Introduction to Annuities Products by victor7

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									Annuities Training Course

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                                 Annuities                                                                                                                                 03

                              Training Course

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As a life insurance professional, you are probably very familiar with the financial problems
incurred when an individual “dies too soon.” But what about the financial difficulties which can
arise from “living too long”?

Thanks to modern advances in medicine, technology, and health information services, Americans
as a group are, indeed, living longer. Twenty-five years ago, a person retiring at age 65 could look
forward to a life expectancy of 15 years; today, the life expectancy is almost 20 years. This
necessitates finding additional ways to supplement Social Security benefits, investment income,
pension benefits, and savings.

The Annuities Training Course provides a thorough, yet totally practical overview of the use of
annuities in what has become an exciting and expanding marketplace. It shows the important role
annuities can play in providing a guaranteed, regular income that can never be outlived. And it
shows how annuities can enhance your existing product portfolio and provides the information
you need to immediately begin making annuity sales.

We hope you find the Annuities Training Course both informative and enjoyable. Good luck and
good reading!

This publication is designed to provide accurate and authoritative information in regard to the
subject matter covered. It is sold with the understanding that the publisher is not engaged in
rendering legal, accounting or other professional service. If legal advice or other expert assistance
is required, the services of a competent professional person should be sought.

                                          —From a Declaration of Principles jointly adopted by a
                                                   Committee of the American Bar Association
                                               and a Committee of Publishers and Associations

                                 Annuities Training Course

c o n t e n t s

   Chapter 1 — The Role Of Annuities .......................................... 1

   Chapter 2 — How And Why Annuities Differ ........................... 9

   Chapter 3 — Annuities In The Marketplace ........................... 25

   Chapter 4 — Matching Annuities To Client Needs ............... 41

   Chapter 5 — Choosing The Right Annuity ............................ 49

   Chapter 6 — Taxation Of Annuities ........................................ 63

   Chapter 7 — Selling Qualified Annuities ............................... 81

   Chapter 8 — Equity-Indexed Annuities .................................. 99

   Chapter 9 — Annuity Mathematics: I .................................... 105

   Chapter 10 — Annuity Mathematics: II ................................. 115

   Final Examination .................................................................... 129
Annuities Training Course                                                                                          1

                                                                 The Role Of Annuities

        c o n t e n t s

                       Annuities And Retirement Planning ......................................... 3

                       What Is An Annuity? .................................................................... 3

                       Who Buys Annuities? .................................................................. 4

                       Who Sells Annuities? .................................................................. 5

                       A Look Ahead ............................................................................... 7
The Role Of Annuities                                                                               3

                               In today’s society, everyone who lives long enough must face this
                               basic question:

                                    “How do I provide for my financial security — and that of
                                    any dependents I may have — in retirement?”

                               The question itself is comparatively new in world history. Only 50
                               years ago, the average worker could not expect to live more than a
                               few years past age 65, the normal retirement age. Now, thanks to
                               advances in medical science and greater public consciousness of
                               what constitutes sound health practices, any healthy person may rea-
                               sonably expect to live into his or her late seventies or even eighties.
                               More people, indeed, are living into their nineties. And revolutionary
                               developments in medical science promise to extend the average life
                               span still further.

Annuities And Retirement Planning

                        Over the years, our society has devised a number of ways to deal with this

                        Social Security, backed by the availability of Medicare, provides a floor
                        income for most people.

                        More people work for corporations and other institutions up to age 70 and
                        beyond, and self-employed people often continue to work as long as their
                        health permits.

                        Corporations, non-profit organizations, and public sector institutions provide
                        pensions for their employees.

                        Nevertheless, despite the widespread availability of such ways of solving the
                        financial problems of old age, many people still face an uncertain financial
                        future when their regular stream of income stops. Some have no company
                        pension. For others, a company pension will be inadequate or may not even
                        be there when they need it. Even those holding considerable assets may be
                        worried, given the basic uncertainty of how long they will live.

                        For such people, purchasing an annuity to guarantee a regular income they
                        cannot outlive can be a highly satisfactory answer.

What Is An Annuity?

                        The word annuity comes from the medieval Latin annuitas, meaning “yearly
                        payment.” Virtually any series of periodic payments falls within this broad
                        definition. Today, a more accurate definition of an annuity might be “the
                        systematic liquidation of capital to provide an income.”

                        Can capital be liquidated to provide income to last for a specified period of
                        years, or for a lifetime — whichever is needed? Can companies that wish to
                        sell annuities measure the risks so as to safely (and profitably) take on the
                        task of holding the capital and guaranteeing the income? The answer to both
                        questions is “Yes.” That’s what commercial annuities (defined as contracts
                        which have been developed by insurance companies for sale) are all about.
4                                                                       Annuities Training Course

Who Buys Annuities?

                There are two primary markets for annuities: individuals and businesses.
                Individuals buy annuities, either on a pay-as-you-go basis or with a single
                sum derived from an inheritance, a sale of assets, life insurance, or a pension

                Individuals may buy annu-          Planning Pointer:
                ities as a primary source of
                                                   Annuities are purchased
                retirement income, as a
                supplement to company pen-         to provide a primary source of retire-
                sions and Social Security, or      ment income, to supplement Social
                simply as a long-term invest-      Security and pension benefits, or as a
                ment that is essentially           safe long-term investment.

                Businesses also buy annuities for their employees, usually as part of a
                tax-qualified retirement program for all employees, but sometimes also for
                selected employees upon termination of employment.

                So, if you decide to sell annuities, you have two broad potential markets: all
                the individuals who may purchase annuities for themselves and their families
                and all the businesses which may purchase them for employees. As explained
                in later chapters, these two markets give you the opportunity to sell both
                qualified and nonqualified annuities.

                The Individual Market

                First, let’s look at some of the reasons why annuities are attractive to indi-
                vidual purchasers:

                   • Annuities appeal to older investors who want security of principal and
                     assured accumulation of interest during and after the contribution pe-
                     riod. Fluctuations in the stock market have taught the lesson that, while
                     stocks are still desirable assets, the direct purchase of stocks and bonds
                     involves risks that may be unacceptable to the older investor.

                   • Since federal tax laws have eliminated many other tax shelters, the tax
                     deferral advantages of annuities are more highly prized than ever.

                   • Because money in-
                     vested in annuities is        Planning Pointer:
                     generally deposited for
                     the long term, annuities      Annuities are particularly attractive
                     are an excellent way to       to older investors who are perhaps less
                     maintain a consistent         interested in higher risk investments
                     investment return and         than their younger counterparts.
                     thus combat older
                     people’s fear of inflation.

                   • Insurance companies offering annuities provide sophisticated invest-
                     ment management as well as guaranteed returns.
The Role Of Annuities                                                                                     5

                           • The relative safety of the nation’s life insurance companies appeals to
                             those seeking investment security.

                           • Modern annuities have built-in flexibility enabling their owners to with-
                             draw funds before maturity if their plans change (of course, taxes will
                             be due and a company may impose a surrender charge).

                           • All of these advantages make annuities attractive as investment ve-
                             hicles, in addition to their basic purpose of providing security in retirement.

                           • Annuities can be structured to meet other individual needs ranging from
                             providing college funds to facilitating charitable giving.

                                The Business Market

                                Now let’s look briefly at your other potential annuity market — the
                                nonprofit institutions and other companies which may want to pur-
                                chase annuities for their employees, through tax-qualified annuity
                                plans, or otherwise. (Nonprofit organizations are a special category,
                                because some of them can offer employees significant tax deferrals
                                through the so-called Tax-sheltered Annuity authorized by Internal
                                Revenue Code Sec. 403[b].)

                                For many years, major companies and other large organizations have
                                provided retirement income for their employees through tax-qualified
                                pension and profit-sharing plans. But the American economic land-
                                scape is rapidly changing. While manufacturing still accounts for a
                                quarter of America’s Gross National Product, fewer employees now
                                produce the required volume of goods. More employees have moved
                                to service industries, or to smaller manufacturing concerns. And
                                former employees often set up small companies of their own. Many
                        of these smaller enterprises do not currently have employee plans of any

                        Some small companies, of course, simply cannot afford to provide significant
                        retirement benefits for their people. Others, however, may well find a retire-
                        ment program to be a useful way of attracting and retaining key employees.
                        Such small companies constitute attractive opportunities for you.

                        In companies, large or small, where retirement plans are already in place,
                        you may find that interim and terminal funding with annuities also offer a
                        market for you.

Who Sells Annuities?

                        Whether purchased by indi-          Planning Pointer:
                        viduals or by companies, most
                        annuities are sold by career        Annuities and life insurance work
                        life insurance agents and by        together to protect an insured against
                        brokers who also sell life in-      dying too soon or living too long.
                        surance. These days annuities
                        can be obtained through banks
                        and from other sources, but there are some very good reasons why those who
                        know and sell life insurance should also sell most of the annuities:
6                                                                          Annuities Training Course

                • Life insurance and annuities work together to provide complete
                  financial protection for an individual and his or her family. Both
                  are insurance contracts which protect against the uncertainty of the
                  time of an individual’s death. A life insurance policy guarantees an
                  estate, no matter when death occurs. An annuity guarantees an
                  income, no matter how long life continues. As has often been said:

                            “Life insurance provides protection against dying
                            too soon, annuities against living too long.”

                • By selling annuities, life insurance agents and brokers are able to
                  offer their clients a more complete financial service than they can
                  provide by selling life insurance alone.

          • Agents and brokers who understand life insurance and how it meets
            family financial needs are better equipped than others to fit annuities
            into their special place in individual financial plans. This is particularly
            true when the agent has personal knowledge of a client’s needs through
            prior life insurance sales.

          • Those who purchase their annuities from life insurance agents and bro-
            kers benefit from the special training and access to company experts
            which most life insurance companies offer their representatives. Their
            life insurance and annuity questions get answered by those whose pri-
            mary business is insurance.

    All of the above are reasons why you — the career life underwriter or broker
    — should consider adding annuities to your portfolio. In addition, by selling
    annuities you have an opportunity to increase your income significantly.
    Here are some of the reasons why this is so:

          • Clients who have purchased life insurance from you, and whose needs
            you know well, are a natural, ready-made market for annuity sales.

          • In 2001 payments into annuities, which are known in the industry as
            “considerations,” reached $274 billion. Of this sum, $142 billion was
            deposited into individual annuity contracts, which numbered more than
            42 million by December 31, 2001.1

          • Annuity purchases generally produce a sizable premium, so that the
            average annuity commission of 5% is usually substantial and amply

          • Annuities are usually easier to sell than life insurance, because the
            benefits are somehow easier for the prospect to see.

          • There are no medical or underwriting hurdles to delay delivery of an
            annuity contract.

    Besides all this, you will have the satisfaction of knowing that you are per-
    forming a valuable social service by providing retirement security for your

        Life Insurers Fact Book 2002, American Council of Life Insurance, pp. 103-105
The Role Of Annuities                                                                              7

A Look Ahead

                        Our purpose in this text is twofold: first, to show you how annuities can
                        enhance the financial services you offer your clients; and second, to provide
                        the basic information you will need to begin making annuity sales. These are
                        the topics covered:

                               • the several basic kinds of annuities

                               • the wide variety of annuity products in the marketplace today

                               • prospective annuity purchasers and why they will buy

                               • making the right product choice

                               • how annuities are affected by the tax laws

                               • the “qualified” annuity market

                               • the foundations that make annuities possible — the laws of prob-
                                 ability and large numbers, mortality tables, and interest functions

                        We hope that by the time you complete your study of these topics you will be
                        completely convinced that annuities belong in your sales kit and that you can
                        sell them. Good luck and good selling!
Annuities Training Course                                                                          9

                                         How And Why Annuities Differ

        c o n t e n t s

                       Anatomy Of An Annuity Contract ............................................ 12

                       Annuities Classified By Method Of Premium Payment ....... 13

                       Annuities Classified By Investment Of Funds ...................... 15

                       Annuities Classified By Payment Method ............................. 17
                  How And Why Annuities Differ                                                                        11

   The Basic Principle                   The basic principle underlying all annuities is simple: Capital is invested to
                                         accumulate and be paid out at a later time. Every annuity has an accumula-
                                         tion period, during which interest is earned and capital grows, and a payment
        ow                               period, during which interest is earned but principal and interest are system-
                                         atically paid out until all principal and interest have been liquidated.
Accumulation              Payment
   Period                  Period        The purchaser of a commercial annuity invests capital in the form of premi-
                                         ums which the issuing company invests in order to make annuity or “benefit”
                                         payments later. The annuity “product” purchased is actually a contract re-
                                         flecting the arrangement between the purchaser and the issuing company.

                                         Certain basic contract provi-
                                         sions are necessary and can       Planning Pointer:
                                         be found, in one form or an-      All annuities share some common
                                         other, in all commercial an-      “skeleton” provisions. However, the
                                         nuity products. For example,
                                                                           basic contract can take various forms
                                         all annuity contracts must
                                         have provisions dealing with      in order to meet differing needs of
                                         premiums, investment of pre-      annuity buyers.
                                         miums, and annuity payout.
                                         These and certain other pro-
                                         visions found in most annuities can be thought of as the “anatomy” or “skel-
                                         eton” of every annuity contract.

                                         But depending upon when premiums are paid, how the premiums are in-
                                         vested, and when and how payout occurs, it is possible to develop many
                                         different types of annuity products to meet a wide variety of needs. This is
                                         what companies selling annuities have done in the past and what they con-
                                         tinue to do today. In fact, from a fairly simple group of what we might call
                                         basic annuity types, companies have produced and now offer an amazing
                                         variety of products. Today there are annuities to fit the needs of virtually
                                         every prospect. It is necessary only to match the right product to the right

                                         This is the important task you must perform if you are to sell annuities
                                         efficiently and profitably. To help you find your way through the maze of
                                         annuity products offered today, we will proceed in stages. In this chapter, we
                                         will look first at certain contract provisions that form the basic structure, or
                                         the “anatomy,” of virtually every annuity contract. After that, we will distin-
                                         guish the several basic types of annuities that companies have developed
                                         over the years by varying the methods of paying premiums, investing premi-
                                         ums, and timing of the annuity payments.

                                         In Chapter 3, we will look at the latest developments in annuity products —
                                         those you will be selling. All of today’s products have been created by add-
                                         ing a variety of features to the basic annuities described in this chapter.
                                         These two chapters should prepare you to compare and contrast various
                                         products for the benefit of your clients (and yourselves), as more fully dis-
                                         cussed in Chapter 4.
12                                                                                              Annuities Training Course

Anatomy Of An Annuity Contract

                          The purpose of any written contract is to spell out the agreement between its
                          parties, and that is true of every annuity contract — or product — that you
                          will sell. When you sell any annuity which calls for a payout several years in
                          the future, these are the basic provisions you can expect it to contain:1

                             • Provisions regarding the premiums to be paid and the timing of pre-
                               mium payments. Even when premiums are neither fixed in amount nor
                               required at specific intervals (as in the flexible contracts described
                               later), there will be provisions to explain that premiums of any amount
                               may be paid at any time.

                             • Provisions regarding the accumulation of funds and how premiums will
                               be invested. In fixed-dollar contracts, there will be a minimum interest
       Accumulations           guarantee and tables to show the increasing cash value of the contract.
                               In variable contracts, there will be a description of the ways in which
                               funds will be invested and how the owner can make investment choices.

                             • Provisions describing the rights of the owner of the contract, generally
                               including the right to name an annuitant, a contingent annuitant, and a
       Owner Rights            contingent owner for the contract. The owner usually also has the right
                               to set the maturity, retirement, or payment date for the annuity and to
                               move the date forward or back, within specified parameters.

                             • A death benefit provision specifying that the contract value, or the pre-
       Death Benefits          miums paid, if greater, will be paid to a beneficiary if the owner or the
                               annuitant dies before payments have begun.

                             • Provisions specifying the conditions for surrendering the contract or
 Surrender/Withdrawal          making withdrawals from the contract’s cash value. The conditions, of
                               course, will vary and may include surrender charges.

                             • Provisions to describe how benefit payments will be affected if the
       Contingencies           maturity date of the contract is moved back or pushed forward, or if
                               periodic premium payments are discontinued.

                             • Settlement option provisions describing several different types of pay-
                               ment arrangements which the owner or annuitant may choose for the
     Settlement Options        annuity payout.

                          In addition, due to Internal Revenue Code requirements, annuities issued
                          since January 18, 1985, contain provisions limiting the length of the death
                          benefit payout period when the holder of a contract dies either before or after
                          annuity payments have begun. (This provision will be discussed further in
                          Chapter 6.)

                          These are the provisions which form the “skeleton” of every annuity. But, as
                          we will see, companies have developed several specific types of annuities by
                          fleshing out the skeletal provisions in different ways. We can best classify
                          the several basic annuity types according to the differences in their premium,
                          investment, and payment provisions.

                            Annuities purchased to provide an income currently (immediate annuities) may not contain all of
                          the basic provisions listed, since they are essentially payment contracts rather than accumulation
How And Why Annuities Differ                                                                                       13

Annuities Classified By Method Of Premium Payment

                       All annuities have an accumulation period and a payment period. The two
                       periods are separate, which means an annuity must be fully paid for before
                       benefit payments can begin. But this requirement does not preclude different
                       methods of premium payment.

                       An annuity that may be
                       purchased with a single            Single-Premium Immediate Annuity
                       investment of funds is re-                   One large premium
                       ferred to as a single-                                             Insurance
                       premium annuity. Since
                       the contract is fully paid

                       for with the single pre-
                       mium, benefit payments                 Payments begin immediately Investment
                       can either begin right
                       away, or they can begin at
                       a later time. An annuity
                       calling for payments to begin right away (or at the end of one short time
                       period) is a single-premium immediate annuity.

                       An annuity calling for
                       payments to begin at                                Single-Premium Deferred Annuity
                       some specified later date
                                                                                   One large premium
                       (such as at age 65) is a                                                        Insurance
                       single-premium deferred
                                                                                          $            Company
                                                          Payments Begin

                       A single-premium annuity
                       is designed to meet the
                       investment requirements                   «        Time
                       of those with a lump sum
                       to invest, perhaps made
                       available through an in-
                       heritance, life insurance proceeds, a one-time sale of assets, or a lump-sum
                       pension distribution. Generally speaking, a retirement-age person might pur-
                       chase an immediate annuity, while a younger individual is more likely to
                       purchase a deferred annuity.

                       Not every client will have a large sum available to purchase an annuity with
                       a single premium. For people without large sums of money to invest, but
                       with a desire to accumulate funds for future income needs, companies offer
                       periodic pay-as-you-go arrangements to fit into a budget. An
                       annual-premium deferred annuity, for example, can be purchased with peri-
                       odic annual premium payments. Note that only deferred annuities can be set
                       up on a pay-as-you-go basis. There is no annual-premium immediate annuity
                       (except in the sense that a purchaser might elect to cash in a contract after a
                       single annual premium payment), since an annuity must be fully paid for
                       before benefit payments begin.
                                                                Annuities Training Course

     The original annuities allowing periodic premium payments called for fixed
     premiums to be paid at regular intervals to provide a predetermined amount
     of income. This was the fixed-premium deferred annuity. The
     annual-premium deferred annuity was of this type and is still sometimes

                       Periodic Fixed-Premium Deferred Annuity

           Annuitant       Year #1         x$       Company
                           Year #2         x$
                           Year #3         x$
                           Etc…            x$
                           Etc…            x$

     Flexible premium contracts are a more recent development. The flexible-
     premium deferred annuity is essentially an accumulation contract which
     permits premiums of varying amounts to be paid at irregular intervals to
     provide an indeterminate amount of future income. This modern product can
     meet the budget needs of individuals whose income may vary from year to
     year, as well as those with steady incomes.

                   Periodic Flexible-Premium Deferred Annuity

           Annuitant     Year #1           x$       Company
                         6 months later    y$
                         Another interval z$
                         Skips a year      0$
                         3 months later   xx$

     The flexible-premium deferred annuity, with special provisions added, can
     also qualify as an “Individual Retirement Annuity” and thus serve as a
     pre-tax investment vehicle for those who can benefit from an IRA.

     Looking back now, we see that by varying the method and timing of pre-
     mium payments, companies have developed these basic types of annuities:

          • Single-premium immediate annuities

          • Single-premium deferred annuities

          • Fixed-premium deferred annuities

          • Flexible-premium deferred annuities

     From an agent’s perspective, each type is needed if annuities are to be sold to
     both the young and the old, and to those on a budget as well as to those with
     substantial sums to invest.
How And Why Annuities Differ                                                                        15

Annuities Classified By Investment Of Funds

                      At one time, all annuities were fixed-dollar annuities. A fixed-dollar annuity
                      is one which, for each premium dollar invested, provides the purchaser with
                      a guaranteed minimum fixed-dollar amount of income which never changes,
                      once payout has begun.

                                               Fixed-Dollar Annuity Payout
                                                                                Annuity Recipient
                               Accumulation   Payment #1 = $1,200                       $
                                              Payment #2 = $1,200                       $
                                              Payment #3 = $1,200                       $
                                              Etc…                                      $
                                              Etc…                                      $

                      Because of the guaranteed payments, the company bears the investment risk
                      for this type of annuity and maintains full control over investment of the
                      funds. Premiums paid are invested in the company’s general accounts, and
                      the underlying investments are generally conservative, fixed-income securi-
                      ties, such as bonds.

                      In an economy marked by periods of high inflation, many people came to
                      fear the declining purchasing power of the fixed-dollar annuity. This consid-
                      eration led to development of the variable annuity as a means of preserving
                      the purchasing power of retirement income. By depositing annuity premiums
                      in segregated accounts invested in securities, such as common stocks, which
                      were expected to increase in value with general price levels, and by gearing
                      the payout to the fluctuating value of the underlying investment portfolio,
                      companies were able to offer the variable annuity as an alternative to the
                      conventional fixed-dollar annuity and as a hedge against inflation.

                      The variable annuity works like this: Premiums are used to purchase “accu-
                      mulation units,” at a current value established by a formula in the contract
                      and based on the current value of the investments supporting the annuity.
                      The annuitant has a certain number of these units standing to his or her credit
                      when benefit payments are scheduled to begin. A variable payout is obtained
                      by applying the total cash value of these units to purchase a certain number
                      of “annuity units,” at the current value of such units. Once established, the
                      number of annuity units remains constant, but the value of the units fluctu-
                      ates according to the investment experience of the underlying portfolio. Each
                      month or each year, the annuitant receives an amount of income which is
                      determined by the value of each annuity unit at the time of the payment.
                      Thus, income fluctuates upwards or downwards as the value of the underly-
                      ing assets changes.
16                                                                          Annuities Training Course

                                     Variable Annuity Payout
         Accumulation Units     Value at time of payment #1 = $1,500                       $

         Accumulation Units     Value at time of payment #2 = $1,489                       $

         Accumulation Units     Value at time of payment #3 = $1,164                       $

         Accumulation Units     Value at time of payment #4 = $1,497                       $

         Accumulation Units     Value at time of payment #5 = $1,632                       $

     Since the variable annuity was first sold in the 1950’s,2 it has become appar-
     ent that a correlation of stock prices with living costs is not exact, particu-
     larly over the short term. As a result, a variable annuity based on common
     stocks probably will not offer total income stability. This knowledge, devel-
     oped during years when prices rose sharply, but the S&P index fell, has led
     to substantial changes in the way variable annuity funds are invested. While
     the variable annuity is apparently here to stay, today’s contracts are much
     more sophisticated than the original models.

     Today, those who purchase a variable annuity may choose from an amazing
     array of products and investment options. Modern variable annuities offer
     the owner a variety of funds in which they may choose to have their premi-
     ums invested. The choices usually include at least a money market account
     and a bond fund, as well as a variety of professionally managed mutual

     Because variable annuities involve mutual funds, they are classified as secu-
     rities and must be sold by registered securities dealers using a prospectus.
     This type of annuity accounts for a substantial share of the total annuity
     market. It has special appeal for those who have confidence in their own
     investment abilities and generally choose stocks and mutual funds as invest-
     ments rather than certificates of deposit.

     It is important to note that a variable annuity shifts the earnings risk from the
     issuing company to the purchaser, at least during the accumulation period.
     However, it is also important to note that today’s variable contracts do not
     require settlement as a variable annuity. Other options are available for the
     funds standing to the annuitant’s credit when payment time arrives. Based on
     the current state of the economy and the annuitant’s financial situation at that
     time, he or she may elect to apply the funds to purchase a fixed-dollar
     income from the issuing company or from another company. Alternatively,
     the annuitant might elect a “systematic withdrawal” of the funds, which
     some contracts permit, usually at the rate of up to 10% a year. See the next
     section and Chapter 3 for more about variable annuities and other annuities
     available at payment time.

      The College Retirement Equities Fund (CREF) was organized as a subsidiary of Teachers’ Insur-
     ance and Annuity Association (TIAA) and authorized by the New York State legislature in 1952 to
     write variable annuities for college and university employees. Other insurance companies entered
     the field later, and variable annuities were first mentioned in the annual Fact Book of the American
     Council of Life Insurance in 1966.
How And Why Annuities Differ                                                                      17

Annuities Classified By Payment Method

                      In addition to the annuities we’ve just discussed, the following terms are
                      used to identify and describe various types of annuities.

                               • Annuity certain

                               • Contingent annuity

                               • Whole-life annuity

                               • Temporary-life annuity

                               • Straight-life annuity

                               • Joint-life annuity

                               • Joint-and-last-survivor annuity

                               • Life annuity with period certain

                               • Installment-refund annuity

                               • Cash-refund annuity

                      This list is a classification of annuities based on the way in which payments
                      are made to the annuitant. Those who purchase deferred annuities will en-
                      counter these payout options when their contracts mature. Most deferred
                      annuity contracts offer a series of settlement options which generally will
                      include some or all of these annuities. The owner may choose to have the
                      accumulated funds paid out in the form of any one of the annuities offered.
                      Alternatively, the funds may be withdrawn in cash or left with the company
                      to accumulate interest.

                      The various types of annuities on this list are also offered for single-premium
                      immediate annuities, so that purchasers who are ready to have their income
                      begin immediately may also have a choice of payment methods.

                      Now let’s examine this list of annuities individually.

                      Are Payments Certain Or Contingent?

                      The first two types of annuities listed above are truly generic. These are the
                      two broad categories of annuity settlements or payment methods generally
                      available. Every series of annuity payments, in other words, is either an
                      annuity certain or a contingent annuity.

                      A series of payments that continue for a period of time regardless of whether
                      the annuitant lives or dies is an annuity certain. An annuity certain, then, is
                      not based on a life contingency. Two types of annuity settlements fall within
                      the annuity certain category:
18                                                             Annuities Training Course

        • Payment of a Specified Amount — This is an annuity certain of a prede-
          termined dollar amount which will be payable for whatever period it
          takes for both principal and interest to be exhausted.


                  Annuity value when payout begins = $500,000
                  Amount annuitant wants per month = $5,000

                  $500,000 ÷ 5,000 = payments of $5,000 each
                  for 100 months, or slightly more than 8 years

        • Payments for a Guaranteed Period — This is an annuity certain of
          whatever amount can be provided by paying out principal and interest
          over a predetermined number of years.


                  Annuity value when payout begins = $500,000
                  Period for which annuitant wants payments to extend = 15 years

                  $500,000 ÷ 15 = $33,333 per year or about $2,777 per month

     An annuity certain, as described above, is a temporary annuity which might
     be chosen by an annuitant with a special need for additional income over a
     limited period of time.

     In contrast to the annuity certain, a contingent annuity involves a series of
     payments that continue only as long as the annuitant lives. That is, payments
     are contingent upon the continuation of life. If death occurs, payments cease.
     Contingent annuities are also called life annuities, because they involve a
     life contingency.

     An annuity payable for life, no matter how long the annuitant lives, is a whole-
     life annuity. A temporary-life annuity provides payments for a fixed period,
     but not beyond the annuitant’s death, if that occurs earlier. Since
     temporary-life annuities are no longer generally offered as a payment option,
     we will not consider them further. All of the life annuities generally offered as
     settlement options or purchased as immediate annuities are whole-life annu-
     ities. Such annuities are both contingent annuities and whole-life annuities.

     How Many Kinds Of Whole-Life Annuities?

     The remaining annuities in our list are all whole-life annuities which differ
     from one another primarily according to (1) how many lives are involved and
     (2) whether or not there is any guaranteed minimum number or amount of
How And Why Annuities Differ                                                                        19

                      Three of the listed annuities differ by reason of the number of lives involved:

                          • The straight-life annuity is measured by a single life, and payments
                            cease when that life terminates. This life annuity offers the highest
                            dollar amount of income per dollar invested, because the entire purchase
                            price is used to provide income over a single lifetime.


                                    Sam’s is the measured life. When Sam dies, all payments

                          • The joint-life annuity is measured by more than one life (most often by
                            two lives). Payments continue only so long as both the named annu-
                            itants (or all, if there are more than two) are still alive. Thus, payments
                            stop at the first death. This form of annuity may be suitable when there
                            is sufficient income from other sources to support one family member,
                            but not two or more.


                                    Sam and his wife Jeanne are the measured lives. If either Sam
                                    or Jeanne dies, payments cease.

                          • The joint-and-last-survivor annuity provides for payments to continue
                            until the last of two (or more) named annuitants dies. This type of
                            annuity is chosen much more often than the joint-life annuity.


                                    Sam and his wife Jeanne are the measured lives. If either Sam
                                    or Jeanne dies, the survivor continues to receive payments until
                                    he or she also dies.

                      A common type of joint-and-last-survivor annuity makes payments of a re-
                      duced amount (one-half or two-thirds) to the survivor of two annuitants, on
                      the theory that one individual needs less income than two.
                      Joint-and-last-survivor annuities are widely used to provide income for a
                      surviving spouse. In fact, in the settlement of benefits under qualified pen-
                      sion plans, a joint-and-last-survivor annuity is required unless the spouse
                      waives the right to an income after the employee’s death. For these plans,
                      many companies now offer a special or qualified joint-and-last-survivor op-
                      tion, which provides a reduction in benefits (to one-half or two-thirds) upon
                      the death of the retired employee, but no reduction if the employee’s spouse
                      is first to die.
20                                                          Annuities Training Course

     Refund Features

     The remaining three types of annuities listed differ from the other whole life
     annuities because they have a refund feature. In a straight-life annuity, all
     premiums are applied to provide benefit payments. Thus, when the annuitant
     dies, all the premiums have been “used up,” and no further payments are due.
     This annuity provides the maximum dollar amount of benefit per dollar
     amount of outlay, not only because it is measured by a single life, but also
     because none of the premium money is reserved to pay any kind of refund in
     case of early death.

     But part of the purchase
     price of a life annuity may be
     applied to guarantee a mini-      Planning Pointer:
     mum number or minimum
     amount of payments — a re-        Dollar-for-dollar, an annuity
     fund — in the event of an         providing a refund pays a smaller
     annuitant’s early death. Ob-      amount than a straight-life annuity. For
     viously, an annuity providing     some annuitants, though, the de-
     a refund will pay a smaller       creased annuity amount is offset by the
     amount per dollar invested        guaranteed premium refund.
     than a straight-life annuity,
     but the guarantee offers as-
     surance that not all is lost if
     death occurs prematurely.

        • The life annuity with period certain is probably selected more often as
          an annuity payment option than any other form of settlement except the
          joint-and-last-survivor annuity. It is a combination of life annuity and
          annuity certain which promises a guaranteed number of payments
          whether the annuitant lives or dies, with a continuation of payments for
          life if the annuitant lives beyond the guaranteed period. Contracts usu-
          ally offer payment guarantees of ten, fifteen, or twenty years. Depend-
          ing upon the company, this form of annuity may be called “payments
          for life with guaranteed period,” “life annuity certain and continuous,”
          or “life annuity with guaranteed return.”

        • An installment-refund annuity guarantees that, if the annuitant dies
          before receiving payments equal to the purchase price, payments will be
          continued to a beneficiary until the full purchase price has been paid.
          Of course, the annuitant may live well beyond the time when payments
          equal the purchase price. In that case, payments continue for the
          annuitant’s lifetime.

        • A cash-refund annuity also guarantees a return of the purchase price,
          but the refund is in the form of a cash payment to the annuitant’s estate
          or to a beneficiary of any difference between the purchase price and the
          payments made to the annuitant prior to death. Once again, of course, if
          the annuitant lives beyond the time when the purchase price has been
          recovered, payments continue for life.
How And Why Annuities Differ                                                                      21

                       It might be well to note here that the insuring company can afford to offer a
                       full refund of the purchase price as well as continuation of payments for life
                       to those who live to receive more than their purchase price. This is possible
                       because the interest earnings on the funds while they are held by the com-
                       pany will, in effect, pay the premium for the life annuity that begins when
                       the purchase price has been refunded.

                       To have the peace of mind that a life annuity with a refund feature can
                       provide usually means sacrificing some income. Since a part of the premi-
                       ums paid must be used to provide the refund, less money is available to fund
                       the income payments.

                       One company’s figures, shown in Table I, illustrate the difference (for males
                       and females) at various ages, between the amount of monthly income a
                       $1,000 premium will purchase as a straight-life annuity, as an installment-
                       refund annuity, and as a life annuity with a 10-year period certain. (This
                       chart is for illustrative purposes only. Always use current data provided by
                       the company that issued the annuity.) Notice that at the younger ages the cost
                       of a refund feature is slight, but at the older ages it becomes considerably
                       more expensive (just like an insurance premium, because it is insurance).

                       By comparing the amount of income available under the various annuity
                       options and assessing their individual needs when payment time arrives,
                       annuitants can create the retirement plan best for them — assisted, of course,
                       by your expertise.
22                                                        Annuities Training Course

                                   TABLE I
                *Monthly Income Purchased By A $1,000 Premium

       Age                 Life           Installment           Life Annuity
       Last              Annuity,           Refund                10 Years
     Birthday           No Refund           Annuity                Certain

                       Male Female        Male Female           Male Female
       45              6.13  5.78         6.03  5.73            6.07  5.76
       46              6.21  5.84         6.09  5.79            6.14  5.81
       47              6.29  5.91         6.17  5.85            6.22  5.88
       48              6.39  5.97         6.24  5.91            6.30  5.94
       49              6.49  6.06         6.32  5.97            6.39  6.02
       50               6.58    6.13      6.41    6.05          6.47     6.09
       51               6.70    6.21      6.49    6.12          6.56     6.16
       52               6.80    6.30      6.58    6.20          6.65     6.24
       53               6.92    6.40      6.68    6.27          6.76     6.33
       54               7.05    6.50      6.78    6.37          6.86     6.42
       55               7.17    6.60      6.88    6.45          6.96     6.51
       56               7.30    6.71      6.99    6.55          7.08     6.61
       57               7.45    6.82      7.11    6.64          7.19     6.72
       58               7.60    6.94      7.23    6.76          7.31     6.82
       59               7.76    7.07      7.35    6.86          7.44     6.93
       60               7.92    7.20      7.49    6.97          7.57     7.05
       61               8.11    7.33      7.63    7.10          7.70     7.18
       62               8.29    7.49      7.78    7.23          7.84     7.30
       63               8.49    7.64      7.93    7.36          7.98     7.45
       64               8.70    7.81      8.10    7.51          8.14     7.59
       65               8.94    7.99      8.27    7.67          8.29     7.75
       66               9.18    8.19      8.45    7.84          8.46     7.91
       67               9.42    8.40      8.64    8.01          8.62     8.08
       68               9.69    8.64      8.85    8.20          8.79     8.25
       69               9.98    8.89      9.06    8.40          8.96     8.44
       70              10.29    9.16       9.29   8.61          9.14     8.63
       71              10.62    9.46       9.53   8.84          9.31     8.83
       72              10.96    9.77       9.77   9.08          9.49     9.02
       73              11.33   10.11      10.05   9.33          9.65     9.22
       74              11.73   10.49      10.33   9.61          9.83     9.42
       75              12.14   10.88      10.63    9.90         9.98     9.62
       76              12.58   11.29      10.94   10.20        10.15     9.81
       77              13.01   11.73      11.27   10.53        10.30     9.99
       78              13.47   12.20      11.62   10.87        10.44    10.18
       79              13.96   12.69      11.98   11.24        10.58    10.34
       80              14.45   13.20      12.37   11.63        10.70    10.49
       81              14.94   13.73      12.77   12.02        10.82    10.62
       82              15.43   14.27      13.19   12.44        10.91    10.74
       83              15.94   14.83      13.65   12.89        11.00    10.85
       84              16.48   15.40      14.12   13.33        11.08    10.94
       85              17.04   15.97      14.64   13.78        11.15    11.02

       *For illustrative purposes only.
How And Why Annuities Differ                                                                         23

A Diagram

                      While it is useful to classify and categorize annuities as we have just done,
                      we need to realize that each classification is one-dimensional, describing
                      only one aspect of any annuity contract. This means that, based on its several
                      aspects, each annuity you sell is bound to fall into at least three of the
                      categories we have described. For example, every fixed-dollar annuity will
                      also be either a single-premium, a flexible-premium or a fixed-premium an-
                      nuity. It will be either a deferred annuity or an immediate annuity, as well. In
                      addition, at payout time, the annuitant may select payment under a settlement
                      option corresponding to still another of the basic annuity types described.

                      The diagram below seeks to show how the several classes of annuities identi-
                      fied in this chapter relate to one another and how any given commercial
                      annuity product combines a number of the basic classifications.


                                                                                          Joint And

                         Fixed $                             Immediate

                                         Flexible Or
                        Variable           Annual             Deferred
                                                                                         Life, Period

Annuities Training Course                                                                                          25

                                               Annuities In The Marketplace

        c o n t e n t s

                       Annuities In The Marketplace .................................................. 27

                       The Single-Premium Immediate Annuity (SPIA) ................... 28

                       The Single-Premium Deferred Annuity (SPDA) ..................... 30

                       The Flexible-Premium Deferred Annuity (FPDA) .................. 34

                       Variable Annuities ...................................................................... 36

                       In Summary ................................................................................. 39

                       For a discussion of equity-indexed annuities, see Chapter 8
Annuities In The Marketplace                                                                         27

Annuities In The Marketplace

                        Looking at the brochures or at any list of the annuity products available for
                        sale today, one wonders if a lot of new annuities have been invented. They
                        have, and they haven’t. There are many new names — C.D. annuity...convertible
           Flexible     annuity...multi-fund. But the annuities of today still fall into the basic annu-

         Deferred       ity categories discussed in Chapter 2. There are fixed-dollar annuities and

   CD Multi-Fund        variable annuities (and combinations of the two); single-premium and
     Fixe Convertible
                        flexible-premium annuities; immediate annuities and deferred annuities. The
                        amazing variety of today’s products has been developed within these broad
                        categories by the addition of special features not generally found in earlier
                        annuities of the same basic type.

                        Today’s annuities have been shaped in response to the individual income and
                        budget needs of an unprecedented variety of purchasers — the young, the
                        old, the affluent, the salaried, those with tolerance for investment risk, and
                        those without such tolerance. Annuities have also been influenced by govern-
                        ment tax policy, which, while changing, continues to favor annuities and
                        annuitants with special tax benefits. (See Chapter 6 for the tax treatment of

                        Still another influence on modern-day annuities has been the need to add
                        flexibility in order to compete with other forms of investment, such as bank
                        certificates of deposit. And, of course, competition among insurance compa-
                        nies also leads to innovation.

                        Some companies selling annuities today offer a “family” of contracts to meet
                        a variety of perceived needs. Some sell both fixed-dollar and variable annu-
                        ities. Some sell only fixed-dollar annuities, but offer both immediate and
                        deferred single-premium annuities, as well as flexible-premium deferred an-
                        nuities. Other companies are more specialized. Some sell only variable annu-
                        ities. Some sell deferred annuities, but offer no immediate annuities. There
                        are all kinds of combinations and specialties. And one thing is certain. When
                        you decide to add annuities to your sales portfolio, you will discover that
                        there is an annuity product to meet the needs of virtually every prospect you

                        Some special terms have developed to describe today’s annuities and their
                        features, which you will need to know. Also, certain annuities have emerged
                        as “favorites” over the last several years. In this chapter, we want to take a
                        new and closer look at single-premium immediate annuities, single-premium
                        deferred annuities and flexible-premium deferred annuities. Then we’ll re-
                        view the several kinds of variable annuities which are sold today. The objec-
                        tive, of course, is to help you sort out the current products and ultimately
                        match them to your clients’ needs.
28                                                                       Annuities Training Course

The Single-Premium Immediate Annuity (SPIA)

                We said earlier that single-premium annuities are purchased with a single
                lump-sum investment of funds. The source of the funds might be life insur-
                ance proceeds, an inheritance, a one-time sale of assets, the sale of a busi-
                ness, a distribution from another annuity, or a distribution from a retirement
                plan. The last three sources are likely to be found in the hands of people who
                have reached retirement age, or soon will do so, and are ready to have
                retirement income begin. Such people provide a market for the
                single-premium immediate annuity, or SPIA. Notice that individuals who
                purchased a deferred annuity at an earlier age are included in the list. Since
                they will have the option of
                taking a cash settlement in-
                stead of an income when the         Planning Pointer:
                original contract matures,          SPIAs generally can be
                they can become prospects
                                                    set up with one of a variety of payment
                for an immediate annuity
                from another company, if the        intervals to meet the income needs of
                settlement options offered by       most clients. Remember that a cash
                the original company are not        settlement from a competitor’s annuity
                favorable. (This might be de-       that offers less favorable payout terms
                sirable despite the fact that       can result in a sale for you. Be sure to
                using funds from one con-
                                                    check the tax liability on this type of
                tract to purchase another can
                trigger an income tax liability.    transaction.
                See Chapter 6 for details.)

                Under an SPIA, income generally begins one payment period after the single
                premium has been paid and the annuity is issued. Income may be deferred
                under an SPIA, but if it is, the contract usually cannot be surrendered for its
                cash value, as is possible with deferred annuities (see next section).

                SPIAs may generally be purchased to pay income on a monthly, quarterly,
                semi-annual, or annual basis. This means that the first income payment will
                generally occur one month, three months, six months, or one year after issue.
                Thus, as mentioned earlier, even an immediate annuity has an accumulation
                period, though a very short one. (The single sum used to purchase the annu-
                ity, of course, often represents a long-term accumulation of funds in some
                other investment vehicle.)

                                         Quarterly Income SPIA

                Single Premium
                                         First income
                                         +3 months
                                                             Second income
                                                             +6 months
                                                                               Third income
                                                                               +9 months

                Deposit Date

                Any of the annuities listed under “Annuities Classified by Payment Method”
                in the preceding chapter can be purchased as an SPIA. For example, one
                company advertises immediate annuities to provide: life income; life income
                with a period certain; joint-and-last-survivor income; life income with in-
                stallment or cash refund; or income for a fixed period. All can be made
Annuities In The Marketplace                                                                          29

                       payable on a monthly, quarterly, semi-annual, or annual basis. In addition,
                       this company states that it will help tailor a payment program to meet indi-
                       vidual circumstances.

                       Another company advertises “an almost limitless variety of immediate annu-
                       ities,” including all the following types of immediate joint life annuities:

                           • level income,

                           • level income with an installment refund guarantee,

                           • level income with period certain,

                           • income reducing at the first death,

                           • income reducing at the death of a specified annuitant, and

                           • income reducing after two events — the end of the period certain and
                             the death of the first annuitant.

                       Whether a purchaser’s need for income is long- or short-term...whether there
                       are dependents...whether there are other income sources available...whatever
                       the circumstances, it should be possible to find an SPIA product to meet the

                       The amount of income               Planning Pointer:
                       needed will, of course, affect     Some purchasers feel that
                       the choice of an SPIA prod-
                                                          the security afforded by a joint-and-
                       uct. As noted in Chapter 2,
                       the dollar amount of income        survivor annuity or a life annuity with a
                       produced by each dollar of         refund feature is worth some sacrifice
                       premium will differ depend-        of income. Others agonize over the
                       ing upon the particular type       choice between the highest possible life
                       of annuity income purchased.       income and a lower income with a
                       For an annuity certain, the
                                                          measure of security. Fortunately, as a
                       length of the income period
                       will determine the amount of       life insurance agent, you will be able to
                       income to be paid. For a life      show your clients that such a sacrifice
                       annuity, the determining fac-      of income isn’t necessary. With enough
                       tors will be the number of         life insurance to provide for a surviving
                       measuring lives and the pres-      dependent, a straight-life annuity can
                       ence or absence of a refund
                                                          be purchased for maximum income
                       feature. And among whole
                       life annuities, the straight-      without risk. Unless there is insurance
                       life annuity with no refund        to remove the risk, the straight-life
                       provides the highest income        annuity option is usually a good choice
                       per dollar invested.               only for very healthy individuals or
                                                          those who have no dependents.
                       In selling SPIAs, you will, of
                       course, help your clients to
                       make the right kind of income choice. If you are a career life underwriter
                       with a company that offers the kind of SPIA you need, you will undoubtedly
                       sell your company’s product. If your company does not offer an SPIA of the
                       type called for, it will probably assist you in finding the right product from a
                       brokerage source. If you are a broker, you will probably have access to a
                       number of companies selling a variety of SPIAs.
30                                                                             Annuities Training Course

                           Most of the SPIAs sold by domestic companies are nonparticipating.
                           That is, they offer level payments based on the highest possible interest
                           rate guarantee instead of using excess interest or dividends to supple-
                           ment low guaranteed payments. This means that an accurate compari-
                           son of the income available under several SPIAs can generally be made
         Checklist         on the basis of the rates quoted by the various issuing companies.
     ✓   Investment
         Philosophy         In making these comparisons, you will find that the income available
     ✓   Earnings           for a specified amount of premium can vary a great deal from one
                            company to another, even for the same type of payout option. This is
     ✓   Expenses
                            the case because companies have different investment philosophies,
     ✓   Mortality          different investment earnings, and they incur different expenses. They
         Tables             may also use somewhat different mortality tables. As an example, one
                            recent listing of the SPIA unisex rates of several companies revealed
                      that an individual age 65 investing $1,000 could purchase a straight-life
                      annuity (no refund) paying as much as $9.87 per month from one of the
                      companies on the list, but only $6.19 from another. The amounts available
                      from the other companies on the list fell between these high and low figures.

                      Of course, in choosing among companies, the amount of income available is
                      only one consideration. Because an annuity is a long-term investment, the
                      safety and reputation of the company are extremely important factors when
                      considering where a client should place his or her funds. When all factors are
                      considered, the company offering the very highest rate of return may not be
                      the company you will want to recommend to your client. See Chapter 5 for
                      more information on this important subject.

The Single-Premium Deferred Annuity (SPDA)

                      The single-premium
                      deferred annuity, or
                      SPDA, is perhaps                                              $      $      $

                                                $              $    $    $     $
                      the most widely                    $
                      known and popular
                      of the annuities
                      sold today. Cer-
                      tainly, through ad-     Single         Left to accumulate for future payout
                      vertising, it has the   Premium
                      highest visibility.     Deposit

                      The SPDA is essentially an accumulation product, which means that it offers
                      a means of accumulating a fund for retirement without the need to make a
                      specific retirement income decision. The precise method of payout is left to
                      be determined at retirement, or whenever the contract is terminated. As a
                      result, purchasing an SPDA involves making an investment decision as much
                      as, or even more than, making a retirement decision.
Annuities In The Marketplace                                                                       31

                        Like the immediate annuity,
                        an SPDA is purchased for a           Planning Pointer:
                        single sum. That sum is then         The single-premium deferred
                        left to accumulate until a           annuity will be most appealing to
                        later “maturity date.” The           planners with: (1) a substantial amount
                        maturity date is usually cho-        of capital to invest, and (2) several
                        sen to coincide with the end
                                                             years until retirement. The longer the
                        of the purchaser’s income-
                        earning years, i.e., antici-         accumulation period, the greater the
                        pated retirement. However,           benefit of compound interest and tax
                        the contract generally per-          deferral.
                        mits extending the deferral
                        period to a later maturity
                        date or shortening it to an earlier one. Throughout the deferral period, the
                        cash value of the annuity builds on a tax-deferred basis. (The power of
                        tax-deferral as a sales incentive is discussed in Chapter 6.)

                        SPDAs usually provide for payment of the accumulated fund to a beneficiary
                        named by the owner of the contract or to the owner’s estate if death occurs
                        during the deferral period. Also, for estate planning and gift purposes, most
                        SPDAs give the owner the right to name the annuitant, as well as a contin-
                        gent owner and a contingent annuitant, if desired.

                        An SPDA is suitable for those who are in a position to invest a substantial
                        amount of cash but are not ready for retirement, i.e., younger investors, but
                        not so young that they are likely to need the money to meet current family
                        expenses. The source of their funds might be life insurance proceeds from a
                        parent, an inheritance, or a maturing C.D., to which an annuity can be an
                        attractive alternative.

                        SPDAs are generally best viewed as long-term investments. The greatest
                        benefit is gained if the funds are left on deposit so that compound interest
                        and tax deferral can have maximum effect. Also, with a few exceptions, the
                        federal government imposes a penalty tax on income withdrawn before age
                        59½ (see Chapter 6).
                        These annuities, in general, are sold                  Withdrawal
                                                                          $                 $
                        without a “front-end load,” in order
                        that all of the funds invested can accu-        $    $      $      Surrender
                        mulate at interest. As a result, early                              Charge
                        withdrawal of the funds on deposit           $    $     $      $
                        may involve a “surrender charge” to
                        enable the issuing company to recover expenses. The surrender charge is
                        generally imposed at a declining rate over a specified number of years and is
                        then eliminated (because by that time, if the funds have been left on deposit,
                        the company will have recovered its initial costs). Surrender charges vary
                        among companies. One company, for example, charges 10% for surrender
                        during the first year after purchase, reducing by 1% a year, until year 11,
                        when the charge disappears; another charges 7% during the first year, reduc-
                        ing by 1% a year until the charge disappears in year 8. Most companies
                        waive the surrender charge in case of payment at the annuitant’s death, or if
                        a withdrawal is annuitized.
32                                                           Annuities Training Course

     Most SPDAs contain a limited “free” withdrawal privilege which enables the
     owner of the contract to use funds invested in the annuity on a limited basis.
     The most common provision allows withdrawal of up to 10% of the accumu-
     lated funds on deposit once each year. Some companies allow the withdrawal
     of accumulated interest without charge at any time. The most obvious trend
     has been toward greater flexibility with regard to withdrawals. It is not un-
     common to find contracts with a “window” of time, typically 30 days, around
     each contract anniversary when a full withdrawal may be made without a
     surrender charge. Such contracts have been termed “C.D. annuities” because of
     their flexibility.

     Funds invested in an SPDA earn interest at a current rate which generally
     reflects the marketplace. Companies set their interest rates on the basis of
     their individual investment philosophies, their investment experience, and
     their own estimates of the level necessary to be competitive with annuities
     offered by other companies and other forms of investment. Responsible com-
     panies are always aware that the rate paid must not be so high as to under-
     mine the company’s financial security or its ability to meet its long-term
     annuity obligations.

     The initial rate on an SPDA will generally be payable for at least the first
     year, but many companies offer a guaranteed interest rate for the first two to
     five years, or even up to 10 years, and the purchaser may choose the guaran-
     teed period. Most contracts also provide a minimum interest guarantee over
     the life of the contract, which is inevitably low in comparison to current
     interest rates but does assure the investor a guaranteed minimum return. In
     addition, many contracts have a “bailout provision” which allows the owner
     to surrender the contract without penalty if the renewal interest rate for a
     particular year drops more than a specified percentage below initial or cur-
     rent rates. Contracts which allow full withdrawal on an annual basis, as
     discussed above, generally do not have a separate bailout provision, because
     it isn’t needed.

     An additional feature of
                                       Planning Pointer:
     some contracts is a provision
     that the owner may cancel         Most SPDAs contain provisions
     the contract and regain the       that allow the annuitant to withdraw
     premium paid if the cash          funds from the account (within limits).
     surrender value of the con-       The trend is toward contracts which
     tract should prove to be less     provide greater flexibility regarding the
     than the premium paid.
                                       withdrawal provisions.
     Many features of today’s
     SPDAs have been added to
     make it possible for people to fund for the future and at the same time know
     that if they need their funds for an emergency, or for other reasons, they are
     not beyond reach. It seems likely that this trend toward flexibility will con-
     tinue and that flexible features will make annuities attractive to more and
     more prospects.
Annuities In The Marketplace                                                                       33

                       Deferred annuities, including the SPDA, have settlement options which en-
                       able the owner to place the funds accumulated at retirement time under any
                       one of a number of annuity options. In addition, the funds may be left with
                       the company at interest, or they may be withdrawn in cash and used to
                       purchase a single-premium immediate annuity from some other company.

                       The SPDA, like other deferred annuities, usually provides for settlement
                       under the various options at the rates the company is offering at the time
                       settlement is made. However, there may be a guarantee that the incomes
                       available to the annuitant will be higher than the corresponding incomes
                       available under an immediate annuity. For example, the single-premium de-
                       ferred annuity contract might state that the monthly income available would
                       be 103% of the corresponding monthly annuity available under the
                       company’s published rates for a single-premium immediate annuity. In gen-
                       eral, this advantage reflects the fact that the company does not incur com-
                       mission expense on the settlement option.

                       Mutual companies generally offer a choice of either participating or nonpar-
                       ticipating settlement options. The guaranteed rate of return under the partici-
                       pating option will generally
                       be quite low, but it will be
                       substantially increased by         Planning Pointer:
                       dividends representing the         Be aware of the versatility a
                       company’s excess earnings.
                                                          SPDA can offer in terms of rate guar-
                       For example, the guaranteed
                       rate of return might be 3%,        antees, bailout provisions, cancelation
                       but dividends could bring the      privileges and settlement options.
                       actual rate of return to

                       If you sell annuities, the SPDA may well be your best seller. With so many
                       companies selling SPDAs, and with such a variety of features available, you
                       will inevitably be called upon to make comparisons. Whether you make your
                       comparisons to overcome objections or to find the right SPDA product, the
                       factors to be evaluated will certainly include these:

                           • Initial interest rate

                           • Length of initial interest rate guarantee

                           • The company’s history of renewal rates (this can be one of the most
                             important indicators of future renewal rates)

   Potential Rate          • Minimum interest guarantee
   With Dividends
                           • Amount and period of surrender charges

    Guaranteed             • “Free” withdrawal privileges
   Rate of Return          • Bailout provisions, if any
34                                                                        Annuities Training Course

                But probably more important than any of these — the reputation and strength
                of the issuing companies should be a major consideration when comparing
                SPDAs. While high interest rates are of great importance to anyone investing
                funds, the reputation and strength of the issuing company is probably of
                greater importance when the investment is an annuity. Career agents will
                know the reputation of their own companies, and both agents and brokers can
                work with annuity marketing firms to learn about a variety of companies. For
                more on evaluating companies and their products, see Chapter 5.

The Flexible-Premium Deferred Annuity (FPDA)

                The annual-premium deferred annuity was developed to put annuities within
                the reach of individuals who wished to purchase annuities for retirement but
                did not have large sums to invest. This annuity requires a specific amount to
                be paid as a premium each year in order to provide a specified amount of
                income at the chosen maturity date.

                More recently, the flexible-
                premium deferred annuity, or        Planning Pointer:
                FPDA, has put annuities             The flexible-premium deferred
                within the reach of people          annuity (also known as the
                whose income may vary
                from year to year. This annu-       annual-premium retirement annuity) is
                ity is also known as an             for the investor whose income may
                annual-premium retirement           vary from one year to the next.

                In contrast to the annual-premium annuity which calls for a specific amount
                of premium to be paid annually, the FPDA permits deposits of any amount to
                be made at any time during the accumulation, or deferral, period. Like the
                single-premium deferred annuity, the flexible-premium deferred annuity is
                essentially an accumulation product, and the ultimate retirement benefit will
                depend upon the amount of
                funds which have accumulated
                at the preselected maturity date.
                                                     Premium Deposits

                Obviously, if a definite amount of
                income is desired at the maturity
                date, the purchaser will have to
                budget toward that amount. Larger
                premiums in some years will have
                to offset smaller premiums or no
                premiums in other years to
                achieve the desired income.           Accumulation Period

                Except for the method of premium payment, most of the characteristics al-
                ready described as applicable to SPDAs also apply to FPDAs. Premiums earn
                interest at a current rate, and the initial interest rate may be guaranteed for a
                period generally ranging from three months to five years. Most contracts
                guarantee a specified minimum interest rate for the life of the contract and
                there may or may not be a bailout provision.
Annuities In The Marketplace                                                                      35

                       Like single-premium deferred annuities, flexible-premium retirement annu-
                       ities usually provide for payment of the accumulated fund to a beneficiary or
                       to the owner’s estate if death occurs before liquidation begins. The owner of
                       an FPDA, like the owner of an SPDA, has the right to name a beneficiary, an
                       annuitant, and a contingent owner and annuitant for the contract, if desired.
                       In addition, withdrawal provisions are generally the same as those already
                       described for SPDAs, with similar surrender charges during the first few

                       The FPDA was actually developed in response to the growth of tax-favored
                       private retirement plans following World War II. By permitting variable pre-
                       miums (or no premiums at all in some years), the FPDA made it possible for
                       companies and self-employed individuals to use a single contract for each
                       covered employee, instead of being forced to use a series of single-premium
                       deferred annuities in different amounts.

                       The IRA Market

                       When the Individual Retirement Account and the Individual Retirement An-
                       nuity (IRAs) were introduced into the Internal Revenue Code, allowing em-
                       ployed individuals to obtain an income tax deduction for limited amounts
                       placed in such an account or annuity, the FPDA received additional impetus.
                       Today, it is a requirement of the Individual Retirement Annuity that it should
                       have flexible premiums. There are certain additional requirements, such as
                       nontransferability, which this tax-qualified annuity must meet, but with the
                       addition of relatively few provisions, a company’s FPDA can become a tax-
                       qualified Individual Retirement Annuity. Most companies offer a “qualified”
                       version of their FPDAs for the IRA market.

                       In addition to the IRA market, the FPDA is also ideally suited for other tax-
                       qualified retirement plans covering both employees and the self-employed.
                       Sales to individuals thus form only one part of the total market for this
                       versatile annuity. Sales to nonprofit organizations and other companies for
                       the purpose of providing retirement benefits for their employees form the
                       other part. See Chapter 7 for more about the important retirement plan mar-
                       ket for FPDAs.

                       The Economic Growth and Tax Relief Reconciliation Act of 2001 paved the
                       way for additional opportunities in these markets by providing for the
                       gradual increase of contribution limits for IRAs and certain other retirement
36                                                                           Annuities Training Course

Variable Annuities

                     In Chapter 2 we explained how variable annuities and fixed-dollar annuities
                     differ. Just to refresh your memory — premiums paid for fixed-dollar annu-
                     ities are invested with the insurance company’s general funds, chiefly in
                     fixed-income types of securities, with the ultimate purpose of providing a
                     level annuity income

                     Premiums paid for variable annuities, on the other hand, go into separate, or
                     segregated, accounts where the company is permitted more investment free-
                     dom than with its general funds. Separate accounts are generally invested in
                     common stocks and other securities expected to increase in value as prices
                     increase. The ultimate purpose is to provide an annuity income that will
                     maintain its purchasing power in inflationary times.

                     Like fixed-dollar annuities,
                     variable annuities are avail-      Planning Pointer:
                     able for purchase with either      Variable annuities are most
                     a single premium or with           appealing to individuals who prefer the
                     flexible premiums. This            potential for greater income in return
                     means that variable annu-          for a greater degree of risk. Typically,
                     ities, too, can be sold to
                     people on a budget as well as      these people like to be involved in the
                     to those with substantial          management of their investments and
                     sums to invest.                    often prefer stocks or bonds over
                                                        savings accounts or C.D.s as invest-
                     In very general terms, a vari-     ment vehicles.
                     able annuity will appeal to
                     those who would choose
                     stocks, bonds, or mutual funds as an investment rather than savings accounts
                     or C.D.s, and who prefer to have a voice in the management of their portfo-
                     lios. However, even though an investor wants the growth opportunity of com-
                     mon stocks and directed investments during an annuity’s accumulation
                     period, he or she may not want to have an annuity income that fluctuates
                     with variations in the value of the underlying securities during the payment
                     period. Even during the accumulation period there may be times when these
                     same purchasers would prefer more stability for all or part of their funds.

                     For these reasons, the trend in variable annuities since the time they were
                     first introduced has been toward greater flexibility both in investment options
                     and in payment options. The owner of a variable annuity does not have to
                     settle it as a variable annuity. Of course, the option of a variable income
                     fluctuating with the value of the underlying investments (according to the
                     mechanism described in Chapter 2) is always available. But most variable
                     annuity contracts also offer a fixed-dollar annuity guaranteed to continue at
                     the level established by the value of the fund at the beginning of the payment
                     period. Indeed, many variable products offer a combination of fixed and
                     variable incomes under the same contract.

                     Some variable annuities include as one of the investment options the oppor-
                     tunity to invest in the issuing company’s general accounts to obtain a fixed
                     rate of return. The point is this: the purchaser of a variable annuity has
                     options and is never totally locked in to the variable principle, either at
                     payment time or during the accumulation period.
Annuities In The Marketplace                                                                        37

                        Most of today’s variable an-
                        nuities offer a diverse “fam-    Planning Pointer:
                        ily of funds,” and the           Today’s variable annuities often
                        purchaser may choose among       permit a wide range of options allowing
                        them and move money from         the purchaser to choose a mix of fixed
                        fund to fund with varying de-
                                                         and variable investments, and to
                        grees of flexibility. It is com-
                        mon to find a bond fund,         modify those choices during the accu-
                        several common stock funds,      mulation period.
                        a fully managed diversified
                        fund, and a money market ac-
                        count among the investment offerings, in addition to a fixed-income fund.

                        Fund Variety

                        Here is an example and brief description of the funds included in one vari-
                        able annuity product:

    Money Markets          • Money Market Fund — Invests in short-term financial instruments for
                             current income and preservation of capital.

                           • Bond Fund — Invests in U.S. government obligations, high-quality cor-
        Bonds                porate bonds, commercial paper, and cash for high current income and
                             the potential for better price performance in the market.

    Growth Funds
                           • Growth Fund — Invests primarily in common stocks of companies
                             which are currently undervalued but have high long-term potential.

                           • Opportunities Fund — Invests in common stocks of companies offering
  Opportunities Funds        new services or technologies.

                           • Managed Fund — Invests in a variety of common stocks, bonds, and
    Managed Funds            money market instruments for long-term total return.

                           • Master Asset Allocation Fund — Invests in up to seven different invest-
     Master Asset            ment categories professionally managed and flexibly allocated to create
      Allocation             a complete long-term investment program.

                           • Social Awareness Fund — Invests in common stocks of companies for
   Social Awareness          long-term total return while adhering to certain social criteria.

                           • Fixed Account — Invests in the issuer’s general account with the objec-
     Fixed Account           tive of guaranteeing a minimum rate of return on principal and crediting
                             a competitive current interest rate.

                        Depending upon the degree of flexibility allowed by the issuing company,
                        the purchaser of such an annuity may have virtually unlimited freedom to
                        switch funds back and forth between the fixed account and the several vari-
                        able accounts during the accumulation period. Changing investment strate-
                        gies to meet changing economic conditions can thus be readily
                        accommodated. In effect, the owner of this type annuity has a combination
                        fixed/variable annuity contract — perhaps the best of all possible worlds.
38                                                            Annuities Training Course

     Insurance companies generally acquire an investment management firm or
     use well-established mutual fund companies to manage the equity accounts
     in their variable products. Variable annuity purchasers, therefore, generally
     have access to the same type of equity investment expertise as do mutual
     fund purchasers. They are relieved of the need to make day-to-day invest-
     ment decisions but nevertheless retain a degree of control through allocating
     their premiums among the various available funds.


     Like direct mutual fund purchasers, variable annuity purchasers are charged
     an annual management fee, ranging between 1% and 2% of the amount in-
     vested. Generally, there is a separate fee for each separate account, so that an
     average annual fee for the entire annuity would depend upon which funds the
     owner chooses. There is usually no management fee for the fixed account
     included in combination fixed/variable annuities.

     Sometimes there may also be
     a flat annual charge for ad-      Planning Pointer:
     ministration of the contract,     Variable annuities are generally
     or for mortality and expense
                                       subject to annual management fees
     risks, but the trend is toward
     handling company expenses         from 1% to 2% of the investment in
     in the way already described      each separate account. In some
     for fixed-dollar SPDAs. To        cases, an annual administration fee
     increase the amount of funds      may also be charged.
     which can go to work for the
     investor, surrender charges
     for early withdrawal are replacing “front-end loads.” Annual partial with-
     drawals not exceeding a stated percentage (10–15%) of the contract value are
     usually permitted without charge, and the surrender charge is generally
     waived if the contract is terminated by death, or if the surrender value is

     Like other annuities, a variable annuity has a “death benefit.” In the event of
     death, this guarantees that a beneficiary of the owner’s choice will receive a
     refund of the entire investment in the contract (total premiums paid), if that
     is a larger amount than the total on
     deposit at date of death, i.e., if the
     total value of the portfolio has Variable Annuity “Death Benefit”
     dropped below cost. This guaran-         Total Premiums
     teed return of principal upon death
     represents a unique and very impor-
     tant advantage which a variable an-         Value of
                                                                  Guaranteed Return
     nuity invested in equities has over                          of All Principal to
     direct investment in stocks and mu-         at Death
     tual funds. It’s a powerful incentive
     for equity investors to become an-
     nuity investors.
Annuities In The Marketplace                                                                                       39

                       Here are two additional benefits of variable annuities:

                           • Unlike an insurance company’s general accounts where fixed-dollar an-
                             nuity premiums are invested, the segregated accounts in which variable
                             annuity premiums are placed are generally protected from creditors of
                             both the issuing company and any mutual fund company used to man-
                             age the assets.

                           • Because variable annuities are legally securities,1 any insurance com-
                             pany offering them for sale is subject to supervision by both the Securi-
                             ties and Exchange Commission (SEC) and the various state insurance
                             departments. The company is subject to regulation by the National As-
                             sociation of Security Dealers (NASD) as well. This extra supervision
                             means added protection for investors.

                       Equity Investments

                    The death benefit and the safeguards just mentioned, of course, do not alter
                    the fact that a variable annuity invested in common stocks is an equity in-
                               vestment, and equity investments involve investment risk, espe-
                               cially over the short term. Even more than in the case of
                               fixed-dollar annuities, variable annuities need to be viewed as
                               long-term investments. Over the long term, equity investments
       Variable                generally can be counted on to show a respectable increase in
       Annuities               value. Over the short term, these investments can be quite specu-
                               lative. Every prospect for a variable annuity needs to understand
       • Prospectus
                               the true nature of such an investment before the sale is made.
       • Licensed                 Variable annuities are required to be sold by means of a prospec-
         securities               tus (which describes all the details of the investment), and only
         broker/dealer            through registered securities broker/dealers. Insurance companies
         only                     that sell variable annuities generally have their own broker/dealer
                                  affiliate. Companies that do not have a variable product will gen-
                                  erally have a broker/dealer connection. Life insurance agents and
                       brokers who wish to sell variable annuities must become licensed to sell
                       securities and may sell only the products offered by a single broker/dealer.

In Summary

                       The annuities we have described in this chapter cover the general range of
                       products available to you if you decide to sell annuities. Although the sheer
                       number of products on the market can seem confusing, they all fall within
                       the categories discussed. As we have tried to show, all the annuities within
                       each category have the same basic characteristics, although they may have
                       quite different special features. In time you will be able to sort them out and
                       make sound decisions, both as to which types of annuities fit the needs of
                       your clients and which companies offer the best products in each category.

                         The U.S. Supreme Court has held that an individual variable annuity is a security within the
                       meaning of the Securities Act of 1933, and that any organization offering such a contract is an
                       investment company subject to the Investment Company Act of 1940.
Annuities Training Course                                                                                          41

                                Matching Annuities To Client Needs

        c o n t e n t s

                       Who Can Benefit From Annuities? ......................................... 43

                       What Benefits Are Offered By Annuities? ............................. 45

                       Even More Advantages ............................................................. 46

                       In Summary ................................................................................. 48
Matching Annuities To Client Needs                                                                   43

                       When you begin to think seriously about adding annuities to your sales
                       portfolio, you are bound to ask, “Who will buy annuities?” and “Why will
                       they buy?” These are logical questions. We’ve touched on a few answers in
                       the preceding chapters. Here, let’s be systematic and catalog all your likely
                       prospects and all the reasons they are likely to buy.

Who Can Benefit From Annuities?

                       Just about anyone with earnings or assets to invest, and a need either to plan
                       for the future or for an immediate guaranteed income, is an annuity prospect.
                       Add in people looking for growth and safety when investing, and those who
                       want to save taxes, and you have some idea of the broad scope of the poten-
                       tial annuity market. As you may already know, annuity sales soared in the
                       late 1970s and early 1980s.
                       Then there was a let-down,
                       due to the perceived effect of
                       some tax law changes. But          Planning Pointer:
                       the tax law changes were           Current tax laws discourage the
                       only peripheral. People con-       use of annuities as a pure investment
                       tinued to buy annuities for        while favoring the use of annuities to
                       their inherent qualities when      provide an income in retirement.
                       they were approached, and
                       annuity sales once again

                       Today’s annuity products can meet the needs of a wide variety of prospects
                       because they are both retirement vehicles and investments which compare
                       favorably with C.D.s and other forms of investment. While government tax
                       policy seeks to discourage the use of annuities purely as an investment, it
                       continues to favor annuities as an investment for retirement purposes. You
                       will understand better after reading Chapter 6 how annuities represent one of
                       the few remaining income tax shelters. (Another, as you know, is life insurance.)

                                Now let’s look at prospective purchasers:

                                Empty Nesters. These are people, generally in their forties or fifties,
                                and usually salaried (sometimes with dual incomes), who no longer
                                have college costs. Perhaps for the first time they are able to direct
                                dollars toward their own retirement needs. Don’t forget that in this
                                group, also, are single people of both sexes who must provide for

                                Salaried Individuals. These people may have company retirement
                                plans, or they may not. Where there is a company plan, it may not be
                                large enough, or secure enough. Many plan participants are likely to
                                need supplementary retirement income.

                                Where there is no company plan, you may be able to install one.
                                Certainly these people will need retirement income, provided either
                                by the employer or by the employees, or by both.

                       Self-Employed Individuals (Professionals and Others). These people may or
                       may not have a retirement plan. You can help them provide for retirement
                       with annuities in a number of ways — through individual purchase, or by
                       means of a tax-qualified SEP or Keogh plan (see discussion in Chapter 7).
44                                                           Annuities Training Course

     Pension Plan Participants Terminating or Retiring. These are individuals
     who may have access to more money at one time than they have ever had in
     their lives — a cash distribution from their company’s pension plan. What
     better place for these funds than an annuity? Depending upon actual retire-
     ment plans, the annuity might be either an immediate or a deferred annuity.
     There might be a rollover to an IRA or not. In either case, there is an
     opportunity for an annuity sale.

            School Teachers and Employees of Certain Tax-Exempt Employers.
            Teachers and other employees of schools and employees of organiza-
            tions (generally charitable or educational) which are exempt from
            income tax under Internal Revenue Code Section 501(c)(3), qualify
            for Tax-Sheltered Annuity (TSA) plans. These special retirement
            plans offer tax deferral on the interest earned on employee annuities.
            TSAs are a big market.

             Small Business Owners. Many small businesses have never installed
             pension or profit-sharing plans. These offer the opportunity of cover-
     ing both the owner and employees with a simplified employee plan (SEP)
     funded with annuities. An owner selling a business at retirement offers an-
     other opportunity for an annuity sale.

     Retirees. Individuals already retired and living on interest or income from
     securities are prime prospects for annuities. More income, more secure in-
     come, and lower taxes are some of the rewards of replacing interest income
     and dividends with annuity income.

     Savers and Investors. Some may be seeking a high rate of return, others
     safety. Some may want shelter from taxes. Still others may want diversity
     and professional management. Some may want all these things, and all are
     possible with an annuity. In particular, the large number of savers who pur-
     chase bank certificates of deposit (C.D.s) represent a group of annuity pros-
     pects not to be overlooked.

            Parents or Grandparents Who Wish To Make Lifetime Gifts. Annu-
            ities offer senior family members a way to make lifetime gifts to
            children or grandchildren without endangering their own security. By
            purchasing an annuity to provide income they cannot outlive, they
            can feel more comfortable about giving away other assets.

            People Who Don’t Like Insurance or Are Uninsurable. Individuals
            who cannot be persuaded to budget for life insurance can often see
            the advantage of budgeting for retirement and will buy an annuity.
            Other individuals who would like to have insurance but can’t buy it
            for health reasons can at least have the assurance of the death benefit
            an annuity provides. An annuity death benefit (usually the greater of
            all amounts invested or the accumulated account value) isn’t
            income-tax-free, but it is guaranteed to be paid to the beneficiary
            named by the purchaser.
Matching Annuities To Client Needs                                                                   45

What Benefits Are Offered By Annuities?

                       Now let’s take a look at some of the specific advantages annuities offer their

                       Tax Deferral. Interest earned
                       on amounts paid into an
                       annuity contract is not con-       Planning Pointer:
                       structively received and,          A major benefit of annuities is
                       therefore, is not subject to
                                                          their tax-deferred status. That is,
                       income tax until actually
                       withdrawn. This is a distinct      interest earned by an annuity is not
                       advantage over, for example,       taxable until it is withdrawn by the
                       a savings account, where in-       annuitant.
                       terest is immediately subject
                       to tax, even though it isn’t

                       Tax-Free Income. A portion of each installment of annuity income is consid-
                       ered a return of the purchaser’s investment and is income-tax-free. Only if
                       the annuitant outlives his or her life expectancy does the annuity income
                       become fully taxable.

                       Freedom from Investment Decisions: Diversification; Professional Manage-
                       ment. Annuity purchasers, if they wish, can be free of investment decisions.
                       With a fixed-dollar annuity, their funds are invested and professionally man-
                       aged along with and in the same manner as the issuing company’s general
                       funds. Annuity purchasers who wish to make some investment decisions can
                       do so with a variable annuity. They may choose from a variety of funds, e.g.,
                       stock or bond funds, which are professionally managed for an annual fee in
                       the manner of mutual funds.

                       Guaranteed Income for Life. By choosing from among the various life annu-
                       ity options offered, purchasers can be assured that neither they nor their
                       spouses will outlive their resources. The ability to provide an income which
                       cannot be outlived is the unique quality of an annuity and its most important
                       advantage over other assets. This lifetime income can be larger than “interest
                       only,” because it involves the systematic liquidation of principal. If interest
                       income alone is not enough, an annuity offers the safest way to supplement
                       interest income with principal.

                       No Contribution Limits. Un-
                       like an IRA or a tax-qualified     Planning Pointer:
                       retirement plan, there is no       The annuity’s unique benefit —
                       limit to the amount which an
                                                          and advantage over other forms of
                       individual can invest in an an-
                       nuity. Thus, the amount of tax-    investment — is its ability to provide a
                       sheltered interest available to    guaranteed income which the annuitant
                       a purchaser is limited only by     can’t outlive.
                       his or her own resources.
46                                                                      Annuities Training Course

                Access to Funds. Annuities offer access to funds accumulated in a variety of
                ways. After the first few years, withdrawal of the entire fund can be made
                with no charge. Prior to that time most annuities allow free complete or
                partial withdrawals at least on an annual basis. The government, however,
                imposes a 10% penalty tax on the taxable interest portion of withdrawals
                made prior to age 59½. (This penalty tax is a part of the tax policy aimed at
                encouraging the use of annuities for retirement.)

                Payout Flexibility. Payouts can be tailored to meet individual conditions
                which may not be foreseeable at the time of purchase. By choosing the
                proper payout option from among the variety of annuity settlement options
                offered, an annuitant can enjoy the maximum amount of life income (with a
                straight-life annuity), provide for a surviving spouse (with a
                joint-and-last-survivor option), or even meet a special short-term need for
                income (with a fixed-period
                option). If the annuitant
                wishes to conserve all the         Planning Pointer:
                principal for the next genera-
                                                   Modern annuities allow a myriad
                tion, an interest-only option
                is available. And the funds        of payout options to meet income
                may be withdrawn in cash, to       needs not yet anticipated by the
                purchase an immediate annu-        purchaser. Flexibility is the keystone of
                ity from another company if        today’s annuities.
                that seems desirable, or to be
                used for an entirely different

                The annuitant also has the contract right, in most cases, to adjust the time of
                payout to meet individual circumstances. Income can begin earlier or later
                than the date originally specified in the contract, with adjustments in the
                amount of income depending on the actual retirement age chosen. Thus, an
                individual retiring early, either voluntarily or involuntarily, need not be de-
                prived of an income.

                A Guaranteed Death Benefit. If death occurs before payments begin, the
                beneficiary named by the purchaser is generally guaranteed to receive the
                full amount accumulated, or the full amount paid in, if that should happen to
                be greater. If death occurs after payments have begun, there may also be a
                death benefit, depending upon the annuity settlement option chosen.

                Estate Tax Savings. An annuity can be a valuable estate planning tool. Annu-
                ity income which terminates when an estate owner dies assures lifetime secu-
                rity but leaves nothing to be taxed at death. Other assets can be given away
                or sheltered from estate tax by the unified credit.

Even More Advantages

                Annuities have even more advantages for investors and future retirees. They
                appeal especially to purchasers who want guaranteed wealth accumulation
                over the long term, because (almost alone among generally available finan-
                cial products) they offer tax-deferred interest earnings. When dollars that
                would otherwise be used to pay current taxes on earned interest are left to
                grow and compound, they can grow at an extremely rapid rate. Even taking
Matching Annuities To Client Needs                                                                  47

                       into account the income tax payable when the funds are withdrawn, tax
                       deferral means many more dollars for the investor. The comparison that fol-
                       lows is just one example of the power of tax deferral.

                       Comparison of principal growth between a bank certificate of deposit subject
                       to income tax annually and an annuity subject to tax only upon withdrawal,
                       assuming a $20,000 initial deposit, a 31% tax bracket and an interest rate of
                       8% on each investment throughout the periods indicated:

                              Deposit Term     C.D. Accumulation        Annuity Accumulation
                                10 years            $ 34,228                  $ 43,178
                                20 years              58,577                    93,219
                                30 years             100,247                   201,253*

                       *Tax would be payable in the year of withdrawal. After 30 years, assuming a
                       tax bracket of 31%, $62,388 would be the tax payable, leaving an after-tax
                       accumulation of $138,865. Thus, the value of tax deferral based on these
                       assumptions would be $38,618.

                       Here are some additional annuity advantages that you will want to point out
                       to your clients:

                           • Retirement income received from an annuity has a tax-free “return of
                             investment” element. (See “Taxation of Annuity Payments,” Chapter 6.)
                             Because this part is not counted in figuring income tax on Social Secu-
                             rity benefits, having income from an annuity rather than from stocks,
                             bonds or savings accounts may reduce or even eliminate tax on Social
                             Security benefits for some retirees.

                           • For annuity purchasers who may be in lower state and/or federal in-
                             come tax brackets after retirement than they were before, annuities offer
                             tax savings as well as deferral.

                           • There are usually no sales charges or initial fees, front-end loads, or
                             administrative fees to be paid when an annuity contract is purchased.
                             (The only deduction may be for a premium tax imposed by the
                             purchaser’s state of residence.) Thus, all of the funds invested generally
                             earn interest from the date of deposit.

                           • Annuities generally provide a minimum guaranteed interest rate, how-
                             ever low the market rate might drop.

                           • Death benefits payable after the annuitant’s death go directly to the
                             named beneficiary. Thus, they escape probate and are freed from vari-
                             ous estate and administration costs. They may also be immune to claims
                             by creditors of the annuitant’s estate.
48                                                                               Annuities Training Course

In Summary

                      It has been well said that, “A person’s older self is a dependent for
                      whom one should provide, just as definitely as one provides for a
                      spouse and children.”1 Today, increased longevity and the possibility
                      of prolonged illness, as well as market fluctuations, employment un-
                      certainties, and fears of inflation have made many people realize the
                      need for personal savings to supplement pensions and Social Secu-
                      rity. Savings can be accumulated in a variety of forms — like stocks,
                      bonds, or real estate. But, without sufficient assets to live on interest
                      alone, any individual faces the danger of depleting principal entirely
                      if he or she lives long enough. Hence the appeal of an annuity: It
                      offers income security — a retirement income which the recipient
                      cannot outlive. It also offers, as we have seen, other important savings
                      and investment advantages.

             By this time you must have realized that by selling annuities you will be
             performing an extremely useful service to a wide variety of individuals. The
             products you will sell are tax-favored, indicating that the United States gov-
             ernment recognizes them as being valuable to society. And, from the listing
             of potential purchasers, you must have recognized that you have a great
             opportunity — both to expand your own earning potential and to help pro-
             vide your clients with the financial security essential to their successful

              Ernest P. Welker, “Annuities From the Buyer’s Point of View,” Economic Education Bulletin, No.
             8, Vol. XXVI, American Institute for Economic Research, p.1.
Annuities Training Course                                                                                          49

                                                   Choosing The Right Annuity

        c o n t e n t s

                        Specific Annuities To Meet Specific Needs ........................... 51

                        Helping You Choose… ............................................................... 57

                        A Company .................................................................................. 57

                        And A Product ............................................................................ 60

                        In Summary ................................................................................. 62
Choosing The Right Annuity                                                                         51

                       When the products have been defined and the prospects identified, the time
                       comes to choose the particular annuity products you will recommend to your
                       clients. There are two distinct parts to this process. The first is matching a
                       particular type of annuity to the budget requirements and the financial objec-
                       tives of an individual client. The second is choosing, from the host of offer-
                       ings you will find in the marketplace, the particular company and product
                       you will recommend.

                       This chapter is intended to help you learn to make these choices. First, we
                       will offer some examples to show how annuities can serve the needs of
                       particular clients. After that we will suggest some of the criteria you will
                       need to apply when choosing from among competing products.

Specific Annuities To Meet Specific Needs

                       In matching products to prospects, there are several factors to consider.
                       Among them:

                             • Whether a prospect’s retirement is imminent or far in the future.

                             • Where the premiums will come from — current salary, insurance pro-
                               ceeds, other investments, a maturing C.D., a pension distribution.

                             • The prospect’s objectives — tax savings, safety of principal, a secure
                               lifetime income, freedom from management worries.

                             • The prospect’s investment preferences — the safety of C.D.s and bonds
                               or the growth potential of stocks and mutual funds.

                       The following examples may help to illustrate the match-up process. (Chap-
                       ter 6 will supply an explanation and further discussion of the tax advantages
                       of annuities mentioned in the examples.)

                                 Example 1: Ann and George Michael have just paid their last college
                                 tuition bill. For the past four years, they have budgeted $10,000 an-
                                 nually to meet the college expenses of their son, Dave, who has just
                                 graduated and accepted his first full-time job. George will be 48
                                 years old this year and, for the first time, can begin to think about
                                 what he and Ann will do when he retires seventeen years from now.
                                 Will his company pension be enough to live on? Even with Social
                                 Security, it may not be enough to allow them to do the traveling
                                 they’ve always wanted to do.

                               The Michaels feel that they want to ease up a little, but that they can
                               still afford to budget $5,000 annually — this time toward their own
                       retirement. They are thinking of simply putting their money into bank C.D.s.
                       The Michaels recognize the power of compound interest, and they don’t want
                       to take any investment risks. However, as you have been their insurance
                       agent for several years, Ann and George ask you for advice.
52                                                                       Annuities Training Course

                Of course, you tell the
                Michaels, they could simply        Planning Pointer:
                put their money into bank          Because of the tax-deferred
                C.D.s. But if they do that,        privilege afforded annuities, there is no
                they will have to pay tax on       tax to pay currently on the interest the
                the interest each year as it is    premiums earn. ALL of the interest
                                                   earned can be left to grow at com-
                Let’s say their first $5,000       pound interest.
                deposit earns $400 in interest
                by the end of the year. At a
                federal tax rate of 28% and excluding any state tax which might be payable,
                they will have to pay $112 in taxes on their interest income, whether they
                withdraw the money or not. Thus, their net yield on the $5,000 deposit will
                be just $288. The Michaels might pay the tax with other money, or they
                might take it out of their retirement fund. Either way, their effective rate of
                interest has been reduced from 8% to 5.76%.

                                You explain to the Michaels that instead of investing in
                                C.D.s, they could put money into a fixed-dollar
                                flexible-premium deferred annuity (FPDA). Because of the
                                tax-deferral privilege afforded annuities, there would be no
     FPDA Solution
                                tax to pay currently on the interest. With no need to make
                                withdrawals to pay taxes, all of the interest earned on their
     • Tax Deferral             deposits is left to grow at compound interest until they reach
     • Compounding              retirement. Even though there will be tax to pay on the inter-
       of Interest              est earned when the time comes to take money out of the
     • Skip or Increase         annuity, the after-tax fund is likely to be substantially larger
       Deposits                 than it would have been with C.D.s, because of the power of
     • Annual
                                tax-deferral combined with the power of compound interest.
                                Besides, although they can’t count on it, they might even be
       Withdrawal               in a lower tax bracket after retirement and end up paying less
       Privileges               in total taxes than if they had paid as they went along. Mean-
                                time, their tax money has been working for them.

                Ann and George decide to purchase the FPDA, with George as owner and
                annuitant. You will have explained that in the event they should need some of
                the money they plan to invest in the annuity, the FPDA gives them complete
                freedom to skip a deposit, and also permits George to make annual with-
                drawals of up to 10% of the contract value, without charge, should they need
                some capital. Since this is their retirement fund, Ann and George already
                recognize that they are investing for the long term and do not anticipate making

                Example 2: Like the Michaels, your clients, Jean and Van Cameron, are also
                “empty nesters.” Van is 45; Jean is 40. Their cost of living over the last
                several years has become high, and they are quite anxious about having
                enough to live on in retirement. There will be a company pension and Social
                Security, but Jean and Van tell you they would feel much more secure if they
                could count on having enough saved to give them additional income of about
                $1,000 a month beginning when Van retires at 65. This would assure them
                the funds to meet their mortgage payments, which will extend well beyond
                Van’s retirement. The Camerons have heard about FPDAs and they ask you
                how much they would have to put into such an annuity, on an annual basis,
                over the next twenty years to provide the extra income they want.
Choosing The Right Annuity                                                                         53

                       You explain that you will have to make some assumptions but that you can
                       give them a good estimate of the amount they should set aside. First of all,
                       the FPDA will offer a variety of income settlement options. Since Jean and
                       Van agree that if something should happen to one of them, they would want
                       income to continue to the other, you base your calculation on a joint and 50%
                       survivor option, which would continue one-half the income for life to which-
                       ever of the two survives.

                       You explain to the Camerons that in your calculation you will use the settle-
                       ment option rates which would be available to them if Van were 65 and
                       retiring today. Their actual annuity income, of course, would be based on the
                       rates in effect when Van reaches retirement in twenty years, but there
                       shouldn’t be a substantial difference, barring dramatic changes in life expect-
                       ancy between now and then, which seems unlikely.

          $1000        According to your company’s tables, for each $1,000 on deposit, $8.30 of
          ÷ 8.30       monthly income is currently available, under the joint and 50% survivor
                       option, to a male age 65 and a female age 60. This is the figure you use. By
     120.48192         dividing $1,000 by $8.30 and multiplying the result by 1,000, you determine
        × 1,000        that the Camerons will need to accumulate a fund of $120,482 by the time
                       Van reaches age 65 to give them the $1,000 of extra monthly income they
      $120,482         want during their joint lifetimes, plus $500 monthly to the survivor.

                       You explain that you will have to make a second assumption as to the amount
                       of interest the Camerons’ deposits will earn over the next twenty years. There
                       is, of course, no way to predict this precisely, because an FPDA earns inter-
                       est at a current rate which generally reflects the marketplace. Your
                       company’s FPDA is currently paying 8%. It might pay more or less in the
                       future depending upon what happens to interest rates generally. Van under-
                       stands this but says he is happy to have you base your calculation on an
                       assumed average interest rate of 8%. He realizes that if the declared interest
                       rate should go below 8% at any time, he would have the option of increasing
                       his deposits to make up for the lower interest earnings and so keep his future
                       income at the desired level.

                       To obtain the amount the Camerons would have to contribute to their annuity
                       annually in order to accumulate $120,482, assuming the fund will earn 8%
                       interest, you use a sinking fund table (from any book of compound interest
                       and annuity tables). According to such a table, the factor for annual deposits
                       made over a 20-year period to accumulate to $1.00 at 8% interest is
                       .0218522. Multiplying $120,482 by this factor gives you $2,632.80 as the
                       amount the Camerons would need to deposit to their FPDA annually.

                       Van and Jean are so delighted with the result of your calculations that Van
                       decides to make an initial deposit of $10,000. After that, he says, he will
                       easily be able to add to the
                       fund at the rate of $3,000 an-
                       nually. This will give him a     Planning Pointer:
                       substantial “cushion” in the     Use your company’s tools and
                       event interest rates fall below  interest-paying assumptions to make
                       8%, or in case he should         educated calculations of the annuity
                       need to skip an annual de-
                       posit.                           deposits required to provide your
                                                          clients with the desired future income
54                                                                                Annuities Training Course

                 Example 3: Your client, John Myers, is 55. He has been saving for retirement
                 for some years and has about $200,000 in several C.D.s. He also has some
                 common stock that he wants to get rid of, because he has become totally
                 disenchanted with the stock market. He plans to sell the stock now, because
                 he can realize just about what he put into it several years ago — some
                 $50,000. But, of course, he will have to reinvest the money. He wants a
                 reasonable rate of return at low risk. What should he buy?

                 You tell John that, of course, he could put the proceeds of the stock sale into
                 another C.D., but has he considered that he paid $4,480 of federal income tax
                 (28%) on the $16,000 of income he earned on his present C.D.s last year,
                 even though he never touched the income? With $50,000 invested in C.D.s
                 and earning 8%, he would earn another $4,000, but he would pay an addi-
                 tional $1,120 in taxes, whether he used the interest or not.

SPDA Solution    If, on the other hand, he used the $50,000 to purchase a single-premium
                 deferred annuity (SPDA), he could avoid any current tax on his earnings. As
• Tax Deferral
                 an example of the difference between a currently taxable C.D. and a tax-
• Compounding    deferred annuity investment, you show him that his $50,000 would grow to
  of Interest    just $87,536 in ten years, if invested in a C.D., assuming interest earnings of
• One-time       8% annually, and taxes of 28% paid annually. The same $50,000 invested in
  Deposit        an SPDA could grow to $107,946 in ten years, assuming an 8% return
                 throughout the period. Taxes would have been deferred until payout time. If
• Annual         the funds were completely withdrawn at the end of the period, there would
  Withdrawal     be a tax of $16,225 to pay (assuming a 28% tax rate), leaving a balance of
  Privileges     $91,721 in the fund. That’s $4,185 more than with a currently taxable invest-
                 ment — in just ten years’ time. An annuity payout instead of a total with-
                 drawal would further defer the payment of tax and also provide John a
                 substantial amount of tax-free income.

                                                                   SPDA               $87,536**


                                                                                10 years
                             * Assumes 8% annual return throughout the period
                            ** Assumes 8% annual return throughout period and 28% tax bracket

                 John asks a number of questions about annuities: Is the interest rate guaran-
                 teed? Will I have access to my money? What if interest rates rise — or drop?
                 This gives you the opportunity to explain how an SPDA pays interest at a
                 current rate reflecting the company’s investment earnings. You also explain
                 the important differences between an annuity and a C.D. and how the advan-
                 tages to be gained from an annuity — tax deferral and maximum accumula-
                 tion — depend upon its being a long-term investment.

                 Satisfied, John Myers not only decides to put his $50,000 of stock proceeds
                 into an SPDA, he decides to purchase additional SPDAs with his existing
                 C.D.s, all of which are due to mature within the next three months! John says
                 he has no intention of withdrawing any of these funds before his retirement,
Choosing The Right Annuity                                                                          55

                       and the annuity withdrawal provisions you have described to him should be
                       more than sufficient to meet any emergency he might encounter in the interim.

                       You are able to show John that, assuming an 8% return throughout the next ten
                       years, his $250,000 investment in SPDAs could amount to $458,606, after the
                       federal tax is paid. He under-
                       stands that the amount of an-
                       nuity income this will provide     Planning Pointer:
                       depends upon the rates in ef-      The interest rate earned on a
                       fect when he actually retires.     single-premium deferred annuity reflects
                       However, he is very pleased
                                                          the issuing company’s current invest-
                       to hear that if he were age 65
                       now, $458,606 would give           ment experience. Maximum growth will
                       him an income of $4,127 per        be gained over the long-term by
                       month, as a straight life annu-    allowing this tax-deferred interest to
                       ity, at your company’s current     accumulate.

                       Example 4: Ed Jones retired five years ago at the age of 60. He and his wife
                       Mary have an annual income of about $45,000, which includes Ed’s Social
                       Security, some taxable interest income, and Mary’s freelance income from
                       writing. They worry about taxes, especially because Mary has to pay a whop-
                       ping self-employment tax on her writing income. Also, because they have an
                       adjusted gross income in excess of $32,000, Ed is taxed on some of his
                       Social Security income. They would like to have more income, and they also
                       worry about the possibility of outliving their capital, since both are presently
                       in very good health and come from fairly long-lived families.

                       You discover that Ed and Mary’s taxable interest income is from bonds and
                       $100,000 in bank C.D.s which earned interest of 7.5% last year. You show
                       them that the $100,000 in C.D.s might be used to purchase a joint and 50%
                            survivor single-premium immediate annuity (SPIA). At Ed’s present
                            age of 65 and Mary’s present age, 60, this SPIA could provide them
                            with an income of $795 per month during their joint lifetimes and
                            $397.50 during the survivor’s remaining lifetime — an income that
                            neither of them could outlive. Compared to the interest income they
                            had been receiving, this would be a $2,040 increase in their annual
                            income ($795 × 12 = $9,540 vs. $7,500 interest income). In addition, a
                            substantial portion of each annuity payment would be tax-free (a return
                            of the Jones’ $100,000 investment). In the Jones’ case, this reduction in
                            their taxable income would also reduce the income tax on Ed’s Social
                            Security payments.

                             Because the SPIA addresses all their concerns — lower taxes, more
                             income, plus income security — the Jones’ make the annuity purchase.

                             Example 5: Sarah Hunter has a new grandchild — her first. She would
                       like to do something special toward the child’s future education. Whether
                       Sarah has sufficient resources to pay a single premium or needs to budget to
                       pay premiums, you can suggest the purchase of an annuity. Either an SPDA
                       or an FPDA would provide an excellent accumulation vehicle. You can show
                       Sarah how she might purchase an annuity as a gift for her grandchild through
                       a custodial arrangement (probably without any gift tax, as explained in the
                       next chapter). Sarah can retain control of the contract as custodian under the
56                                                            Annuities Training Course

            appropriate State Uniform Transfers to Minors Act. Over a 15- to 18-
            year period the funds can grow tax-deferred. When Sarah’s grand-
            child is ready for college, the contract can be annuitized over a 4- or
            5-year period. Under current income tax rules, because of the
            annuitant’s young age, there would be a 10% penalty tax on the
            income portion of the payments, but this would be a tax added to the
            child’s tax bracket (if the child is age 14 or over). Based on current
            rates, this would likely mean a total federal tax rate of no more than
            20-25% (10% or 15% bracket + 10% penalty). That’s lower than
            Sarah’s current tax bracket of 31%. Meantime, Sarah remains in con-
            trol of the gift, as custodian, until her grandchild is 18.

             Example 6: Dick Oldham has a tuition problem of another kind. He
             is 60 years old, but his youngest daughter Ellen is just now entering
             college! The tuition is taken care of, but he wonders whether he can
             afford to dip into some $100,000 of savings, which he would like to
             keep for his own retirement, to pay his daughter’s living expenses
     through college and a year of graduate school. He figures the expenses will
     be at least $600 per month. Should his daughter work or borrow to pay these
     additional costs?

     Fortunately, you have a solution for Dick’s dilemma. He can pay his
     daughter’s college bills and still have $100,000 for his own retirement, with a
     combination of an immediate annuity and a deferred annuity. You can recom-
     mend a deferred annuity which will guarantee Dick an 8% return for a
     five-year period. From a present value table (a table showing the present
     worth of $1 to be collected at the end of a given time), you determine that at
     8%, it will take just $68,058 to accumulate to $100,000 in five years’ time.
     This is the amount that you recommend be invested in the deferred annuity,
     to accumulate for at least five years on a tax-deferred basis.

     The remainder of the
     $100,000, ($31,942) is avail-     Planning Pointer:
     able to provide an income         Sometimes a client’s needs can
     over the next five years. This    best be met by combining the advan-
     amount invested in an imme-
                                       tages offered by an immediate annuity
     diate annuity with a company
     you can recommend will pay        and a deferred annuity.
     Dick a guaranteed monthly
     income of $635 for the next
     five years. And 83.8% of this income will be completely tax-free. At a 28%
     rate, federal income tax on the remaining 16.2% will amount to just $28.80,
     for an after-tax monthly income of $606.20.

     Of course, Dick could put his $100,000 into a bank C.D. and perhaps get an
     8% return over the next five years. This would give him interest income of
     $667 per month. But he would have to pay at least $187 of income tax on
     this amount, thus reducing his net monthly income to $480.

     With the combination of annuities, you have shown Dick a particularly ad-
     vantageous way to pay his daughter’s college expenses, with some left over,
     and still have a $100,000 retirement fund. Dick is convinced and buys the
     annuity combination.
Choosing The Right Annuity                                                                                          57

                       These have been just a few examples to get you started. You will think of
                       many prospective annuity purchasers. Be sure to keep in mind that annuities
                       are good investments as well as ideal retirement vehicles.

Helping You Choose…

                       If you are a career life insurance agent with a company that sells all kinds of
                       annuity products, your work may be done when you have determined which
                       particular type of annuity your client needs. Undoubtedly, you will have
                       confidence in your company and in the annuity products it has designed for
                       its markets. Even in this situation, however, your client may want to be
                       assured that your company’s product is really the best. Or, you may be in a
                       competitive situation where you will need to compare your products with
                       products available from another company.

                       If you are a broker, you will undoubtedly find it necessary to compare the
                       products of several companies to find the companies you will represent or
                       the products you will recommend to your clients.

                       To help in all of these cases, we now want to talk about how to go about
                       comparing companies and products. What should you and your client look
                       for? What kind of company or product should you not sell?

…A Company

                                The supervision and regulation of insurance companies for the pro-
                                tection of the insuring public has long been a major concern of both
                                state and federal governments. Rightly so, because the financial secu-
                                rity of millions of people, as well as the welfare of the economy as a
                                whole, are intimately bound up with the welfare of the insurers to
                                which the public entrusts its funds.

                                This is not the place for a detailed history of the development of
                                government regulation and the respective roles of the federal and
                                state governments in providing supervision of companies.1 Suffice it
                                to say that the major responsibility for regulation of the insurance
                                industry belongs to the states and that the supervisory controls devel-
                                oped by the various states provide a very important “safety net” for
                                those who purchase insurance and annuity contracts.

                               Nearly every aspect of insurance company operations is subject to gov-
                       ernment regulation. Through an insurance department (or agency) headed by
                       a commissioner (or superintendent) of insurance, the several states exercise
                       varying degrees of control over their own (domestic) companies as well as
                       the out-of-state (foreign) companies they license to do business within the
                       state. Areas of governmental concern include review and approval of the
                       types of products to be sold within the state, supervision of company busi-
                       ness practices, safeguard of company investments and financial condition,
                       and provisions relating to the conservation and liquidation of insolvent com-

                        An excellent treatment of the history and development of government supervision of insurance can
                       be found in Life Insurance, Black & Skipper, Prentice-Hall, Inc., Englewood Cliffs, N.J.
58                                                                               Annuities Training Course

                      A primary purpose of state regulation of insurance companies is to provide
                      the safeguards necessary to prevent any company from ever becoming insol-
                      vent. Nevertheless, to further protect the insuring public, most jurisdictions
     Guaranty Funds   have also established guaranty funds to which solvent companies are required to
                      contribute, generally according to a formula based on premium receipts. (To
                      alleviate perceived unfairness to the policyholders of solvent companies,
                      many states allow companies to offset these assessments against taxes.) In
                      the event any company does become insolvent, the state guaranty fund pro-
                      vides a means of payment to the company’s policyholders and annuitants.

                      One of the main objectives of the National Association of Insurance Com-
                      missioners (NAIC), which has been in operation since 1870, is to promote
                      uniform legislation and administrative treatment of insurance companies
        NAIC          throughout the country. Despite many NAIC successes, however, legislation
                      still differs from state to state, and the various jurisdictions exercise differing
                      degrees of supervisory control. Some states, like New York, exercise very
                      strict control over the operations and investments of companies within their
                      jurisdiction. Other states are less restrictive.

                      Whenever a company requests and obtains a license to do business in a state
                      other than the state of its domicile, that state has the right to exercise control
                      over the company’s operations within the state. Thus, one very useful way to
       Licensing      evaluate a company is to find out whether it is licensed to do business within
                      your state, as well as in other states, such as New York, which are known for
                      the rigorous nature of their supervision of licensed companies.

                      “Unauthorized insurers” have been of major concern to state insurance de-
                      partments, and to multi-state companies, for years. These are those few com-
                      panies which have sought to escape regulation by all except their home states
                      through refusing to apply for a license or to set up offices in other states,
                      doing business by mail instead. Policyholders of such companies are denied
                      many of the important regulatory safeguards protecting the policyholders of
                      multi-licensed companies.

                      Even with government regulation, of course, there is still room for company
                      management to affect the financial stability of individual companies. As with
                      any other industry, there can be prudent, conservative company management,
                      and there can be aggressive
     Management       company management which
      Practices       always offers the possibility
                      of imprudent action. Since         Planning Pointer:
                      annuities are long-term in-        At least as important to the
                      vestments, usually intended        investor as the interest rate paid on an
                      to provide security in retire-
                                                         annuity is the financial stability of the
                      ment, there is surely nothing
                      more important than trying         issuing company. Since an annuity
                      to make sure that the issuing      purchase is usually a long-term invest-
                      company is prudently man-          ment, consumers should carefully
                      aged, reliable, and likely to      consider the company’s track record,
                      be in existence, with ample        assets held, investment experience,
                      financial resources to meet
                                                         and management philosophy.
                      its annuity obligations when
                      payment time comes.
Choosing The Right Annuity                                                                        59

                       In today’s competitive marketplace, company promises of high interest and
                       payout rates can be very alluring, but it is vital to look beyond the promises
                       to the company behind them. How long has the company been in business?
                       What is its track record? What kind of assets are in its investment portfolio?

                       Fortunately, you need not make these kinds of determinations alone. There
                       are excellent independent reporting services to help you.

                       Best’s Insurance Reports, Life-Health, published by the A.M. Best Com-
                       pany of Oldwick, NJ, is an annual publication which reports on nearly all
                       U.S. insurance companies and many Canadian companies. Companies are
        Best's         assigned the following ratings: A++ and A+ (Superior), A and A- (Excellent),
                       B+ (Very Good), B and B- (Good), C+ (Fairly Good), and C and C- (Fair).
                       According to Best’s, the objective of their rating system is “to evaluate the
                       various factors affecting the overall performance of an insurance company
                       in order to provide our opinion as to the company’s relative financial
                       strength and ability to meet its contractual obligations.”

                       Information about a company’s investment practices can also be obtained
                       from Best’s. For example, the reports tell you what percentage of each
                       company’s admitted assets is invested in bonds and how much of the bond
                       portfolio is comprised of
                       investment-grade securities.
                       Thus, it is easy to determine    Planning Pointer:
                       how much of its portfolio a      Best’s Insurance Reports provides
                       company may have invested        information about an insurer’s invest-
                       in below-grade securities, a
                       telling indicator of the         ment practices that can help you
                       company’s investment phi-        discern the company’s attitude toward
                       losophy and attendant risk       risk.
                       for its policyholders.

                       Best’s also reports the percentage of each company’s portfolio which is in-
                       vested in stocks and how much of that in common stocks. Conservative
                       investment, of course, generally means that common stocks will not be a
                       substantial part of an insurance company’s portfolio.

                       Standard & Poor’s Insurance Book is another good source of information
                       about insurance companies. Here, insurers are rated according to S&P’s
                       judgment of their claims-paying ability. A company given a “AAA” rating, in
                       S&P’s judgment, offers “superior financial security.” A “AA” rating means
        S&P            “excellent financial security,” and a rating of “A” is indicative of “strong
                       financial security.” The ratings range downward, all the way to a “D,” which
                       indicates that the company has been placed under an order of liquidation.

                       Not only are the companies assigned a rating by S&P, each one is given a
                       4-page “Rating Analysis,” which describes the rationale for the assigned
                       rating and gives an informative account of the company’s management strat-
                       egy and all aspects of its operating performance, its financial condition and
                       its prospects. S&P also now offers an annual “Insurer Solvency Review” and
                       a monthly “Insurer Ratings List” to help agents and brokers readily access
                       their insurer ratings.
60                                                                        Annuities Training Course

                 Moody’s Credit Opinions — Life Insurance, a product of Moody’s Investors
                 Service, Inc., New York, NY, affords another excellent independent source of
                 information about insurance companies. Moody’s Insurance Financial
     Moody's     Strength Ratings are assigned, in the company’s words, “to summarize
                 Moody’s opinion concerning the likelihood that an insurance company will
                 be able to meet its obligations pursuant to its insurance policies.” The finan-
                 cial security of companies which Moody’s classifies as “strong” are given
                 ratings of Aaa (Exceptional), Aa (Excellent), A (Good) and Baa (Adequate).
                 The last rating, Moody’s explains, means that the company offers adequate
                 financial security, “however, certain protective elements may be lacking or
                 may be characteristically unreliable over any great length of time.”

                 The financial security of companies which Moody’s classifies as “weak” are
                 assigned ratings of Ba (Questionable), B (Poor), Caa (Very Poor) Ca (Ex-
                 tremely poor) and C (Lowest). Numerical modifiers 1, 2, and 3 are added to
                 each rating category from Aa to B to indicate, respectively, that the company
                 ranks in the higher, mid-range, or lower end of its rating category. Moody’s
                 also supplies a separate analysis of each company it has rated, with an expla-
                 nation of the rationale for its rating.

                       All independent ratings are subjective and can never be infallible,
                       since they invariably involve judgments about the future. Nevertheless,
                       the research facilities of the rating services just mentioned are impres-
                       sive, and their judgments are highly respected. If the annuities you
                       offer your clients are issued by companies given a high rating by these
                       services, you are offering your clients a high degree of assurance that
                       their funds are in good hands.

                       Many of the large brokerage firms do a great deal of research and can
                       give you valuable information about the companies they represent. If
                       you are a career life insurance agent, another good source of informa-
                       tion for you will be your own company’s competition unit or depart-
                       ment. Competition units generally maintain files of information about
                       various companies (and their products) which they will share with

                 The public press can also sometimes give both you and your clients impor-
                 tant information about companies — particularly companies which are in
                 financial difficulty. Unfavorable newspaper publicity about a company has
                 been known to cause annuitants such concern that they insist on shifting
                 funds out of an existing annuity contract to a new one with a different com-
                 pany. While this kind of situation needs to be handled very carefully, because
                 of surrender charges, tax penalties and ethical concerns, it can offer an excel-
                 lent opportunity for you to help someone out of a difficult situation and gain
                 a client in the process.

…And A Product

                 Being satisfied about the financial strength, the investment and operating
                 practices, and the general reputation of the issuing company puts you a long
                 way along the road toward choosing the right annuity for your client. Other
                 factors to be considered deal mostly with the products themselves. And the
                 difficulty in choosing a particular product stems mainly from the fact that
                 competition has produced so many similar products from which to choose.
Choosing The Right Annuity                                                                         61

                       With accumulation products like fixed-dollar SPDAs and FPDAs, prospective
                       purchasers are likely to want to focus mainly on the initial interest rate
                       offered. After all, they probably have purchased FDIC-insured bank C.D.s by
                       simply choosing the highest interest rate.

                       But C.D.s are relatively short-term arrangements — six months to, at the
                       most, five years — while an annuity investment is for the long-term — ten,
                       fifteen, twenty years, and even longer. The long-term nature of an annuity
                       makes the past performance of the issuing company extremely important to
                       the purchaser of a new annuity. How has the company performed with re-
                       spect to its annuity depositors over the past five or ten years? Are renewal
                       interest rates maintained at a high level, or has there been a significant drop
                       in renewal rates while initial interest rates remain high?

                       Interest Rates and Company Philosophy

                       These are very important questions for annuity purchasers, since the answers
              5.85%    are indicative of a company’s operating philosophy and offer a clue to the

                       likely future treatment of new customers.

   7%       6.8%
                       There are essentially two philosophies concerning renewal rates to be found
     4.9%     7.5%     in the marketplace today. A few companies, to attract new business, follow a
                       policy of lowering their renewal rates as much as possible so as to continu-
                       ally offer initial rates higher than their competitors. Other companies prefer
                       to pay the highest possible renewal rates on their existing business, even
                       though this means their initial interest rate may be lower than that of some of
                       their competitors. If they understand this, most annuity purchasers will favor
                       the latter philosophy. Over the long run, such a philosophy obviously works
                       for the benefit of continuing customers.

                       Educate your clients to the
                       fact, also, that a company’s        Planning Pointer:
                       interest rates are dependent        A company’s interest rates are
                       upon its investment earnings.       dependent upon its investment earn-
                       Unusually high initial inter-
                                                           ings. Unusually high initial interest
                       est rates can be indicative of
                       a high-risk investment policy       rates can be indicative of a high-risk
                       (too many below-grade secu-         investment policy (too many
                       rities) which could lead the        below-grade securities) which could
                       company into trouble later          lead the company into trouble later on.
                       on. If you find that a com-
                       pany has a high percentage
                       of its portfolio invested in securities which are below investment grade, be
                       wary. One authority says that he is “uncomfortable” with more than 20% of
                       total assets in below-grade securities. Another says that companies with more
                       than 20% of their bond portfolio in issues rated BB and below should be
                       avoided. Bottom line: It’s always important to find out why any company
                       offers an unusually high initial interest rate on its annuities.
62                                                                    Annuities Training Course

             Performance Records

             When it comes to choosing a variable annuity from among competing prod-
             ucts, the record of performance for the various available investment funds
             should be examined. How has each performed over the past several years?
             Here, the investment and management acumen of the company and its chosen
             fund managers becomes very important. Interestingly, the financial condition
             of the insurance company itself may be a somewhat less important factor
             when choosing between variable annuities than it is when choosing between
             fixed-dollar annuities. The reason, of course, is that the funds invested in
             variable annuities, as we said earlier, are generally held in separate accounts,
             not subject to the claims of the insurance company’s creditors. Having said
             this, however, we must also hasten to say that for the desirable hybrid or
             combination variable annuity which offers the option of investing in a fixed
             account (see the discussion of variable annuities in Chapter 3), the financial
             status of the company once again becomes every bit as important as it is in
             the case of fixed-dollar annuities.

             There are several special services which supply valuable information about
             fixed-dollar and variable annuities. One example in each category: United
             States Annuities, Englishtown, NJ, offers rates and comparative information
             about fixed-dollar SPIAs, SPDAs, FPDAs and other specialized annuities in
             its publication, Annuity Shopper. Lipper Analytical Services, Denver, moni-
             tors variable annuity funds and publishes comparative information about
             their performance records. Your company may subscribe to such services, or
             you may want to become a subscriber yourself.

In Summary

             In summary, here are guidelines you can use to choose the right annuity:

                • Carefully match the type of annuity you offer a particular client to his
                  or her individual budget requirements and financial objectives.

                • Choose carefully the companies you will represent or will recommend
                  to your clients. Learn as much as you can about each company’s general
                  financial condition, investment policies, and claims-paying ability.
                  Limit yourself to companies which are given high marks by the recog-
                  nized rating services.

                • When choosing among several similar but competing products, compare
                  all important contract features (including withdrawal privileges, bailout
                  provisions, surrender charges, death benefits, and — for variable annu-
                  ities — investment alternatives, ease of moving from fund to fund, and
                  management fees). In general, eliminate any annuities which are very
                  restrictive, have too many charges, or unduly limit your client’s access
                  to invested funds.

                • Make it a rule never to choose a fixed-dollar SPDA or FPDA solely on
                  the basis of the initial interest rate. Be suspicious of exceptionally high
                  rates and find out why they’re being offered. Follow the precept: If it
                  seems too good to be true, it probably is.
Annuities Training Course                                                                                           63

                                                                   Taxation Of Annuities

        c o n t e n t s

                       Tax Deferral ................................................................................. 65

                       Taxation Of Annuity Payments ................................................ 66

                       Amounts Not Received As Annuities
                       (Withdrawals, Loans, Dividends) ............................................. 70

                       Forced After-Death Distributions ............................................ 72

                       Tax-Free Exchanges .................................................................. 74

                       Federal Estate Tax ...................................................................... 75

                       Federal Gift Tax .......................................................................... 78

                       Other Tax Questions .................................................................. 80
Taxation Of Annuities                                                                               65

                               In preceding chapters, we said little about the taxation of annuities,
                               other than to stress the fact of income tax deferral. But if you sell
                               annuities, you need to become familiar with the fundamental tax
                               rules affecting them. In this chapter we want to explain those rules in
                               a non-technical way. The intention is not to make you a tax expert,
                               but to enable you to appreciate the favorable tax status of annuities as
                               compared to many other financial instruments and to answer some of
                               the tax questions your clients will inevitably raise.

                                 To begin, you need to be aware that some major changes were made
                                 in the law beginning with the Tax Equity and Fiscal Responsibility
                                 Act of 1982 (TEFRA) and continuing with the Tax Reform Act of
                                 1986. The effect has been to restrict some of the uses of annuities
                                 which Congress viewed as being incompatible with the spirit of the
                                 tax laws. Nevertheless, the taxation of annuities was changed rela-
                        tively little in comparison with changes made in other tax shelters, and annu-
                        ities remain an excellent purchase.

                        This chapter deals with the important rules that apply to individually pur-
                        chased annuities and to annuities purchased for the benefit of employees
                        outside of tax-qualified retirement plans; in other words, nonqualified annu-
                        ities. (Some of the different rules which apply to the qualified annuities in
                        various tax-favored retirement plans will be explained in Chapter 7.)

Tax Deferral

                        The income credited to an individually owned deferred annuity contract dur-
                        ing the accumulation period does not have to be included in the owner’s
                        current taxable income. This fact is probably the greatest helper any agent or
                        broker has in selling annuities to the general public.

                        The income taxation of annu-
                        ities is governed by Section         Planning Pointer:
                        72 of the Internal Revenue           The income credited to an
                        Code (IRC), which provides
                        for annuity income to be             individually owned deferred annuity
                        taxed when it is received. In        contract during the accumulation
                        general, income is subject to        period does not have to be included in
                        tax when it is either actually       the owner’s current taxable income.
                        received (as when cash is put        Tax on annuity income is deferred until
                        in the pocket) or construc-          actual receipt.
                        tively received (as when the
                        recipient has an unrestricted
                        right to take cash but chooses
                        to delay actually taking it). The income credited annually to an annuity
                        contract, however, is deemed not constructively received and therefore, not
                        currently taxable, because the owner of the contract must give up valuable
                        rights, i.e., the right to future income, if he or she elects to make a with-
                        drawal. Tax on annuity income, therefore, is effectively deferred until actual
66                                                                                         Annuities Training Course

                The Tax Reform Act of 1986 generally limited this tax deferral rule to annu-
                ities owned by natural persons. If a corporation, for example, purchases an
                annuity to provide nonqualified retirement income for an employee, the con-
                tract is not treated as an annuity. Instead, the company is taxed currently, i.e.,
                annually, on the “income on the contract.”1 Although the estate of a deceased
                person is not a natural person, there is a special exception to this tax rule for
                any annuity acquired by an estate.2

Taxation Of Annuity Payments

                Code Section 72 divides annuity payments into “amounts received as an
                annuity” and “amounts not received as annuities.” A different general tax
                rule applies to each type of payment.

                Under Section 72, “amounts received as an annuity” include, generally, all
                periodic payments payable either over a lifetime or lifetimes or for a definite
                period. In other words, both annuities certain and annuities involving a life
                contingency are subject to tax under the same general annuity rule.

                That rule states that each periodic pay-
                ment received represents, in part, a return                         Annuity Payment     654321
                of the principal paid in, called the owner’s                                            654321
                “investment in the contract.” This part of                                              654321

                each annuity payment has, in theory, al-                                                654321
                ready been taxed and so need not be taxed                                               654321
                again. Only the balance of each payment,                                                654321
                which represents earnings on the owner’s                                                65432
                                                                                  Return of principal
                investment, is subject to tax. Thus, under                                              Earnings (taxed
                                                                                     (not taxed at
                the annuity rule, a part of each periodic                                               at distribution)
                payment is income-tax-free to the recipient.

                Exclusion Ratio

                The tax-free portion of the annuity payments is a fraction determined by
                comparing the “investment in the contract” to the “expected return” and is
                called the “exclusion ratio.” To find the exclusion ratio, it is necessary simply
                to divide the investment in the contract (in general, the cost of the annuity)
                by the expected return (the guaranteed annual return multiplied — depending
                on the type of annuity — either by the life expectancy in years of the

                  IRC §72(u). In general, “income on the contract” means the amount by which the surrender value
                of the contract at the end of the year, plus all distributions under the contract to date, exceeds total
                premiums paid, less any dividends. This rule applies only to income attributable to premiums paid
                on the contract after February 28, 1986.
                  There are other exceptions, including exceptions for: annuities in qualified plans; IRAs; and
                immediate annuities. IRC §72(u)(2).
Taxation Of Annuities                                                                                             67

                        annuitant(s), or by the guaranteed period). For example, if $50,000 were
                        invested in a contract guaranteed to return a total of $75,000 to the annuitant
                        over a period of ten years, the exclusion ratio would be 50,000/75,000, or
                        66.7%. If the monthly periodic payments were $625 each, $416.88 is the
                        amount of each payment which the annuitant would be entitled to receive
                        tax-free (66.7% of $625).
                        Investment in contract
                                                 = Exclusion Ratio
                            Expected Return

                                          = 66.7%

                               $625 × 66.7% = $416.88 received tax-free
                                                 $208.12 taxed

                        Calculating Expected Return

                        When determining the expected return for life annuities, government tables
                        supplied in Treasury Regulations issued under IRC Section 72 are used to
                        supply life expectancies. The life expectancy of the annuitant(s) as of the
                        birthday nearest the “annuity starting date” is used. The annuity starting date
                        is the first day of the first period for which an amount is received as an
                        annuity. For example, according to the government’s unisex table for ordi-
                        nary life annuities, the life expectancy of a 65-year-old is 20 years.3 There-
                        fore, for a straight-life annuity providing an annual income of $6,000
                        beginning at age 65 (and payable monthly) the expected return would be
                        $6,000 × 20, or $120,000.

                        Similarly, the expected return for a joint-life annuity or a joint-and-
                        last-survivor annuity is determined by using a combined life expectancy for
                        the two annuitants obtained from other appropriate tables in the Regulations.

                        In actually making the tax
                        calculation for particular an-    Planning Pointer:
                        nuities, various adjustments      Once an exclusion ratio has
                        must be made. For example,
                                                          been calculated at the annuity starting
                        in calculating the investment
                        in the contract for a life an-    date, the same portion of each periodic
                        nuity with a refund feature,      payment received thereafter is ex-
                        the cost of the refund feature    cluded from taxable income until the
                        (as determined by another         entire investment in the contract has
                        prescribed annuity table) has     been recovered.
                        to be excluded. In calculating
                        the expected return for an
                        annuity with quarterly, semi- annual, or annual payments (instead of monthly
                        payments), a frequency of payment adjustment is required (using factors
                        from a “Frequency of Payment Adjustment Table” in the Regulations).

                         Table V: Ordinary Life Annuities - One Life - Expected Return Multiples. Reg. §1.72-5. The
                        multiples in the table are based on monthly payments and must be adjusted (see text above) for
                        annual, semi-annual or quarterly payments.
68                                                                              Annuities Training Course

     While it is entirely possible (and not too difficult) to make the exclusion
     ratio calculation for any annuity by following the directions in the Regula-
     tions, it usually isn’t necessary for either the annuitant or the agent to do so.
     After payments begin, the insurance company will usually be able to tell the
     annuitant or the agent or broker how much of each payment is taxable.
     Companies generally make this calculation in connection with meeting their
     government-imposed tax information reporting requirements.

     Once an exclusion ratio has been calculated at the annuity starting date, the
     same portion of each periodic payment received thereafter is excluded from
     taxable income until the entire investment in the contract has been recov-
     ered. In the case of an annuity certain (income payable over a definite period
     of time) this means that the same portion of each payment will be excluded
     for as long as payments are made. In the case of a life annuity, however,
     payments will become fully taxable once the annuitant outlives the life ex-
     pectancy used in making the annuity calculation. Thus, very long-lived annu-
     itants will outlive both their tabular life expectancies and their exclusion
     ratios, although, of course, they will never outlive their life annuity income.4

     But what if the original owner or annuitant dies while receiving annuity
     payments, but before there has been full recovery of the investment in the

     If there are no further payments to be made, as in the case of a straight-life
     annuity, a deduction for the unrecovered cost (investment in the contract less
     excludable amounts already received) is allowed on the decedent’s final in-
     come tax return.

     Taxation of Beneficiaries

     If payments for a period certain will continue to a beneficiary under a refund
     feature of the annuity contract, the payments are entirely tax-free to the
     beneficiary, as a refund of cost, until such time as the payments received
     equal the unrecovered cost. Thereafter, any amounts received are fully tax-
     able. If a refund is payable in a lump sum but it is less than the remaining
     investment in the contract, the beneficiary is allowed an income tax deduc-
     tion for any unrecovered amount.

     If annuity payments are to continue to a surviving annuitant under a joint-
     and-last survivor annuity, the surviving annuitant continues to exclude and to
     report the payments as income under the original exclusion ratio until such
     time as the sum of the amounts excluded by the decedent and the survivor
     equal the original investment in the contract. Any payments after that are
     fully taxable. (If the payments to the original annuitant began before January
     1, 1987, an earlier rule would apply. See footnote 4.)

     What if the death benefit of a deferred annuity becomes payable to a benefi-
     ciary because of death occurring before annuity payments have begun, i.e.,
     before the statutory “annuity starting date”? Is there any tax?

      For life annuities with a starting date before January 1, 1987, an earlier rule applies. For these, the
     exclusion ratio remains in effect for life, even though the investment in the contract has been fully
Taxation of Annuities                                                                                                 69

                        There is neither a tax-free
                        death benefit, nor any step up             Planning Pointer:
                        in cost basis at death under               When an annuitant dies before
                        an annuity contract. The ben-              annuity payments begin, the benefi-
                        eficiary has the same cost ba-             ciary generally receives the annuity
                        sis, or investment in the
                                                                   proceeds under the same tax require-
                        contract, that the decedent
                        had. Generally this will be                ments that would have applied had the
                        the premiums paid for the                  annuitant lived to receive payments. An
                        annuity, less any amounts re-              exception is how the exclusion ratio is
                        ceived under the contract                  calculated if the beneficiary takes a life
                        which were excludable from                 income or annuity certain rather than a
                        income. If the death benefit
                                                                   lump sum.
                        is paid in a lump sum, there
                        will be income tax on the
                        amount by which the cash re-
                        ceived exceeds the invest-
                        ment in the contract.

                        If the beneficiary, within 60 days after the death, exercises an option to take
                        a life income or an annuity certain instead of the lump sum, the usual annuity
                        tax rule applies. The exclusion ratio is calculated, however, by using the
                        decedent’s investment in the contract and the beneficiary’s expected return.

                        Variable Annuities

                        Payments made under variable annuities are taxed in essentially the same
                        way as payments made under fixed-dollar annuities.5 That is, a portion of
                        each periodic payment is excluded as a tax-free return of cost until the in-
                        vestment in the contract is recovered. However, since the expected return
                        cannot be determined for an annuity which fluctuates, the tax-free portion of
                        the payments has to be calculated somewhat differently. No exclusion ratio is
                        calculated. Instead, the investment in the contract is simply divided by the
                        number of years over which the annuity will be payable to obtain the amount
                        to be excluded each year. Once again, life expectancies taken from tables in
                        the Regulations are used for life annuity calculations. Here is an example:

                                     Investment in contract
                                                            = Amount not taxed each year
                                    Number of years payable

                                                    = $2,500 not taxed each year
                                           20 years

                        Assume that $50,000 was invested in a variable annuity which is settled as a
                        variable straight-life annuity payable monthly beginning at age 65. Using the
                        same unisex table we used in the case of the fixed-dollar example, we again
                        find that the annuitant’s life expectancy at age 65 is 20 years. Then $50,000/20
                        gives us $2,500 as the amount which can be excluded from the annuitant’s
                        taxable income each year. Whatever is received over and above this amount
                        annually is taxable income.
                         Companies issuing variable annuity contracts must keep the investments in the segregated asset
                        accounts underlying the annuities “adequately diversified” in accordance with Treasury Regulations
                        in order for the contracts to be taxed as annuities under the rules described here. IRC §817(h).
70                                                                        Annuities Training Course

Amounts Not Received As Annuities (Withdrawals, Loans, Dividends)

                 Under Section 72, “amounts not received as an annuity” include:

                    • cash withdrawals

                    • dividends (unless reinvested)

                    • loans made under the annuity contract before annuity payments begin

                 In other words, any cash taken during the accumulation period, as a dividend,
                 as a partial withdrawal, by surrender of the contract, or as the proceeds of a
                 loan, if not taken as a series of periodic payments (an annuity), is subject to
                 tax under Section 72 as an amount “not received as an annuity.”

                 Amounts not received as an annuity are fully taxable to the extent that the
                 contract value (the total accumulation) at the time of the payment exceeds
                 the investment in the contract. In other words, if there is any income in the
                 contract, that income will be taxed before the owner is allowed to recover his
                 or her cost.

                 This last-in-first-out (LIFO) tax treatment (interest earnings in last, but out
                 first) was introduced by TEFRA effective as of August 13, 1982. The rule
                 applies to all annuity contracts issued after that date and also, on a pro rata
                 basis, to the earnings applicable to any post-August 13, 1982, investments
                 made in older annuity contracts.

                 LIFO vs. FIFO

                 Pre-TEFRA law had permitted the amount of an annuity owner’s investment
                 to be recovered first before any tax was payable. This was the so-called first-
                 in-first-out (FIFO) method: investment in first, investment out first, and only
                 then interest taxable. The FIFO rule still applies to withdrawals from pre-
                 August 13, 1982, annuities to the extent of the earnings on investments made
                 before that date. When a withdrawal is made from a contract with both pre-
                 and post-August 13, 1982, deposits, the amount received is allocated (under
                 the FIFO rule) first to the pre-August 13, 1982, investments, second to the
                 earnings on those investments, third (under the LIFO rule) to the income
                 from post-August 13, 1982, investments, and finally, to the post-August 13,
                 1982, investments themselves.
Taxation Of Annuities                                                                                       71

                                    Example. The purchaser of a deferred annuity issued on September
                                    1, 1980, had paid premiums amounting to $5,000 prior to August 13,
                                    1982. After that date he invested an additional $45,000. He wished to
                                    withdraw $8,000 and asked his agent if he would have any tax to pay.

                                    At the time the withdrawal was to be made, the contract was not
                                    subject to surrender charges. The cash value of the annuity amounted
                                    to $55,000. Thus, total earnings on the owner’s investment amounted
                                    to $5,000. Of this amount, $500 was attributable to premiums paid
                                    before August 13, 1982. The $8,000 withdrawal would be allocated
                                    as follows:

                                    $5,000 to pre-August 13, 1982, deposits (tax-free)
                                       500 to earnings on these deposits (taxable)
                                     2,500 to earnings on post-August 13, 1982, deposits (taxable)
                                    $8,000 total withdrawal

                                 Of this amount, $3,000 ($500 + $2,500) would be subject to tax.6

                        Had the annuity in this example been purchased after August 13, 1982,
                        $5,000 of the $8,000 withdrawal would have been taxable (under the LIFO
                        rule). Notice that $3,000 of the amount withdrawn would have been a non-
                        taxable return of cost, because the withdrawal exceeded the $5,000 total
                        earnings on the contract.

                        If all of the deposits in the example had been made before August 13, 1982,
                        the entire $8,000 withdrawal would have been a nontaxable return of cost,
                        under the old FIFO rule.

                        In addition to substituting LIFO for FIFO as the method of taxing withdraw-
                        als, TEFRA also changed the law so as to treat loans as withdrawals. Previ-
                        ously, even if the amount of a loan taken against an annuity exceeded the
                        total investment in the contract, the proceeds of the loan were not subject to
                        tax. This change was made to discourage the use of annuity loans as a
                        tax-free source of income.

                        In the example above, if the owner had borrowed $8,000 against the contract
                        instead of making a withdrawal, the $2,500 of post-August 13, 1982, earn-
                        ings would have been subject to tax just as if a withdrawal had been made.
                        However, there would have been no tax on the $500 of pre-August 13, 1982,
                        earnings borrowed, because the old law which did not require loans to be
                        treated as withdrawals would apply to that part.

                        Penalty Tax

                        A penalty tax of 10% is generally added to the regular income tax payable if
                        a withdrawal or loan is made before the taxpayer’s age 59½. However, no
                        penalty is imposed for earlier withdrawals occasioned by death or disability,
                        or for any withdrawal which is annuitized. Annuitization, under the law,
                        means that the withdrawal must be part of a series of substantially equal
                        periodic payments made annually (or more frequently) for the life of the
                        owner or the lives of the owner and a beneficiary.
                            The allocation in this example is confirmed by Rev. Rul 85-159, 1985-2 CB 29.
72                                                                                        Annuities Training Course

                  There is also an exception
                  from the penalty tax for im-       Planning Pointer:
                  mediate annuities. An imme-        A penalty tax of 10% is generally
                  diate annuity is defined to        added to the regular tax payable if a
                  mean an annuity purchased          withdrawal or loan is made before the
                  with a single premium having       taxpayer’s age 591/2. However, no
                  an annuity starting date no
                  later than one year from the       penalty is imposed for earlier withdraw-
                  purchase date. Thus, there is      als occasioned by death or disability, or
                  no penalty if someone              for any withdrawal which is annuitized.
                  younger than age 59½ wishes
                  to purchase and begin to re-
                  ceive an income under an immediate annuity.7 Clearly, this penalty tax is
                  designed to discourage the use of annuities as short-term investments and to
                  encourage their use as savings for retirement.

                  Note: While the penalty tax is a deterrent, it is important to remember that it
                  is not imposed on the entire withdrawal but only on the part which is subject
                  to tax. The effect, therefore, is simply to increase the owner’s tax rate on the
                  taxable portion by 10%. For example, if the owner is in a 28% federal tax
                  bracket, the tax rate on a premature withdrawal will be 38%. Thus, if there is
                  legitimate need to make an early withdrawal — to pay college tuition, for
                  example, the penalty tax need not be a serious deterrent. In many cases, the
                  gain from the tax-deferred accumulation will more than offset the penalty

Forced After-Death Distributions

                  Because of the advantages of tax deferral, there is a real incentive to extend
                  the accumulation period of an annuity for as long as possible. Traditionally,
                  the distribution provisions of an annuity contract are triggered only by the
                  death or retirement of the annuitant. Thus, when an individual purchases an
                  annuity contract for his or her own retirement and is both owner and annu-
                  itant under the contract, the accumulation period extends for most or all of
                  the purchaser’s lifetime, but not longer. At the owner-annuitant’s death or
                  retirement, some tax must generally be paid, because a full or partial distri-
                  bution occurs.

                  But what if someone other than the annuitant is the owner of the contract?
                  What happens if the owner dies but the annuitant is still alive? Traditionally,
                  under the provisions of most annuity contracts, nothing happened. There was
                  no distribution, because the annuitant was still alive. Someone else would
                  become the owner of the contract (through the owner’s estate, or by having
                  been named contingent owner), and the accumulation period would continue.
                  Thus, if the owner and the annuitant were not the same person, and espe-
                  cially if the named annuitant were a very young person, the accumulation
                  period might be extended and the payment of any tax deferred far beyond the
                  lifetime of the purchaser of the contract.

                  As an example, a grandfather might purchase an annuity but name a young
                  grandchild as annuitant. At grandfather’s death, ownership of the contract
                   It would also appear that there would be no penalty tax if a contract meeting the definition of an
                  immediate annuity were totally surrendered either before or after the annuity starting date, even if
                  the taxpayer was younger than 59½.
Taxation Of Annuities                                                                                                       73

                        might pass to the child’s mother. At the mother’s death, ownership might
                        pass to the grandchild who could still be several years from retirement. Since
                        no distributions accompanied the successive transfers of ownership, income
                        tax on substantial accumulations created by grandfather’s funds might be
                        deferred for many years beyond grandfather’s death.

                        Distribution Rules Changes

                        In 1984, Congress acted to stem the perceived loss of revenue such untaxed
                        ownership transfers had entailed. In order to enjoy the privilege of being
                        taxed as an annuity, contracts issued after January 18, 1985 were required to
                        contain new provisions calling for distributions to be made after the owner’s8
                        death. Generally, the new distribution provisions were the same as those
                        which already applied to distributions from qualified plans and IRAs.

                        These are the required provisions for contracts issued after January 18, 1985:

                            • If an annuity owner dies on or after the annuity starting date, any
                              remaining payments must be made to a beneficiary at least as rapidly as
                              under the method of distribution being used while the owner was alive.

                            • If the owner dies before the annuity starting date, any remaining value
                              in the contract must be distributed within five years after the owner’s

                             Under the law, either of these distribution requirements is considered to
                             have been met if any remaining value in the contract is set up to be paid
                             to the beneficiary as an annuity not extending beyond the beneficiary’s
                             life expectancy and beginning within one year after the owner’s death.

                             With these provisions made mandatory, it is no longer possible to extend
                             the accumulation period and defer income tax beyond the original
                             owner’s lifetime. Death of an owner other than the annuitant now trig-
                             gers a distribution similar to the distribution which occurs when the
                             annuitant dies. The law does allow one very important exception, how-
                             ever. If the surviving spouse of the owner is named to take ownership at
                             the owner’s death, he or she steps into the deceased owner’s shoes,
                             allowing distribution (and taxation) to await the spouse’s death.

                            To prevent avoidance of the new after-death distribution rules, the 1986
                        Act also included a new lifetime transfer provision. If the individual owner
                        of an annuity contract transfers it to another “without full and adequate
                        consideration,” the transfer or will be treated as having received a distribu-
                        tion under the contract at the time of the transfer. The distribution will be
                        subject to income tax as “an amount not received as an annuity.” That is, the
                        original owner will be taxed on any excess of the contract value over the
                        investment in the contract. The only time this rule does not apply is when the
                        transfer is between spouses or incident to a divorce.10

                         The actual term used in the statute was “holder” of the contract. IRC §72(s).
                         Where the owner is a corporation, or other non-individual, these rules are applied at the death of
                        the “primary annuitant.” Also, if there is a change in the primary annuitant, they are applied as if the
                        primary annuitant had died. IRC §72(s)(6) and (7).
                           IRC §72(e)(4)(C). Any amount the transferor has to include in income under this rule is added to
                        the transferee’s investment in the contract.
74                                                                                    Annuities Training Course

Tax-Free Exchanges

                Sometimes the owner of an annuity contract will want to use the money in
                that contract to purchase an annuity with a different company. Perhaps the
                owner is worried about the financial situation of the first company.

                In this situation, you will need to know about the Section 1035 exchange.
                The term refers to IRC Section 1035, which permits certain tax-free ex-
                changes of insurance policies, among them, the exchange of “an annuity
                contract for an annuity contract.” Through various revenue rulings, specific
                requirements have been established for making sure that what occurs is re-
                ally an exchange of contracts and not
                the surrender of one for cash and the Tax-Free Exchange
                purchase of another. Most insurance                                    New
                companies have devised exchange                        $ $     $     Annuity
                procedures to comply with the Code                                   Contract
                and the revenue rulings. Therefore,
                whenever the funds for purchase of an
                annuity are to come from an existing Taxation of Released Portion
                contract, you must follow your
                                                             Old                       New
                company’s procedure for effecting an                  $ $      $
                                                           Annuity                   Annuity
                exchange in order to avoid or mini-
                                                           Contract      Owner       Contract

                mize any tax liability for your client.
                Generally, if the correct procedure is
                followed and the full value of the old contract is used to acquire the new
                contract, the exchange is entirely tax-free. If any money is released in the
                exchange, however, the money will be taxed to the extent that the value of
                the new contract, plus the cash, exceeds the cost of the old policy.

                When an exchange has been made under Section 1035 with no release of
                cash, the cost basis of the original annuity contract is transferred to the new
                one.11 This effectively defers tax on the gain in the old contract until the time
                when distributions are taken under the new one.

                Transfer of Tax Status

                The tax status of the original contract is also transferred to the new one.12
                This means that if the original annuity was purchased before August 13,
                1982, the new annuity will also be deemed to have been purchased before
                that date. Thus, despite the exchange occurring after this crucial date, the old
                FIFO tax rule will apply to some or all of the distributions later taken under
                the new contract. (Of course, if additional premiums are paid after the ex-
                change, the new LIFO rule will apply to whatever part of the distribution is
                applicable to those premiums. See the example under the “Amounts Not
                Received As Annuities” section above.)

                   IRC §1031(d). If money was released in the exchange, the basis of the new contract is decreased
                by the amount of money released and increased by the amount of any gain recognized in the
                exchange because of the receipt of cash.
                   Rev. Rul. 85-159, 1985-2 CB 29
Taxation Of Annuities                                                                                  75

Federal Estate Tax

                        Though not as universally felt as the income tax, the federal estate tax also
                        applies to annuities, because annuities are “property.” To help you answer
                        your clients’ questions and also to set up ownership and beneficiary arrange-
                        ments so as to avoid problems and possibly minimize taxes, we will examine
                        the estate tax rules briefly.

                        Theoretically, the estate tax provisions of the Internal Revenue Code apply to
                        all annuities, because all of a deceased person’s property must be included in
                        his or her gross estate for tax purposes. Practically, however, many annuities
                        will be unaffected by the estate tax, either because they terminate at death
                        leaving nothing to be taxed, because the estate is not large enough to incur an
                        estate tax, or because the estate tax is avoided by naming the surviving spouse to
                        receive annuity benefits (thus securing the unlimited marital deduction).

                        Adjusted Gross Estate
                                                             Planning Pointer:
                        No federal estate tax is pay-     Many annuities will be unaffected
                        able unless the federal estate    by the estate tax, either because they
                        tax base (taxable estate plus     terminate at death leaving nothing to
                        “adjusted taxable gifts”)         be taxed, because the estate is not
                        exceeds certain limits. The
                                                          large enough to incur an estate tax, or
                        amount in 2004–2005 is
                        $1.5 million. The Economic        because estate tax is avoided by
                        Growth and Tax Relief Rec-        naming the surviving spouse to receive
                        onciliation Act of 2001 in-       annuity benefits.
                        creases the exemption for
                        future years, eventually in-
                        creasing to $3.5 million in 2009. The federal estate tax is slated for a one-
                        year repeal on January 1, 2010. Even greater amounts can be sheltered by
                        leaving assets to a surviving spouse in such a way as to qualify for the
                        marital deduction.

                        To plan for larger estates or cases where there is no spouse, however, it is
                        necessary to know when and how an annuity becomes a part of the gross
                        estate, and conversely, how it may be excluded. Two of the inclusion sections
                        of the estate tax law are particularly important.

                        IRC Section 2033 is the general “property” section of the estate tax law. It
                        brings into the gross estate the value of “all property to the extent of the
                        interest…of the decedent at the time of his death.” We will see that an
                        annuity can be brought into an estate under this section of the law.

                        IRC Section 2039 deals specifically with annuities. It provides, in effect,
                        that the value of an annuity or any other payment which “any beneficiary” is
                        entitled to receive, by reason of surviving a decedent (under any annuity
                        issued after March 3, 1931), is to be included in the decedent’s gross estate
                        for estate tax purposes if the decedent, at the time of death, had a right to an
                        annuity or other payment under the contract. However, if someone other than
                        the annuitant (or the annuitant’s employer) paid any of the premiums on the
                        contract, only that proportion of the total value of the post-death payments
                        purchased by the decedent is includible in the estate. This means, for example,
76                                                            Annuities Training Course

     that if the survivor under a
     joint-and-last-survivor annu-       Planning Pointer:
     ity had paid all the premiums       Give careful attention to IRC
     on the contract, no part of the     Sections 2033 and 2039 of the estate
     value of the payments to the        tax law in determining how various
     survivor would be includible        types of annuities should be set up in
     in the estate of the first to die
     under Section 2039.                 order to avoid inclusion in a wealthy
                                         client’s estate subject to taxation.
     Notice that there is no simi-
     lar premium payment excep-
     tion under Section 2033. Notice, also, that Section 2039 applies only when
     there is to be payment to “a beneficiary.” If annuity payments are to continue
     to a deceased annuitant’s estate, or if there is to be a cash refund to the
     estate, Section 2033 will apply, but Section 2039 will not. The result of these
     two circumstances is that unless a beneficiary other than the estate has been
     named to receive payment, the full value of the refund or continuing pay-
     ments will be includible in the deceased annuitant’s gross estate, even if the
     deceased annuitant paid none of the premiums.

     For planning purposes, this suggests that when someone other than the annuitant
     has paid the premiums on a refund or survivorship annuity, or when two
     individuals have shared in paying such premiums, an estate tax savings might
     result by naming an individual beneficiary to receive any post-death payments.

     Straight-Life Annuities

     A straight-life annuity will generally be totally unaffected by Section 2033,
     Section 2039, or any other provision of the estate tax law. Since a straight-
     life annuity terminates at the annuitant’s death, there is nothing to be in-
     cluded in the estate or subjected to tax if the annuitant dies while receiving
     payments. (This is the reason why such an annuity can often be a valuable
     estate planning tool for individuals with sizable estates, enabling them to
     reduce their estates through lifetime gifts of other property.)

             Refund or Survivorship Annuities

             On the other hand, if the annuitant dies while receiving payments
             under a refund or survivorship annuity, the refund or continuing pay-
             ments have a value and may be includible in the annuitant’s gross
             estate under either Section 2033 or Section 2039, depending upon the
             particular circumstances.

             If the deceased annuitant was also the purchaser of the refund or
             survivorship annuity, the full value of the refund or the continuing
             annuity payments will be includible in the annuitant’s gross estate
             under Section 2039 if payable to a named beneficiary, or under Sec-
             tion 2033 if payable to the annuitant’s estate.

              If someone else purchased the annuity — simply naming the dece-
     dent as annuitant and giving him or her no ownership rights in the contract
     — the value of the refund or the continuing payments would only be includ-
     ible in the annuitant’s estate (under Section 2033) if the estate was to receive
Taxation Of Annuities                                                                                                77

                        the post-death payments. If the refund or continuing payments were payable
                        to a beneficiary named by the contract’s owner (which the deceased annu-
                        itant had no power to change), their value should not be includible in the
                        annuitant’s estate under Sections 2033 or 2039.

                        Notice that we have been discussing the annuitant’s estate when the annu-
                        itant dies before annuity payments have begun, and he or she is also the
                        owner of the annuity. In this case, the accumulated value in the contract, or
                        the death benefit, will be includible in the gross estate — under Section
                        2039, if payable to a named beneficiary, or under Section 2033, if payable to
                        the estate — just as explained above.

                        Non-Owner Annuitant

                        But what if the annuitant is not the owner of the contract, did not provide any
                        of the premiums, has no other rights in the contract, and dies before annuity
                        payments have begun? In that case, it would appear that there is no property
                        to be included in the annuitant’s estate. On the other hand, if the owner of
                        the contract dies before annuity payments have begun, retaining all owner-
                        ship rights at time of death, e.g., the right to change the refund beneficiary
                        and to name a contingent annuitant or contingent owner, then the value of the
                        contract will be includible in the deceased owner’s gross estate under the
                        general “property” provision of Section 2033.

                                 Marital Deduction

                                 But even though post-death payments have to be included in the
                                 gross estate, they are often removed from the taxable estate by the
                                 marital deduction already mentioned. IRC Section 2056 provides, in
                                 effect, that payments passing from an annuitant to the annuitant’s
                                 surviving spouse under an annuity contract will qualify for the mari-
                                 tal deduction (and therefore reduce the taxable estate) if:

                                 • payments are payable only to the surviving spouse during the
                                   spouse’s lifetime, and

                                 • the spouse has an unlimited power to appoint all amounts payable
                                   under the contract to the spouse or the spouse’s estate.

                        Thus, where refund or annuity payments are to be made to an annuitant’s
                        spouse, they can be made to qualify for the marital deduction, thereby effec-
                        tively removing them from the taxable estate, provided the spouse actually
                        survives the annuitant.13

                        Most of your cases will be straightforward situations where owner and annu-
                        itant are the same. Also, there will be many cases where the marital deduc-
                        tion can be utilized, and other cases where — because of the size of the
                        estate — the estate tax will not be a concern.

                           Where the owner of an annuity dies before payments have begun, the contract value or death
                        benefit may also be arranged so as to qualify for the marital deduction, and thereby removed from
                        the owner’s taxable estate.
78                                                                            Annuities Training Course

                   You should know, however,
                   that there are sections of the     Planning Pointer:
                   estate tax law other than Sec-     Sections of the estate tax law that
                   tions 2033 and 2039 which          can affect annuity inclusion in the
                   can bring an annuity into the      gross estate are:
                   gross estate. In particular,
                   under certain circumstances,         • 2033             • 2037
                   Sections 2035, 2036, 2037            • 2035             • 2038
                   and 2038 can bring back into         • 2036             • 2039
                   the estate an annuity contract
                   or other property which the
                   owner may have given away
                   before death, usually retaining some “string” on the property.

                   If you have a client who wants an unusual or sophisticated ownership or
                   beneficiary arrangement, be aware that there may be estate tax consequences.
                   In such a situation, especially if sizable amounts are involved, you will want
                   to secure expert tax assistance or enlist the aid of the client’s own tax advisor.

Federal Gift Tax

                   The federal gift tax is not a great concern for most people because of the
                   substantial amount which can be given away without incurring a gift tax. The
                   gift tax annual exclusion allows a donor to give as much as $11,000 (indexed
                   after 2004) annually (or $22,000 when husband and wife join) to each of any
                   number of donees. Provided the gift qualifies as a “gift of a present interest,”
                   meaning, generally, that the donee doesn’t have to wait to enjoy the gift, the
                   exclusion applies. By using the applicable credit amount, a donor can also
                   make additional gifts (over and above amounts sheltered by the gift tax
                   annual exclusion) totaling $1 million in the aggregate.

                   Important Note: The gift tax applicable credit amount (“unified credit”) is
                   frozen at $1 million from 2002 on, barring any future legislative action by
                   Congress. It will NOT rise with the scheduled increases in the estate tax
                   applicable credit amount that begin in 2004.

                   Unrestricted gifts in any amount to the donor’s spouse are generally totally
                   exempt from gift tax by reason of the unlimited gift tax marital deduction.

                   In combination, these gift tax provisions give donors considerable leeway to
                   make gifts, including gifts of annuities. Nevertheless, there will be times
                   when you need to know how the gift tax provisions affect annuity transfers.
                   In particular, you will need to be aware that a taxable gift can sometimes be
                   made inadvertently, because there are so many ways to transfer an interest in
                   an annuity contract.

                   A gift of an interest in an annuity can occur in any of the following ways:

                      • By purchasing an annuity and naming someone else as owner of the
Taxation Of Annuities                                                                                                     79

                             • By transferring ownership of an existing annuity contract to someone

                             • By purchasing a joint-and-survivor annuity without reserving the right
                               to change the recipient of the survivorship payments.

                             • By naming an irrevocable beneficiary for an annuity with a refund feature.

                                  Of course, not all such transfers will result in a gift tax, but some-
                                  times, though no tax is payable, a gift tax return will have to be filed.
                                  Also, such a transfer, in combination with any prior gifts made by the
                                  same donor, might give rise to a tax because the gift tax is imposed
                                  on aggregate gifts.

                                  If another person is named owner of a newly purchased annuity, the
                                  amount of the gift is the amount of the premium paid. Each premium
                                  paid by the purchaser thereafter is another gift.

                                If an existing annuity contract is transferred to someone else, the
                                amount of the gift, generally, is the single premium the company
                        issuing the contract would charge for the same kind of contract issued to a
                        person of the annuitant’s age at the time of the gift.

                        Both of the gifts just described would ordinarily be gifts of a present interest
                        and so, up to $11,000 ($22,000 if gift-splitting is elected by spouses) would
                        be exempt from gift tax by reason of the gift tax annual exclusion (or more if
                        the exclusion amount is indexed after 2004).

                        The gifts which can occur upon the purchase of a joint-and-survivor annuity
                        or upon naming a beneficiary irrevocably are future interest gifts, because
                        the donees must wait until the annuitant’s death to receive them. The gift tax
                        regulations prescribe the method(s) for evaluating future interest gifts. Such
                        gifts do not qualify for the annual exclusion, but they can escape gift tax
                        through use of the donor’s applicable credit amount.

                        If spouses have elected to gift-split, both spouses may draw on their respec-
                        tive applicable credit amounts to shelter a gift that exceeds their combined
                        annual exclusions.

                        Example: Father makes a $50,000 gift to Daughter in 2004, and Mother
                        agrees to split the gift with him. Each is deemed to make a $25,000 gross
                        gift to Daughter, and each would use the $11,000 annual exclusion to shelter
                        part of his/her gift. Father and Mother would also draw upon their $1 mil-
                        lion exemption amount to shelter the remaining $14,000 taxable gift that
                        each makes to Daughter.

                          There is an important income tax deterrent to outright gifts of an annuity after issue (to anyone
                        other than a spouse or a former spouse incident to a divorce). If the cash value of the annuity at the
                        date of the gift exceeds the investment in the contract, the donor must pay income tax on the excess,
                        just as if a withdrawal had been made. IRC §72(e)(4)(C).
80                                                                       Annuities Training Course

Other Tax Questions

                 What we have just completed is a summary of the basic tax rules which
                 apply to nonqualified annuity contracts (meaning those which are not part of
                 any kind of tax-qualified retirement plan). The rules for qualified annuities,
                 which are different because of certain applicable qualified plan rules, are
                 explained in the next chapter.

                 You can certainly answer general tax questions about the annuity products
                 you sell. There are many tax publications to help you, or you can consult
                 your company’s tax experts. Remember, however, that it is not your function
                 to offer tax advice to your annuity clients. That is the business of the
                 client’s own attorney or accountant. When questions arise relating to a
                 client’s individual circumstances, you will need to refer the client to his or
                 her own tax advisors. As you sell more and more annuities, you will learn a
                 great deal from these tax experts. Since these advisors will generally need to
                 consult with you, as the annuity expert, for information about the product,
                 you should never hesitate to bring them into the picture.
Annuities Training Course                                                                                          81

                                                     Selling Qualified Annuities

        c o n t e n t s

                       Tax-Sheltered Annuities (TSAs)............................................... 84

                       Individual Retirement Accounts/Annuities (IRAs) ................ 87

                       Individual Retirement Annuities .............................................. 91

                       Simplified Employee Pensions (SEP-IRAs) ........................... 92

                       SIMPLE IRAs ............................................................................... 94

                       About Rollovers — Some Rules You Need To Know ............ 96

                       In Summary ................................................................................. 98
Selling Qualified Annuities                                                                                              83

                                  Until now we have been discussing nonqualified annuities, pur-
                                  chased with after-tax dollars, and without benefit of any special tax
                                  rules other than the annuity rules explained in Chapter 6.

                                  But qualified annuities are a major part of the annuity business.
                                  Qualified annuities are contracts companies have developed for sale
                                  under certain “tax-qualified retirement plans.” Every agent or broker
                                  who sells annuities needs to be aware of the special tax advantages
                                  afforded by these qualified retirement plans and the qualified annu-
                                  ities sold under them.

                                  Annuities purchased under a qualified retirement plan offer the ulti-
                                  mate tax advantage. Not only is there tax-deferral on interest earned,
                                  there is also tax deferral on principal invested. That’s because, within
                                  limits depending upon the type of plan, the law allows a deduction
                                  for plan contributions. Annuity premiums are thus paid with
                                  “tax-deductible dollars,” the best of all possible worlds.

                         There are several types of
                         qualified retirement plans. Cor-
                         porate and self-employed                     Planning Pointer:
                         (Keogh) pension and profit-                  Annuities purchased under a
                         sharing plans come first to                  qualified retirement plan offer the
                         mind. But we will discuss in                 ultimate tax advantage. Not only is
                         detail here only qualified annu-             there tax-deferral on interest earned,
                         ity plans. Tax-qualified annuity             there is also tax-deferral on principal
                         plans offer you the best possi-
                         bility for substantial qualified             invested.
                         annuity sales without becoming
                         a pension expert.

                         The qualified annuity plans that offer substantial sales opportunities are:

                               • Tax-Sheltered Annuity Plans
                               • Individual Retirement Annuity Plans
                               • Simplified Employee Pensions
                               • SIMPLE IRAs

                         We will explain how plan requirements and special tax rules make these
                         qualified annuities different from the nonqualifed annuities discussed in
                         earlier chapters.

                         NOTE: Of course, corporations and the self-employed can also use annuities
                         as a funding vehicle for their qualified pension and profit-sharing plans,
                         both during the employment period (as a plan investment) and at the retire-
                         ment stage (as a vehicle for funding the payout). Such annuities, though
                         owned by a trust or a corporation, enjoy the same tax deferral on interest
                         earned as do annuities owned by natural persons.1 Thus, there is no reason
                         why annuities should not be sold to pension and profit-sharing plans. In fact,

                          Annuities held by qualified pension, profit-sharing, or stock bonus plans, or used to fund benefits
                         under such plans, enjoy a special exemption from the general rule which taxes annuity income
                         currently if the owner is not a natural person. IRC §72(u).
84                                                                         Annuities Training Course

                   several special types of annuities have been developed for this market. These
                   include group annuities, guaranteed income contracts (GICs), and special
                   terminal funding annuities (which are beyond the scope of this course).

                   There is a large body of tax law specific to pension and profit-sharing plans.
                   Here we will only scratch the surface. Any further discussion of pensions we
                   will leave for a pension course, where a discussion of the group annuities
                   and other special annuity products developed for this market also properly

Tax-Sheltered Annuities (TSAs)

                   The tax-sheltered annuity, or TSA, is a specialized market which requires
                   some knowledge of a special set of tax rules. But it is specifically an annuity
                   market, and one which produces contributions in the billions of dollars made
                   by millions of eligible employees.
                   The TSA (also often referred to as a TDA, for tax-deferred annuity) is a
                   unique retirement plan authorized by Section 403(b) of the Internal Revenue

                   Code and available primarily to employees of public schools and certain
                   non-profit organizations. (Reflecting its source, a TSA is also often referred
       TDA         to as a Section 403(b) annuity or Section 403(b) plan.)

                   Only public school systems and organizations which qualify for tax exemp-
                   tion under Section 501(c)(3) of the Code are eligible to provide their em-
                   ployees with TSAs. In general, the qualifying organizations are funds,
                   community chests, foundations, or nonprofit corporations devoted to educa-
                   tional, scientific, and charitable purposes. Examples include private schools
                   and universities, some hospitals, nursing homes, and museums.

                   Basically, a TSA is an annuity contract purchased by an eligible employer
                   for an employee. The premium dollars may come either from a salary in-
                   crease or from a salary reduction agreed to by employer and employee. In
                   either case, the premiums are paid with “before-tax dollars.” The employee’s
                   tax on this portion of his or her compensation is deferred, along with the tax
                   on any annuity earnings, until such time as there is a distribution under the

                   The advantage of this type of tax deferral is easy to demonstrate. For ex-
                   ample, an employee in a 35% combined state and federal tax bracket can
                   invest $1,000 in a TSA through a salary reduction plan, reducing spendable
                   income by only $650. If the same investment is made each year over a
                   10-year period, and 8% is earned, the employee will have accumulated
                   $14,487 by the end of the period.

                   Compare this with $650 invested annually over a 10-year period in an annu-
                   ity earning 8% outside a TSA. Here the accumulation would amount to just
                   $9,416, a difference of $5,071, for the same out-of-pocket expenditure. Ex-
                   amples as simple as this have convinced thousands of eligible employers as
                   well as their employees that the TSA offers an opportunity too good to
Selling Qualified Annuities                                                                            85

                         The tax deferral advantage
                         offered by a TSA is so simi-      Planning Pointer:
                         lar to that of corporate quali-   The TSA is a unique retirement
                         fied plans that Congress has      plan available only to employees of
                         seen fit to apply to              public schools and certain non-profit
                         tax-sheltered annuity pro-        organizations. The premiums are paid
                         grams some of the same
                         kinds of special tax rules that   with “before tax dollars.” The employee’s
                         apply to corporate qualified      tax on this portion of his or her com-
                         retirement plans. These rules     pensation is deferred, along with the
                         include certain nondiscrimi-      tax on any annuity earnings, until such
                         nation requirements, contri-      time as there is a distribution under the
                         bution ceilings, and special      contract.
                         withdrawal, loan and pay-
                         ment provisions.

                         You need a basic understanding of these rules to sell TSAs. Here is a sum-
                         mary to get you started:


                         Nondiscrimination rules apply to TSA programs. Briefly, for elective plans
                         (where premiums are paid by salary reduction), if premiums exceed $200, all
                         nonexcludable employees must have the right to make the salary reduction

                         Nonelective plans (where premiums are paid as extra compensation) must
                         comply with most of the nondiscrimination requirements and tests which
                         apply to corporate qualified plans. Partly for this reason, many TSAs today
                         are sold under salary reduction plans.

                         Note that the single exception to the nondiscrimination rules is for TSAs
                         purchased by a church.2

                         Contribution Limits

                         Congress has placed limits on the total amount of an employee’s compensa-
                         tion on which tax can be deferred through contributions to any tax-favored
                         retirement plan.

                         Section 415 Overall Limit on Contributions: Section 403(b) plans are de-
                         fined contribution plans subject to the IRC Section 415’s overall limits on
                         contributions from all sources (employer and employee). In 2004, the Sec-
                         tion 415 defined contribution limit is the lesser of 100% of compensation or

                         Annual Limit on Elective Salary Deferrals: The dollar limit on a
                         participant’s elective salary deferrals into a 403(b) plan, and additional

                             IRC §403(b)(1)(d)
86                                                             Annuities Training Course

     “catch-up” deferrals permitted for participants age 50 and over, are deter-
     mined from the following table:

             Year            Deferral Limit       Deferral Limit
                             Under Age 50        Age 50 and Over
             2003               $12,000              $14,000
             2004               $13,000              $16,000
             2005               $14,000              $18,000
             2006               $15,000              $20,000

     After 2006, the basic elective deferral limit ($15,000) and age-50+ catch-up
     amount ($5,000) will be indexed to inflation in $500 increments.

     A plan is not required to allow additional “catch-up” contributions by partici-
     pants age 50 and over; it is merely permitted to do so. A participant is
     deemed to be age 50 for a
     particular year if he or she
     turns 50 during that year.         Planning Pointer:
                                         The effect of the two ceilings
     The Economic Growth and
                                         on TSA contributions is to limit annual
     Tax Relief Reconciliation
     Act of 2001 repealed the old        deferrals under salary reduction plans
     403(b) exclusion allowance          to the lowest amount allowable.
     for 2002 and after.

     Withdrawal, Loan And Payment Provisions

     In several ways the tax rules respecting withdrawals, loans, and distributions
     from a TSA are different from those that apply to regular annuities. Here are
     the major differences:

        • There are before-death distribution requirements for a TSA. In general,
          distributions must begin no later than April 1 of the year following the
          later of (1) the year of actual retirement, or (2) the year of attainment of
          age 70½, and must be taken in minimum (or greater) annual amounts as
          determined under the government’s Uniform Lifetime Table. Excep-
          tion: If the TSA owner’s beneficiary is a spouse who is more than 10
          years younger, the Joint Life Table is used to calculate the required
          minimum annual distribution rather than the Uniform Lifetime Table.

        • Because investments in a TSA are made pre-tax, withdrawals and retire-
          ment payments are generally fully taxable. There is usually no
          employee cost to be recovered.

        • Loans may be made without tax consequence under a TSA, within cer-
          tain specified limits (the same loan limits applicable to other qualified
          retirement plans). In very general terms, this means that an employee
          may borrow at least $10,000 (if there is that much value in the contract)
          but not more than $50,000, or one-half the contract value, if less. Loans
          must be repaid, with at least quarterly payments, within five years.
          Loans used to purchase a personal primary residence may be repaid
          over a longer period.
Selling Qualified Annuities                                                                          87

                         TSA Penalty Tax

                         As is true for regular annuities, a 10% penalty tax applies to withdrawals
                         from a TSA made before age 59½, with certain exceptions. Some of the
                         exceptions to the penalty tax are the same for TSAs and regular annuities,
                         and some are different. There is no penalty tax in either case for withdrawals
                         due to the death or disability of the employee or annuitant, or if a withdrawal
                         is taken as a life or joint-life annuity. The penalty is also avoided under a
                         TSA (but not under a regular annuity) if a withdrawal is due to early retire-
                         ment after age 55, or is for medical expenses (but only for amounts sufficient
                         to produce an income tax deduction for the employee).

                         With this much information about the special characteristics of tax-sheltered
                         annuity plans, you should be able to venture into TSA territory. If you are an
                         agent with a company which sells a TSA product, your own company’s ex-
                         perts will be your best source for further information. If you are a broker,
                         you will be able to find TSA specialists in the companies whose products
                         you sell. And there are many articles in trade magazines written by TSA
                         experts, as you no doubt have noticed. Like any technical area, the TSA rules
                         seem complex in the beginning, but with a bit of time and effort, become
                         easy to understand. The logic of the various special provisions will become
                         apparent as you grow more familiar with them, and in the process, you will
                         be gaining an entirely new group of clients — the teachers and not-for-profit
                         employees who are eligible for this unique retirement plan.

Individual Retirement Accounts/Annuities (IRAs)

                               Traditional IRAs are tax-qualified personal retirement savings pro-
                               grams which provide tax deductions and tax deferral for millions of
                               working individuals and their spouses.

                               In the individual retirement account, contributions are made to a trust
                               established with a bank or other approved trustee. In the individual
                               retirement annuity, contributions are used to pay premiums on a
                               qualified annuity contract issued by an insurance company.

                               Most of our discussion will be about the individual retirement annuity.
                               But we begin with a bit of the history of both types of IRAs.

                               First made available in 1975 to individuals not covered by qualified
                               pension and profit-sharing plans, IRAs received their real impetus
                               when ERTA (the Economic Recovery Tax Act of 1981) made them
                         available to working individuals and their spouses, whether or not they were
                         covered by other plans.

                         Beginning in 1982, millions of working people took advantage of the oppor-
                         tunity to contribute up to $2,000 annually on a tax-deductible basis to an
                         IRA. It was necessary to have only $2,000 of earned income (including self-
                         employment income or alimony) to get the maximum IRA deduction.
88                                                                           Annuities Training Course

     1986 Tax Reform Act

     This method of tax-deferred
     saving became so widespread        Planning Pointer:
     and popular that, in the 1986      While limitations have been
     Tax Reform Act, Congress           imposed, many taxpayers are still
     acted to limit deductible IRA      entitled to a full or partial deduction for
     contributions for active par-
     ticipants (and their spouses)      IRA contributions. And both deductible
     in other qualified plans. De-      and nondeductible IRA contributions
     ductible contributions were        are allowed to accumulate on a tax-
     completely eliminated for          deferred basis.
     married couples filing a joint
     return when either spouse
     was an active qualified plan participant and combined adjusted gross income
     exceeded a maximum amount (set at $75,000 of adjusted gross income for
     2004). For unmarried individuals who are active participants in their
     employer’s plans, the IRA deduction is lost completely at $55,000 of AGI in

     Qualified plan participants with less income are entitled to at least a partial
     IRA deduction. For them, the current contribution limit is phased out, begin-
     ning at $65,000 for married couples filing a joint return and $45,000 for
     singles in 2004. (The phaseout begins with the first dollar of adjusted gross
     income for a married individual filing separately.) But such plan participants
     are allowed to make a nondeductible contribution to bring their total contri-
     bution (deductible and nondeductible) up to the annual contribution limit.

     Individuals not disqualified by “active participant” rules remain entitled to
     the full IRA deduction. And both deductible and nondeductible IRA contri-
     butions accumulate earnings on a tax-deferred basis.3

     Taxpayer Relief Act of 1997

     TRA ’97 kept the basic structure of TRA ’86, but the AGI phaseout range
     increased in 1998 and will continue to do so for several years.

     The following table summarizes the scheduled increases in the AGI phaseout
     ranges for unmarried taxpayers and joint filers over the next several years:

                                        Unmarried                   Married Filing Jointly
                                   Phaseout     Phaseout          Phaseout       Phaseout
           Year                     Begins        Ends             Begins          Ends

           2003                     $40,000        $50,000         $60,000          $70,000
           2004                     $45,000        $55,000         $65,000          $75,000
           2005                     $50,000        $60,000         $70,000          $80,000
           2006                     $50,000        $60,000         $75,000          $85,000
           2007 and later           $50,000        $60,000         $80,000         $100,000

         However, no IRA deduction is permitted to anyone after they reach age 70½. IRC §219(d)(1).
Selling Qualified Annuities                                                                        89

                         When the Spouse Is an “Active Participant.” Under prior law, a married
                         person often could not make a deductible IRA contribution because his or
                         her spouse was an “active participant” in a qualified employer retirement
                         plan. This was the case even if the spouse who wanted to deduct the IRA
                         contribution was not covered by an employer plan.

                         Beginning in 1998, the non-covered spouse is no longer disqualified from
                         making a deductible IRA contribution because of the other spouse’s partici-
                         pation in a plan. However, in this situation, the IRA deduction will begin to
                         phase out when the couple’s joint AGI reaches $150,000, and the deduction
                         will disappear when their joint AGI reaches $160,000. These amounts do not
                         increase automatically each year.

                         The Economic Growth and Tax Relief Reconciliation Act of 2001. This
                         tax law increased the contribution limits for both traditional and Roth IRAs
                         (discussed below) beginning in 2002. Further, taxpayers who have reached at
                         least age 50 by December 31 of a year are permitted to make additional
                         “catch-up” contributions to IRAs. The new limits are summarized in the
                         following table:

                                Year          Contribution Limit       Contribution Limit
                                                Under Age 50           Age 50 and Over
                                 2003               $3,000                   $3,500
                                 2004               $3,000                   $3,500
                                 2005               $4,000                   $4,500
                                 2006               $4,000                   $5,000
                                 2007               $4,000                   $5,000
                                2008+               $5,000                   $6,000

                         Beginning in 2009, the annual limits on IRA contributions and catch-ups will
                         be inflation-indexed.

                         The 100%-of-earned-income limitation on IRA contributions has not
                         changed. Thus, a person who has only investment income for a particular
                         year may not contribute to an IRA.

                         Roth IRAs. A new type of
                         IRA became available to           Planning Pointer:
                         many taxpayers in 1998. The
                                                           The annual contribution permitted to
                         so-called “Roth IRA” is
                         unique in that no up-front de-    Roth IRAs must be reduced by any
                         duction is allowed when con-      contributions to non-Roth IRAs made
                         tributions are made to the        the same year.
                         IRA, but neither is any tax
                         due when qualifying distribu-
                         tions are taken from the IRA. Traditional IRAs continue to be available; the
                         Roth IRA is simply a new option.

                         Higher-income taxpayers cannot participate in the Roth IRA. Joint filers with
                         AGIs above $160,000 and single filers with AGIs above $110,000 cannot
                         participate in Roth IRAs. These amounts do not increase automatically each
90                                                              Annuities Training Course

     The annual contribution limit for a Roth IRA is the same as the table above.
     However, the contribution to the Roth IRA must be reduced by contributions
     to other non-Roth IRAs made during the same year.

     After the contribution has been in the Roth IRA for at least five years,
     generally it may be withdrawn income tax-free:

          • after the owner reaches age 59½,
          • following the owner’s death,
          • following the owner’s disability, or
          • if used for first-time homebuyer expenses.

             IRA Distributions for First-Time Homebuyers. Under prior law, an
             IRA distribution taken before age 59½ was subject not only to the
             regular income tax, but also to a 10% penalty tax as a “premature
             distribution.” Certain exceptions to the age 59½ rule were allowed,
             such as death and disability.

             Beginning in 1998, the law allows a new exception: an IRA distribu-
             tion taken before age 59½ will avoid the 10% penalty tax if it is used
             within 120 days to pay certain acquisition costs of a first-time
             homebuyer. This exception becomes available for IRA distributions
             taken in 1998 and after, and applies both to traditional IRAs and the
             new Roth IRAs. The lifetime maximum under this exception is only
             $10,000, however.

     Investment of IRA Contributions. Generally, IRA contributions and the
     earnings thereon cannot be invested in collectibles such as antiques, artwork,
     etc. However, under prior law, investment in certain types of coins was al-
     lowed as an exception to this general rule.

     The exception for coins has been expanded to include (1) certain platinum
     coins and (2) certain gold, silver, platinum, or palladium bullion of sufficient
     purity that it could be delivered in satisfaction of a regulated futures contract.
     The bullion must be held in the physical possession of the IRA trustee for the
     exception to apply.

     The new exceptions became available beginning in 1998.
Selling Qualified Annuities                                                                              91

Individual Retirement Annuities

                         To meet the requirements of the law governing IRAs, an insurance company
                         can either develop a special prototype plan or, alternatively, it can modify an
                         appropriate annuity contract by adding all the required plan provisions,
                         thereby transforming the annuity itself into an IRA. As far as the company’s
                         clients are concerned, there is really no practical difference between these
                         two methods. Whichever approach it takes, the company will secure the
                         necessary Internal Revenue Service approval of its plan or modified contract,
                         relieving its IRA clients of that responsibility.

                         Either fixed-dollar or vari-
                         able annuities can be quali-
                         fied as IRAs. Under the law,        Planning Pointer:
                         premiums must not be fixed,         Insurance companies offering
                         which means that only a             individual retirement annuities provide
                         flexible-premium annuity
                                                             the assurance that their IRAs meet all
                         can qualify as a contributory
                         IRA. But a single-premium           IRS provisions for tax-favored treatment.
                         annuity can qualify as a
                         rollover IRA.

                         There must be provisions in the plan or contract to keep annual premiums on
                         an IRA from exceeding the statutory contribution limits. There is no limit on
                         the amount of rollover contributions.

                         The owner’s interest in the annuity must be both nonforfeitable and non-
                         transferable. Also, obtaining a loan against the contract, even from the is-
                         suer, will disqualify it as an IRA. For this reason, annuities qualified as IRAs
                         do not contain a loan provision.

                         In the same manner as TSAs and other qualified plans, distributions from an
                         IRA must begin by April 1 of the year following the year in which the owner
                         reaches age 70½. For IRAs the beginning date may not be delayed until
                         actual retirement (if later than age 70½) as is the case with most other
                         retirement plans. Distributions from an IRA must be taken in minimum (or
                         greater) annual amounts as determined under the government’s Uniform
                         Lifetime Table. Exception: If the IRA owner’s beneficiary is a spouse who is
                         more than 10 years younger, the Joint Life Table is used to calculate the
                         required minimum annual distribution rather than the Uniform Lifetime

                         Like other annuities, distributions from an IRA contract occurring before age
                         59½ are subject to a 10% penalty tax, except that no penalty is imposed for

                              • occasioned by the owner’s death or disability;
                              • annuitized (paid in substantially equal periodic payments made at least
                                annually over the life of the owner or lives of the owner and a benefi-
                                ciary); or
                              • that meet the first-time homebuyer exception.
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                 Distributions from IRAs will be taxable distributions to the extent attribut-
                 able to pre-tax contributions and tax-deferred earnings.

                 If any nondeductible contributions were made, the owner is entitled to re-
                 cover them tax-free under the regular annuity rules. That is, a portion of each
                 payment will be excluded as a return of cost, the amount depending upon the
                 ratio of the taxpayer’s total nondeductible contributions to the total expected
                 return under the contract. But the total amount excluded will never be al-
                 lowed to exceed the total of nondeductible contributions made.

                 For the purpose of making a tax calculation (if one is required), all IRAs
                 owned by the same individual are considered as a single contract.4

Simplified Employee Pensions (SEP-IRAs)

                             By using IRA contracts, owners of small businesses, both incorpo-
                             rated and unincorporated, can establish a Simplified Employee Pen-
                             sion (SEP) for themselves and their employees. Special rules apply to
                             these SEP-IRAs, but they are much less complicated than the regular
                             pension and profit-sharing plan rules, and therefore may be more
                             desirable for small business owners than are other qualified plans.5

                             SEP Requirements

                          In very general terms, an employer establishing a SEP must include
                          all employees who are at least 21 years old, and must make contribu-
                          tions according to a specific plan formula which does not discrimi-
                 nate in favor of the employer or highly compensated employees. The
                 employer may not require employees to leave all or part of the contributions
                 in the plan as a condition for future contributions, nor may the employer
                 restrict an employee’s right to withdraw funds from the plan.

                 Provided all requirements are met, contributions to a SEP-IRA are deductible
                 by the employer and are not currently taxable to the employees. Deductible
                 contributions for SEP-IRAs are not restricted to the usual IRA limits, but
                 may go as high as 25% of compensation, with compensation capped at
                 $205,000 in 2004.

                 Elective (Salary Reduction) SEPs

                 Under other specific rules, an employer with no more than 25 employees
                 may offer a SEP (called a SARSEP) on an elective basis. That is, like a TSA,
                 individual employees may be allowed to choose between having contribu-
                 tions made to the SEP or receiving cash instead. Elective contributions to
                 this type of SEP (when combined with elective contributions to any other
                 plan) may not exceed the annual limits in the table on the next page. New
                 SARSEPs may not be established after 1996, but contributions may still be made
                 to pre-1997 SARSEPs.

                     The various provisions regarding IRAs, including rollover IRAs, are found in IRC §§219 and 408.
                     Most of the SEP rules are set out in IRC §408(k).
Selling Qualified Annuities                                                                          93

                         The SARSEP arrangement is very similar to a 401(k) plan. SARSEP elective
                         deferrals are not currently taxed to the employee. The salary reduction
                         amount is limited to an annual maximum in accordance with the following

                                 Year            Deferral Limit      Deferral Limit
                                                 Under Age 50       Age 50 and Over
                                 2003               $12,000             $14,000
                                 2004               $13,000             $16,000
                                 2005               $14,000             $18,000
                                 2006               $15,000             $20,000

                         Unlike individual IRAs, employees are eligible to participate in a SEP-IRA
                         whether or not they are also participants in another qualified plan. Thus,
                         for example, an individual employed by a corporation and participating in
                         its qualified pension plan
                         might also have some
                         self-employment income          Planning Pointer:
                         from a business conducted       Contributions to an SEP-IRA are
                         on the side. Such an indi-
                         vidual may establish a SEP      deductible by the employer and are not
                         and make deductible contri-     currently taxable to the employees.
                         butions, as well as participat- Deductible contributions for SEP-IRAs
                         ing in the corporate plan. Of   are not restricted to the usual IRA
                         course, contributions would     limits.
                         also have to be made for any
                         other employees of the side

                         The SEP distribution provisions and the tax rules relating to distributions are
                         generally the same as the rules for individual IRAs already described.

                         A Variety of Plans

                         The SEP was introduced in 1979 to allow employers, particularly smaller
                         employers, whether incorporated or not, to have the tax advantages of a
                         qualified plan for themselves and their employees without all of the filing
                         and paperwork required of pension and profit-sharing plans. Given a choice
                         between a Keogh and a SEP-IRA, many sole proprietors, in particular, will
                         choose the SEP. For you, the SEP-IRA offers a way to extend your qualified
                         annuity sales to another significant group of prospects. With TSAs for
                         schools and tax-exempt organizations, IRAs for working individuals, and
                         SEP-IRAs for small businesses, you have the means for offering qualified
                         retirement plans and annuities to a broad segment of the business community
                         — without the need to become a pension specialist.
94                                                                   Annuities Training Course


              Effective January 1, 1997, a new type of employer-sponsored retirement plan
              became available — the Savings Incentive Match Plan for Employees

              SIMPLE plans can be established by employers with 100 or fewer employees
              who received at least $5,000 each in compensation from the employer in the
              preceding year, provided the employer does not maintain another qualified
              retirement plan, 403(b) annuity plan, 501(c)(18) trust, SEP, or governmental
              plan. An employer who contributes to a collectively bargained plan for some
              employees may set up a SIMPLE 401(k) plan or SIMPLE IRA for other
              employees; however, those employees still count towards the 100-employee

              If an employer goes over the 100-employee limit as its business expands, the
              employer may continue to maintain the SIMPLE plan for another two years.

                     SIMPLE retirement plans can be established in two ways:

                     •   as an IRA for each employee, or

                     •   as part of a 401(k) plan.

                     Here we will address only SIMPLE IRAs. In a SIMPLE IRA plan,
                     contributions allowed are:

                     • employee elective salary deferrals, and

                     • required employer matching contributions, or employer “nonelec-
                       tive” contributions.

                     Employees’ elective salary deferrals must be expressed as a percent-
                     age, or dollar amount, of compensation. Employees may defer up to
                     100% of their compensation after FICA withholding, subject to the
                     current deferral limit.

              The annual elective deferral limit for SIMPLE IRAs, and additional “catch-
              up” contributions permitted for participants age 50 and over, are determined
              from the following table:

                     Year            Deferral Limit      Deferral Limit
                                     Under Age 50       Age 50 and Over
                     2003              $8,000             $9,000
                     2004              $9,000            $10,500
                     2005             $10,000            $12,000
                     2006             $10,000*           $12,500

              *After 2005, the basic elective deferral limit ($10,000) for SIMPLE IRAs will
              be indexed to inflation in $500 increments. The age-50+ catch-up amount
              ($2,500) will be indexed after 2006.

              Employees must be allowed to discontinue their voluntary salary deferrals at
              any time during the year. They can elect to participate, and to alter their
Selling Qualified Annuities                                                                            95

                         previous elections, within at least 60 days before the start of the plan year (or
                         in the case of a new participant, at least 60 days before or after the date of

                         An employee may participate in a SIMPLE IRA plan even if he or she also
                         participates in another employer’s qualified retirement plan in the same year,
                         provided the SIMPLE plan employer is outside of a controlled group. How-
                         ever, his or her aggregate salary deferrals for the year are subject to the
                         annual cap on such deferrals.

                         With respect to employer contributions, the employer must either:

                              • match employee contributions dollar-for-dollar up to 3% of actual em-
                                ployee compensation for the year (but the match percentage can be as
                                low as 1% in no more than two out of the five years ending with the
                                year of the contribution), or

                              • make a nonelective contribution for each eligible employee who has
                                earned at least $5,000 in compensation from the employer during the
                                year, of 2% of annual compensation (up to a maximum compensation of
                                $205,000 in 2004), regardless of whether the employee contributes.

                         The employer must notify the employees of the type and percentage of em-
                         ployer contribution within a reasonable period before the annual 60-day elec-
                         tion period for the year.

                         Employee salary deferrals
                         and employer contributions          Planning Pointer:
                         are excludable from em-             Some keys features of SIMPLE
                         ployee gross income and de-         IRAs are:
                         ductible to the employer in
                         the year made.                     • 100 or fewer employees receiving at
                                                              least $5,000 each in compensation
                         Employee deferrals are not         • Elective employee salary deferrals
                         considered wages for pur-
                         poses of income tax with-          • Required employer matching
                         holding, but they are counted        contributions
                         as wages for FICA, FUTA            • Immediate vesting of both employee
                         and Medicare tax purposes.           and employer contributions
                         Employer matching contribu-
                         tions are not counted as           • Excludable from gross income
                         wages for income tax with-         • Tax-deductible to employer
                         holding, FICA, FUTA, and
                         Medicare tax purposes.

                         Employees who received at least $5,000 in compensation from the employer
                         during any two preceding years, and who are reasonably expected to receive
                         at least $5,000 in compensation during the current year, are eligible to par-
                         ticipate. The employer may elect to exclude employees who are nonresident
                         aliens and those covered under a collectively bargained arrangement. An
                         employer may adopt less restrictive rules than these minimum standards set
                         by the tax code, thereby allowing more employees to participate.

                         All contributions to a SIMPLE IRA vest fully and immediately to the em-
                         ployee, including those made by the employer.
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                Contributions to SIMPLE IRAs and the earnings thereon are not taxed until
                withdrawn. The usual 10% penalty tax applies to early withdrawals (gener-
                ally before age 59½ with exceptions). However, if the withdrawal occurs
                within the first two years of plan participation, the penalty tax is 25% if the
                participant is under age 59½. Otherwise, SIMPLE IRA distributions are
                taxed the same as IRA withdrawals.

                Distributions from SIMPLE IRAs during the first two years of plan participa-
                tion are not eligible for tax-free rollover unless rolled to another SIMPLE
                IRA. After the two-year period expires, tax-deferred rollovers may be made
                to traditional IRAs as well as to other SIMPLE IRAs.

About Rollovers — Some Rules You Need To Know

                To sell qualified annuities — TSAs, IRAs, SEP-IRAs and SIMPLE IRAs —
                you needn’t be an expert on the detailed and intricate tax rules that apply to
                these and other qualified plans. If questions arise, consult company experts
                or work with your client’s tax advisor.

                However, the funds for a new annuity sale will often come from a qualified
                source, i.e., a distribution from some form of qualified retirement plan. The
                distribution might occur because an employee retires or changes jobs. It
                might occur when a qualified retirement plan is terminated. It might also
                occur simply because an employee or the owner of an IRA wants to invest
                the funds somewhere else. In such situations, you must know how to protect
                your clients from unintended tax consequences. You will not want your client
                to incur tax on the purchase of an annuity from you.

                Any distribution or withdrawal of funds from a qualified retirement plan is
                generally a taxable event. However, the tax can usually be deferred by means
                of a rollover of funds. In simple terms, a rollover is a tax-free transfer of
                funds from an IRA or a tax-qualified retirement plan to another IRA or
                qualified plan. The Internal Revenue Code sets out precise rules for such
                tax-free transfers, and only
                those transfers that meet all
                the statutory requirements will              Tax-Free Rollover
                have the desired tax deferral
                                                   Former $ $                         Your
                effect. It follows that you must
                                                                     TAX $ $          Plan
                have a good grasp of the
                rollover rules, especially the
                facts in the following para-

                Qualified Plan to Qualified Plan

                When a client takes funds from a qualified plan, he or she cannot use those
                funds to purchase a nonqualified annuity without incurring tax conse-
                quences. The client will be deemed to have made a taxable withdrawal from
                the qualified plan and used the cash to purchase the nonqualified annuity. So,
                as a general rule: Funds from any qualified source should be reinvested
                only in a qualified annuity. If the qualified funds come from a qualified
                pension or profit-sharing plan, or from a TSA, investment in a special
Selling Qualified Annuities                                                                            97

                         rollover IRA — as opposed to a contributory IRA — may also be desirable,
                         because this will allow the funds to be rolled over again to another such
                         qualified plan, without the loss of tax benefits.

                         In general, any part of an otherwise taxable distribution from a TSA or
                         employer’s qualified plan is eligible for tax-deferral through rollover into an
                         IRA (or into another qualified plan). Thus, there is no disqualification if the
                         employee wishes to take a part of the distribution in cash and invest the
                         balance (although the portion withdrawn in cash will be subject to tax). The
                         distribution may be all or any part of the employee’s account. There is no
                         qualifying percentage which must be withdrawn.

                         All or any portion of an IRA can be transferred to another IRA by rollover,
                         but only one such rollover is allowed within a 12-month period. But, if an
                         individual owns several IRAs, there can be a rollover from each one of them,
                         to the same or different new IRAs, within a single 12-month period.

                         A rollover must take place (i.e., the funds must be reinvested) within 60 days
                         after the distribution of funds from the previous plan or IRA. The IRS en-
                         forces this requirement strictly, and failure to meet the deadline could be
                         very costly to a client.

                         Income Tax Withholding

                         Here is how income tax withholding applies to certain rollovers:

                                 If a distribution from a TSA or employer’s qualified plan qualifies for
                                 rollover and is paid direct to the employee, income tax will be with-
                                 held at the rate of 20%. Withholding is required from such a distribu-
                                 tion even though the employee intends to (and actually does) place
                                 the funds in an IRA (or another qualified plan) within 60 days.

                                 The IRS will credit the tax withheld to the taxpayer’s account and
                                 will refund it if a rollover is accomplished within 60 days after the
                         distribution (and this fact is reported in the tax return), but, a caveat: unless
                         the employee replaces the withheld amount with other money so as to roll
                         over the full amount of the distribution, there will be a tax liability on the
                         amount withheld.

                                   Example: An employee has a distribution of $10,000, and
                                   due to withholding, receives a check for $8,000. Unless the
                                   employee finds $2,000 with which to replace the withheld
                                   amount, so as to rollover the full $10,000, a tax (of $560, if
                                   the tax rate is 28%) will be due at tax time. Yes, it’s true.
                                   The IRS causes the $2,000 shortfall, then requires the tax-
                                   payer to “fix” it in order to avoid the further taxation.

                         Withholding, with this attendant tax problem, can be avoided only if the
                         employee asks the employer before receiving anything to transfer the funds
                         directly to the new plan, i.e., by means of a “trustee to trustee” transfer,
                         where the employee never has direct access to the funds. The employer is
                         required to comply with such a request from an employee.
98                                                                   Annuities Training Course

In Summary

             If you were to remember only one point made in this chapter, it should be
             this: Using funds from a qualified source to purchase a nonqualified annuity
             will always produce a tax liability for your client. The sale for you in this
             situation is a qualified product.

             You will serve your clients well if you make them aware that when dealing
             with qualified funds, the tax rules are especially important and are strictly
             applied. For example, you can give a client early warning about the conse-
             quences of accepting a check when taking a distribution from a qualified
             plan. If they receive a check, it is too late to avoid withholding.

             Armed with the material presented in this chapter, you should feel confident
             about presenting qualified annuities to your clients in the appropriate situa-
             tions. If you have any doubts at all, consult the experts available to you.
             Don’t take chances with your client’s welfare — or your own.
Annuities Training Course                                                                                   99

                                                       Equity-Indexed Annuities

        c o n t e n t s
                       What Is An Equity-Indexed Annuity? .................................... 101

                       The Vocabulary Of EIAs .......................................................... 101

                       How The EIA Works .................................................................. 102
Equity-Indexed Annuities                                                                                           101

What Is An Equity-Indexed Annuity?

                                   An equity-indexed annuity (EIA) is either a single premium deferred
                                   annuity (SPDA) or a flexible premium deferred annuity (FPDA).
                                   Generally, an equity-indexed annuity is a fixed annuity with a key
                                   difference: in addition to its guaranteed interest rate, it delivers
                                   growth linked to an index which measures the performance of equity
                                   markets. The most commonly used index is the Standard & Poor’s
                                   500® (S&P 500®) index.1

                                   The equity index could move up or down. If it goes up, the accumula-
                                   tion value of the EIA increases. If the index goes down, the accumu-
                                   lation value of the equity-indexed annuity decreases. However, the
                                   equity-indexed annuity includes a key element: a built-in stop-loss
                                   type feature protects the downside and limits the decrease that can be
                                   experienced. In this manner, the EIA offers participation in market
                                   upswings (like a variable annuity) with guarantees the owner can
                                   count on (like a fixed annuity).

                       Equity-indexed annuities offer payout options common to other annuities and
                       also offer tax-deferred growth of accumulations. Taxation occurs when
                       money is withdrawn and a 10% federal tax penalty may apply to withdrawals
                       before age 59½.

The Vocabulary Of EIAs

                       With the EIA, it’s important to remember that the index is a link or a measur-
                       ing tool and nothing more. An equity-indexed annuity does not represent
                       investment in a security. It is a fixed annuity with accumulation values that
                       increase or decrease in direct correlation to the increases or decreases in the
                       equity index identified in the contract. Remember, however, that a guarantee
                       limits the amount of decrease the owner can experience.

                       Here are some terms you need to know when marketing EIAs.

                       Index Term: The index term is the period over which the interest rate is
                       calculated. Terms vary from one to ten years, with six or seven years as the
                       most common. Some EIAs have multiple terms, with a time window to with-
                       draw money at the end of each term, and an EIA purchased with installments
                       may begin a new term with each premium.

                       Index Date: The index date is the date (or dates) during the term when the
                       index value is noted for purposes of calculation. The first day of the annuity
                       contract is always an important index date. Anniversaries of the first day are
                       generally used as an index date in subsequent years of the contract.

                       Participation Rate: The participation rate identifies the percentage of the
                       S&P 500® index gain to be reflected in the annuity interest gains for the
                       policy term.

                       Indexing Methods: The indexing method refers to the approach used to
                       measure the amount of change in an index. Three popular approaches are
                       annual reset (ratcheting), high-water mark, and point-to-point.
                           Standard & Poor’s 500® and S&P 500® are trademarks of The McGraw-Hill Companies, Inc.
102                                                                        Annuities Training Course

                    • Annual reset compares the index value at the beginning of the contract
                      year with its value at the end of the contract year. The appropriate
                      interest is then added to the value of the annuity each year.

                    • High-water mark credits interest at the end of the term. The interest is
                      based on the difference between the index value at the start of the term
                      and the highest anniversary value during the term.

                    • Point-to-point is like annual reset except that interest earned is based
                      on the difference between the index value at the beginning and end of
                      the index term rather than annually. Various methods are used to mea-
                      sure this change.

How The EIA Works

               No insurance company could guarantee to match the performance of the S&P
               500® Index exactly and still offer protection against downside loss. So, EIAs
               identify a participation rate, which is the percentage of the S&P 500® Index
               gain that will be reflected in the annuity interest gains. For example, assume
               the S&P 500® Index increases 10% over the index term, and the EIA partici-
               pation rate is 70%. The gain credited to the EIA will be 7%, which is the
               participation rate multiplied by the index increase percentage.

               There are other factors that have an impact on the EIA value.

                    • Averaging: The date when interest is averaged can dramatically affect
                      overall policy values. Various EIAs may average the index values daily,
                      monthly, yearly, at the end of the term, or use a combination of these

                    • Floor: The floor is the minimum interest rate that will be credited. For
                      example, if the floor is 0% and the index turns into a negative number,
                      the lowest possible index-linked interest rate credited to the EIA will be
                      0%, not the negative number. Keep in mind that the EIA has a guaran-
                      teed interest rate during the index term.

                    • Cap: The cap is the upper limit of index-linked interest which can be
                      earned. If an EIA has a cap of 7% and the index-linked interest totals
                      8%, only 7% will be credited.

                    • Interest compounding: If simple interest is paid, the interest is added
                      to the premium amount but does not compound. If compound interest is
                      paid, the interest credited during a term also earns interest in the future.

                    • Vesting: The percentage of interest that is actually credited is the per-
                      centage that is vested. At the end of the term, 100% is always vested.
                      However, if the owner surrenders the contract before the end of the
                      term, only a fraction of the interest may be vested.
Equity-Indexed Annuities                                                                        103

                       As you can see, insurance companies consider a number of variables when
                       designing an EIA contract. It is the combination of these variables working
                       together that determines the ultimate value of the annuity. For example, the
                       participation rate and cap rate are usually inversely related. Typically, the
                       higher the participation rate offered by the company, the lower the cap rate.
                       If the company offers a high cap rate, it may be offset by a lower participa-
                       tion rate. When selling EIAs and comparing contracts, you need to be aware
                       of all these variables and what they mean to the buyer.
Annuities Training Course                                                                                        105

                                                              Annuity Mathematics: I

        c o n t e n t s

                       Pricing Questions .................................................................... 107

                       The Pricing Equation ............................................................... 107

                       Basic Probability Theory ........................................................ 108

                       The Law Of Large Numbers ................................................... 110

                       Building Mortality Tables ........................................................ 111

                       Mortality Tables And Annuities .............................................. 113

                       In Summary ............................................................................... 118
Annuity Mathematics: I                                                                               107

                                Whether you are mathematically inclined or simply intellectually cu-
                                rious, these final two chapters are intended to help you understand
                                how insurance companies go about pricing the products.

                                In Chapter 9 the pricing equation is explained in simplified terms,
                                and the factors involved in solving it are introduced. Following that
                                is an explanation of how actuaries use probability theory, the law of
                                large numbers and company experience to develop the mortality
                                tables they use in pricing.

                                Chapter 10 contains the time value of money, describes basic annuity
                                calculations, and goes on to show how the interest factor and the
                                mortality factor act to determine the price of annuities.

                         For those who want to read even more about the mathematics of annuities,
                         these two chapters can serve as an introduction to the more detailed explana-
                         tions to be found in Life Office Management Association (LOMA), college
                         and actuarial texts.

Pricing Questions

                         Since an annuity is the systematic liquidation of capital to provide an in-
                         come, it becomes essential to ask, “How much?” How much capital? How
                         much income?

                         From the point of view of the one who purchases an annuity, the question
                         becomes: “How much capital must I accumulate to provide the income I will
                         want or need?” or “How much must I pay for an annuity?”

                         From the point of view of the company that sells an annuity, the question
                         becomes: “How much must we charge in order to provide the desired income?”

                         To show how the company goes about answering these pricing questions, we
                         need to work with just two annuities: the annuity certain and the
                         straight-life annuity. Using just these two — one involving a life contin-
                         gency and the other not — we can show how interest alone and also how
                         interest combined with mortality affect annuity pricing. These are the two
                         most important pricing elements. Aside from these, the only other element a
                         company has to consider in setting a price for its annuities is the “load” it
                         will add to cover expenses.

The Pricing Equation

                         It is fairly obvious that the amount available to pay any desired income must
                         at least equal the total amount to be paid out (with some profit, of course, for
                         the seller). The pricing equation can thus be stated in this very simple form:

                                         principal accumulated = annuity payments

                                                                          $         $
                                                  $       $
                                              $       $       $       =   $         $
                                          $       $       $       $       $
108                                                                        Annuities Training Course

                 Time Value of Money

                           Arriving at the values on both sides of this equation always involves
                           the time value of money, or the interest factor. Because the principal
                           required to make the annuity payments will generally be accumulated
                           over a period of time and paid out (generally periodically) at a later
                           time, interest will be earned in the interim. Regardless of the amount
                           to be paid out, whatever amounts are collected can be expected to
                           earn interest until payout is completed. The pricing equation can,
                           therefore, be restated like this:

                               amount(s) collected + interest earned = annuity payments

                 When the company knows the number of annuity payments it has to make, as
                 it does with an annuity certain, the interest to be earned is the only factor
                 involved in determining the amount(s) to be collected. When pricing an an-
                 nuity contingent on survivorship, i.e., a life annuity, on the other hand, the
                 company does not know how many annuity payments it will have to make.
                 Thus, a mortality or survivorship factor becomes involved in solving the
                 pricing equation.

                 Since no one can predict how long any individual will live, companies use
                 the mathematical laws of probability and of large numbers, plus their own
                 experience with large groups, to develop mortality statistics and tables. Us-
                 ing these tables, they can predict with a great degree of accuracy how many
                 annuity purchasers will survive to receive their payments and how long they
                 will live. With this information insurers can calculate the total annuity pay-
                 ments they will have to make to the survivors of a large group. By plugging
                 this amount into the pricing equation, along with the number of original
                 purchasers, they are able to determine how much each individual purchaser
                 of a life annuity should pay for a contract.

                 In the next chapter we will make some calculations. But first, let’s talk about
                 mathematics and mortality tables.

Basic Probability Theory

                 Probability theory deals with the likelihood of events taking place. Insurance
                 companies use probability theory to determine the likelihood of individuals
                 living or dying.

                 The outer limits of probability range from certainty that something will hap-
                 pen to certainty that it will not. Certainty that something will not happen can
                 be expressed mathematically as 0. Certainty that something will happen can
                 be expressed as 1.

                 It follows from this that if an event may or may not happen, given a certain
                 number of trials or opportunities, the probability of its happening (or not
                 happening) can be expressed by a fraction which will have a value between 0
                 and 1. The denominator of the fraction will be the total number of trials or
                 opportunities, and the numerator will be the number of times the event can
                 be expected to happen (or fail to happen), given that number of opportunities.
Annuity Mathematics: I                                                                                  109

                         Simple Probability

                                 Consider what happens when you toss a coin in the air. It is bound to
                                 fall either heads or tails (we’re assuming that it lands on a flat sur-
                                 face, and can’t end up on its edge). This is a certainty, which we have
                                 said can be expressed as 1. Therefore, the probability that the coin
                                 will fall either heads or tails is also 1 (p = 1). The certainty that the
                                 coin will fall neither heads or tails, which we can also express as the
                                 probability it will do neither, is 0 (p = 0).

                                  If we wish to express the probability that the coin will land heads,
                                  and the separate probability that it will land tails (i.e., will not land
                                  heads), we will use a fraction in
                                  each case. The denominator of each                                       1
                                  fraction will be the number of               Probability of heads
                                                                                                        = —
                                  times we plan to toss the coin. If          Number of coin tosses        2
                                  we will be tossing the coin only
                         two times, the denominator will be 2.                  Probability of tails        1
                         Since there are only two possibilities, the                                    = —
                         probability that the coin will fall heads is         Number of coin tosses         2
                         obviously equal to the probability that it
                         will fall tails. Each probability can, therefore, be represented by the fraction ½.

                         If we toss the coin 10 times, it is probable that it will land heads 5 times and
                         that it will not land heads (but will land tails) 5 times. Our equal probabili-
                         ties in this case are each expressed by the fraction 5/10. If we add the two
                         probabilities in each coin illustration, we get: ½ + ½ = 1 and also 5/10 + 5/10 =
                         1. We have thus illustrated the rule that when dealing with related events,
                         i.e., events only one of which can occur at any one time, certainty equals the
                         sum of all the probabilities.

                         Actuaries apply the law of simple probability just illustrated in calculating
                         the probability that death will or will not occur at particular ages. The prob-
                         ability that death will occur in a given year, when added to the probability
                         that death will not occur that year is always equal to certainty, or 1. A
                         tabulation of the probabilities of dying during the year at each age becomes a
                         mortality table for use in determining the premiums to be charged for
                         single-life annuities.

                         Compound Probability

                         Sometimes it is necessary to determine the likelihood of two (or more) mutu-
                         ally independent events occurring together. Now we are dealing with com-
                         pound probability. An application of compound probability is found
                         whenever actuaries must determine the probability of two individuals living
                         to a particular age.

                         Consider what happens when two coins are tossed. Each toss is an indepen-
                         dent event, even though the tosses are made at the same time. What is the
                         probability that both coins will land heads? The law of simple probability
                         still says that the separate probability of each coin landing heads is ½ (p = ½).
110                                                                       Annuities Training Course

               But, altogether, we now have the following four possibilities:

                          1. Both A and B heads

                          2. Both A and B tails

                          3. A heads and B tails

                          4. A tails and B heads

               Since there are no other possibilities, we can see that the probability of one
               of these combined events happening is 1 in 4 (p = ¼). This is expressed as a
               law of compound probabilities which states that the probability of two (or
               more) independent events occurring together is obtained by multiplying the
               simple probabilities of each of the events occurring separately. Thus, in our
               two-coin example, the compound probability of both coins landing heads is:
               ½ (probability of coin A landing heads) × ½ (probability of coin B landing
               heads) = ¼ (probability of both A and B landing heads).

               Actuaries use compound probability in calculating the cost of joint life annuities.

The Law Of Large Numbers

               How far can a company rely on these calculations to determine the ages at
               which its annuitants will die, and thus how much to charge for its policies?
               After all, a coin might very well land heads 7 times out of 10 tosses. So how
               do probabilities help?

                       The answer is the law of large numbers, formulated in the 17th
                       Century by the Swiss mathematician Jakob Bernoulli. According to
                       this concept, if there is a sufficiently large number of opportunities
                       for an event to occur, the actual ratio of occurrences to opportunities
                       will be very close to the mathematical probability calculated accord-
                       ing to the rules we have just examined. In general, the larger the
                       number of opportunities, the smaller the degree of difference between
                       the observed occurrences and the mathematical calculation.

                       As we saw, the calculated mathematical probability of a single coin
                       falling heads is 1 in 2 (p = ½). While a few tosses may produce a
                       greater or lesser percentage of heads, the law of large numbers tells
                       us that the more the coin is tossed, the more probable it is that the
                       number of times it falls heads and the number it falls tails will be
                       equally divided. Without going into the details of the concept, which
                       are complicated, we can rely on this rule to assure us that if we were
                       to depend on observation alone to tell us the number of times heads
                       would appear, we would come very close to complete mathematical
                       accuracy provided only that we tossed the coin a sufficiently large
                       number of times.
Annuity Mathematics: I                                                                              111

                         Mortality Experience

                         The concept is similar with the probability of living or dying. Provided they
                         work with large enough groups to allow the law of large numbers to work,
                         company actuaries can use past mortality experience to accurately predict
                         future mortality rates and so enable companies to price the annuities they
                         would sell. Basically, actuaries consider groups of individuals who are simi-
                         larly situated with respect to certain factors known to affect whether a person
                         lives or dies (age, sex, health condition, geographic location) and calculate
                         the rates of mortality experienced in the group over a period of time. Then,
                         using this experience data, they construct tables of mortality which can be
                         used with a degree of probability approaching certainty (because of the large
                         numbers involved) to estimate the future mortality rates of similarly situated
                         groups of individuals who purchase annuities. Based on these tables, a com-
                         pany can estimate with reasonable accuracy the amount it will have to pay
                         out in the future to the members of the group who survive, and from this, the
                         amount each individual purchaser of an annuity must contribute to the pool
                         of funds which will benefit all.

Building Mortality Tables

                         Figure 1 is an excerpt from a typical mortality table, showing the basic
                         columns contained in such tables.

                                                        Figure 1
                                    1983 Individual Annuity Mortality Table — Female

                               (1)              (2)                   (3)                  (4)
                             Age at       Number Living         Number Dying       Yearly Probability
                           Beginning     Beginning of Year       During Year           of Dying
                           of Year (x)          (lx)                 (dx)                 (qx)

                               5              10,000,000             1,940               .000194
                               6               9,998,060             1,600               .000160
                               7               9,996,460             1,339               .000134
                               8               9,995,121             1,339               .000134
                               9               9,993,781             1,359               .000136
                               10              9,992,422             1,409               .000141

                         Actuaries generally construct mortality tables starting with an arbitrary very
                         large number of people — 10,000,000 in Figure 1 — at a very young age.
                         Then, on the basis of past actual deaths occurring in an observed group, they
                         develop figures to show, at each age, the number of expected deaths and the
                         number still living at the next age, continuing until everyone in the original
                         group is assumed to have died. Thus, a mortality table has been said to
                         represent a generation of individuals passing through time.

                         Looking at Figure 1 we see (in column 3) that 1,940 of the original group of
                         10,000,000 five-year-old females are projected to die within the first year,
                         leaving 9,998,060 to reach age six. The table goes on in the same way to
                         record the number dying in each year of life and the number remaining alive
                         at the beginning of each succeeding year (column 2).
112                                                            Annuities Training Course

      Rate of Mortality

      But the most important part of the table is the yearly probability of dying, or
      the rate of mortality, developed from the mortality figures. This rate is sim-
      ply the ratio of the number of individuals dying during a particular year to
      the number of individuals who entered the year alive. Applying the law of
      simple probability described earlier, actuaries represent the yearly probabil-
      ity of dying by a fraction, with the numerator being the number of deaths
      occurring within the year and the denominator being the total number of
      people entering the year alive.

                Number of deaths during year
                                                       = Mortality Rate
            Number of living people, beginning of year

      Thus, Figure 1 on the previous page tells us that, based on our experience
      data, 1,940 of the original 10,000,000 individuals are expected to die be-
      tween age five and age six, so the mortality rate for the first year is:

                                        = .000194

      Now look at the second year. Of the 9,998,060 left alive at the beginning of
      the year (because 1,940 of the original group have already died), we learn
      that 1,600 are expected to die within the year. So we have a new fraction,
      with a numerator of 1,600 and a denominator of 9,998,060. The mortality
      rate for year two of the table is thus:

                                        = .000160,
                              9,998,060   and so on for each ensuing year

      Survivor Rate

      The yearly probability of surviving can be similarly calculated, and mortality
      tables often have a column to show that probability (px). Since an individual
      is certain either to live or to die within a given year, and certainty is repre-
      sented mathematically as 1, the yearly probability of surviving is simply the
      difference between the probability of dying and 1. In the third year of our
      table, for example, the probability of dying is shown to be .000134. There-
      fore, the probability of surviving (px) would be 1.000000 – .000134, or

      We can confirm that this is correct by multiplying 9,996,460 (the number
      who entered the year alive) by .999866. The result is 9,995,120.4, essentially
      the same as the number shown entering the fourth year of the table alive.

      Based, as they are, on probability theory and the law of large numbers,
      mortality tables such as Figure 1 and Table 2 in Chapter 10 (an earlier table)
      can be highly accurate in predicting how long individuals of a particular age
      will live and how many of a particular group are likely to survive to any
      given time in the future. Because these data serve as the basis for pricing
      companies’ products, actuaries in the insurance industry spend a great deal of
      time updating and refining their experience data so as to improve the reliabil-
      ity of the tables they formulate.
Annuity Mathematics: I                                                                               113

Mortality Tables And Annuities

                         If a company underestimates the number of annuitants who will survive to
                         receive their annuity payments, it will not collect enough in premiums to
                         meet its future liability to make those payments. Because people generally
                         live longer lives than they did even a few years ago, mortality tables based
                         solely on past experience will tend to understate future mortality. This pre-
                         sents no problem in setting life insurance premiums, because improvements
                         in mortality act to reduce the company’s future liability under its insurance

                         The opposite is true, however, in the case of annuities. Improvements in
                         mortality increase the company’s future liability. Thus, insurance company
                         actuaries must find ways to establish and maintain a proper “safety net” for
                         their companies. The following paragraphs describe some of the ways in
                         which actuaries make their mortality tables reliable.

                         Good Statistical Data

                                   They start with better-than-average statistics. The death records of
                                the general public reported to the National Office of Vital Statistics
                                are much less accurate than the death records of insured individuals
                                maintained by insurance companies. Individual insurance companies
                                maintain records showing the number of insured individuals in every
                                age group, the period of observation for each group, and the number
                                of individuals dying at each age. Records like this from many insur-
                                ance companies can be combined to obtain a large enough sample for
                                construction of a mortality table. Both insurance and annuity prod-
                                ucts have historically been priced on the basis of mortality tables
                                created with insurance company data.

                         Data Refinement

                         Actuaries also refine their data in many ways. For example, they know (from
                         experience) that a group of newly insured individuals, each of whom has
                         recently passed a medical examination, will experience a lower mortality rate
                         than an unexamined group of the same age. They also know that the effect of
                         medical selection wears off in 5 to 15 years’ time. So the ultimate mortality
                         rate for a group that was insured and examined at, say, age 20 should be
                         about the same, beginning at age 35, as that of an unselected group of
                         35-year-olds. But at ages 20 through 34 the select group would have experi-
                         enced a lower rate of mortality.

                         Such data as this enables actuaries to construct select tables, ultimate tables,
                         and aggregate tables of mortality for various insurance purposes. Select
                         tables include data on newly insured lives only; ultimate tables exclude data
                         on lives recently insured, and aggregate tables include data on all the lives.
                         For calculating insurance premiums, it is safer to use an ultimate or aggre-
                         gate table rather than a select table of mortality.
114                                                                  Annuities Training Course

             Special Annuity Tables

             Actuaries also know from experience that mortality rates for groups of annu-
             itants are generally lower than those for groups of insureds. No doubt one
             reason for this is that people who buy annuities are generally in good health
             and believe they will live to collect. Whatever the reason, a company cannot
             safely rely on life insurance tables to set annuity premiums. Annuitants’
             mortality would be overstated, and the company’s future commitment to
             those who survive would be understated. Actuaries, therefore, construct spe-
             cial mortality tables as a basis for calculating annuity premiums. Annuity
             tables used in the past include the 1937 Standard Annuity Mortality Table,
             the Annuity Table for 1949,
             the 1955 American Annuity
             Table, and the 1971 Indi-           Planning Pointer:
             vidual Annuity Mortality            The mortality rates for groups of
             Table. At present, companies
                                                 annuitants are generally lower than
             are using the 1983 Individual
             Annuity Mortality Table. All        those for groups of insureds. One
             of these are “static” mortality     reason for this is that people who buy
             tables. That is, they are based     annuities are generally in good health
             on data from a past static pe-      and believe they will live to collect.
             riod of time.

             Age Setbacks

             One way actuaries have preserved a margin of safety for their companies as
             people live longer and longer lives is to continue to use static annuity tables
             constructed some time ago (like those above), but with the addition of age
             setbacks. A table with setbacks would substitute for the actual static mortal-
             ity rate at each age the lower mortality rate of a person one or more years
             younger. For example, the mortality rate for a person age 58 or 59 might be
             used for a 60-year-old annuitant, thereby increasing the amount the company
             would charge for a given amount of annuity income. This use of setbacks has
             enabled companies to avoid the large expense of constructing new static
             tables every year or so.

             Projection Factors

             Alternatively, actuaries have developed projection factors that can be applied
             to a basic table to make allowance for future improvements in life expect-
             ancy. The Annuity Table for 1949 was the first table published with projec-
             tion factors.

In Summary

             As the sale of annuities continues to grow in proportion to the total business
             of life insurance companies, the work of actuaries on annuity mortality tables
             becomes more and more significant. This chapter has provided no more than
             a glimpse into the actuary’s world. Formulas and tabulations used in practice
             are far more complex than any we have outlined. But you needn’t be an
             actuary to sell annuities. You do need to have confidence in your product and
             its ability to serve your clients’ needs. Knowing something about the matters
             discussed in this chapter may help give you that confidence.
Annuities Training Course                                                                                    115

                                                           Annuity Mathematics: II

        c o n t e n t s

                       The Interest Factor .................................................................. 117

                       Calculations For The Annuity Certain .................................. 118

                       Periodic Payments ................................................................... 119

                       Calculating A Contingent (Life) Annuity .............................. 121

                       The Effect Of Mortality ............................................................ 124
Annuity Mathematics: II                                                                              117

                          This is the annuity pricing equation stated in Chapter 9:

                                  amount(s) collected + interest earned = annuity payments

                          We said that arriving at the values on both sides of this equation always
                          involves the time value of money, or the interest factor. We also said that
                          when annuity payments are contingent on survivorship, a mortality factor is
                          also involved. Now we are ready to make some calculations to show how the
                          equation is worked out. In doing this we will be working first with two quite
                          familiar interest formulas.

The Interest Factor

                          Let’s assign some symbols to use in our interest calculations:

                          Let A = amount invested
                              i = annual interest rate
                              S = sum (amount invested plus interest)

                          Do the symbols seem familiar? Of course they do. They are the ones we use
                          any time we want to calculate how much we will have at year end if we put
                          money in the bank today. The familiar formula we use is:
                          S = A(1 + i)

                          If the money remains on deposit for a number of years, n, the formula be-

                          S = A(1 + i)n (indicating that the same calculation is repeated n times)

                          From this comes the equally familiar formula for calculating the amount to
                          invest now to obtain a particular future goal:

                          A = (1 + i)n

                          We need these same two formulas to work out the values on the two sides of
                          our annuity pricing equation. In our calculations, we will let the symbol “A”
                          stand for present value, meaning the amount of money which must be in-
                          vested on a particular date to accumulate to a desired amount on a later date.
                          The symbol “i” will stand for assumed interest rate, meaning the annual rate
                          the company issuing the annuity expects to earn over the accumulation pe-
                          riod. And, finally, the symbol “S” will stand for accumulated value, which is
                          just another term for the original investment increased by interest.

                          Accumulated Value Formula

                          We will use the first formula (the accumulated value formula) to tell us
                          what the annuity payments will be when the amount to be invested is given.
                          It will answer these questions:
118                                                                      Annuities Training Course

                 From the prospective annuitant: “How much will I have at age 65 if I invest
                 $50,000 dollars in an annuity now?”

                 From the issuing company: “How much can we pay out at age 65 to an
                 annuitant who invests $50,000 dollars with us now?”

                 Present Value Formula

                 We will use the second formula (the present value formula) to determine the
                 amount to be collected when the desired future payment is known. It will
                 answer these questions:

                 From the prospective annuitant: “How much will I have to pay for an annu-
                 ity which will pay me $100,000 at age 65?”

                 From the issuing company: “What must we charge an annuitant now for an
                 annuity which will pay $100,000 at age 65?”

                 The assumed rate of interest is extremely important when these formulas are
                 used in annuity calculations. A company must use a reasonable rate, which
                 means one which it can expect to earn, on average, year in and year out, over
                 long periods. If the rate assumed is too high when premiums are set, the
                 company will not collect enough in premiums and may not be able to meet
                 its annuity obligations. Conversely, if the rate is too low, the contract may
                 not be saleable because it costs too much.

                 To illustrate the basic annuity calculations, we’ll start with the annuity cer-
                 tain which involves only the interest factor. Life annuity calculations which
                 are more complex — because they must take the mortality factor into ac-
                 count — will come later.

Calculations For The Annuity Certain

                        Since they do not involve a life contingency, payments made from an
                        annuity certain allow us to easily see the basic relationship between
                        amount paid in (present value) and amount paid out (accumulated
                        value). Since our focus is on the calculations, let’s start with the
                        simplest of illustrations and keep our numbers small.

                        Suppose a prospect has just $1,000 to invest in an annuity which
                        guarantees an interest rate of 6% for the first five years. Assuming
                        there is no surrender charge, how much can be withdrawn in a single
                        sum in five years’ time?

                        To answer this we use the accumulated value formula, S = A(1 + i)n.
                        After five years, the prospective annuitant could withdraw:

                 $1,000 (1 + .06)5, or
                 $1,000 × 1.06 × 1.06 × 1.06 × 1.06 × 1.06 = $1,338.23

                 Thus, the accumulated value of $1,000 at a 6% interest rate is $1,338.23, and
                 that is the amount which the investor could expect to receive in five years
                 time from a $1,000 investment made now.
Annuity Mathematics: II                                                                               119

                          Accumulated Values

                          When long accumulation periods are involved, this calculation gets cumber-
                          some. So the formula is used to create tables of accumulated values, such as
                          column 1 in Table 1 at the end of this chapter. Instead of making a calcula-
                          tion, we can get the same answer as above by using Table 1. In this case, n,
                          the number of years of accumulation, is 5. Entering the table at this point
                          gives us $1.338226 as the accumulated value of $1 in five years’ time. Thus,
                          the amount our prospect would receive is simply 1,000 times that, or
                          $1,338.23, the same amount we calculated.

                          Next, assume the prospect wants to know how much to invest now in order
                          to be able to draw $1,338.23 five years from now (assuming there is a
                          special reason for needing this odd sum). This time we use the present value

                              S                                S
                                     = A, or reversing, A =
                           (1 + i) n                        (1 + i)n
                          and the answer is       (1.06)5 = $1,000

                          Simplifying the Calculation

                          Actuaries generally do two things to simplify this calculation. First, they
                          substitute the symbol, v, for the fraction 1 , so that the formula can be
                                                                    (1 + i)
                          made to read A = Svn and the solution can be obtained by multiplying instead
                          of dividing.

                          Second, they use the formula to create a table of values for vn, or the present
                          value of 1, at various rates of interest. Column 2 of Table 1 shows such a
                          tabulation at 6% interest. By using the table, we can readily see that where n
                          is 5, the value of vn, i.e., the present value of $1 at an assumed interest rate
                          of 6%, is .747258. Therefore, the present value of $1,338.23 payable in five
                          years’ time is $1,338.23 × .747258, or $1,000, just as we calculated it to be.

Periodic Payments

                          Now let’s make things a bit more complex. Let’s still assume a single invest-
                          ment, but this time the prospect wants an income supplement for a special
                          purpose. The question is, “How much do I have to invest now to have extra
                          income of $1,000 per year for a period of ten years, starting five years from

                          Assuming the company would sell such a deferred annuity certain, their
                          question would be, “How much must we charge as a single premium so that,
                          commencing five years from now, we can pay this annuitant (or the
                          annuitant’s beneficiary) $1,000 annually for a period of ten years?” (We will
                          ignore the expenses which, in practice, the company would factor into its
120                                                           Annuities Training Course

      Present Value Calculation

      The same present value calculation we looked at above will provide the
      answer to both these questions. The present value of a series of annual annu-
      ity payments beginning five years in the future and continuing for ten years
      is simply the sum of a series of individual accumulations using the above
      formula and substituting for n the numbers 5, 6, 7, 8, 9, 10, 11, 12, 13, and
      14. (The last of the ten payments would be made at the end of the 14th year,
      or the beginning of the 15th.) So we could get our answer with the following

      A=    $1,000     +    $1,000    +    $1,000 …… $1,000          = $5,829.88
            (1.06)5         (1.06)6        (1.06)7   (1.06)14

      Present Value Per Period

             Once again, to simplify this type of annuity calculation, tabulations
             are made. Values for each of the above present value fractions can be
             found in Column 2 of Table 1, and can be added to get the result. But
             there is yet an easier way. Look at Column 4 of Table 1. It shows the
             present value of $1 per period; that is, the present value of $1 pay-
             able annually for any number of years. Notice that the values are for
             payments made at the end of each year. You can tell this is so by
             looking at the first number in the column, which shows the present
             value of $1 as $.943396. That is the amount which, if invested imme-
             diately at 6%, will produce $1 in one year’s time.

              In our case there will be ten annual payments of $1,000 each, the
              first payable at the end of the fifth year. Using 10 as the value of n,
              we see that the present value of a series of ten payments of $1 each,
      when the first payment is due just one period hence (an immediate annuity),
      is $7.360087, at a 6% interest rate. Thus, the present value of an immediate
      annuity with ten annual payments of $1,000 each is $77,360.09.

      But in our case, the first payment will not be made until five years from now.
      We are evaluating a deferred annuity certain. This means the amount in-
      vested now will be on deposit for four years longer than in the case of the
      immediate annuity certain just calculated. In other words, we know we will
      need $7,360.09 to make the ten payments when the first payment is just one
      year in the future. But with payments postponed for an additional four years,
      during which time interest can be earned, a smaller investment will produce
      the desired result. We can discount the $7,360.09 still further. What we need
      to know now is the present value of $7,360.09 due in four years’ time.

      Use Table 1 again. This time take $7,360.09 — the amount which will be
      needed four years from now — and discount it further. In other words, deter-
      mine the present value of this amount, which is the accumulation we already
      know will be required in four years’ time in order to make the desired pay-
      ments five years from now.

      Looking at Column 2, we see that the present value of $1 due in four years is
      $.792094. If we multiply this factor by $7,360.09, we get $5,829.89, which
      is the amount which must be invested now in order to produce the series of
      ten payments of $1,000 each due to begin five years from now. Notice that
      we obtained the same result (except for the final decimal place) when we
      used the present value formula for each year and added the results (see above).
Annuity Mathematics: II                                                                               121

                          Net vs. Gross Premiums

                          With these calculations we have illustrated the procedure a company would
                          use to price an annuity which does not involve a life contingency. If the
                          company were planning to sell a single-premium deferred annuity certain, it
                          would follow the complete procedure just described. For a single-premium
                          immediate annuity certain, it would omit the final discounting. In each case,
                          the company would only have to add an expense factor to the present value
                          we obtained to create the single premium it would have to charge for these
                          annuities. The present value is the net single premium for the annuity. The
                          present value increased by an expense factor becomes the gross single pre-
                          mium which the company would actually charge.

                          Now let’s go back to our simplified pricing equation:
                                   amounts collected + interest earned = annuity payments

                          If the company sold the deferred annuity certain just described, we would
                          have in our equation:
                                                 $5,829.89 + interest = $10,000

                          If the company earned precisely the 6% interest it anticipated throughout the
                          accumulation period (and throughout the payment period until the fund was
                          exhausted), it would earn $1,530.20 during the accumulation period
                          ($7,360.09 — $5,829.89) and $2,639.91 during the payment period ($10,000
                          — $7,360.09), for a total of $4,170.11 interest. The pricing equation would
                          be in perfect balance:
                                                 $5,829.89 + 4,170.11 = $10,000

Calculating A Contingent (Life) Annuity

                          In our classification of annuities in Chapter 2, we explained that life annu-
                          ities are contingent annuities. Unlike an annuity certain, payments under a
                          whole life annuity depend upon continuation of a life (or lives). (A life
                          annuity may have a refund feature, but the life contingency remains.) This
                          introduces the additional factor of mortality into the pricing calculations for
                          life annuities.

                          So, as well as calculating interest (the only operative factor in the case of an
                          annuity certain) the company must now also deal with the probabilities, large
                          numbers, and mortality tables discussed in Chapter 9.

                          A typical mortality table such as Table 2 at the end of this chapter generally
                          has at least four columns to show:

                            1. all the ages at which contracts will be sold;

                            2. the number of individuals still living at each age out of the experience
                               group (some large predetermined number of individuals assumed to be
                               living at the youngest age);

                            3. the number of individuals expected to die each year; and

                            4. the rate of mortality.
122                                                                            Annuities Training Course


      Notice the symbols used in Table 2 to label each of the first four columns.
      The symbol x is used to designate current age; then 1x becomes the symbol
      for the number living at a particular age; dx is the symbol for the number
      who will die during the year; and qx is the symbol for the rate of mortality.1

      The two additional columns in Table 2 show values obtained using so-called
      commutation functions which actuaries use to simplify their annuity

      Making the Calculation

                  To determine what it must charge for a contingent life annuity, the
                  issuing company uses such a mortality table. To see how it is used
                  let’s go back to the basic formula we used to determine the present
                  value of an annuity certain, which was:
                  A=                      or A = Svn.
                            (1 + i)n
                  Suppose we ask the question, “What must a 40-year-old male indi-
                  vidual pay now in order to receive $1,000 at age 65, payable only if
                  he is alive at that time?” There is, of course, no way of knowing
                  whether any particular 40-year-old will live to age 65. So, to get the
                  answer, we have to use an annuity mortality table in conjunction with
                  the above basic present value formula.

      We substitute $1,000 for S and 25 for n (because there are 25 years between
      the ages 40 and 65). Then, according to column 1x in annuity mortality Table
      2,2 we find that 9,765,867 individuals from the original 10,000,000 are living
      at age 40, and 8,135,192 are expected to be living at age 65.

      We substitute for A in the formula, A = Svn, the total amount the mortality
      table tells us will have to be paid out to those annuitants who are still alive at
      age 65. Therefore:

      A = $1,000(l 65) = $1,000 × 8,135,192 = $8,135,192,000

          The formula for determining the mortality rate, qx, is   dx = qx . In other words, the rate of
      mortality at a particular age is simply the ratio of the number expected to die during the year to the
      number of individuals who were alive at the beginning of the year. This can be shown by using
      values of 1x and dx from Table 2. For example, 1x at age 10 is 9,979,377, and dx at the same age is
      3,892. Dividing 3,892 by 9,979,377 gives .000390, which is the value of qx, as the table also shows.
      (As a matter of interest, look back to Figure 1 in Chapter 9 and notice that the same calculation
      made at age 10 using the figures from that table results in a mortality rate of .00141. The lower rate
      is to be expected because Figure 1 is a 1983 table of mortality, while Table 2 is an earlier (1971)
      table. The different mortality rates illustrate that people are indeed living longer.)

       Notice that this is an earlier mortality table than the one shown in Figure 1 of Chapter 9, because
      the author did not have access to a complete version of the later table. Since we are only interested
      in learning how mortality tables work, the difference in actual mortality figures is unimportant for
      our purposes.
Annuities Mathematics: II                                                                         123

                        Since this amount will not be paid out until 25 years from now, we obtain the
                        present value of the payment by multiplying by the factor for v25 at our
                        assumed interest rate, which we will say is still 6%. From Table 1 we find
                        that v25 is .232999. Therefore:

                        Svn = ($8,135,192,000)(.232999) = $1,895,491,600.

                        All the money to be paid in now, A in our formula, must equal this figure.
                        That’s what the formula, A = Svn, tells us. Since we assume that all the
                        40-year-old male individuals in the mortality table will contribute and since
                        140 as shown by our mortality table is 9,765,867, we can substitute for A in
                        the formula the product of this multiplication:
                        (Amount each individual will contribute)(9,765,867).

                        The equation then becomes:
                        (Amount each individual will contribute)(9,765,867) = $1,895,491,600

                        Then, A = 1,895,491,600 = $194.09

                        If each individual age 40 now living pays in $194.09, and if deaths occur
                        exactly as projected by the mortality table we used, there will be just enough
                        money in the fund in 25 years’ time to pay $1,000 to each of the individuals
                        in our group who survived to the age of 65, provided, of course, that the
                        funds on deposit have earned 6% interest throughout the intervening period.
                        We can prove that this is so as follows:

                        Total paid in by 40-year-old group = 9,765,867 × $194.09 = $1,895,491,600
                        Accumulated value of this fund in 25 years’ time at 6% =
                        $1,895,491,600 (1.06)25 =
                        $1,895,491,600 (4.291871) = $8,135,199,500

                        Amount payable to each individual still living at age 65 =

                        $8,135,199,500        $8,135,199,500
                                          =                     = $1,000
                              165                8,135,192

                        Thus, $194.09 is the net single premium which a 40-year-old male would
                        have to pay in order to receive a single $1,000 payment at age 65, payable
                        only if he is alive at that time.

                        For a series of such payments, payable annually on successive anniversaries
                        of the first payment, provided the investor is alive on the payment date (a
                        straight-life annuity), the above calculation would have to be repeated for
                        each payment. The values of 1x and of vn would, of course, change for each
                        calculation. All the amounts obtained added together would then be the net
                        single premium required for the series of payments, just as in the case of the
                        annuity certain calculation. When a whole-life annuity is being evaluated,
                        there has to be a separate calculation for each year that the mortality table
                        indicates there would be surviving members of the age group. Clearly, annu-
                        ity calculations become extremely lengthy and tedious. Fortunately, actuaries
                        can use commutation functions, as seen in Table 2, to help simplify their
124                                                                        Annuities Training Course

The Effect Of Mortality

                  To appreciate the effect the element of mortality has had on the premium
                  developed in our calculation, let’s make a comparison. Look at the present
                  value of a $1,000 payment which is certain to be paid in 25 years’ time
                  versus the $194.09 we have just obtained as the net single premium (or
                  present value) for a $1,000 payment contingent on survivorship.

                  Returning to our basic accumulation formula, A = Svn, we have:

                  A = $1,000(v25 at 6%) = $1,000(.232999) = $233.00

                  Thus, the price of a payment which will certainly be made is more than the
                  price of a payment which will be made only if the investor lives to receive it.
                  In this case, the cost is $38.91 more. The extra amount can be viewed as the
                  cost of insuring the payments against the risk of death occurring before the
                  payment date.

                  Rate Tables And Quotes Substitute For Complex Calculations

                  In this chapter we have used the annuity certain and the straight-life annuity
                  to illustrate the basic calculations involving interest and probabilities which
                  enter into the pricing of all annuities. Annuities with various kinds of refund
                  features and based on more than one life introduce varying degrees of com-
                  plexity to the calculations described here. In some cases, such annuities
                  involve combinations of more basic annuities. For example, a life annuity
                  with a period certain is a combination of an annuity certain with a deferred
                  straight-life annuity.

                  But it isn’t necessary for us to do more calculations. Those who are inter-
                  ested can pursue the mathematics in books on that subject. Fortunately, com-
                  panies make the calculations and publish the results in rate tables or via rate
                  quotations. So there is ready access to premium rates and values for the
                  annuities companies offer for sale, as well as those they offer in settlement at
                  payout time.
Annuity Mathematics: II                                                                        125

                                                         TABLE 1

                                           (1)               (2)               (3)          (4)
                                                                          Accumulated    Present
                          Number       Accumulated     Present             Value of 1   Value of 1
                          of Periods    Value of 1    Value of 1           per Period   per Period

                              n          (1 + i)n    vn or
                                                               (1 + i)n

                              1         1.060000       .943396             1.000000     0.943396
                              2         1.123600       .889996             2.060000     1.833393
                              3         1.191016       .839619             3.183600     2.673012
                              4         1.262477       .792094             4.374616     3.465106
                              5         1.338226       .747258             5.637093     4.212364

                             6          1.418519       .704961             6.975319     4.917324
                             7          1.503630       .665057             8.393838     5.582381
                             8          1.593848       .627412             9.897468     6.209794
                             9          1.689479       .591898            11.491316     6.801692
                             10         1.790848       .558395            13.180795     7.360087

                             11         1.898299       .526788            14.971643     7.886875
                             12         2.012196       .496969            16.869941     8.383844
                             13         2.132928       .468839            18.882138     8.852683
                             14         2.260904       .442301            21.015066     9.294984
                             15         2.396558       .417265            23.275970     9.712249

                             16         2.540352       .393646            25.672528     10.105895
                             17         2.692773       .371364            28.212880     10.477260
                             18         2.854339       .350344            30.905653     10.827603
                             19         3.025600       .330513            33.759992     11.158116
                             20         3.207135       .311805            36.785591     11.469921

                             21         3.399564       .294155            39.992727     11.764077
                             22         3.603537       .277505            43.392290     12.041582
                             23         3.819750       .261797            46.995828     12.303379
                             24         4.048935       .246979            50.815577     12.550358
                             25         4.291871       .232999            54.864512     12.783356

                          From Mathematical Foundations of Life Insurance, Lewis C. Workman, Life
                          Management Institute LOMA, Atlanta, GA.
126                                                  Annuities Training Course

                               TABLE 2
             1971 Individual Annuity Mortality Table (male)
                              6% Interest

       x        lx         dx        qx         Dx                  Nx

       5    10,000,000   4,560    .000456   7,472,582         128,564,758
       6    9,995,440    4,238    .000424   7,046,390         121,092,176
       7    9,991,202    4,026    .000403   6,644,720         114,045,786
       8    9,987,176    3,915    .000392   6,266,078         107,401,066
       9    9,983,261    3,884    .000389   5,909,077         101,134,988

      10    9,979,377    3,892    .000390   5,572,432          95,225,911
      11    9,975,485    3,960    .000397   5,254,961          89,653,479
      12    9,971,525    4,039    .000405   4,955,542          84,398,518
      13    9,967,486    4,116    .000413   4,673,147          79,442,976
      14    9,963,370    4,205    .000422   4,406,808          74,769,829

      15    9,959,165    4,312    .000433   4,155,612          70,363,021
      16    9,954,853    4,420    .000444   3,918,691          66,207,409
      17    9,950,433    4,547    .000457   3,695,236          62,288,718
      18    9,945,886    4,685    .000471   3,484,480          58,593,482
      19    9,941,201    4,831    .000486   3,285,696          55,109,002

      20    9,936,370    4,998    .000503   3,098,207          51,823,306
      21    9,931,372    5,184    .000522   2,921,367          48,725,099
      22    9,926,188    5,400    .000544   2,754,568          45,803,732
      23    9,920,788    5,615    .000566   2,597,235          43,049,164
      24    9,915,173    5,860    .000591   2,448,835          40,451,929

      25    9,909,313    6,134    .000619   2,308,856          38,003,094
      26    9,903,179    6,437    .000650   2,176,818          35,694,238
      27    9,896,742    6,770    .000684   2,052,267          33,517,420
      28    9,889,972    7,140    .000722   1,934,777          31,465,153
      29    9,882,832    7,541    .000763   1,823,943          29,530,376

      30    9,875,291    7,989    .000809   1,719,389          27,706,433
      31    9,867,302    8,486    .000860   1,620,752          25,987,044
      32    9,858,816    9,030    .000916   1,527,696          24,366,292
      33    9,849,786    9,634    .000978   1,439,903          22,838,596
      34    9,840,152    10,292   .001046   1,357,071          21,398,693

      35    9,829,860    11,029   .001122   1,278,916          20,041,622
      36    9,818,831    11,822   .001204   1,205,171          18,762,706
      37    9,807,009    12,700   .001295   1,135,585          17,557,535
      38    9,794,309    13,683   .001397   1,069,919          16,421,950
      39    9,780,626    14,759   .001509   1,007,947          15,352,031

      40    9,765,867    15,948   .001633    949,459           14,344,084
      41    9,749,919    17,442   .001789    894,254           13,394,625
      42    9,732,477    19,465   .002000    842,126           12,500,371
      43    9,713,012    21,952   .002260    792,869           11,658,245
      44    9,691,060    24,896   .002569    746,300           10,865,376
Annuity Mathematics: II                                                              127

                                             TABLE 2 (Continued)

                           x       Ix         dx        qx         Dx        NX

                          45    9,666,164   28,245    .002922   702,247   10,119,076
                          46    9,637,919   31,978    .003318   660,562    9,416,829
                          47    9,605,941   36,061    .003754   621,104    8,756,267
                          48    9,569,880   40,461    .004228   583,748    8,135,163
                          49    9,529,419   45,170    .004740   548,376    7,551,415

                          50    9,484,249   50,124    .005285   514,885   7,003,039
                          51    9,434,125   55,284    .005860   483,173   6,488,154
                          52    9,378,841   60,597    .006461   453,152   6,004,981
                          53    9,318,244   66,047    .007088   424,740   5,551,829
                          54    9,252,197   71,612    .007740   397,858   5,127,089

                          55    9,180,585    77,273   .008417   372,433   4,729,231
                          56    9,103,312    83,014   .009119   348,394   4,356,798
                          57    9,020,298    88,849   .009850   325,676   4,008,404
                          58    8,931,449    94,790   .010613   304,216   3,682,728
                          59    8,836,659   100,835   .011411   283,950   3,378,512

                          60    8,735,824   107,005   .012249   264,821   3,094,562
                          61    8,628,819   113,322   .013133   246,771   2,829,741
                          62    8,515,497   119,839   .014073   229,745   2,582,970
                          63    8,395,658   126,632   .015083   213,690   2,353,225
                          64    8,269,026   133,834   .016185   198,555   2,139,535

                          65    8,135,192   141,593   .017405   184,283   1,940,980
                          66    7,993,599   150,016   .018767   170,827   1,756,697
                          67    7,843,583   159,146   .020290   158,132   1,585,870
                          68    7,684,437   168,996   .021992   146,155   1,427,738
                          69    7,515,441   179,544   .023890   134,850   1,281,583

                          70    7,335,897   190,733   .026000   124,177   1,146,733
                          71    7,145,164   202,502   .028341   114,103   1,022,556
                          72    6,942,662   214,757   .030933   104,593    908,453
                          73    6,727,905   227,410   .033801    95,621    803,860
                          74    6,500,495   240,362   .036976    87,159    708,239

                          75    6,260,133   253,498   .040494   79,185     621,080
                          76    6,006,635   266,652   .044393   71,678     541,895
                          77    5,739,983   279,624   .048715   64,619     470,217
                          78    5,460,359   292,129   .053500   57,991     405,598
                          79    5,168,230   303,825   .058787   51,782     347,607

                          80    4,864,405   314,235   .064599   45,979     295,825
                          81    4,550,170   322,616   .070902   40,575     249,846
                          82    4,227,554   328,346   .077668   35,563     209,271
                          83    3,899,208   331,203   .084941   30,945     173,708
                          84    3,568,005   331,374   .092874   26,714     142,763
128                                                       Annuities Training Course

                              TABLE 2 (Continued)

       x           Ix          dx          qx           Dx              NX

       85      3,236,631    329,130      .101689        22,861        116,049
       86      2,907,501    324,628      .111652        19,374         93,188
       87      2,582,873    317,818      .123048        16,236         73,814
       88      2,265,055    308,326      .136123        13,433         57,578
       89      1,956,729    295,603      .151070        10,947         44,145

       90      1,661,126    279,136      .168040         8,768         33,198
       91      1,381,990    258,635      .187147         6,881         24,430
       92      1,123,355    234,171      .208457         5,277         17,549
       93        889,184    206,189      .231885         3,940         12,272
       94        682,995    175,629      .257146         2,856          8,332

       95       507,366     144,011      .283841         2,001           5,476
       96       363,355     113,209      .311565         1,352           3,475
       97       250,146      85,103      .340214           878           2,123
       98       165,043      61,028      .369769           546           1,245
       99       104,015      41,626      .400194           325             699

      100         62,389      26,915     .431413          184              374
      101         35,474      16,436     .463312           99              190
      102         19,038       9,438     .495756           50               91
      103          9,600       5,075     .528599           24               41
      104          4,525       2,541     .561692           10               17

      105          1,984       1,180     .594884             4                 7
      106            804         505     .628022             2                 3
      107            299         198     .660949             1                 1
      108            101          70     .693503             0                 0
      109             31          22     .725521             0                 0

      110               9           7    .756852             0                 0
      111               2           2    .787390             0                 0
      112               0           0    .817125             0                 0
      113               0           0    .846198             0                 0
      114               0           0    .874915             0                 0

      115               0           0   1.000000             0                 0

      From Mathematical Foundations of Life Insurance
Final Examination                                                                                129

                                      FINAL EXAMINATION

1. Society’s methods of dealing with an increasing life span and longer periods of retirement
   include all of the following EXCEPT:

              A.    allowing employees to work longer.
              B.    pension plans for employees.
              C.    government loans to buy annuities.
              D.    Social Security and Medicare.
2. Individuals buy annuities for all of the following reasons EXCEPT:
              A.    as a primary source of retirement income.
              B.    to supplement company pensions and Social Security.
              C.    to reduce current cash outflows.
              D.    as a long-term, worry-free investment.
3. All of the following are among the reasons why annuities are attractive EXCEPT:
              A. Annuities appeal to older investors who want secure investments.
              B. Insurance companies provide sophisticated investment management for
                 funds deposited in annuities.
              C. Annuity owners may never withdraw funds before maturity.
              D. Annuities can be used to provide funds for college.
4. By varying the method and timing of premium payments, companies have developed the
   following types of annuities:
        I.   Fixed-premium immediate annuities
       II.   Fixed-premium deferred annuities
      III.   Flexible-premium immediate annuities
      IV.    Single-premium immediate annuities
              A. All of the above
              B. II, III and IV
              C. II and IV
              D. I, II and IV
5. A flexible-premium deferred annuity is useful for the following reasons:
        I.   It can meet the budget needs of individuals whose incomes vary from year to year.
       II.   Premiums are not paid unless earnings reach $20,000 a year.
      III.   With special provisions added, it can qualify as an IRA.
      IV.    Cash withdrawals may be made at any time without penalty.
               A. All of the above
               B. I and III
               C. II, III and IV
               D. III and IV
130                                                                               Annuities Training Course

6. A client might prefer a fixed-dollar annuity to a variable annuity for the following reason:

              A.   The company bears the investment risk.
              B.   Premium payments are low.
              C.   It provides a better hedge against inflation.
              D.   It provides better protection against the declining purchasing power of the dollar.
7. Which of the following statements about variable annuities is/are correct?
        I.   The company bears the risks of investment.
       II.   The variable annuity was developed to preserve the purchasing power of retirement income.
      III.   A variable income is the only settlement choice.
      IV.    Variable annuities can only be sold by registered security dealers.
              A. I and III
              B. I, II and III
              C. II and IV
              D. IV only
8. A list of annuities classified by method of payment to the annuitant(s) would include the
   following annuity type:
              A.   Variable annuity
              B.   Fixed-dollar annuity
              C.   Single-premium immediate annuity
              D.   Life annuity with period certain
9. An annuity certain can be written to guarantee:
        I.   payment of a specified amount.
       II.   payment for a guaranteed period.
      III.   payment for life.
      IV.    convertibility to an IRA.
              A. I only
              B. I and II
              C. II and IV
              D. I, II and III
10. Life annuities with a refund feature include all of the following EXCEPT:
              A.   Straight-life annuities
              B.   Life annuities with period certain
              C.   Cash-refund annuities
              D.   Installment-refund annuities
11. A $1,000 premium can be expected to provide the highest income when it is invested in:
              A.   a straight-life annuity.
              B.   an installment-refund annuity.
              C.   a life annuity with period certain.
              D.   a cash-refund annuity.
Final Examination                                                                                   131

12. Which of the following statements about single-premium immediate annuities is/are true?
        I.   A SPIA is likely to be purchased by someone ready to retire.
       II.   A SPIA has a longer accumulation period than a SPDA.
      III.   Current income is the usual source of premium funds for a SPIA.
      IV.    A SPIA might be purchased to provide either monthly, quarterly, semiannual, or annual
              A. I only
              B. I and IV
              C. IV only
              D. All of the above
13. Which of the following statements about single-premium deferred annuities is/are true?
              A.    A SPDA is an accumulation product.
              B.    A SPDA is suitable for someone with cash to invest who is not yet ready to retire.
              C.    Both A and B
              D.    Neither A nor B
14. Most SPDAs today have:
              A.    a front-end load that restricts interest accumulation.
              B.    limited free withdrawal privileges.
              C.    Both A and B
              D.    Neither A nor B
15. When you evaluate SPDAs, you should consider:
        I.   the overall strength of the company selling them.
       II.   the length of initial interest rate guarantees.
      III.   the company’s history of renewal rates.
      IV.    withdrawal privileges.
              A. I and III
              B. II, III and IV
              C. I, III and IV
              D. All of the above
16. Variable annuity premiums may be invested in:
        I.   bond funds.
       II.   high-potential stocks.
      III.   stocks of companies with a good record in protecting the environment.
      IV.    stocks of high-technology companies.
              A. II and IV
              B. I, II and IV
              C. II, III and IV
              D. Any of the above
132                                                                              Annuities Training Course

17. Purchasers of variable annuities:
        I.   generally like to have a voice in the management of their investments.
       II.   pay an annual fee for fund management.
      III.   may pay a surrender charge for withdrawals.
      IV.    usually pay a front-end load.
              A. I only
              B. I and II
              C. I, II and III
              D. All of the above
18. People who qualify for TSA plans include:
        I.   college and university professors.
       II.   lawyers who are self-employed.
      III.   employees of charitable organizations.
      IV.    only employees earning less than $10,000 a year.
               A. I only
               B. I, II and III
               C. I, II and IV
               D. I and III
19. Installment payments under an annuity become fully taxable when:
              A.   they begin.
              B.   five years have passed since the initial payment.
              C.   the annuitant has exceeded his or her life expectancy.
              D.   the annuitant’s principal plus interest has been returned.
20. The unique advantage of an annuity over other forms of investment is that:

              A.   it can be expected to outperform the stock market in the long run.
              B.   it provides an income that cannot be outlived.
              C.   it can provide income for contingent beneficiaries.
              D.   it is highly desirable as a tax shelter.
21. An annuity can be a valuable estate planning tool because:
              A.   annuity income which terminates at death leaves nothing to be taxed.
              B.   the value of an annuity is difficult to establish.
              C.   annuities are not taxable assets.
              D.   annuitants are not subject to estate tax.
22. Which of the following are among an annuity’s advantages?
              A.   Death benefits escape probate and attendant costs.
              B.   Annuities offer tax-deferred interest accumulation.
              C.   Both A and B
              D.   Neither A nor B
Final Examination                                                                             133

23. Factors to consider when matching annuity products to prospects include all of the following

              A.    the prospect’s financial objectives.
              B.    the source of funds to pay premiums.
              C.    whether the prospect has purchased life insurance from you.
              D.    the prospect’s investment preferences.
24. A flexible-premium deferred annuity:
              A.    requires a premium payment each year.
              B.    is suitable for individuals who wish to retire in the future.
              C.    Both A and B
              D     Neither A nor B
25. A single-premium deferred annuity:
        I.   is suitable for a client with a lump sum to invest.
       II.   is suitable for individuals who wish to retire in the future.
      III.   is suitable for individuals who wish to retire immediately.
      IV.    pays interest at a guaranteed rate until maturity.
               A. I, II and IV
               B. I and II
               C. I and III
               D. I, II and III
26. John Jones intends to continue working until at least age 65. However, at age 45, he has just
    inherited $50,000 from his father’s estate. Which of the following annuities might you suggest
    that he purchase?

              A.    A FPDA
              B.    A SPIA
              C.    A SPDA
              D.    A TSA
27. Margaret Moore is 65, single, and ready to retire. She has saved $100,000 and wants to
    purchase an annuity. Which annuity would you suggest?
              A.    A SPIA
              B.    A SPDA
              C.    A FPDA
              D.    An IRA
28. Ed Smart is 40 years old and willing to save $1,000 annually toward his retirement. You
    suggest an annuity. Which one?
              A.    A SPDA
              B.    A SPIA
              C.    A FPDA
              D.    An APIA
134                                                                             Annuities Training Course

29. Since annuities are long-term investments intended to provide retirement security, it is
    important for the issuing company to:

           A.   be prudently managed.
           B.   pay the highest current rate of interest.
           C.   Both A and B
           D.   Neither A nor B
30. If a corporation purchases an annuity:
           A.   the corporation is taxed just like an individual.
           B.   the income is not taxed currently.
           C.   Both A and B
           D.   Neither A nor B
31. Annuity tax rules found in IRC Section 72 include the following:
           A. The tax-free portion of annuity income received after the “annuity starting date” is
              determined by an exclusion ratio.
           B. The expected return for a variable annuity is determined in exactly the same way as
              for a fixed-dollar annuity.
           C. Both A and B
           D. Neither A nor B
32. Which of the following are correct statements of an annuity tax rule?

           A. Cash withdrawals are deemed amounts not received as an annuity.
           B. A 10% penalty tax is generally added to the regular tax payable if cash is withdrawn
              from an annuity before age 65.
           C. Both A and B
           D. Neither A nor B
33. If one annuity contract is exchanged for another:
           A.   the two must be of equal value.
           B.   a tax will always be payable when the exchange occurs.
           C.   no tax will ever be payable.
           D.   no tax will be payable currently as long as no cash is released in the exchange and the
                requirements of IRC Section 1035 are met.
34. Which of the following statements concerning the federal estate tax is/are correct?
           A. A straight-life annuity will be fully includible in the gross estate when the annuitant
              dies after payments have begun.
           B. The gross estate of a deceased annuitant will include the full value of any annuity
              refund made payable to the estate, whether or not the annuitant paid the annuity
           C. Both A and B
           D. Neither A nor B
Final Examination                                                                                     135

35. Which of the following statements about the federal gift tax provisions is correct?

              A. The federal gift tax provisions permit tax-free gifts only to immediate family members.
              B. The gift tax annual exclusion allows a donor to give up to a specified dollar amount
                 annually (twice that amount if a spouse joins in gift-splitting) to any number of donees,
                 without tax.
              C. A gift tax is payable on every gift of a present interest regardless of the amount.
              D. The gift tax does not apply to gifts of annuities.
36. A gift of an interest in an annuity can occur in which of the following ways?
        I.   By transferring ownership of an existing annuity.
       II.   By naming someone other than the purchaser as original owner of an annuity.
      III.   By naming an irrevocable beneficiary to receive an annuity refund.
      IV.    By purchasing a joint-and-survivor annuity without reserving the right to change the
             recipient of the survivorship payments.
              A. All of the above
              B. I only
              C. II and III
              D. II, III and IV
37. All of the following statements regarding qualified annuities are true EXCEPT:
              A.    they are purchased with after-tax dollars.
              B.    they are specifically designed to fund qualified retirement plans.
              C.    they provide tax deferral on interest earned.
              D.    they provide tax deferral on principal invested.
38. Which of the following are tax-qualified retirement plans?
        I.   Tax-Sheltered Annuity Plans
       II.   Corporate Profit-Sharing Plans
      III.   Keogh Plans
      IV.    Simplified Employee Pension Plans
              A. All of the above
              B. I, II and III
              C. II, III and IV
              D. I, III and IV
39. Which of the following statements about Tax-Sheltered Annuities is/are correct?
        I.   TSA premiums are paid with after-tax dollars.
       II.   TSA premiums are paid by the employer.
      III.   Employees of all non-profit organizations are eligible for a TSA.
      IV.    Elective salary deferrals are subject to a specific annual limit.
              A. All of the above
              B. I, II and IV
              C. II and IV
              D. II, III and IV
136                                                                            Annuities Training Course

40. Which of the following is/are true concerning the penalty tax for withdrawals from a TSA?

           A. With some exceptions, withdrawals before age 59½ result in a 10% penalty tax.
           B. No penalty applies if withdrawal is due to early retirement after age 55 and is taken
              as a life annuity.
           C. The penalty does not apply when the withdrawals result from the disability of the
           D. All of the above.
41. An annuitant has arranged a type of annuity payout that provides for payments guaranteed
    for at least 10 years, but the annuity will continue to pay a regular income to the annuitant
    even if he lives longer than 10 years after payments begin. What type of arrangement is
           A.   Straight life annuity
           B.   Life annuity with period certain
           C.   Last survivor annuity
           D.   Installment refund annuity
42. Which of the following statements about Individual Retirement Annuities is correct?
           A. To make an IRA contribution requires $10,000 of earned income.
           B. By law, distributions from an IRA must begin by April 1 of the year following the
              year in which the owner reaches age 65½.
           C. The law requires the premiums for an Individual Retirement Annuity to be fixed in amount.
           D. A company’s FPDA can become an IRA if certain provisions required by statute are
              added to the contract.
43. All of the following statements about SEP-IRAs are correct EXCEPT:

           A. A SEP enables a small business owner to have a pension plan without onerous filing
           B. Contributions to a SEP are used to pay premiums on IRA contracts.
           C. Employee contributions to a SEP-IRA are tax-deductible within statutory limits.
           D. There are no nondiscrimination requirements for SEP-IRAs.
44. Which statement concerning SIMPLE IRAs is correct?
           A. These plans are limited to employers with 100 or fewer employees.
           B. Employees who earned at least $5,000 each from the employer in the preceding year
              are eligible to participate in the plan.
           C. Both A and B
           D. Neither A nor B
45. With an equity-indexed annuity, the percentage of the S&P 500® index gain that will be
    reflected in the annuity interest gains for the policy term is known as the:
           A.   annual reset.
           B.   high water mark.
           C.   participation rate.
           D.   index ratchet.
Final Examination                                                                                    137

46. The law of compound probability comes into play when actuaries calculate:

             A.     the cost of a SPDA.
             B.     the cost of a straight-life annuity.
             C.     the cost of a joint-and-survivor annuity.
             D.     the cost of any annuity.
47. Select any correct statement.
             A. Mortality tables based on past experience are an adequate basis by themselves for
                setting insurance premiums.
             B. Mortality rates for groups of annuitants are generally lower than for groups of insureds.
             C. Both A and B
             D. Neither A nor B
48. Select the correct statement about an IRA.
             A. An IRA may not be a variable annuity.
             B. The earliest that funds may be withdrawn from an IRA without penalty is the same
                year the owner begins receiving Social Security.
             C. The law requires the premiums paid into an IRA to be fixed in amount.
             D. IRA owners who also participate in a qualified plan may not be able to deduct
                contributions to an IRA in some cases, but may still make nondeductible contributions
                to the IRA.
49. Which of the following questions does the present value formula answer?

             A. “What net single premium must the company charge a 40-year-old who wants to
                have $50,000 at age 65?”
             B. “What will the company be able to pay out at age 60 to someone who pays a $50,000
                premium now?”
             C. Both A and B
             D. Neither A nor B
50. All of the following are true about the equity-indexed annuity EXCEPT:
             A.     It does not represent investment in a security.
             B.     It has a built-in stop-loss type feature.
             C.     It is an immediate annuity.
             D.     It can use a variety of indexing methods.
    Final Examination                                                                      139

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    140                                                     Annuities Training Course

                      Annuities Training Course

                           Answer Sheet

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    a     b   c   d            a   b   c   d
5   ■ ■ ■ ■                 22 ■ ■ ■ ■              a   b     c   d

                                                  39 ■ ■ ■ ■

    a     b   c   d            a   b   c   d

6   ■ ■ ■ ■                 23 ■ ■ ■ ■              a   b     c   d
                                                  40 ■ ■ ■ ■

    a     b   c   d            a   b   c   d

7   ■ ■ ■ ■                 24 ■ ■ ■ ■              a   b     c   d

                                                  41 ■ ■ ■ ■

    a     b   c   d            a   b   c   d
    ■ ■ ■ ■                 25 ■ ■ ■ ■

8                                                   a   b     c   d
                                                  42 ■ ■ ■ ■

    a     b   c   d            a   b   c   d

9   ■ ■ ■ ■                 26 ■ ■ ■ ■              a   b     c   d

                                                  43 ■ ■ ■ ■

    a     b   c   d            a   b   c   d
10 ■ ■ ■ ■                  27 ■ ■ ■ ■              a   b     c   d

                                                  44 ■ ■ ■ ■

    a     b   c   d            a   b   c   d

11 ■ ■ ■ ■                  28 ■ ■ ■ ■              a   b     c   d
                                                  45 ■ ■ ■ ■

    a     b   c   d            a   b   c   d
12 ■ ■ ■ ■                  29 ■ ■ ■ ■              a   b     c   d

                                                  46 ■ ■ ■ ■

    a     b   c   d            a   b   c   d

13 ■ ■ ■ ■                  30 ■ ■ ■ ■              a   b     c   d
                                                  47 ■ ■ ■ ■

    a     b   c   d            a   b   c   d
14 ■ ■ ■ ■                  31 ■ ■ ■ ■              a   b     c   d

                                                  48 ■ ■ ■ ■

    a     b   c   d            a   b   c   d

15 ■ ■ ■ ■                  32 ■ ■ ■ ■              a   b     c   d
                                                  49 ■ ■ ■ ■

    a     b   c   d            a   b   c   d
16 ■ ■ ■ ■                  33 ■ ■ ■ ■              a   b     c   d

                                                  50 ■ ■ ■ ■
    a     b   c   d            a   b   c   d                                            ○

17 ■ ■ ■ ■                  34 ■ ■ ■ ■


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