid.”
     “Reissued with any reduction in cash value.”
     “Pledged as collateral or subjected to borrowing whether in a single loan or under a
       schedule of borrowing over a period of time for amounts in the aggregate exceeding 25%
       of the loan value set forth in the policy.”

    “Conservation” means any attempt by the existing insurer or agent to try to “dissuade” a
policyowner from replacing of the existing annuity but does not include routine administrative
functions to preserve the business such as “late payment reminders, late payment offers or
reinstatement offers.”68
    “’Direct-response sales’ means any sale of (an)…annuity where the insurer does not utilize
an agent in the sale or delivery of the policy.”69
    “Registered Contract” means variable annuities and investment annuities under which the
benefits vary in accordance with unit values held in separate accounts.70
    Every application for an annuity submitted to the insurer must contain (a) a statement
whether or not replacement of an existing annuity is involved in the transaction, and (b) a
statement as to whether or not the agent knows that a replacement is involved in the transaction.
    If there is a replacement involved, the agent is required to perform several functions.71
    The duties of the replacing insurer are set out in detail in the regulations 72 which requires
the replacing insurer to provide a detailed financial report on both the prior annuity and the
proposed annuity in a fashion that allows the applicant to be fully informed of his/her financial
situation in respect to the proposed transaction. Without stating so specifically, it must be
assumed that the financial report must be factual and not just a “projection” based upon
assumptions that may or may not be obtained – such as some financial projections used to sell
Universal Life Insurance in the past.
                   ILLUSTRATION – NOT PRE-PRINTED APPLICATION
    When “nonpreprinted illustrations” of nonguaranteed values are illustrated, the following
statement must be attached (in bold or bright capitalized print:
“THIS IS AN ILLUSTRATION ONLY. AN ILLUSTRATION IS NOT INTENDED TO
PREDICT ACTUAL PERFORMANCE. INTEREST RATES, DIVIDENDS, OR VALUES
THAT ARE SET FORTH IN THE ILLUSTRATION ARE NOT GUARANTEED,
EXCEPT FOR THESE ITEMS CLEARLY LABELED AS GUARANTEED.”72A




                                               170
     In addition, the replacing insurer must provide in its policy or accompanying information
delivered with the policy, a notice that the applicant has the right to an unconditional refund of
all premiums paid (FREE LOOK), and such right would be effective from the date of delivery of
the annuity and for a period of 30 days thereafter. If the contract is a variable contract, the return
of the contract during this cancellation period entitles the owner to a refund of account value and
policy fees paid for the policy. If the applicant had instructed the insurer to deposit the
premiums into a specific fund, then the regulations provide instructions as how to determine the
amount that would be returned to the applicant.
     If the replacement is the result of a direct response sale, the replacing insurer must provide
the required information that would otherwise be the responsibility of the selling agent.
     It is a violation of this regulation if an agent or insurer recommends the replacement or
conservation of an annuity by using “materially inaccurate presentation of comparison of an
existing contract’s premiums and benefits or dividends and values, if any, or recommends that an
insured 65 years of age or older purchase an unnecessary replacement annuity.
                                  UNNECESSARY REPLACEMENT
     “Unnecessary replacement” is defined as selling an annuity that replaces an existing annuity
which requires that the contract owner will pay a surrender charge on the replaced annuity.
Further, the replacement annuity does not give the contract owner a “substantial financial
benefit” over the life of the policy so that a “reasonable person would believe that the purchase is
unnecessary.”73
     However, if a policyowner purchases replacement policies from the same agent after
indicating on the application that replacement is not involved, this constitutes a “rebuttable
presumption” that replacement was intended in selling these annuities and further, this also
establishes a “rebuttable assumption” that there was an intent of the agent to violate this
regulation.

    CONSUMER APPLICATION
    Agent Jones represents Annuity Life Ins. and sells a Deferred Annuity to Smith as part of
Smith’s estate plan. When the stock market was bullish, Smith told Jones that he wanted to take
out his money and move it to a mutual fund as he expected that any penalty would be more than
offset by the investment gains. Jones convinced Smith that a Variable Annuity was preferable
because of tax reasons. Since Annuity Life did not sell Variable Annuities, he placed the new
annuity with Vari-Ann Annuity Co. Since the replaced annuity was a deferred annuity and was
replaced by a Variable Annuity, Jones felt this was not a “replacement.”
    Smith was so pleased that he asked Jones to replace another annuity that he had purchased
through another agent and company. Jones did so and again, he felt that it really was not a
“replacement.”
    When the stock market started to slide, Smith became concerned and indicated that what he
really needed was to have an annuity that not only provided variable benefits, with some sort of a
“floor” so he would not lose everything in case the market collapsed. Jones remembered that
Annuity Life had recently offered an equity indexed annuity.
    Smith was delighted that he could have some guarantee that he would not lose everything.
Jones felt that this was not a “replacement” as it was a completely different product, so no such
notice was provided to the insurer.


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    Technically, Jones had run afoul of the replacement regulations and it would probably be
assumed that he was in violation of the regulations because the insurers had not been notified
when the annuity plans were exchanged/replaced. The Code refers only to an “annuity” and
makes no distinction between types of annuities being replaced or issued as a result of
replacement.

    In the above Consumer Application, Jones could be fined up to $1,000 for the first violation,
In addition, for second or subsequent violations, he could be fined $5,000 to $50,000. For each
violation – therefore he could possibly be fined as much as $101,000.
                    REPLACEMENT OF ANNUITIES SOLD TO SENIORS
    State Insurance Departments are protective of their elderly consumers and they have
reinforced their concern by providing guidelines and requirements in order to regulate the
activities of insurers and agents with respect to the replacement of existing life insurance and
annuities when seniors are involved.74 The stated purpose of these regulations is to protect the
interests of life insurance annuity purchasers over age 65 by, as they state so clearly,
“establishing minimum standards of conduct to be observed in replacement transactions, thereby
assuring that the purchaser receives information with which a decision can be made in his or her
best interest, at the same time, reducing the opportunity for misrepresentation and incomplete
disclosures.” They also establish penalties for failure to comply with their requirements for
replacement.
    Exempt from these regulations when annuities are involved are group annuities, transactions
where the replacing insurer and the existing insurer are the same. Such agents must provide to
and leave with the applicant, a written statement containing information relating to premiums,
cash values, death benefits, and outstanding indebtedness, and dividends and dividend
accumulations, if any, for the existing policy, both immediately before and after replacement,
and for the proposed annuity.
    Each agent who accepts an application must submit to the insurer with which an application
for an annuity is presented, or as part of each application, both of the following:
  (1) A statement signed by the applicant as to whether replacement of existing life insurance or
      annuity is involved in the transaction.
 (2) A signed statement as to whether or not the agent knows replacement is or may be involved
      in the transaction.
Where a replacement is involved, the agent shall do all of the following:
  (1) Present to the applicant, not later than at the time of taking the application, a "Notice
      Regarding Replacement of Life Insurance" in the form (see below). The notice shall be
      signed by both the applicant and the agent and the original left with the applicant.
  (2) Obtain with or as part of each application a list of all existing life insurance or annuities to
      be replaced and properly identified by name of insurer, the insured and contract number. If
      a contract number has not been assigned by the existing insurer, alternative identification,
      such as an application or receipt number, shall be listed.
  (3) Leave with the applicant the original or a copy of all printed communications used for
      presentation to the applicant.
  (4) Submit to the replacing insurer with the application a copy of the replacement notice.


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Each agent or broker shall present to an applicant the following notice:

                        NOTICE REGARDING REPLACEMENT
               REPLACING YOUR LIFE INSURANCE POLICY OR ANNUITY?

   Are you thinking about buying a new life insurance policy or
annuity and discontinuing or changing an existing one? If you
are, your decision could be a good one--or a mistake. You will
not know for sure unless you make a careful comparison of your
existing benefits and the proposed benefits.
   Make sure you understand the facts. You should ask the
company or agent that sold you your existing policy to give you
information about it.
   Hear both sides before you decide. This way you can be sure
you are making a decision that is in your best interest.
   We are required by law to notify your existing company that
you may be replacing their policy.



___________________              ____________________              ____________________

      (applicant)                              (agent)                             (date)



    Every life insurer must inform its field representatives, agents. and other personnel
responsible for compliance with these requirements and they must require with, or as part of,
each completed application for an annuity a statement signed by the applicant as to whether such
proposed insurance or annuity will replace existing life insurance or annuity. Plus, the agent
must sign and submit a statement as to whether he or she knows replacement is or may be
involved in the transaction.
    If such a replacement is involved, the insurer must require from the agent. along with the
application for life insurance or annuity:
    (i) a list of all of the applicant's existing life insurance or annuity to be replaced, and
    (ii) a copy of the replacement notice provided the applicant pursuant to this regulation.75
    The existing annuity must be identified by name of insurer, insured, and contract number or
    an application or receipt number if a number has not otherwise been listed.
    Further, the insurer is required to send within three working days after the application has
been received, to each existing life/annuity insurer written information advising them that the
policy will be replaced, with proper identification of the policy, along with a policy summary,
contract summary, or ledger statement containing policy data on the proposed life insurance or
annuity.



                                               173
    Within 20 days from the date that the written communication is received by the existing
insurer, (plus all the substantiating materials), the existing insurer must furnish the policyowner
with a policy summary for the existing life insurance or ledger statement containing policy data
on the existing policy or annuity and information relating to premiums, cash values, death
benefits, and dividends, if any, shall be computed from the current policy year of the existing life
insurance and will include the amount of any outstanding indebtedness, the sum of any dividend
accumulations or additions, and may include any other information that is not in violation of any
regulation or statute. When annuities are involved, the disclosure information shall be that in the
contract summary.
    Then the replacing insurer may request the existing insurer to furnish it with a copy of the
summaries or ledger statement within five working days of the receipt of the request. The
replacing insurer and the existing insurer must maintain all evidence of the policy summaries and
other identifying information and conservation efforts, for a period of at least 3 years.
    The replacing insurer must provide in its policy or in a separate written notice which is
delivered with the policy that the applicant has a right to an unconditional refund of all
premiums paid and this right may be exercised within a period of 30 days commencing from the
date of delivery of the policy. In the case of Variable Annuity contracts, variable life insurance
contracts, and modified guaranteed contracts, return of the contract during the cancellation
period shall entitle the owner to a refund of account value and any policy fee paid for the policy.
The account value and policy fee shall be refunded by the insurer to the owner within 30 days
from the date that the insurer is notified that the owner has canceled the policy.
    If in the solicitation of a direct response sale, an insurer does not propose the replacement,
and a replacement is involved, the insurer must send to the applicant with the policy a
replacement notice as described above. In those instances the insurer may delete the last
sentence and the reference to signatures from the form without having to obtain approval of the
form from the commissioner.
    If the insurer proposed the replacement it must:
             (1) Provide to applicants or prospective applicants with or as part of the application a
                 replacement notice as indicated above (Notice regarding replacement).
             (2) Request from the applicant with or as part of the application, a list of all existing
                 life insurance or annuities to be replaced and properly identified by name of
                 insurer and insured.
             (3) Comply with the requirements of the regulations and appropriate insurance code.


   A violation of this article will occur if an agent or insurer recommends the
replacement or conservation of an existing policy by use of a materially inaccurate
presentation or comparison of an existing contract's premiums and benefits or dividends
and values, if any, or recommends that an insured 65 years of age or older purchase an
unnecessary replacement annuity.




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                             PRESUMPTION OF INTENTION TO REPLACE
    If an agent consistently replaces policies of a particular individual and the individual does not
indicate that replacement was involved, it is therefore assumed that the agent is in violation of
the replacement regulations.
                                            PENALTIES
     Any agent or other person or entity engaged in the business of insurance, other than an
        insurer, who violates this (insurance Code) is liable for an administrative penalty of no
        less than one thousand dollars ($1,000) for the first violation.
     Any agent or other person or entity engaged in the business of insurance, other than an
        insurer, who engages in practices prohibited by this chapter a second or subsequent time
        or who commits a knowing violation of this article, is liable for an administrative penalty
        of no less than five thousand dollars ($5,000) and no more than fifty thousand dollars
        ($50,000) for each violation.
     Any insurer who violates this article is liable for an administrative penalty of ten
        thousand dollars ($10,000) for the first violation.
     Any insurer who violates this article with a frequency as to indicate a general business
        practice or commits a knowing violation of this article, is liable for an administrative
        penalty of no less than thirty thousand dollars ($30,000) and no more than three hundred
        thousand dollars ($300,000) for each violation.
     After a hearing conducted in accordance with (appropriate Code and/or regulations), the
        commissioner may suspend or revoke the license of any person or entity that violates this
        article.
                             MISREPRESENTATION OF POLICY
    “Misrepresentation” is a fundamental problem that has existed for generations to some
degree or other. The California Insurance Code does not allow misrepresentation and it defines
misrepresentation quite well.76
    Any insurer, officer or agent of the insurer, or broker or solicitor of the insurer, must not
allow or “cause” any misrepresentation in respect to
     (a) The terms of a policy issued by the insurer or sought to be negotiated by the person
         making or permitting the misrepresentation.
     (b) The benefits or privileges promised thereunder.
     (c) The future dividends, payable thereunder.”

    A person shall not make any misrepresentation to any other person for the purpose of
persuading another to take out an insurance policy, or to persuade another to refuse to accept a
policy that was issued as the result of an application and thereafter, take out another policy.
Further, no person shall persuade a policyholder in any insurer to lapse, forfeit or surrender his
insurance.
    An agent cannot misrepresent or compare insurers or policies to an insured which are
misleading, for the purpose of persuading the person to lapse, forfeit, change or surrender his
insurance – whether temporary or permanent insurance.77



                                                175
                             PENALTIES FOR VIOLATION OF CODE
    Any person violating the (above) provisions is guilty of a misdemeanor and punishable by a
fine not exceeding one thousand five hundred dollars ($1,500) or by imprisonment not exceeding
six months.78
    If an insurance agent, broker, or solicitor knowingly violates any these provisions, the
commissioner may hold a hearing and after doing so, may suspend the license of any such person
for (a period) not exceeding three years.79
    The Code provides that if an insurance company knowingly violates any of these provisions
– or if the company knowingly permits any officer, agent or employee to violate any of these
provisions, the Insurance Commissioner may suspend the certificate of authority to operate in
that state for the class of insurance in which such violation occurred.80
    The California Code81 states that “any person may be compelled to testify and produce
books and writings at the trial or hearing of any person charged with violating any provision of
“(the appropriate Code Section)82 “even though such testimony or evidence may incriminate
him. A person shall not be prosecuted for any act concerning which he is compelled so to testify
or produce evidence, except for perjury committed in so testifying.”

   These penalties involves certain actions or failure of action including
     Breach of the duty of honesty, good faith and fair dealing.
     Failure to provide the 30-day (or longer) free look period.
     Failure to provide a written comparison when required.
     Failure to disclose that an agent may contact a potential insured as a result of a lead
        based on responses.
     Deception in advertising.
     Failure of certain health policies to return benefits according to specified minimum loss
        ratios.
     Failure to provide required Medi-Cal and other disclosures in selling insurance
        products.
     Inappropriate sale of an annuity in violation of regulations that do not allow the sale of
        products that can affect or is intended to affect, Medi-Cal eligibility.
     Failure to provide the required notice, presenting proper identification and other such
        requirements, when meeting with a senior in his home.




CONSUMER APPLICATION
    Agent Smith has a client – Adam - who is a prospect for an annuity to replace funds that had
been invested in Certificates of Deposits but who is concerned that he may need the principal
earlier than the annuity term (10 years) but he would be penalized by withdrawal penalties.
Smith discussed this with the Agency Director at Acme Life & Annuity and they agreed that a
projection in which the penalties were ignored would do the trick, especially since Smith was



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positive that his client would not need the funds before 10 years as his business was doing quite
well.
    Adam purchased the annuity and since no penalties were discussed in the projections, he
assumed that there were none and the company had so agreed to this.
    The annuity had been in force for 5 years when the Adam’s company’s principal supplier
announced that they were going out of business. Adam’s accountants decided that the supplier
could be purchased for a modest sum and they could also run that company, solving their
immediate business problem. Adam’s company was strapped for cash at that particular time, so
remembering the annuity, he withdrew the principal from the annuity. Much to his dismay, he
did not receive all of the funds due to the penalties. Thereupon, Adam sued Smith and Acme and
the situation was duly reported to the Department of Insurance which conducted its own
investigation.
    During the hearing before the Commissioner, Smith and the Agency Director for Acme were
interrogated. The Department reviewed the “phony” projection, but Smith and the Director
pleaded innocent as they did not actually do the projection themselves, but Claire, a young
Associated in the Actuarial Department did the projection. Claire was called to testify, but her
attorney advised her not to acknowledge that she had anything to do with the projection.
However, after the Code was reviewed, she was able to testify that she had created the
projections upon direction of the Agency Director, and she thought it was to be for agent training
or something, not given to a prospect. She could not be prosecuted for her part in this sham.


                LIQUIDATION OF ASSETS IN PURCHASING AN ANNUITY
   Before an agent can sell a life insurance policy or annuity to an elder (defined for this purpose
as those age 65 or older), they must advise the elder (or the elder’s agent) in writing, “that the
sale or liquidation of any stock, bond, IRA, certificate of deposit, mutual fund, annuity, or other
asset to fund the purchase of the product, may have tax consequences.” There could also be
other penalties, such as early withdrawal penalties. In any event, the elder (or his agent) may
wish to obtain an independent legal and/or accounting, or other financial, advice before selling,
liquidating, or converting any asset.83A Also note discussion under discussions on “suitability.”
            MISREPRESENTATION OF ASSET TREATMENT FOR MEDI-CAL
   It is almost unnecessary to formally state, but regulations state that an agent may not sell or
fraudulently misrepresent a financial product to an elder on the basis of the treatment of any asset
under the Med-Cal regulations as it pertains to the determination of eligibility.


                     DISCLOSURES FOR MEDI-CAL ELIGIBILITY

        Notice Regarding Standards for Medi-Cal Eligibility. The elder or spouse, if
         contemplating purchasing a financial product because of its Medi-Cal treatment, do
         not have to use all of their savings.
        Unmarried Resident. An unmarried resident may be eligible for Medi-Cal if they
         have less than the amount allowed at that time for qualification. The Medi-Cal


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            recipient is allowed to keep monthly income a personal allowance and the amount of
            health insurance premiums paid, with the remainder paid to the nursing facility.
          Married Resident. There is a Community Spouse Resource Allowance that provides
            that if one spouse lives in a nursing facility and the other does not, Medi-Cal will pay
            some or all of the nursing home allowance, provided that the couple does not have
            more than a specified amount of community countable assets. In addition, there is a
            Minimum Monthly Maintenance Needs Allowance which allows the spouse living at
            home to keep a monthly amount with specified maximum.
          Fair Hearing and Court Orders. Under certain circumstances, the at-home spouse
            may be allowed to keep additional resources by the order of an administrative judge.
                      REAL AND PERSONAL PROPERTY EXEMPTIONS
          One Principal Residence. The home is usually exempt if the applicant intends to
            return to it someday and if the spouse and/or dependent relative continue to live in it.
            If the home is sold, they have 6 months to apply the funds from the sale to the
            purchase of a new home.
          Real Property Used in a Business or Trade. Real estate used in a business or trade is
            exempt regardless of its equity value or whether it produces income.
                   PERSONAL PROPERTY AND OTHER EXEMPT ASSETS
        IRAs, KEOGHs, and Other Work-related Pension Plans. These funds are exempt if
         the family member who owns the plan benefits does not want Medi-Cal, otherwise if
         payments are being received, the balance is considered unavailable is not counted. It is
         not necessary to annuitize, convert to an annuity, or otherwise change the form of the
         assets in order for them to be unavailable.
        Personal Property Used in a Trade or Business.
        One Motor Vehicle.
        Irrevocable Burial Trusts or Irrevocable Prepaid Burial Contracts.
        There May be Other Assets That May be Exempt.

  Advice is also given in this Disclosure that the applicant may want to call the County welfare
Department, and are advised to contact an independent attorney.



STUDY QUESTIONS

1. A major concern of many elderly folks is
   A. outliving their resources.
   B. buying the right automobile.
   C. leaving their money to charity
   D. living to more than 100.

2. When an agent offers to sell an annuity in California, one of the duties of the agent is
   A. to tell the prospect how much commission will be paid on the annuity.
   B. to inform the prospect as to the financial standing of any competing insurer.


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   C. to make sure that the prospect is wealthy and in good health.
   D. to advise the client that they may want to consult an independent legal or financial advi-
      sor before selling any asset.

3. If a Variable Annuity is sold to a senior citizen and returned within the 30 day cancellation
    period, and the client has not directed that the premium for the contract to be invested in the
    mutual funds underlying the contract during the cancellation period, then
    A. this will have the effect of voiding the annuity.
    B. the insurance company must provide continued coverage for the client for one year.
    C. there will be no chargeback against the agent.
    D. the insurer may take legal action against the client for misrepresentation.

4. Whenever an insurer provides an annual statement to a senior policyowner of an individual
   annuity contract,
   A. the insurer must also provide the current accumulation value and current cash surrender
      value.
   B. it must be hand-delivered by the agent who must explain it all to the client.
   C. then no other information as to the particular annuity need be submitted to the client.
   D. they must so notify the Department of Insurance and the SEC.


5. One of the most used methods to get seniors to attend a meeting in order to sell investment
   products, including annuities, is to hold a “seminar” luncheon at a fancy restaurant with a
   speaker who is an “expert” in some area of interest to the seniors. There is no problem with
   this
   A. as long as the seniors do not have to pay for their meal.
   B. as long as the speaker is an actual expert in that particular field, even though they may be
        sponsored by an insurance organization whose products are not discussed in the
        invitation.
   C. if there is an announcement at the seminar that insurance products will be available after
        the meeting.
   D. the advertised speaker is, indeed, an expert in the field as advertised, and if prior notice
        was given in the invitation that insurance products will be offered for sale and there will
        an insurance sales presentation.

6. When a marketing scheme to sell insurance or annuities through a seminar or meeting, created
   by misrepresentation or identity and touting the use of a living trust as a financial planning
   device this is considered as a
   A. educational seminar.
   B. citizen’s gathering which is their constitutional right.
   C. living trust mill
   D. presentation as a public service.

7. The above (6) situation is
   A. legal and within the rights of those making the presentations.
   B. often used and is endorsed by the National Association of Insurance Commissioners.



                                                179
     C. is a marketing technique taught by the American College of Life Underwriters.
     D. illegal and may result in cease and desist orders, financial penalties and suspension or
        revocation of the certificate of authority or insurance licenses.

8. Contacting a senior citizen for the purpose of selling insurance or annuities as the result of a
   lead system is
   A. illegal.
   B. legal provided that the agent shows his license during the meeting.
   C. legal provided that at time of contact, the agent must disclose the fact that the agent is
       there as a result of the lead, and abides by other regulations in this respect.
   D. only legal where the agent performs other services than selling insurance, such as selling
       medical supplies, giving the senior an informational publication, etc.

9. Any person who meets with a senior in the senior’s home for the purpose of selling insurance
   or annuities
   A. must deliver a notice in writing to the senior no less than 24 hours prior to that meeting.
   B. may legally do so simply by asking the prospect if he can come in for a little while and
       discuss an item of importance.
   C. must have a professional designation such as CLU, ChFP, or CPA.
   D. must be dressed presentably, treat the prospect with respect, and ask for the telephone
       number of the prospect’s physician.

10. The State of California has taken action to stop the sale and use of annuities
    A. that are sold to persons over the age of 70 ½.
    B. for estate planning purposes.
    C. to provide additional retirement income for a person on Social Security.
    D. to avoid Medi-Cal reimbursement where the senior would otherwise qualify for Medi-
       Cal and the purpose of purchasing the annuity is to affect Medi-Cal eligibility and
       after the purchase of the annuity, the senior or spouse would not qualify for Medi-Cal.

ANSWERS TO STUDY QUESTIONS
1A   2D   3A   4A   5D   6C   7D   8C   9A   10D




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    CHAPTER ELEVEN - 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 would probably not be 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.


                               INSURANCE RATING SERVICES
    The most overlooked factor in selecting an insurer from which to purchase annuities (or any
other types of insurance) is the financial stability of the company. If a customer purchases from
a financially strong company, then there is an increased likelihood that benefits will be paid
when they are due. In the 1970’s, Baldwin United Life Insurance Co. was taken over by the
insurance departments due to their financial instability. Their portfolio (consisting primarily of
annuities) was eventually moved to several other insurers. Those companies assuming the
annuities were able to keep the annuities in force but they could only do so if the insurers did not
have to pay the interest accumulated for a period of time. The result was that many individuals –
including many senior citizens who depended upon their annuity payments in order to survive,
suffered, but at least they eventually received interest income again.
    Life insurance and annuity companies otherwise always fulfilled their obligations until 1991
when a large California company was taken over by regulators. Since that time there have been
several large and old insurers that met the same fate. While this was well publicized, many, if
not most, purchasers still simply ask the agent if the company was financially strong. Sometimes
a “handout” from the company is provided which usually states that the company has “sufficient
funds” to meet its obligations.
    There is no guarantee system for insurance policyholders similar to the FDIC that guarantees
bank customers that their funds are protected by the federal government. In the insurance
industry, insurers are assessed through state guaranty associations and in most states, the
company can take subsequent credit against their state taxes for the assessments – therefore most
of the cost associated with failed companies is out of the pockets of the taxpayers.
    Regardless, when a company is taken over by a regulator the primary purpose of the
regulator is to rehabilitate or sell the company and often, as with the Baldwin United case,
regulators may find it necessary to recommend that the court approve altering the policies in
force, such as placing liens on cash values, reducing minimum interest rates guaranteed in the
policy, and in one case, noncancellable policies were made guaranteed renewable.


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     For the typical insurance purchaser, understanding financial standing of insurers is confusing,
to say the least, and the professional agent is heavily relied upon to provide this service.
Therefore, the agent must be familiar with the rating services.
     There are five principal rating services: A.M. Best Co.; Fitch Ratings; Moody’s Investors
Service; Standard and Poor’s (S&P); and Weiss Ratings. These companies provide rating
services which is “an expression of the rating firm’s opinion about the financial strength of a
company.”83 Therefore, a high rating does not mean that a company will survive, but the higher
the rating, the more likely it is that the company will survive. Conversely, a low rating does not
mean that the company will fail, but there is a good likelihood that it will fail. An astute
professional will not only look at the ratings, but will also read the rating firm’s reports regarding
the company. And, of course, one should never rely too heavily upon what a company has to say
about itself – or pay much attention as to what a competitor says about another company.
     To confuse the matter even more, it is important to know where a rating fits among the rating
firm’s categories. For instance, one would probably think that an A+ rating would be the top
rating, and for Weiss Ratings, this is so. But for Best’s, it is the second best (after A++), Fitch’s
fifth class (after AAA, AA+, AA, AA-) and S&P’s it is also the fifth. In the same vein, A1
might seem to be the best, but for Moody’s Ratings, it also is 5th. To muddy the waters further,
Best has 15 ratings, Fitch has 22, Moody’s has 21, S&P has 19 and Weiss has 16.
     As of Aug 1, 2003, Best had assigned ratings to 1,209 life-health insurance companies, Fitch
had rated 279, Moody’s 179, S&P 462 and Weiss 1,025. Therefore, for purposes of this text, it
could be suggested that if no other reason than more companies are rated, Best and Weiss should
be consulted and if the agency or agent does not have access to their ratings, the public libraries
can help. Best will provide ratings without charge on their website. (Incidentally, they will
provide two types of ratings – one for those companies that have consulted with Best plus an
analysis of several years of financial data provided by the company, and an evaluation of the
company’s balance sheet and operating performances. The other, “pd” rating is provided from
information from public data but with no consultation, etc. with Best.
     The Insurance Forum, a private publication that rates companies in depth and uses all of the
rating services for their recommendations, suggests that a company that has a high rating from at
least 3 of the 5 firms be considered as “extremely conservative, and as of 9/03, 55 companies
would be in this category. “Very conservative” consisted of 142 companies (including the 55
companies) by expanding the ratings requirements, and “conservative” for 196 companies
(including the ones in the previous categories).
     Also, The Insurance Forum publishes a list of life-health insurance companies that are on the
watch list, which is a list of companies that has a low rating from at least one of the rating
services, plus other information that would indicate that there could be financial problems in the
future.
     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 or someone who is a part-timer or moonlighter.


                                                 182
                  OTHER FACTORS IN THE REPLACEMENT SITUATION
    An annuity owner should not only be aware of the financial strength of the replacing insurer,
but also of the replaced insurer. One company could be much more financially stronger than the
other, and if the client is considering exchanging an annuity from a highly rated insurer, to an
insurer that is rated lower – or perhaps one on the “watch list” – then, “there you go.”
                                 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, then 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


                                                183
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 the state's Department of Insurance.
    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 second rating from a company such as Standard & Poor's or Moody's Investors Service
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 included
Metropolitan Life). 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 and were
depending upon the promised return for their living expenses.


                               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


                                               184
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 a 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 types 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.
    Perhaps the best advice in this matter came from a very success 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.
          LIFE AND HEALTH INSURANCE GUARANTEE ASSOCIATION
    Individual states each have a guaranty fund which protect policyholders and beneficiaries
within the state in case the insurer becomes insolvent or is taken over by the state Department of
Insurance through receivership. The funds are financially supported by insurers who are
authorized to conduct business within the state.
    California’s fund, the California Life and Health Guarantee Association (CLHGA) is
authorized under the California Insurance Code87 and through this Association, coverage is
provided to the covered parties for the extent of coverage as provided in the Code.
                                       COVERED PARTIES
    Coverage is provided to owners and beneficiaries, including assignees and payees of life,
health and annuity policies. Coverage is provided to annuity owners who are California
residents, but coverage for non-residents will be provided if the insurer is domiciled in California
and has never been authorized in the state in which the annuity owner resides, if the owner’s
residence state maintains a guarantee fund which is similar to the CLHGA but the owner is not
eligible for coverage with that fund.

   In addition to owners, protection is provided for beneficiaries, assignees and payees.



                                                185
                                           COVERAGE
    Coverage is provided to group annuity contracts, non-group annuity contracts and
supplemental contracts (which are designed to liquidate a principal sum over a predetermined
period of time). CLHGA specifically covers the following contracts:
           allocated annuity contracts;
           structured settlement contracts;
           immediate and deferred annuity contracts, and
           certain unallocated annuity contracts.

   Coverage is NOT provided by CLHGA for the following types of contacts:
        A self-funded or uninsured plan provided by an employer or association for the
         benefit of its members or employees.
        GICs, funding agreements deposit administration contracts, most all other unallocated
         annuity contracts, except for certain unallocated annuity contracts that are sold
         between specified dates and that provide deferred compensation or pension benefits.
        Annuities that are issued by a charitable organization, qualified by the IRS, and which
         does not have insurance as its primary business.
        Annuities that were issued in California by a member insurer who was not licensed or
         have a Certificate of Authority to issue such contract in California.

   CLHGA coverage is limited for other annuity contracts:
      There is no coverage provided for any part of a contract not guaranteed by the insurer
       or under a contract whereby the contract owner assumes the risk.
      There is no coverage provided to the extent that the interest rate on which it is based
       exceeds
       (a) an interest rate determined by subtracting 6 percentage points from Moody’s
           Corporate Bond Yield Average for the four year period prior to the date CLHGA
           became obligated under the contract – but not less than -0- percent; or
       (b) an interest rate determined by subtracting 6 percentage points from Moody’s
           Average for the period starting with the date that the CLHGA becomes obligated
           under the contract, but not less than 3%.

    Other limitations are placed on benefits as to the lesser of 80% of the contractual obligations
for each contract, or $100,000 in present value of annuity benefits, with total CLHGA coverage
in aggregate for life insurance and annuities, is limited to $250 for any one life.




                                                186
STUDY QUESTIONS

1. When an individual decides to purchase an annuity, the most overlooked factor usually is
   A. the qualifications of the agent.
   B. the commissions paid to the agent.
   C. the financial stability of the insurance company.
   D. the location of the insurance company.

2. When an insurance company is taken over by the regulators such as the Department of
   Insurance, the primary purpose of the regulators is
   A. to sweep the failure of the company under the carpet for political reasons.
   B. to blame the federal authorities.
   C. to rehabilitate or sell the company.
   D. to make sure all agents are paid promptly.

3. There are five rating services, including
   A. A.M. Best Co.
   B. Dow Jones Investor’s Service.
   C. Medical Information Bureau.
   D. Forbe’s.

4. The Insurance Forum, a publication that rates companies in depth, has suggested that a
   company that has a high rating from at least 3 of the 5 rating firms, are
   A. on the “watch” list.
   B. would be good companies in which to invest.
   C. considered as extremely conservative - which is a high recommendation.
   D. considered as “average” for financial stability.

5. Financial information on life and health insurers may be obtained
   A. only from insurance agencies.
   B. only from direct contact with the Department of Insurance.
   C. from public libraries, insurance agencies and the Department of Insurance.
   D. only from the insurer as most financial information is highly confidential.

6. The Wall Street Journal, Barron’s , Standard & Poor’s and Moody’s Investor Services are
   particularly good sources of
   A. information on the investment portfolios of insurers.
   B. information regarding the comparable number of policyholders of an insurer.
   C. inside information of insurance companies, such as the backgrounds of the various
        officers and their salaries.
   D. lists of agents.




                                               187
7. A general consensus of investment advisors say that their clients can feel quite confident if
   they only do business with
   A. the 25% of insurers that has Best ratings of A++ or A+.
   B. companies that are rated A1 with Moody’s Rating Service.
   C. insurance companies that have local offices and more than 10 agents in a locale.
   D. companies that have a Weiss rating of A.

8. Most insurers, while rated by Best, are not rated by the debt rating agencies such as Standard
   & Poor’s because they only rate those insurers that pay to be rated, therefore
   A. every insurer that can afford to pay the rates, will be rated.
   B. only the very poor and struggling companies will want to be rated by these agencies.
   C. there largest and most likely to get a high rating have chosen to be so rated.
   D. many states do not allow insurers to pay for these services.

9. There are two types of insurance rating services,
   A. those that rate life and health companies, and those that rate property & casualty
       companies.
   B. those that charge the companies a fee to be rated and those that do not charge.
   C. those that rate a company only by claims-paying ability and those that rate only by
       the quality of their investment portfolio.
   D. those that rate mutual companies and those that rate stock companies/

10. If an agent markets annuities and does not have actual, factual and up-to-date information
   about the stability of the insurer,
   A. there is no worry as the guarantee association will bail the company out if it gets into
        trouble.
   B. an agent is forbidden by law to recommend one insurer over another, regardless.
   C. an agent is not considered as a professional investment advisor, so he can recommend
        any company – particularly if they pay the highest commissions – without concern.
   D. a professional will make an extra effort to become acquainted with the financial standing
        of any company that they represent through not only the rating services, but also from a
        review of their investment portfolio, etc.


ANSWERS TO STUDY QUESTIONS
1C   2C   3A   4C   5C   6A   7A   8C   9B   10D




                                                   188
                                  TEXT REFERENCES
                             th
1. Life & Health Insurance, 13 Edition
2. Getting Started in Annuities, Comprehensive Coverage
3. Annuities Answer Book 2004 Cumulative Supplement
3A. CIC Section 10540
4. Dictionary of Insurance Terms, Third Edition
5. Getting Started in Annuities, Comprehensive Coverage
6. Gallup Study of Owners of Nonqualified Annuity Contracts – 2001
7. Dictionary of Insurance Terms
8. Life & Health Insurance, 13th Edition (including following 3 paragraphs)
9. Ibid.
10. Ibid.
11. Ibid.
12. Weiss Ratings, Inc.
12A. CIC Section 10541
12B. CIC Section 10112
13. Weiss Ratings, Inc.
14. National Association of Insurance Commissioners (NAIC) website
15. California Insurance Code (CIC) Section 10168.1
16. CIC Section 10168.2
17. CIC Section 1068.25
18. CIC Section 1068.3
19. CIC Section 1068.4
20. CIC Section 10168.5
21. CIC Section 10168.7
22. CIC Section 10168.9
23. Annuities Answer Book 2004 Cumulative Supplement
24. Ernst & Young Tax Guide 2004
25. Personal Financial Planning Guide, Ernst & Young
26. Annuities Answer Book 2004 Cumulative Supplement
27. Life Insurance Selling, April 2002
28. Sarasota Herald-Tribune, Jonathan Clements, 7/8/04
28. Annuities Answer Book 2004 Cumulative Supplement
29. IRC 401(a)(31), 403(b)(10), 457(d)(1)(C)
30. Treas Reg 1.401(a)(31)-1, Q&As 9, 11
31. IRC 402©(3), 408 (d)(3)(A), 457(e)(16); Rev Proc 2003-16, 2003-4 IRB 305
32. (under IRS Code Section 72(e))


                                           189
33. IRC letter ruling 7/13/2000
33A. PLR 200022003
34. Treas. Reg. #25.2511-1(h)(g)
35. IRS 2503(b)(1), 102; Rev. Proc. 2001-59, 2001-52 IRB 1
36. IRC 2503(b)(2)
37. IRC 2033,2039
37A. [IRC 2010(c)]

38. IRC 1014(b)(9)(A); Rev. Rul 79-335, 19979-2 CB 292
39. Variable Annuity Research and Data Service [VARD]
40. CIC Section 10127.10
41. A Producer’s Guide to Variable Annuities 2003, Life Insurance Selling
42. http://www.sec/gov/investor/pubs/varannty.htm
43. http://www.nasd.com.alert_02-01.htm
44. VARD's Profilers — Third Quarter 1999
45. under Section 26(c)
46. A Producer’s Guide to Equity indexed Annuities 2003, Life Insurance Selling
47. Section 3(a)(8)
48. Malone v Addison ins. Mktg., Inc., 225 F Supp 2d 743 (WD Ky 2002)
49. A Producer’s Guide to Equity indexed Annuities 2003, Life Insurance Selling
50. Ibid.
51. Ibid.
52. Ibid.
53. IRS Code Section 72
54. California Insurance Code Section 789.8
55. CIC Section 10127.10-10127.12
56. CIC Section 10127.11
57. CIC Section 1027.12
58. CIC Section 787(k)
59. Black’s Law Dictionary, Fourth Edition
60. State of Calif., Department of Insurance, Attachment II, Page 26, 12/12/01 Living Trust
    Mills and Pretext Interviews
61. CIC Sections 17299 and 17500
61A. CIC Section 791 and sequential portions
62. CIC Section 791.03
63. CIC Section 787
63(A) CIC Section 787(a)
63(B) CIC 1725.5



                                              190
63(C) CIC 1725.5(a)
63(D) CIC 1725.5(d)
63(E) CIC 1725.5(e-j)
64. CIC Section 789.8
65. CIC Section 789.9
66. CIC Code Section 1724
67. CIC Section 10509.2
68. CIC Section 10509.2(b)
69. CIC Section 10509.2(c)
70. CIC Section 10509.2(g)
71. CIC Section 10509.4
72. CIC Section 10509.6
72A. CIC Section 1027.11
73. CIC Section 10509.8
74. CIC Section 10509-10509.9
75. CIC Section 10509.4
76. CIC Section 780
77. CIC Section 781
78. CIC Section 782
79. CIC Code Section 783
80. CIC Section 783.5
81. CIC Section 784
82. CIC Sections 780 or 781
83. The Insurance Forum, Vol.30,No.9
83A CIC Section 798.8 (a) (b)
83B. 798.8(c-end)
84. Treas. Reg. 1.1035-1
85. Ltr Rul 8515063, 8310033 and Ltr Rul 8746052, and Treas Reg 1.1002-1(d)
86. 2002-45 IRB 812
87. CIC Code Section 1067 – 1067.18
88. Calif. Civil Code 38 & 39
90. CIC Code Section 787(b)
91. CIC Code Section 1668.1
92. Wikipedia
93. Wikipedia




                                           191
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




                                              192
Life Insurance
        Kenneth Black & Harold Skipper
        Prentice Hall 1993

Annuities Answer Book, 2004 Cumulative Supplement
       John T. Adney, Joseph McKeever III, Barbara Seymon-Hirsch
       Aspen Publishers, 2004

Getting Started in Annuities
       Gordon K. Williamson
       John Wiley & Sons 1999

Ernst & Young’s Personal Financial Planning Guide,
       Robert Garner, Robert Coplan, Martin Nissenbaum, Barbara Raasch, Charles
       Ratner
       John Wiley & Sons, Inc. 1999

Ernst & Young’s Personal Financial Planning Guide, Special Tax Edition
       Robert Garner, Robert Coplan, Martin Nissenbaum, Barbara Raasch, Charles
       Ratner
       John Wiley & Sons, Inc. 2002

Ernst & Young, Tax Saver’s Guide, 2004
       Tax Partners and Professionals of Ernst & Young LLP
       John Wiley & Sons, Inc. 2004

The Ernst & Young Tax Guide 2004
       Tax Partners and Professionals of Ernst & Young LLP
       John Wiley & Sons, Inc. 2004

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




                                           193
                     PERIODICALS, NEWSPAPERS AND MAGAZINES


Life Insurance Selling
        Oct., Nov., 1998; Jan., Feb., April., Sept., Oct., 1999, Jan, Feb, 2000, March 2001, April
        2001, various other publications in 2002, 2003, 2994

Health Insurance Underwriters
       Publications of 1997, 1998, 1999, 2000, 2001,2002,2003.

National Underwriter
       April, May 1998, Feb, April, June, Oct., 1999, Feb. 2000, Mar 2001, Aug 2003

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

How To Perform Due Care
     Richard M. Weber, CLU
     Life Insurance Selling Feb 2000

Reaching Deeper into the EIA Market
      David O’Neill


                                               194
       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 - 2004



                                              195
       Life Insurance Selling   March 2004

A Producer’s Guide to Equity Indexed Annuities
      Life Insurance Selling 2003

A Producer’s Guide to Variable Annuities - 2003
      Life Insurance Selling 2003

Answering the Bells & Whistles,
      Thomas Oliphant & Scott Dunn, CLU,
      Life Insurance Selling March 2000.

Funding Retirement with Your House
      Jonathon Clements – Getting Going
      Sarasota Herald-Tribune, July 8, 2004




                                              196
                                    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



                                              197
Equity-indexed Annuities, The best thing since sliced bread?
       insure.com/life/annuity/eiamain.html

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

Wikipedia, The Internet Encyclopedia (used several times)




                                              198
                                         ATTACHMENT I
Provider Legislative Reference
Attachment I
Understanding of the following annuity legislation is significant. It provides the evolutionary changes
for each law throughout the years. It is important to know what impact the following pieces of
legislation have had on annuity insurance. To review or obtain copies of the following pieces of
legislation, you may log onto the California Legislature's Web site at http://www.leginfo.ca.gov or you
may call the Legislative Bill Room at (916) 445-2645 to order copies of this legislation.
                                               Year: 2003
SB 620, 2003, (Scott, Chapter 547), Annuities: life insurance: required disclosures and prohibited sales
practices.
An act to amend Sections 787, 1725.5, 10127. 10, and 10509.8 of, and to add Sections 789.9, 789.10,
1724, and 1749.8 to, the Insurance Code, relating to insurance.
       Enacts additional restrictions on advertising practices that target senior citizens and
           would expand the scope of existing restrictions, currently applicable to disability
           insurance, to life insurance and annuities.
       Prohibits the sale of annuities to seniors in certain circumstances.
       Prohibits insurance agents, brokers, and solicitors who are not attorneys from sharing
           commissions or other compensation with attorneys.
       Requires, effective January 1, 2005, specific training for life agents in order for these
           producers to sell annuities, unless the agents are nonresident agents who represent a direct
           response provider, as defined.
       Limits the investment of premiums during the 30-day cancellation period, except as
           specified, and revises the disclosure requirements applicable to the sale of life insurance
           and annuity products to seniors.
       Imposes restrictions on the sale of life insurance policies and annuities in the home of a senior
           citizen.
       Prohibits an agent or insurer from recommending the unnecessary replacement, as
           defined, of an annuity by a senior citizen.
       Imposes certain duties on the Insurance Commissioner in this regard, and enacts other related
           provisions.
SB 618, (Scott, Chapter 546), Insurance: unfair acts: licenses.
An act to amend Sections 782, 786, 789.3, and 10509.9 of, and to add Sections 1668.1 and 1738.5 to,
the Insurance Code, relating to unfair acts.
      Raises the fine for a violation of these provisions to $1,500.
      Extends to individuals age 65 or older who purchase life insurance the protections described
         above that apply to those individuals who purchase disability policies. •           Declares
         that it applies to the purchase of life insurance only to the extent that it does not conflict
         with the provisions of law regarding cancellation of life insurance policies and annuities.
      Increases the amounts of these monetary penalties, as specified.




                                                  199
       Provides that, if the commissioner brings an action against a licensee under these provisions
        and determines that the licensee may reasonably be expected to cause significant harm to
        seniors, the commissioner may suspend the license pending the outcome of the action. It
        allows the commissioner to require the rescission of any contract marketed, offered, or
        issued in violation of these provisions.
    Authorizes the commissioner to suspend or revoke any permanent license issued if the licensee
        induces the client to make a loan or gift to or investment with the licensee, or to otherwise act
        in other specified ways that benefit the licensee or other people acquainted with or related to
        the licensee.
    Requires that, if a disciplinary hearing of this type involves allegations of misconduct directed
        against a person age 65 or over, the hearing be held within 90 days after the Department of
        Insurance receives the notice of defense, unless a continuance is granted.
    Sets forth the grounds for granting a continuance, and provides that the burden of proof in
        a hearing shall be by a preponderance of the evidence.
    Increases the amounts of these monetary penalties, as specified, and allows the
        commissioner to suspend or revoke the license of any person who violates these
        provisions.
AB 284 (Chavez, Chapter 381), Deferred annuities: nonforfeiture
An act to amend Sections 10168.1 and 10168.2 of, and to add Sections 10168.25 and
10168.92 to, the Insurance Code, relating to annuities.

     • Requires that these annuity contracts also provide that the company shall grant the paid-up
       annuity benefit upon the written request of the contract owner.
     • Eliminates the requirement applicable to certain contracts that a company reserve the right to
       defer the payment of the cash surrender benefit for a period of 6 months, and instead allows the
       company to reserve that right after making written request and receiving written approval of the
       commissioner, as specified.
     • Allows payment of the cash surrender benefit to be deferred for a period not to exceed
       6 months.
     • Provides for a uniform method of calculating minimum nonforfeiture amounts under these
       contracts. It modifies the interest rate applicable to accumulations under these contracts, the
       amounts by which those accumulations may be decreased, and the minimum amount of
       considerations used to determine the minimum nonforfeiture amount, as specified.
   •   Provides that these provisions shall apply to contracts issued on and after January 1, 2006,
       but that a company may elect to apply them, on a contract-form-by-contract form basis, to
       any contract issued on or after January 1, 2004, and before January 1, 2006.
   •   Allows the Insurance Commissioner to adopt regulations to implement these provisions and to
       adjust the calculation of minimum nonforfeiture amounts for certain other contracts.



Provider Legislative Reference Annuities
                                          Year: 2002
AB 2984 (Committee on Insurance, Chapter 203), Insurance: depository institutions:
production agencies: surplus line brokers: reinsurance intermediaries.
An act to amend Sections 1628, 1637, 1639, 1656, 1662, 1679, 1704, 1750.5, 1765.2, 1767, 1768,
1781.3, and 10234.93 of, to add Sections 1638.5 and 1639.1 to, to add Article 5.2 (commencing with


                                                  200
Section 759) to Chapter 1 of Part 2 of Division 1 of, and to repeal Sections 1647, 1648, 1649, 1659, and
1714 of, the Insurance Code, relating to insurance.
•       Establishes provisions regulating retail sales practices, solicitations, advertising, and offers of
        any insurance product or annuity to a consumer by a depository institution, or any person
        engaged in those activities at the office of a depository institution or on behalf of a depository
        institution.
   •    Revises licensing provisions with regard to production agencies, surplus line brokers, and
        reinsurance intermediaries, and also revises requirements for certain licensees within those
        categories. Because this bill expands the duties of a surplus line broker and thereby expand the
        definitions of crimes associated with a violation of these duties, the bill imposes a state-
        mandated local program.
   •    Provides that no reimbursement is required by this act for a specified reason.
                                          Year: 2000
SB 423 (Johnston, Chapter 694), Life insurance: guaranteed living benefits
An act to add Section 10506.5 to the Insurance Code, relating to insurance, and declaring the
urgency thereof, to take effect immediately.
   •    Authorizes a life insurer to deliver or issue for delivery variable contracts or riders to variable
        contracts containing guaranteed living benefits, as defined, under certain conditions.
AB 2107 (Scott, Chapter 442), Elder Abuse
An act to add Section 6177 to the Business and Professions Code, and to amend and renumber
Section 10193 of, to amend Section 10234.8 of, and to add Section 789.8 to, the Insurance Code,
and to amend Section 15610.30 of the Welfare and Institutions Code, relating to elder abuse.
   •    Imposes the duty of honesty, good faith, and fair dealing on insurers, brokers, agents, and
        others engaged in the business of Medicare supplemental insurance and long term care
        insurance with respect to prospective policyholders.
   •    Only permits life agents, on or after July 1, 2001, to sell or offer for sale to an elder or his or
        her agent any financial product on the basis of the product's treatment under Medi-Cal after
        providing the elder or his or her agent with a specified disclosure, in writing, explaining the
        resource and income requirements of the Medi-Cal program, including, but not limited to,
        dertain exempt resources, certain protections against spousal impoverishment, and certain
        circumstances under which an interest in a home may be transferred without affecting Medi-Cal
        eligibility. The bill excludes from the application of these disclosure provisions credit life
        insurance, as defined.



Provider Legislative Reference Annuities
    • Requires the State Bar to make a report, by December 31 of each year, to the Legislature on the
       provision of financial services by lawyers to elders, as specified. The report would include the
       number of complaints filed and investigations initiated, the type of charges made, and the
       number and nature of disciplinary actions taken by the State Bar.
    • Revises the definition of existing law that defines financial abuse for the purpose of reporting
       and investigating elder and dependent adult abuse.




                                                   201
                                           Year: 1998


SB 1718 (Calderon, Chapter 386), Life insurance.
An act to amend Sections 10509.6 and 10541 of the Insurance Code, relating to life
insurance.
     • Existing law provides that every life insurer that uses an agent shall, among other things, when
        a replacement of insurance is involved, provide a notice delivered with the policy that the
        applicant has a right to an unconditional refund of all premiums, which right may be exercised
        within 20 days of the date of delivery of the policy. Existing law contains other provisions
        applicable to variable annuity contracts, variable life insurance contracts, and modified
        guaranteed contracts that authorize the return of the contract during the cancellation period.
        This bill adds the latter provision to the previous provisions requiring the applicant to be given
        notice of a right to an unconditional refund, and changes the 20-day period for the exercise of
        the right to obtain a refund to a 30-day period.
     • Existing law permits certain insurers to issue funding agreements and provides that this
        authorization does not affect the priority of claims against insolvent insurers. This bill
        corrects a cross-reference relating to this priority of claims.
                                           Year: 1997
SB 203 (Lewis, Chapter 28), Insurers: mortality tables.
An act to amend Sections 10163.2, 10489.2, and 10489.3 of the Insurance Code, relating to insurance.
    • Existing law regulates the types of benefits to be paid under a policy of life insurance in the
        event of a default in premium payments or upon surrender of the policy, and also regulates the
        manner in which reserves are to be maintained by insurers issuing life insurance policies and
        annuity and pure endowment contracts.
    • Existing law provides for insurers to use certain mortality tables for these purposes that have
        been approved by the Insurance Commissioner through promulgation of a regulation. This
        bill alternatively allows the commissioner to approve mortality tables through issuance of a
        bulletin.



                                           Year: 1994
SB 1505 (Calderon, Chapter 984), Life insurance and annuity contracts: senior citizen policies
and annuities.
An act to amend Sections 10127.10, 10127.11, 10127.12, 10127.13, and 10506.3 of the Insurance
Code, relating to life insurance, and declaring the urgency thereof, to take effect immediately.
    • Makes specified changes in the cancellation procedures and notice requirements and, in
        addition, applies those procedures and requirements to individual annuity contracts. In addition,
        for variable annuity contracts, variable life insurance contracts, and modified guaranteed
        contracts, a cancelling purchaser would be entitled to a refund of any policy fee paid as well as
        payment for the value of the account. These provisions do not apply to specified types of group
        life insurance or group annuity contracts. Under specified circumstances, senior citizens are
        entitled to refunds if they cancel policies of group term life insurance during the first 30 days of
        the policy period. The bill also makes conforming changes.



                                                    202
   •     Also adds the options of stating only the location in the policy text of the required
         information in 12-point bold type on the cover page of the policy, or by disclosing that
         information on a sticker that is affixed to the cover page of the policy or to the policy jacket.
    •    Provides that modified guaranteed annuities are subject to the forfeiture provisions for
         individual deferred annuities computed under the terms of the annuity, but excluding market
         adjustment factors, as specified. In addition, group annuities exempted from the provisions
         governing individual deferred annuities are also exempted from any modified guaranteed
         annuity regulations.
    •    This exemption is retroactive to January 1, 1987, to the extent that the assets underlying the
         group contracts have not been maintained in a separate account. The bill provides that it is to
         take effect immediately as an urgency statute.
AB 1667 (Hoge, Chapter 6), California Insurance Guarantee Association
An act to amend Sections 1063, 1063.1, 1063.2, 1063.4, 1063.5, 1063.7, 1067.04, 1067.05, and
10112.5 of, to add Section 1067.055 to, and to repeal and add Section 1063.3 of, the Insurance Code,
relating to insurance, and declaring the urgency thereof, to take effect immediately.
    •    Existing law establishes a California Insurance Guarantee Association and specifies those
         insurers that are required to be members of the association. It exempts certain classes of
         insurance from assessments and other requirements of the association.
         This bill specifically enumerates those exempt classes of insurance, and provides that any
         insurer admitted to transact only those classes or kinds of insurance excluded from specified
         provisions shall not be a member of the association.
    •    Existing law provides that the association shall be managed by a board of governors serving
         for 3 year terms. Those terms expire each year. This bill provides that those terms expire each
         year on December 31.
    •    This bill also, among other things, does all of the following with respect to the California
         Insurance Guarantee Association: (a) Revises the definition of "insolvent insurer," and
         "covered claims," and defines "ocean marine insurance," as specified.
         (b) Revises certain policy construction and cancellation provisions with respect to insurer
         insolvency. (c) Revises the authorization of the association to submit reports and make
         recommendations to the Insurance Commissioner regarding the financial condition of member
         insurers, and certain examination and other report requirements, as specified. (d) Revises
         insolvency premium provisions, as specified. (e) Specifies certain notice provisions with
         respect to an ancillary liquidator.
  •     Existing law provides for the California Life and Health Insurance Guarantee Association.
        The statute that established that association abolished the California Life Insurance Guaranty
        Association and the Robbins-Seastrand Health Insurance Guaranty Association. This bill
        provides that the California Life and Health Insurance Guarantee Association is created by the
        merger of the Robbins-Seastrand Health Insurance Guaranty Association with and into the
        California Life Insurance Guaranty Association and that the association succeeds to the rights,
        property, and obligations of the predecessors, as specified.
•     Revises provisions dealing with the applicability of specified disability insurance policies issued
      outside of California to an employer whose principle place of business and majority of employees
      are located outside of California.
                                           Year: 1993
SB 1065 (Mello, Chapter 516), Life insurance.
An act to add Sections 10127.10, 10127.11, 10127.12, and 10127.13 to the Insurance Code, relating
to insurance.



                                                   203
• Adds additional provisions which permit a senior citizen, as defined, to cancel any policy of
  life insurance within 30 days following delivery, as specified. It requires those policies to
  contain a notice of that provision. Those provisions are inapplicable to individual life insurance
  policies issued in connection with a credit transaction or issued under a contractual policy
  change or conversion privilege provisions contained in a policy.
• Additionally makes those provisions inapplicable to noncontributory employer group life
  insurance contracts.
• Requires offerings of life insurance policies to senior citizens that contain illustrations of
  nonguaranteed values to contain certain disclosures. It requires annual statements to senior
  citizen policyowners to disclose the current accumulation value and current cash surrender
  value and requires life insurance policies for senior citizens, which contain a surrender charge
  period to disclose the surrender period and penalties associated therewith.




                                             204
                                         ATTACHMENT II

Attachment II - Life Agent Disclosure Requirements
Code 789.9



Life Agent Disclosure Requirements for Sales to Elders
At the time of the enactment of this law, a life agent is required to make specified disclosures about
the potential consequences of entering into financial transactions related to an elder's potential
eligibility for Medi-Cal coverage and prohibits a life agent from negligently misrepresenting a
product based on its treatment under Medi-Cal.
  Table of Contents                                                       Page Number
  Required Medi-Cal Disclosure                                                     30
  Department of Health Services Forms                                              32
  Life Agent's Duties                                                              32
  Elder Abuse                                                                      33
  Life Agent Financial Products Disclosure                                         33
  Assembly Bill 2107, Scott, Chapter 442,
  Statutes of 2000, Licensing a Life Agent                                        34



                              Required Medi-Cal Disclosure
A life agent who offers for sale or sells any financial product on the basis of its treatment under the
Medi-Cal program shall provide, in writing, the following disclosure to the elder or the elder's agent:
         NOTICE REGARDING STANDARDS FOR MEDI-CAL ELIGIBILITY
               If you or your spouse are considering purchasing a financial product based on its
       treatment under the Medi-Cal program, read this important message! You or your spouse do
       not have to use up all of your savings before applying for Medi-Cal.
UNMARRIED RESIDENT
               An unmarried resident may be eligible for Medi-Cal benefits if he or she has less
       than $2,000 in countable resources.

              The Medi-Cal recipient is allowed to keep from his or her monthly income a
      personal allowance of $35 plus the amount of any health insurance premiums paid.
      The remainder of the monthly income is paid to the nursing facility as a monthly
      share of cost.



MARRIED RESIDENT
           COMMUNITY SPOUSE RESOURCE ALLOWANCE: If one spouse lives in a
   nursing facility, and the other spouse does not live in a facility, the Medi-Cal program will



                                                   205
      pay some or all of the nursing facility costs as long as the couple together does not have
      more than $92,760 + $2,000 (for 2004).
               MINIMUM MONTHLY MAINTENANCE NEEDS ALLOWANCE: If a spouse is
      eligible for Medi-Cal payment of nursing facility costs, the spouse living at home is allowed
      to keep a monthly income of at least his or her
       individual monthly income or $2319 (for 2004), whichever is greater.

    FAIR HEARINGS AND COURT ORDERS
            Under certain circumstances, an at-home spouse can obtain an order from an
    administrative law judge or court that will allow the at-home spouse to retain additional
    resources or income. The order may allow the couple to retain more than $92,760 + $2,000
    (for 2004) in countable resources. The order also may allow the at-home spouse to retain
    more than $2319 (for 2004) in monthly income.

REAL AND PERSONAL PROPERTY EXEMPTIONS

       Many of your assets may already be exempt. Exempt means that the assets are not counted
when determining eligibility for Medi-Cal.
       REAL PROPERTY EXEMPTIONS

        ONE PRINCIPAL RESIDENCE. One property used as a home is exempt. The home will
remain exempt in determining eligibility if the applicant intends to return home someday.
        The home also continues to be exempt if the applicant's spouse or dependent relative
continues to live in it.
        Money received from the sale of a home can be exempt for up to six months if the money
is going to be used for the purchase of another home.
        REAL PROPERTY USED IN A BUSINESS OR TRADE. Real estate used in a trade or
business is exempt regardless of its equity value and whether it produces income.
        PERSONAL PROPERTY AND OTHER EXEMPT ASSETS

        IRAs, KEOGHs, AND OTHER WORK-RELATED PENSION PLANS. These funds are
exempt if the family member whose name it is in does not want Medi-Cal. If held in the name of a
person who wants Medi-Cal and payments of principal and interest are being received, the balance is
considered unavailable and is not counted. It is not necessary to annuitize, convert to an annuity, or
otherwise change the form of the assets in order for them to be unavailable.
        PERSONAL PROPERTY USED IN A TRADE OR BUSINESS
        ONE MOTOR VEHICLE
        IRREVOCABLE BURIAL TRUSTS OR IRREVOCABLE PREPAID BURIAL
        CONTRACTS.
               THERE MAY BE OTHER ASSETS THAT MAY BE EXEMPT.
               This is only a brief description of the Medi-Cal eligibility rules, for more detailed
      information, you should call your county welfare department. Also, you are advised to
      contact a legal services program for seniors or an attorney that is
      not connected with the sale of this product.
      I have read the above notice and have received a copy.


                                                  206
       Dated:

       Signature:

       Signature:

________________________________________________________________________________



The statement required in this subdivision shall be printed in at least 12-point type, shall be clearly
separate from any other document or writing, and shall be signed by the prospective purchaser and that
person's spouse, and legal representative, if any.
The State Department of Health Services (http://www.dhs.ca.gov/mcs/default.htm) shall update this
form to ensure consistency with state and federal law and make the disclosure available to agents and
brokers through its Internet Web site.
                                   Life Agent's Duties

Pursuant to Section 10193 of the California Insurance Code, with regard to Medicare supplement
insurance and long-term care insurance, all insurers, brokers, agents, and others engaged in the business
of insurance owe a policyholder or a prospective policyholder a duty of honesty, and a duty of good
faith and fair dealing.
Conduct of an insurer, broker, or agent during the offer and sale of a policy previous to the purchase is
relevant to any action alleging a breach of the duty of honesty, and a duty of good faith and fair
dealing.
                                        Elder Abuse

Pursuant to Section 15610.30 of the California Welfare & Institutions Code:
(a) "Financial abuse" of an elder or dependent adult occurs when a person or entity does any
of the following:
      (1) Takes, secretes, appropriates, or retains real or personal property of an elder or
          dependent adult to a wrongful use or with intent to defraud, or both.
      (2) Assists in taking, secreting, appropriating, or retaining real or personal property of
          an elder or dependent adult to a wrongful use or with intent to defraud, or both.

(b) A person or entity shall be deemed to have taken, secreted, appropriated, or retained
property for a wrongful use if, among other things, the person or entity takes, secretes,
appropriates or retains possession of property in bad faith.
     (1) A person or entity shall be deemed to have acted in bad faith if the person or entity
         knew or should have known that the elder or dependent adult had the right to have
         the property transferred or made readily available to the elder or dependent adult or
         to his or her representative.



                                                  207
     (2) For purposes of this section, a person or entity should have known of a right
         specified in paragraph (1) if, on the basis of the information received by the person
         or entity or the person or entity's authorized third party, or both, it is obvious to a
         reasonable person that the elder or dependent adult has a right specified in
         paragraph (1).

                     Life Agent Financial Products Disclosure

Pursuant to Section 789.8 of the California Insurance Code, if a life agent offers to sell to
an elder any life insurance or annuity product, the life agent shall advise an elder or elder's
agent in writing that the sale or liquidation of any stock, bond, IRA, certificate of deposit,
mutual fund, annuity, or other asset to fund the purchase of this product may have tax
consequences, early withdrawal penalties, or other costs or penalties as a result of the sale
or liquidation, and that the elder or elder's agent may wish to consult independent legal or
financial advice before selling or liquidating any assets and prior to t he purchase of any life
or annuity products being solicited, offered for sale, or sold. This section does not apply to
a credit life insurance product.
A life agent who offers for sale or sells a financial product to an elder on the basis of the
product's treatment under the Medi-Cal program may not negligently misrepresent the
treatment of any asset under the rules and regulations of the Medi-Cal program, as it
pertains to the determination of the elder's eligibility for any program of public assistance.
A life agent who offers for sale or sells any financial product on the basis of its treatment
under the Medi-Cal Program shall provide, in writing, the required disclosure.

                          BILL NUMBER: AB 2107 CHAPTERED BILL
                          TEXT
CHAPTER 442
FILED WITH SECRETARY OF STATE SEPTEMBER 14, 2000 APPROVED BY GOVERNOR
SEPTEMBER 13, 2000 PASSED THE ASSEMBLY AUGUST 29, 2000
PASSED THE SENATE AUGUST 28, 2000 AMENDED IN SENATE AUGUST
24, 2000 AMENDED IN SENATE AUGUST 18, 2000 AMENDED IN SENATE
AUGUST 7, 2000 AMENDED IN ASSEMBLY MAY 31, 2000 AMENDED IN
ASSEMBLY MAY 16, 2000 AMENDED IN ASSEMBLY APRIL 24, 2000
AMENDED IN ASSEMBLY APRIL 3, 2000
INTRODUCED BY Assembly Member Scott (Coauthor: Assembly Member Jackson)
                                    FEBRUARY 22, 2000
 An act to add Section 6177 to the Business and Professions Code, and to amend and renumber Section
10193 of, to amend Section 10234.8 of, and to add Section 789.8 to, the Insurance Code, and to amend
Section 15610.30 of the Welfare and Institutions Code, relating to elder abuse.
                            LEGISLATIVE COUNSEL'S DIGEST
AB 2107, Scott. Elder abuse.
 (1) Existing law imposes on all insurers, brokers, agents, and others engaged in the business of
Medicare supplemental insurance and long-term care insurance with a policyholder, a duty of honesty,
good faith, and fair dealing.



                                                208
  This bill would impose the duty of honesty, good faith, and fair dealing on insurers, brokers, agents,
and others engaged in the business of Medicare supplemental insurance and long-term care insurance
with respect to prospective policyholders.
  The bill would only permit life agents, on or after July 1, 2001, to sell or offer for sale to an elder or
his or her agent any financial product on the basis of the product's treatment under MediCal after
providing the elder or his or her agent with a specified disclosure, in writing, explaining the resource
and income requirements of the Medi-Cal program, including, but not limited to, certain exempt
resources, certain protections against spousal impoverishment, and certain circumstances under which
an interest in a home may be transferred without affecting Medi-Cal eligibility.
The bill would exclude from the application of these disclosure provisions credit life insurance, as
defined.
   (2) Existing law prohibits conflicts of interest between an attorney and client.
   This bill would require the State Bar to make a report, by December 31 of each year, to the
Legislature on the provision of financial services by lawyers to elders, as specified. The report would
include the number of complaints filed and investigations initiated, the type of charges made, and the
number and nature of disciplinary actions taken by the State Bar.
   (3) Existing law defines financial abuse for the purpose of reporting and investigating elder and
dependent adult abuse. This bill would revise that definition.
THE PEOPLE OF THE STATE OF CALIFORNIA DO ENACT AS FOLLOWS:
SECTION 1. Section 6177 is added to the Business and Professions Code, to read:

6177. The State Bar by December 31 of each year shall report to the Legislature on the number of
complaints filed against California attorneys alleging a violation of this article. The report shall also
include the type of charges made in each complaint, the number of resulting investigations initiated,
and the number and nature of any disciplinary actions take by the State Bar for violations of this article.
SEC. 2. Section 789.8 is added to the Insurance Code, to read:
789.8. (a) "Elder" for purposes of this section means any person residing in this state, 65 years of age or
older.

   (b) If a life agent offers to sell to an elder any life insurance or annuity product, the life agent shall
advise an elder or elder's agent in writing that the sale or liquidation of any stock, bond, IRA, certificate
of deposit, mutual fund, annuity, or other asset to fund the purchase of this product may have tax
consequences, early withdrawal penalties, or other costs or penalties as a result of the sale or
liquidation, and that the elder or elder's agent may wish to consult independent legal or financial advice
before selling or liquidating any assets and prior to the purchase of any life or annuity products being
solicited, offered for sale, or sold. This section does not apply to a credit life insurance product as
defined in Section 779.2.

   (c) A life agent who offers for sale or sells a financial product to an elder on the basis of the
product's treatment under the Medi-Cal program may not negligently misrepresent the treatment of any
asset under the statutes and rules and regulations of the Medi-Cal program, as it pertains to the
determination of the elder's eligibility for any program of public assistance.
    (d) A life agent who offers for sale or sells any financial product on the basis of its treatment under
the Medi-Cal program shall provide, in writing, the following disclosure to the elder or the elder's
agent:
"NOTICE REGARDING STANDARDS FOR MEDI-CAL ELIGIBILITY”



                                                    209
If you or your spouse are considering purchasing a financial product based on its treatment under the
Medi-Cal program, read this important message!
You or your spouse do not have to use up all of your savings before applying for Medi-Cal.
UNMARRIED RESIDENT
An unmarried resident may be eligible for Medi-Cal benefits if he or she has less than (insert amount of
individual's resource allowance) in countable resources.
The Medi-Cal recipient is allowed to keep from his or her monthly income a personal allowance of
(insert amount of personal needs allowance) plus the amount of any health insurance premiums paid.
The remainder of the monthly income is paid to the nursing facility as a monthly share of cost.
MARRIED RESIDENT
COMMUNITY SPOUSE RESOURCE ALLOWANCE: If one spouse lives in a nursing facility, and
the other spouse does not live in a facility, the Medi-Cal program will pay some or all of the nursing
facility costs as long as the couple together does not have more than (insert amount of community
countable assets).
MINIMUM MONTHLY MAINTENANCE NEEDS ALLOWANCE: If a spouse is eligible for
Medi-Cal payment of nursing facility costs, the spouse living at home is allowed to keep a monthly
income of at least his or her individual monthly income or (insert amount of the minimum monthly
maintenance needs allowance), whichever is greater.
FAIR HEARINGS AND COURT ORDERS
Under certain circumstances, an at-home spouse can obtain an order from an administrative law judge
or court that will allow the at-home spouse to retain additional resources or income. The order may
allow the couple to retain more than (insert amount of community spouse resource allowance plus
individual's resource allowance) in countable resources. The order also may allow the at-home spouse
to retain more than (insert amount of the monthly maintenance need allowance) in monthly income.
REAL AND PERSONAL PROPERTY EXEMPTIONS
Many of your assets may already be exempt. Exempt means that the assets are not counted when
determining eligibility for Medi-Cal.
                                   REAL PROPERTY EXEMPTIONS
ONE PRINCIPAL RESIDENCE. One property used as a home is exempt. The home will remain
exempt in determining eligibility if the applicant intends to return home someday.
The home also continues to be exempt if the applicant's spouse or dependent relative continues to live
in it.
Money received from the sale of a home can be exempt for up to six months if the money is going to be
used for the purchase of another home.
REAL PROPERTY USED IN A BUSINESS OR TRADE. Real estate used in a trade or business is
exempt regardless of its equity value and whether it produces income.
                      PERSONAL PROPERTY AND OTHER EXEMPT ASSETS
IRAs, KEOGHs, AND OTHER WORK-RELATED PENSION PLANS. These funds are exempt if the
family member whose name it is in does not want Medi-Cal. If held in the name of a person who wants
Medi-Cal and payments of principal and interest are being received, the balance is considered
unavailable and is not counted. It is not necessary to annuitize, convert to an annuity, or otherwise
change the form of the assets in order for them to be unavailable.
                    PERSONAL PROPERTY USED IN A TRADE OR BUSINESS.
ONE MOTOR VEHICLE.
IRREVOCABLE BURIAL TRUSTS OR IRREVOCABLE PREPAID BURIAL CONTRACTS.
THERE MAY BE OTHER ASSETS THAT MAY BE EXEMPT.


                                                  210
This is only a brief description of the Medi-Cal eligibility rules, for more detailed information, you
should call your county welfare department. Also, you are advised to contact a legal services program
for seniors or an attorney that is not connected with the sale of this product.
I have read the above notice and have received a copy. Dated: Signature:              "
The statement required in this subdivision shall be printed in at least 12-point type, shall be clearly
separate from any other document or writing, and shall be signed by the prospective purchaser and that
person's spouse, and legal representative, if any.
  (e) The State Department of Health Services shall update this form to ensure consistency with state
and federal law and make the disclosure available to agents and brokers through its Internet website.
  (f) Nothing in this section allows or is intended to allow the unlawful practice of law.
  (g) Subdivisions (b) and (d) shall become operative on July 1, 2001.
SEC. 3. Section 10193 of the Insurance Code is amended and renumbered to read:
10192.55. (a) With regard to Medicare supplement insurance, all insurers, brokers, agents, and others
engaged in the business of insurance owe a policyholder or a prospective policyholder a duty of
honesty, and a duty of good faith and fair dealing.
  (b) Conduct of an insurer, broker, or agent during the offer and sale of a policy previous to the
purchase is relevant to any action alleging a breach of the duty of honesty, and a duty of good faith and
fair dealing.
SEC. 4. Section 10234.8 of the Insurance Code is amended to read:
10234.8. (a) With regard to long-term care insurance, all insurers, brokers, agents, and others engaged
in the business of insurance owe a policyholder or a prospective policyholder a duty of honesty, and a
duty of good faith and fair dealing.
  (b) Conduct of an insurer, broker, or agent during the offer and sale of a policy previous to the
purchase is relevant to any action alleging a breach of the duty of honesty, and a duty of good faith and
fair dealing.
SEC. 5. Section 15610.30 of the Welfare and Institutions Code is amended to read:
15610.30. (a) "Financial abuse" of an elder or dependent adult occurs when a person or entity does any
of the following:
        (1) Takes, secretes, appropriates, or retains real or personal property of an elder or
        dependent adult to a wrongful use or with intent to defraud, or both.
(2) Assists in taking, secreting, appropriating, or retaining real or personal property of an elder or
dependent adult to a wrongful use or with intent to defraud, or both.
  (b) A person or entity shall be deemed to have taken, secreted, appropriated, or retained property for a
wrongful use if, among other things, the person or entity takes, secretes, appropriates or retains
possession of property in bad faith.
      (1) A person or entity shall be deemed to have acted in bad faith if the person or entity knew or
     should have known that the elder or dependent adult had the right to have the property transferred
     or made readily available to the elder or dependent adult or to his or her representative.
     (2) For purposes of this section, a person or entity should have known of a right specified in
     paragraph (1) if, on the basis of the information received by the person or entity or the person or
     entity' s authorized third party, or both, it is obvious to a reasonable person that the elder or
     dependent adult has a right specified in paragraph (1).
    (c) For purposes of this section, "representative" means a person or entity that is either of the
following:
     (1) A conservator, trustee, or other representative of the estate of an elder or dependent adult.



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      (2) An attorney-in-fact of an elder or dependent adult who acts within the authority of the power of
      attorney.


                              (SAMPLE FROM INSURER)
                        TITLE:________________________________________________
To: _________________________________________________
Prospective California Client (please prim)
From: _______________________________________________
Agent (please print)
Pursuant to California Insurance regulation, I am required to advise you of the following:
In the event I recommend that you sell or liquidate any stocks, bonds, IRA, certificate of
deposit, mutual fund annuity, or other assets to fund the purchase of an annuity from an
insurance company, you may be subject to some or all of the following:
  1. Tax consequences;
  2. Early withdrawal penalties;
  3. Or, other costs or penalties.
You may wish to consult an independent legal or financial advisor before selling or liquidating
any assets and prior to purchasing an annuity.
I acknowledge receipt of this disclosure and understand its contents.

Signature of Prospective California Client:                 Date
Signature of Agent                                          Date




                                (SAMPLE FROM INSURER)
        NOTICE REGARDING STANDARDS FOR MEDI-CAL ELIGIBILITY
        If you or your spouse are considering purchasing a financial product based on its treatment
under the Medi-Cal program, read this important message!
       You or your spouse do not have to use up all of your savings before applying for Medi-
       Cal.
                               UNMARRIED RESIDENT
       An unmarried resident may be eligible for Medi-Cal benefits if he or she has less than
$2,000 in countable resources.
       The Medi-Cal recipient is allowed to keep from his or her monthly income a personal
allowance of $35 plus the amount of any health insurance premiums paid. The remainder of the
monthly income is paid to the nursing facility as a monthly share of cost.
                                    MARRIED RESIDENT
         COMMUNITY SPOUSE RESOURCE ALLOWANCE: If one spouse lives in a nursing
facility, and the other spouse does not live in a facility, the Medi-Cal program will pay some or all of
the nursing facility costs as long as the couple together does not have more than $92,760 + $2,000
(for 2004).
        MINIMUM MONTHLY MAINTENANCE NEEDS ALLOWANCE: If a spouse is
eligible for Medi-Cal payment of nursing facility costs, the spouse living at home is allowed to


                                                    212
keep a monthly income of at least his or her individual monthly income or $2319 (for 2004),
whichever is greater.
                       FAIR HEARINGS AND COURT ORDERS
         Under certain circumstances, an at-home spouse can obtain an order from an
administrative law judge or court that will allow the at-home spouse to retain additional
resources or income. The order may allow the couple to retain more than $92,760 + $2,000 (for
2004) in countable resources. The order also may allow the at-home spouse to retain more than
$2319 (for 2004) in monthly income.
                 REAL AND PERSONAL PROPERTY EXEMPTIONS
         Many of your assets may already be exempt. Exempt means that the assets are not
counted when determining eligibility for Medi-Cal.
                           REAL PROPERTY EXEMPTIONS
         ONE PRINCIPAL RESIDENCE. One property used as a home is exempt. The home
will remain exempt in determining eligibility if the applicant intends to return home someday.
The home also continues to be exempt if the applicant's spouse or dependent relative continues
to live in it.

Money received from the sale of a home can be exempt for up to six months if the money is
going to be used for the purchase of another home.
         REAL PROPERTY USED IN A BUSINESS OR TRADE. Real estate used in a trade or
business is exempt regardless of its equity value and whether it produces income.
               PERSONAL PROPERTY AND OTHER EXEMPT ASSETS
         IRAs, KEOGHS, AND OTHER WORK-RELATED PENSION PLANS. These funds are
exempt if the family member whose name it is in does not want Medi -Cal. If held in the name
of a person who wants Medi-Cal and payments of principal and interest are being received, the
balance is considered unavailable and is not counted.
It is not necessary to annuitize, convert to an annuity, or otherwise change the form of the assets
in order for them to be unavailable.
                  PERSONAL PROPERTY USED IN A TRADE OR BUSINESS
ONE MOTOR VEHICLE
IRREVOCABLE BURIAL TRUSTS OR IRREVOCABLE PREPAID BURIAL
CONTRACTS.
       THERE MAY BE OTHER ASSETS THAT MAY BE EXEMPT.
        This is only a brief description of the Medi-Cal eligibility rules, for more detailed
information, you should call your county welfare department. Also, you are advised to contact a
legal services program for seniors or an attorney that is not connected with the sale of this
product.
I have read the above notice and have received a copy.

Dated:_______________________________________

Signature: ___________________________________




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Signature:____________________________________


              ATTACHMENT III – STRUCTURED SETTLEMENT ANNUITIES


A structured settlement is a financial or insurance arrangement, including periodic payments,
that a claimant accepts to resolve a personal injury tort claim or to compromise a statutory
periodic payment obligation. Structured settlements were first utilized in Canada and the United
States during the 1970s as an alternative to lump sum settlements. Structured settlements are now
part of the statutory tort law of several common law countries including Australia, Canada,
England and the United States. Structured settlements may include income tax and spendthrift
requirements as well as benefits and are considered to be an asset backed security. Often the
structured settlement will be created through the purchase of one or more annuities, which
guarantee the future payments. Structured settlement payments are sometimes called “periodic
payments” and when incorporated into a trial judgment is called a “periodic payment judgment."
This is also called a coupon for a regular bond.

   

               STRUCTURED SETTLEMENTS IN THE UNITED STATES
The United States has enacted structured settlement laws and regulations at both the federal and
state levels. Federal structured settlement laws include sections of the (federal) Internal Revenue
Code. State structured settlement laws include structured settlement protection statutes and
periodic payment of judgment statutes. Medicaid and Medicare laws and regulations affect
structured settlements. To preserve a claimant’s Medicare and Medicaid benefits, structured
settlement payments may be incorporated into “Medicare Set Aside Arrangements” “Special
Needs Trusts."
Structured settlements have been endorsed by many of the nation's largest disability rights
organizations, including the American Association of People with Disabilities and the National
Organization on Disability.
In April 2009, financial writer Suze Orman wrote in a column that structured settlements
"provide ongoing income and reduce the risk of blowing a Lump sum through poor financial
choices." In response to a reader's question, she added that financial security can be improved "if
you use the structured payouts wisely."
                                         DEFINITIONS

A definition of “structured settlement” can be found in Internal Revenue Code Section
5891(c)(1) (26 U.S.C. § 5891(c)(1)), which states that a structured settlement is an
"arrangement" that meets the following requirements:
      A structured settlement must be established by:




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           o   A suit or agreement for periodic payment of damages excludable from gross
               income under Internal Revenue Code Section 104(a)(2) (26 U.S.C. § 104(a)(2));
               or
           o   An agreement for the periodic payment of compensation under any workers’
               compensation law excludable under Internal Revenue Code Section 104(a)(1) (26
               U.S.C. § 104(a)(1)); and
      The periodic payments must be of the character described in subparagraphs (A) and (B)
       of Internal Revenue Code Section 130(c)(2) (26 U.S.C. § 130(c)(2))) and must be payable
       by a person who:
           o   Is a party to the suit or agreement or to a workers' compensation claim; or
           o   By a person who has assumed the liability for such periodic payments under a
               qualified assignment in accordance with Internal Revenue Code Section 130 (26
               U.S.C. § 130).
It is important to note that the language immediately prior to Internal Revenue Code Section
5891(c)(1) states that the definition that appears there is "for the purposes of this section".
Internal Revenue Code Section 5891 entitled "Structured Settlement Factoring Transactions"
deals with the excise tax imposed on the "factoring discount" (see IRC 5891(c)(4)), when there is
a purchase of structured settlement payment rights and the exceptions to the excise tax. A
number of structured settlement industry commentators have been observed attempting to
broaden the express language that appears in the Internal Revenue Code.
                                      LEGAL STRUCTURE

The typical structured settlement arises and is structured as follows: An injured party (the
claimant) settles a tort suit with the defendant (or its insurance carrier) pursuant to a settlement
agreement that provides that, in exchange for the claimant's securing the dismissal of the lawsuit,
the defendant (or, more commonly, its insurer) agrees to make a series of periodic payments over
time. The defendant, or the property/casualty insurance company, thus finds itself with a long-
term payment obligation to the claimant. To fund this obligation, the property/casualty insurer
generally takes one of two typical approaches: It either purchases an annuity from a life
insurance company (an arrangement called a "buy and hold" case) or it assigns (or, more
properly, delegates) its periodic payment obligation to a third party ("assigned case") which in
turn purchases a "qualified funding asset" to finance the assigned periodic payment obligation.
Pursuant to IRC 130(d) a "qualified funding asset" may be an annuity or an obligation of the
United States government.
In an unassigned case, the defendant or property/casualty insurer retains the periodic payment
obligation and funds it by purchasing an annuity from a life insurance company, thereby
offsetting its obligation with a matching asset. The payment stream purchased under the annuity
matches exactly, in timing and amounts, the periodic payments agreed to in the settlement
agreement. The defendant or property/casualty company owns the annuity and names the
claimant as the payee under the annuity, thereby directing the annuity issuer to send payments
directly to the claimant. If any of the periodic payments are life-contingent (i.e., the obligation to
make a payment is contingent on someone continuing to be alive), then the claimant (or whoever


                                                 215
is determined to be the measuring life) is named as the annuitant or measuring life under the
annuity.
In an assigned case, the defendant or property/casualty company does not wish to retain the long-
term periodic payment obligation on its books. Accordingly, the defendant or property/casualty
insurer transfers the obligation, through a legal device called a qualified assignment, to a third
party. The third party, called an assignment company, will require the defendant or
property/casualty company to pay it an amount sufficient to enable it to buy an annuity that will
fund its newly accepted periodic payment obligation. If the claimant consents to the transfer of
the periodic payment obligation (either in the settlement agreement or, failing that, in a special
form of qualified assignment known as a qualified assignment and release), the defendant and/or
its property/casualty company has no further liability to make the periodic payments. This
method of substituting the obligor is desirable for defendants or property/casualty companies that
do not want to retain the periodic payment obligation on their books. A qualified assignment is
also advantageous for the claimant as it will not have to rely on the continued credit of the
defendant or property/casualty company as a general creditor. Typically, an assignment company
is an affiliate of the life insurance company from which the annuity is purchased.
An assignment is said to be "qualified" if it satisfies the criteria set forth in Internal Revenue
Code Section 130 [2]. Qualification of the assignment is important to assignment companies
because without it the amount they receive to induce them to accept periodic payment
obligations would be considered income for federal income tax purposes. If an assignment
qualifies under Section 130, however, the amount received is excluded from the income of the
assignment company. This provision of the tax code was enacted to encourage assigned cases;
without it, assignment companies would owe federal income taxes but would typically have no
source from which to make the payments. 93




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