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									CHAPTER 11


Not necessarily the person who receives the payments.
The annuitant is the person whose life contingency determines the
continued payments.

Is not based on any life contingency.

Payments are made for the duration of a life.

Payments for a lifetime or for a specified period of time,
whichever is shorter.

An unmarried person, aged 65, needs $1,972 per month for
minimum living expenses in addition to this social security income.

He has $220,000 to invest but no other assets. He has no need to
leave assets to anyone after his death.

Where should he invest the $220,000?

        Age 65         7.8%
        Age 75         10.1%
        Age 85         15.5%

The scientific liquidation of principal. Each payment is composed of
both principal and interest. Will provide a lifetime income that will be
larger than interest alone.


                                       MALE AGE
   TYPE                        65      70    75    80
Life                         $6.54   $7.47 $8.89 $10.90
10 yr. certain                6.32    6.98  7.79   8.65
Refund                        6.18    6.49  7.74   8.90

Example: Age 65, life annuity
         $6.54 X 12 months = $78.48
         78/48 / 1,000 = 7.84%

Each annuity payment is composed of:
       1. return of premiums
       2. return of interest earnings
       3. unliquidated principal of annuitants who die early

       Both protect against loss of income.
       Both use pooling.
       Both use mortality tables.
       Premiums are discounted for interest.

       Annuities protect against excessive longevity.
       Different mortality tables are used.

How much money would a person have to have invested in stocks, bonds,
real estate, etc. to provide the same $23,664 per year?

Using the 4% rule:
        .04 X = $23,664
        X = $591,600


Number of lives covered
Most cover one life. A joint life annuity stops payments when the
first of two people dies (seldom used). A joint and last survivor
annuity continues payments when the first dies. May be joint and
2/3 or ½.

Time when benefits start
Immediate annuities start after one payment interval. More than one
payment interval is a deferred annuity.

Method of premium payment
Can be lump sum or periodic payments. Can be flexible deposits.

     Most deferred annuities refund all premiums paid,
     with or without interest, if the annuitant dies during
     the accumulation period.
     Pure (straight life)
     No guarantee. Provides the maximum income.
     Life annuity with period certain
     5, 10, or 20 years can be guaranteed. The longer the
     period, the less the income.
     Installment refund
     At a minimum, payments are continued until the
     entire purchase price has been received.

Cash refund
At a minimum, the beneficiary receives a lump sum that is the difference
between what has been received and what has been paid. This is
more expensive than an installment refund because the insurer has
the money less time.

50% refund
This is an installment refund approach but guarantees only 50%
will be received.

Modified cash refund annuity
Used in contributory pension plans. Guarantees a lump sum
refund to the beneficiary to the extent that pension benefits received
are less than the total value of the employee’s contributions
(with or without interest) have been received.

The “normal form” of benefit in a retirement plan is a “Joint and
½ Annuity.”

Client can select a less expensive form of payment (e.g., life
annuity with no guarantees). This will increase retirement
income significantly. Both spouses must sign.

EXAMPLE: Bob and Sue can take $3,000 per month from the
plan as a J & ½ annuity. If they change to a life annuity, their
monthly income can increase $700 per month.
However, if Bob dies Sue’s income will be zero.

Therefore, buy life insurance on Bob that will provide $700
per month for Sue. If the life insurance costs less than
$700 per month they will be ahead.

Interest guarantees and the bail-out provision
During the accumulation period, a minimum rate of interest is
Many companies also provide a secondary guaranteed rate for a
period of time (usually several years) which is higher than the
minimum rate.

The bail-out provision allows surrender without a surrender charge.
Usually operational only if the interest rate falls below a stipulated rate
(which may be 2 percentage points less than the guaranteed rate). May
not be attractive because rates from other companies probably have
decreased, and because income taxes may be payable on the amount
taken and possibly a 10% premature penalty.

Liquidation Options
Usually a date or age is set for liquidation but this can be changed. If cash is
taken there is considerable adverse selection and a penalty of some type
probably will be involved (e.g., crediting a much lower interest rate retroactively)

Fixed versus variable benefits

ACCUMULATION PHASE                                     TOTAL
MONTHLY    MINUS   NET          VALUE       #          ACCUM.
$1,035     $35        $1,000    $100       10.000        10
$1,035     $35        $1,000    $140        7.143        17.143
$1,035     $35        $1,000    $ 90       11.111        28.254
$1,035     $35        $1,000    $ 50       20.000        48.254

At retirement, they are converted into ________ units and the number
of annuity units that will be paid each month does not change. For
example: Suppose a person has 234,555 accumulation units and the
annuity factor is 256.444. The person would then receive the value
of 914.6441 units each month. As the value changes each month, the
amount of cash sent to the owner would fluctuate.
Assumed Investment Rate
Most variable annuities have an assumed investment rate the
portfolio must earn for the benefit payments to remain level.

If the investment performance exceeds the AIR, the level of
benefits will increase. If the investments underperform the AIR,
the level of benefits will decrease.

In some contracts, the purchaser is able to select the AIR from a
narrow range of possible rates (e.g., 3, 5, or 7%). It is much easier
to receive an increasing stream of benefits by selecting a low AIR.
However, this can be initially more expensive (i.e., the starting
monthly payment will be reduced).

Variable annuities are based on a__________________,
not on the CPI.

Dividends are usually used to buy additional units.

Variable annuities are securities and are subject to the SEC
(as well as the state insurance departments).

  1.   Investment management fees (.25% to about 1%)
  2.   Administrative expense and mortality risk charge
         Typically about .5% to as much as 2%
  3.   Annual maintenance charge
         About $25 to $100
  4.   Charges for each fund exchange
         $0 to $10
  5.   Surrender charges
The Death Benefit
Most variable annuities have a death benefit. Typically, if the annuitant
dies, the beneficiary (such as the spouse or child) will receive the
greater of: (i) all the money in your account, or (ii) some guaranteed
minimum (such as all purchase payments minus prior withdrawals).

Example: You own a variable annuity that offers a death benefit
equal to the greater of account value or total purchase payments
minus withdrawals. You have made purchase payments totaling
 $50,000. In addition, you have withdrawn $5,000 from your
account. Because of these withdrawals and investment losses,
your account value is currently $40,000. If you die, your
designated beneficiary will receive $45,000 (the $50,000
in purchase payments you put in minus $5,000 in withdrawals).

Variable annuities come with a host of optional features that you can
select for an additional annual fee. One common and very popular type
of additional feature is the guaranteed minimum income benefit,
also known as a GMIB. The GMIB is exactly what the name implies –
a guaranteed minimum level of annuity payments by the insurance
company, regardless of the performance of your annuity.
For example: suppose you were to invest $100,000 in an annuity with a
GMIB that guarantees the greater of a) the actual value, b) 5% interest
compounded annually, or c) the highest contract anniversary value of the
annuity. Ten years later, due to poor market performance, the actual value
of the annuity is worth only $70,000. But with the GMIB provision of the
annuity you have the option of being able to “annuitize” $162,889
($100,000 compounded annually for ten years at 5%). This will provide
$8,150 per year for life. Note that this is 5% of $162,889. Since one of the
biggest fears of retirees is outliving their income, many investors find that
the GMIB and the lifetime stream of income brings them tremendous peace
of mind, and is a reason why many investors prefer this type of variable
annuity to standard mutual funds.

Notice that 5% is made up of interest and principal liquidation.

GMIB provisions go by different names.

GMIB provisions are typically exercisable only after the 10th year and
require that you annuitize the entire contract (some contracts allow you
to exercise your GMIB provision sooner, others allow for partial
annuitizations). There are a multitude of payout options from which to

Early withdrawal penalties can be severe.
Fees might be very high.


These are fixed, deferred annuities with basic guarantees and limited
participation in equity markets. They are fixed-interest annuities.
They guarantee a minimum rate of interest but pay a higher rate if a
specified stock index increases enough. They do not require a securities

Formula for Participation
They pay only a portion of the capital gain from the index. The insurer
sets the participation rate, which may be as high as 80 or 90
percent. The rate is usually guaranteed for several years. The company
reserves the right to change the rate at the end of each term. The rate
cannot be changed more than once each year in most contracts. The
rate cannot be negative. Some contracts have a cap on the maximum
rate that can be credited. (Often 10%).

There is a connection between guaranteed interest rates and the
percentage participation. Strong participation is usually linked to
lower guarantees and vice versa.
Guaranteed Interest rates
The minimum guaranteed rate is lower than that in conventional fixed
annuities and the guarantee usually pertains only to a percentage of the
amount paid for the annuity. (Usually 90%) Normally it takes 3-4
years for a person to break even.

If the contact is surrendered before the end of a term, the person receives
only the guaranteed interest rate or the total of all premiums minus any

S&P 500 is the most common.

Indexing method
There are 8-10 different methods. The simplest is “point-to-point.”
It takes an index at some point and calculates the gain at a
specified future point. Another is the “high water mark.”
It calculates the gain from a starting point to the highest level
of the index during the period.

How does the company make the contract participate?
The companies match their investments to the index and/or they
use derivatives.

Is it possible to lose money in an EIA?
Yes. Many insurance companies only guarantee that you'll
receive 87.5 percent of the premiums you paid, plus 1 to 3 percent
interest. If you don't receive any index-linked interest, you could
lose money on your investment, e.g. the index declines. Another
way you may lose is if you surrender your EIA before maturity. Some
insurance companies will not credit you with index-linked interest
when you surrender your annuity early.
The insurance company adds 3% - 5% to each of your early premium
payments. For example, if you invest $10,000 in a bonus annuity the
insurance company will add $300 -- $500. How is the insurance
company paid for the bonus? Sometimes the life insurance company
        1) raise their fees to pay for the bonus and/or
        2) the surrender period is lengthened. For example, eight to
           nine years, or longer versus the typical seven-year
           surrender) and each subsequent bonus payment will have
           its own eight or nine year surrender period.

They pay one interest rate if the contract is in force for less than a
certain period of time and a higher rate if the contract is in force for a
longer period.

Generally, they require annuitization to get the higher interest rate and
there there may be no lump sum option upon death.
Marketing “Do’s and Don’ts”
  1. Refer to the index as a factor in determining interest rates
  2. Describe the equity index product as a long-term retirement
  3. Emphasize that the EIA is designed as an appropriate
     planning vehicle for retirement planning.
  4. Emphasize the guarantees.
  5. Always use the term “equity” with “linked” or “indexed.”
  6. Always market as fixed annuity product.
   1. Never use investment terms such as “stock market,” etc.
      except with extreme care.
   2. Never describe the EIA as a means of participating in the
      stock market.
   3. Never use standard equity market terminology.
   4. Do not refer to securities unless it is in the contract.
   5. Don’t unduly focus on indexed interest features.
Annuitants live longer, hence special mortality tables. Most annuitants
are women. Improved mortality hurts annuity insurers.
They adjust by using mortality tables that have built-in adjustments
for improvements in mortality, by using low interest assumptions, and
by issuing participating contracts.

Accumulation Period
  Amounts taken during the accumulation period (either as loans
  or withdrawals) are considered to be withdrawals of growth (earnings)
  first (fully taxable) and principal second. In addition, there
  may be a 10% penalty tax if before age 59 1/2.
      Accumulated value        $260,000
      Amount paid in             200,000
      Withdrawal                   60,000
      This withdrawal will be fully taxable.
If $85,000 were taken: $60,000 would be fully taxable and the extra
$25,000 would be treated as a tax-free return of capital.
Liquidation Period
   Exclusion Ratio Formula:
        Investment in the contract
           Expected Return
“Expected return” is the payments specified X life expectancy
  60 year old pays $12,000 for an annuity that will pay him $89.64
  per month. His life expectancy is 18 years. How much is
  considered taxable income?

  $89.64 X 12 months = $1,075.68
  $1,075.68 X 18 years = $19,362
  $12,000 / 19,362 = 61.98%
  The exclusion ratio is 61.98%

  $89.64 X .6198 = $55.56 is considered a return of principal
  The remainder, 89.64 – 55.56 or $34.08 per month is taxable
  This amount, $34.08 will be taxed at ordinary income rates.
After the entire investment is returned the total benefit will be
taxed. With a joint and survivor annuity, the surviving owner
excludes from income the same percentage of each payment that
was excludible by the first annuitant.
What is the “expected return” in a variable annuity?

With a variable annuity it is impossible to determine the expected return
because there is no specified payment.

   Different exclusion ratio:

        Investment in the contract
       # of years of expected return

 1. When a person want a retirement income that can never
    be outlived.
 2. When safety of principal is important.
 3. When an individual wants a monthly income equal to or
    higher than other conservative investments and is willing
    to (or especially if he wants to) have principal liquidated.
 4. When the person want to avoid probate and pass a large
    sum of money by contract to an heir to reduce the
    possibility of a will contest.
 5. When a tax-deferred accumulation is desired.
 6. When the investor want to be free of the responsibility of
    investing and managing assets.
 7. As a supplement to an IRA (where contributions are
 8. The client can “time” the receipt of income and shift it to
    lower bracket years.

 1.   The owner is too young.
 2.   The annuitant is not in good health.
 3.   Withdrawals before age 59 ½ may incur the 10% penalty tax
 4.   Liquidation in the early years could be expensive
 5.   Investment earnings are taxed at the owner’s ordinary
      income tax rate (not the long-term captial gains rate that
      would apply to mutual funds)
 6.   If the annuity owner dies, the heirs will be taxed on the
      earnings in the same way the owner would have been
      taxed had he lived. In contrast, mutual funds in a taxable
      account pass to the heirs free of income taxes because
      of the “stepped up” cost basis.
 7.   Fees, especially in variable annuities, may be high
 8.   If the owner is not a natural person (e.g. a corporation or
      trust), income is currently taxed (no inside tax free build
Client enters into a contract to donate cash or other assets to a charity.
In exchange, the charity agrees (in the contract) to provide a lifetime
income to the donor.

The gift is irrevocable; therefore an immediate income tax deduction
is provided to the donor. The deduction is the difference between
the value of the assets and the present value of the annuity income.

Annuity payments may be annual, monthly, or whatever. Only a
portion of the annuity payment is taxable because part is a return
of the taxpayer’s gift.

Annuity rates (not income tax rates) are negotiable but most use
the rates of the American Council on Gift Annuities. Many states
require charities to maintain adequate reserves to meet annuity
obligations. If the donor lives long enough, the charity may not
realize any net benefits from the gift. If the donor dies soon, the
transaction will be very profitable for the charity. The financial
strength of the charity is very important.
Since almost all charities follow the rates suggested by the ACGA,
donors generally find the rates offered by various charities are
identical. This tends to make gifts dependent on the cause of the
charities, rather than the rates they offer.

Charitable gift annuity rates are lower than those offered by insurance
companies. This makes a significant portion of the contribution
available for charitable purposes.

Takes into account the annuitant’s decreased life expectancy.
Some annuities contain a long-term care rider.

Large court judgments or settlements are often paid as a
negotiated income, which can be provided by an annuity. A
liability insurance company normally arranges a structured
settlement by buying an annuity from a life insurance company.

A lump sum payment for a personal injury is generally tax-free,
but earnings on the invested lump-sum are taxable.

With a structured settlement, income is tax free IF the claimant
has no ownership of the annuity and no constructive receipt.
Even the interest on the contract is tax free.

The annuity may be flat rate, step rate or increased as some
compound annual rate. The periodic payment schedule
cannot be changed. Income guarantees (e.g. refund annuity)
can be used.

Structured settlements are useful for:
      Ongoing regular medical treatments
      Adequate income to replace wages that can no longer be
      Ongoing household help
      Occupational therapy and rehabilitation
      Educational needs of children
      Payment of legal fees
      Trusts, endowments and annuities to take care of dependents

Factors to consider in determining the amount and terms
of a structured settlement include:
      The life expectancy of the claimant
      The likely cost of future medical expenses, rehab, therapy, etc.
      Cost of reasonable living expenses
      Cost of dependents needs
      Legal fees
      Lump sums for special contingencies
If an injury has decreased the claimant’s life expectancy, the
structured settlement broker may shop several insurers to get
the highest payment.

  1.   Income can be tailored to the needs of the recipient.

  2.   Income can be set up to last a lifetime.

  3.   Periodic income takes the worry out of the process.


Recipient loses control of the money. (Many people take only a
portion of their money as a structured settlement).

The sale of a structured settlement is free of federal income taxes.
To qualify there must be a court order to sell the agreement. If
there is no court order a tax of 40% is required. (40% of the
difference between the settlement amount and the total of the
undiscounted future payments).

Some people think they can earn a higher return than the return
implicit in the settlement.


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