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Market Value Adjustment - Annuities - PowerPoint


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1.   Reverse application of the law of large
     numbers as it is used in life insurance.
2.   Law of averages permits a lifetime
     guaranteed income to each annuitant.
3.   Persons who live longer than average offset
     those who live a shorter-than-average
4.   Every payment to annuitant is part interest,
     part principal, and part survivorship benefit.


Classification of annuities
1.   Individual versus Group
2.   Fixed versus Variable
3.   Immediate versus Deferred
4.   Single Premium versus Installment
5.   Single Life versus Two or More Lives
6.   Pure Life Annuity versus Annuity Certain

           Annuity Certain Contracts

1.   Pure life annuity

2.   Life annuity with period certain

3.   Life annuity with installment refund

4.   Life annuity with cash refund

             Tax Treatment of Annuities

            Investment      Nontaxable
Payment X     in Contract = Return of
          Expected Return    Capital

$6,000   =            $60,000   =     $60,000
               ($500 X 12) X 15       $90,000

$6,000   X            $60,000     =       $4,000
            Specialized Annuities

Single-Premium Deferred Annuity
1. Increased popularity since TRA-86
   eliminated many tax shelters.
2. Currently taxed same as other annuities:
   earnings accumulate on tax-deferred basis.
3. Some insurers sell SPDAs with deposit
   premium as low as $2,500, but more
   common minimum is $10,000.

               Specialized Annuities

Market-Value Adjusted Annuities
1.   Cross between variable and fixed dollar
2.   Interest rate is fixed for a specified period,
     but cash surrender value fluctuates with
     value of underlying securities if policy is
     surrendered before end of period
3.   At set intervals (e.g., 5 or 10 years)
     withdrawals permitted without market
     value adjustment
            Specialized Annuities

Two-Tier Annuity
1. A dual value, dual interest annuity
    • accumulation value, equal to premiums
      paid plus interest
    • surrender value, which is subject to a
      permanent increasing surrender charge,
      designed to discourage lump-sum
2. Accumulation value is available only under
   an annuity pay-out
              Specialized Annuities

Reversionary or Survivorship Annuity
1.   Life insurance on one person (nominator).
2.   Policy proceeds paid as a lifetime annuity
     to the beneficiary (annuitant).
3.   If beneficiary dies before the nominator,
     the policy expires without value.
4.   Usually written with a young person as the
     nominator and an older person (e.g.,
     parent) as the annuitant.
           Equity-Indexed Annuities

First appeared in 1996 and quickly captured a
significant portion of the annuities market.
A fixed annuity that earns interest or provides
benefits linked to performance of an equity
index, such as the S&P 500.
Generally, the crediting rate is a function of
  the relative change in the index,
  the participation rate (i.e., percentage of
    index growth passed on to policyholders),
  any caps imposed on the crediting rate.
Also usually have minimum interest guarantees
and comply with the minimum nonforfeiture law.
               Variable Annuity

1. Designed as means of coping with inflation.
2. Premiums invested in common stocks or
   similar investments.
3. Based on assumption that the value of a
   diversified portfolio of common stocks will
   change in the same direction as price level.
4. Variable annuity may be variable during
   accumulation period and fixed during
   payout period of variable during both
   accumulation and payout period.
           History of Variable Annuity

1.   Originated in 1952 by CREF, which was
     created by the TIAA for college faculty.
2.   First variable annuities for the public were
     issued in 1954 by PALIC of Little Rock,
     Arkansas, (intrastate only) followed by
     VALIC (interstate).
3.   Litigation over regulation by the SEC or
     state insurance departments was settled
     by U.S. Supreme Court: currently
     regulated by both SEC and the states.
  CREF Performance

Year          Value
1952          $1.02
1955           1.95
1960           3.39
1965           5.40
1970           6.17
1975           6.48
1980          11.71
1985          24.42
1990          44.41
1995          80.81
1998         151.74

     Annuities as Investments for Retirement

1.   Return earned over life of an annuity
     depends on several features.
2.   Most important determinants of the rate of
     return are:
       • interest rate
       • surrender charge
       • administrative expenses

              Annuities - Interest

1. “Current” rate of interest is guaranteed for
   a specified number of years, after which it
   may be changed, subject to a specified

2. Guarantee period may range from 1 year to
   up to 10.

3. Usually, the longer the guarantee period,
   the lower the guaranteed rate.

         Annuities - Surrender Charges

1.   Although some insurers still use a front-
     end sales fee (4% or 5% of premium), most
     insurers use a surrender fee for early

2.   Surrender fee usually begins at from 8% to
     10% and declines to zero after from 7 to 15

     Annuities - Administrative Expenses

In addition to the surrender charges, most
insurers charge an administrative fee.

 • annual maintenance fee usually from $25 to

 • for variable annuities, asset management
   feels ranging from 0.25% to 2% of
   accumulated assets are charged.

          Qualified Retirement Plans

Qualified plans are those that conform to the
requirements of federal tax laws and for which
the law provides favorable tax treatment.
 1. Employee contributions are tax
    deductible when they are made.
 2. Employee is not taxed on employer’s
    contribution or investment earnings until
    benefits are distributed.


Employee Retirement Income Security Act of
1974 (ERISA) establishes federal standards for
qualified retirement plans:
 1. Prescribes which employees must be
 2. Establishes minimum vesting standards.
 3. Sets minimum funding standards.
 4. Requires extensive reporting and
    disclosure information about pensions
    and other employee welfare programs.
           Qualification Requirements

1. Designed for exclusive benefit of employees.
2. In writing and communicated to employees.
3. Must meet one of several vesting schedules.
4. Cannot discriminate in favor of officers, stock-
   holders or highly compensated employees.
5. Must provide for definite contributions by
   employer or definite benefits at retirement.
6. Life insurance included only on an incidental
7. Top-heavy plans are subject to special vesting
   and contribution requirements.
              Vesting Requirements

1.   No vesting for 5 years, 100% vested after 5
2.   20% vested after 3 years with 20% per year
     thereafter so employee is 100% vested at
     the end of 7 years.
3.   For top-heavy plans:
      •   100% in three years, or
      •   20% per year after first year

            Types of Qualified Plans

1.   Defined Benefit Pension Plans
2.   Defined Contribution Pension Plans
3.   Qualified Profit-sharing Plans
4.   Employee Stock Ownership Plans
5.   Section 401(k) Plans
6.   Simplified Employee Pensions
7.   Keogh Plans
8.   Section 403(b) Plans
9.   SIMPLE IRAs and SIMPLE 401(k) plans
      Factors Influencing Benefit Levels

Benefit received by employees at retirement is
based on a formula applicable to all
 1. All plans fall into one of two benefit
    formula categories
      • defined contribution
      • defined benefit.
 2. Plans may be contributory (with employee
    contributions) or noncontributory (where
    employer bears the entire cost).
             Employee Contributions

1.   When employees contribute to a profit-
     sharing plan, it is usually called a “thrift”
     or “savings” plan.

2.   Employee contributions are not usually
     deductible, but investment income on
     such contributions is exempt from taxes
     until distributed.

      Amount of Benefits or Contributions

Defined Contribution Plans

1.   Work exactly as the name implies:
     employer’s contribution is set by the
     employment agreement

2.   Contribution is usually a percentage of
     compensation, such as 5% or 10% of
     employee wages

      Amount of Benefits or Contribution

Defined Benefit Plans
1. In defined benefit plan, amount of benefits
   employee will receive is specified in the
   benefit formula
2. In most benefit formulas, retirement benefit
   is a function of employee’s salary, the
   benefit accrual rate, and employee’s years
   of service
3. Most plans are final average salary plans
   but some are career average salary plans.
     Amount of Benefits or Contributions

Benefit depends on salary earned in final years
of employment and number of years worked
 • example: 1% of average monthly salary
   during final three years of employment for
   each year employed
 • an employee with 35 years employment
   would receive 35% of average monthly
   employment in the final three years

      Amount of Benefits or Contributions

Benefit depends on salary earned in all years
of employment and number of years worked
 •   example: 1% of average monthly salary
     during all years of employment for each
     year employed,
 •   an employee with 35 years employment
     would receive 35% of average monthly
     employment over employment career.

     Amount of Benefits and Contributions

Defined Contribution Plans
1. Maximum allowable contribution to a defined
   contribution plan varies with the type of plan
2. For a defined contribution pension plan, the
   limit is 25% of year’s earnings, subject to a
   dollar maximum that is adjusted for inflation
3. Dollar maximum was set at $30,000 in 1986
   and will be adjusted for inflation when dollar
   maximum for defined benefit plans reaches
     Amount of Benefits or Contributions

Defined Benefit Plans
1. Maximum benefit in a defined benefit plan
   is 100% of employee’s earnings in three
   consecutive years of highest earnings.
2. Dollar maximum for defined benefit was set
   at $90,000 in 1988 and is adjusted for
   inflation since that time.

      Minimum Contribution or Benefit -
             Top-Heavy Plans

1. For defined contribution plans, minimum
   contribution is 3% of employee
2. For defined benefit plan, minimum is the
   contribution required to fund a benefit
   equal to 2% of average compensation in 5
   highest years times years of service.
   • Minimum benefit need not exceed 20%
     of such average compensation.

         Contribution for Keogh Plans

1. Keogh plans are subject to essentially the
   same limitations, deductions and benefits
   as applicable to corporate pension and
   profit-sharing plans.
2. A special definition of earned income is
   used to make contributions by self-
   employed persons correspond to those for
   a common-law employee.
3. Percentage limitations apply after the
   contribution to the plan is deducted from
      Keogh Plan Contribution Illustrated

Partnership establishes a defined contribution
plan with 25% of employee compensation.
Partner earns $100,000.
Partner’s contribution is limited to 25% of
income after the contribution:
             Taxable      Nontaxable
              Income      Contribution     Total
Employee     $40,000       $10,000       $50,000
Owner         80,000        20,000       100,000

          Integrated Benefit Formulas

Integration: Adjusting for Social Security
1. Internal Revenue Code provides that the
   employer may consider social security
   benefits in setting contribution rates
2. Employer may contribute a higher percentage
   for wages in excess of the maximum FICA
   wage base than for wages below the base
3. Compensates for the fact that social security
   provides a higher replacement rate for lower-
   paid workers than for highly-paid workers

             Integration Formulas

1. Excess Plan
   Provides greater benefits on compensation
   that exceeds wages subject to FICA tax.

2. Offset Plan
   Provides benefits on employee’s full
   compensation, but reduces benefits by a
   percentage of social security benefit.

      Maximum Contribution 401(k) Plans

1. Permit pretax contributions (called “elective
   deferrals”) by employees.
2. Employees elect to contribute to a profit-
   sharing plan and instruct employer to make
   contributions on their behalf.
3. I.R.C. treats contributions as if they were
   made by employer rather than by employee.
4. Limit on employee deferrals to 401(k) plan or
   SEP is the lesser of 25% of compensation or
   a dollar maximum (set at $7,000 in 1988 and
   indexed for inflation since that time).

     Maximum Contribution - Simple Plans

Eligible employees may choose to have the
employer make payments to the SIMPLE plan or
to receive these payments directly in cash.
 • Employee must be permitted to elect salary
    reduction contributions, expressed as a
    percentage of compensation for the year.
 • Employer must match contributions of
    employees up to 3% or contribute a flat 2% of
    compensation for each employee regardless
    of whether the employee elects to participate.
The maximum annual pretax contribution an
employee may make under a SIMPLE is $6,000,
which will be indexed for inflation after 1997.
       Nature of the Employer’s Promise

Under defined contribution plan, employer
promises to make contributions to an account
that earns investment income.
• Since benefits depend on contributions and
  investment income, the employee bears the
  investment risk in defined contribution plans.
• Because the employee bears the investment
  risk, he or she is likely to have some say in
  how funds are invested.

       Nature of the Employer’s Promise


In a defined benefit plan, the employer
promises to provide a certain level of
retirement benefits to the employee.
  • Employer therefore bears the investment
    risk in a defined benefit plan.

 Advantages to Younger and Older Employees

1. A higher proportion of ultimate retirement
   benefits are earned in early years of
   participation in a defined contribution plan.

2. Present value of benefits promised to
   younger workers under a defined benefit
   plan tends to be small compared with
   present value of benefits promised when
   the worker is closer to retirement.


1.   Forfeitures in defined contribution plans
     may be used to reduce future employer
     contributions or they may be reallocated
     among participants.

2.   In a defined benefit plan, forfeitures may
     be used only to reduce future employer

             Protection for Inflation

1. Defined benefit final average salary plans
   provide greatest protection against inflation
   since retirement benefits are based on
   earnings immediately preceding retirement.
2. Career average plans base benefits on
   employee’s salary throughout career.
3. Some plans provide cost-of-living
   adjustments during retirement years, but this
   is not common.

                  Other Benefits

Pre-Retirement Death Benefit
1.   Optional, except for contributory plans,
     where employee’s contribution is payable as
     death benefit.
2.   Some employers pay death benefit based on
     employer’s contribution.
3.   Federal law requires payment of a qualified
     preretirement survivor annuity to surviving
     spouse of a vested participant.
4.   Some plans provide preretirement death
     benefit through life insurance.
                  Other Benefits

Postretirement Death Benefits

1.   Survivor benefits may be provided by
     annuities with joint and survivor options or
     period certain payments.

2.   Federal law requires spousal consent for a
     participant to elect out of the automatic
     50% joint and survivor option.

                  Other Benefits

Disability Benefits

1.   Some plans treat disability as an early

2.   More favorable approach provides for
     continued contributions on behalf of a
     disabled employee.

          Distribution Requirements

1. Commencement of benefits: April 1 after
   year in which individual reaches age 70 1/2
   or the date of retirement, if later.
2. Distribution must be made over
   • the life of the participant or joint lives of
     participant and spouse (i.e., an annuity).
   • the life expectancy of the participant and
     his or her beneficiary.

           Premature Distributions

10% penalty prior to age 59 1/2 except for
 • deductible medical expenses
 • in form of lifetime annuity
 • at age 55 by worker who meets plan
   requirements for retirement

            Taxation of Distributions

1. Retirement benefits traditionally paid to
   participants in form of a lifetime annuity.
2. Installment distributions taxable only to the
   extent they exceed employee’s investment
   in the contract.
3. Lump-sum distributions may be rolled-over
   into an annuity and taxed under installment
4. Lump-sum distributions that are not rolled-
   over may be subject to five-year averaging.
        Individual Retirement Accounts

1. A person who is not covered by an employer-
   sponsored plan can make tax-deductible
   contribution to an IRA of $2,000 annually.
2. Persons covered by an employer plan may be
   entitled to same deduction, a partial
   deduction, or no deduction, depending on
3. Persons not eligible for deduction may make
   a nondeductible contribution.
4. New rules under TRA-97 allow a full $2,000
   deductible contribution by a spouse who is
   not employed outside the home.
        Individual Retirement Accounts

Adjusted Gross Income Phase Out Levels

 $25,000 to $35,000 for single taxpayers
 $40,000 to $50,000 for married filing jointly
       0 to $10,000 for married filing jointly

TRA-97 gradually increases AGI phase-out
levels to double the present level by 2007.

                 IRA Taxation Formula

                 Nondeductible               Tax-Free
  Amount        Contributions All           Withdrawals
Distributed          Years to IRAs            in Prior Years
 From IRA       Fair Market Value        Amount Distributed
During Year       of all IRAs at     +    From IRA During
                   End of Year               the Year

                The New Roth IRA

Beginning in January of 1998, contributions
permitted to Roth IRA
  contributions only on a non-deductible basis.
  earnings tax-free when the funds are
   withdrawn for retirement (i.e., after age 59½).
  annual contributions of $2,000 (100% of
   compensation) per individual.
  AGI phase-out $95,000 single $150,000 joint.
  no requirement for withdrawals at 70½ and
   contributions may continue after age 70½.
  $2,000 limit for Traditional IRA and a Roth IRA.

                   Education IRA
Introduced by TRA-97 - despite its designation, has
nothing to do with retirement.
  designed for saving for higher education.
  up to $500 annually per student (to age 18).
  phased out for joint filers - $150,000 to $160,000,
    $95,000 and $110,000 for single taxpayers.
  nondeductible, but earnings tax-free.
  distributions under age 30 not taxable if used for
    qualified higher education expenses.
  distributions in excess of qualified education
    expenses taxable with a 10% penalty.
  Education IRA contributions are in addition to
    Roth IRA Plus and traditional IRAs.

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