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Introduction to Annuities


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Lesson 1Definition of an Annuity

Lesson 1 Objectives

After completing this lesson, you will be able to:

1. Define an annuity and describe how a basic one might work.

2. Explain what is meant by a “nonqualified” annuity.

3. Indicate why annuities have been growing in popularity.

4. Give an accounting of the unique feature of an annuity.

5. Define the accumulation phase and the annuitization phase.

Lesson 1: Definition of an Annuity

Lesson 1 Key Terms Glossary

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What is an Annuity?

An annuity has one basic purpose, to provide a series of payments over a period of time. Usually, this period of time is an individual’s lifetime.

In its pure form, a whole life annuity is a contract whereby for a consideration (the premium), one party (the insurer) agrees to pay the other (annuitant) a stipulated amount (the annuity) periodically throughout life.

For a purchase price or premium, an annuity will pay an individual an income over a certain period of years, often over the individual’s lifetime. This income commences at a specified or contingent date, and continues for a fixed period or for the duration of a designated life.


What is an Annuity

Before defining an annuity in more depth, it’s important to understand why annuities are receiving so much attention and why they’re being purchased in record numbers. Annual sales of annuities in recent years have surpassed $100 billion. More than 25 million fixed annuity contracts are in force.

Sales of variable annuities have increased at an even faster pace than the sales of annuities overall. Annual sales now exceed $150 billion. In the last several years, variable annuities have been on the increasing percentage of total nonqualified annuity sales. Variable annuities now account for about two-thirds of total annuity sales. And equity-indexed annuities continue to grow in popularity, along with the debate as to whether they are fixed annuities and treated as insurance products or variable annuities and treated as securities.


What is an Annuity

In recent years, baby boomers—Americans born in the years following World War II—have begun reaching the age when retirement planning becomes a priority. In 1980, only 11% of the U.S. population was 65 years of age or older. By 2008, the figure had risen to 12.7%, by 2020 it is anticipated the figure will reach 16.2%, and by 2050, 21% of the country’s population – more than one person in five –will be at least 65 years of age.

If we consider how long people are living in the context of the entire twentieth century, the evolution is even more dramatic. In 1900, the life expectancy of the average American was only about 47 years. By 1950, that average lifespan had risen to 68 years, and currently, that lifespan is over 78 years.


What is an Annuity

The number of annuity owners in the United States has also seen rapid expansion. In 1940, all of the annuity owners in the U.S. could fit into a single small town: there were only 695 of them!


Question 1-1

PROPERTIES

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The Annuity’s Unique Feature

One feature of the annuity is not to be found in any other investment vehicle. The unique feature of an annuity is that it provides a stream of income that the annuitant cannot outlive.

If the annuity benefits are to be paid over the annuitant’s lifetime, the monthly or annual benefit amount is guaranteed to come each month or year regardless of how long the annuitant lives.

In this sense an annuity can be said to offer protection against living “too long.”


Who Purchases Annuities?

Many think that annuities are purchased only by the wealthy—those individuals who have already accumulated a large estate and can place enormous sums into a single annuity contract at one time.

Purchases of this type are certainly made, but it’s not true that all annuities are purchased by the wealthy. Many nonqualified annuity contracts are purchased by people of modest income to help accumulate an estate or to provide financial income after retirement.



There are others who find annuities attractive because of particular investment situations. Some people—such as entertainers and professional athletes—earn a majority of their life’s income in a short period of time. Even a small business owner who creates a large influx of income by landing a big contract or selling a portion of his or her business may consider the purchase of an annuity.

Also, annuities are often purchased with life insurance proceeds. If a surviving spouse or children receive a large lump sum payment of death proceeds from a life insurance policy, they might choose to purchase a single premium annuity. By doing so, and by selecting some type of lifetime payout option, they can make sure the life insurance proceeds will last the survivor’s lifetime and not be frittered away in a few years.


Question 1-2

PROPERTIES



Now let’s return to our definition of an annuity. You’ll recall how we established that annuities pay an income to an individual for a fixed period or for the duration of a life. Assume that Mr. Vaughn is age 50 and ready to begin planning for his retirement at age 65. As part of his financial plan, he purchases a nonqualified annuity and pays a monthly premium of $300 each month for 15 years.

When he reaches age 65, Mr. Vaughn will have accumulated a sum of about $95,000, assuming an interest rate of 7%. If he chooses, he can ask the insurance company to pay his annuity to him for life. He will receive a check each month for approximately $635 for the remainder of his life, whether it is three years or thirty years.


What is a Nonqualified Annuity?

Keep in mind that the designation of “nonqualified” has nothing to do with the quality of either the annuity or qualifications of the insurance company. It merely refers to whether the annuity is part of an employee benefit plan that meets certain requirements as “qualified” under the Internal Revenue Code.

A nonqualified annuity may be purchased by any individual or entity, and is not associated with an employer-provided plan.


Question 1-3

PROPERTIES


The Timeline of an Annuity

An annuity contract passes through two distinct phases during its existence: the accumulation phase and the annuitization phase.

The accumulation phase is that period of time from the purchase of the annuity until the annuity owner decides to begin receiving benefit payments. It is during this period that the annuity builds up or accumulates the funds that will provide the future benefits.

One important feature of the annuity is that the interest credited to its premiums by the insurance company is not taxed each year to the holder of the annuity. Rather, tax on this income is delayed or deferred until the annuity holder begins drawing benefits from the contract.


This deferral of taxation allows interest to be credited on every dollar of interest previously accrued, resulting in a much larger accumulation of funds than would be possible if a portion of the interest were withdrawn each year to pay income tax.

The Timeline of an Annuity


The Accumulation Phase

With a nonqualified annuity, the accumulation phase can last from a few years to many years. Take the case of Mr. Reese, age 60, who has just purchased an annuity. He plans to pay premiums for five years until he reaches age 65, and then receive benefit payments from the annuity for the remainder of his life. The accumulation phase of his annuity will be relatively short only five years.

In contrast, take the case of Ms. Jones. Having purchased an annuity at age 25, she plans to pay premiums until she reaches age 55. The accumulation phase of her annuity will be 30 years.


The Annuitization Phase

The second phase that an annuity contract passes through is the annuitization phase. This begins with payment of the first benefit amount from the annuity to the annuity holder. The annuitization phase is sometimes referred to as the payout period or the benefit period.

Continuing with the example of Mr. Reese, the annuitization phase of his annuity will begin when he reaches age 65 and will continue for the rest of his life. Assuming that Mr. Reese lives to age 85, his annuity will have an accumulation phase of five years and an annuitization phase of about 20 years.


Question 1-4

PROPERTIES


Other Types of Annuities

Earlier in this session, the definition of a nonqualified annuity was discussed and contrasted with that of a qualified annuity. This course confines itself to a discussion of nonqualified annuities and does not address in detail annuities purchased as part of a qualified retirement plan, Individual Retirement Annuities, or Tax Sheltered Annuities.

While there are some similarities between the nonqualified annuity and these other types, there tend to be significant differences.


You’ve completed Lesson 1.

This concludes Lesson 1.

A brief quiz over the material from the entire lesson should be taken before moving on to the next lesson.


Lesson 1 Quiz

PROPERTIES


Lesson 1 Read More Supplement

If you will be taking the mastery exam at the end of the course or wish to earn CE credit, it is necessary for you to review the information in the supplemental section. Information contained only in this section will be included on the exam. Review information by clicking here.


https://clients.pinpointglobal.com/NUCO/upload/Ann-RM1.pdf


Lesson 2Parties to an Annuity

Lesson 2 Objectives


1. Name the key parties to an annuity and explain their roles in relation to the contract.

2. Explain both the obligations and the rights of particular parties to an annuity.

3. Identify which multiple roles might be filed by a single individual.

4. Describe a typical set of parties to an annuity contract, as well as variation on that typical situation.

5. Identify which parties must be living individuals.

Lesson 2: Parties to an Annuity

The Parties to an Annuity

An annuity contract is exactly that; a contract in which certain parties make certain promises and other parties have certain rights. It is important to understand who the parties to the contract are, and to be familiar with the general rights and obligations of each party.

Typically, there are four potential parties to a nonqualified annuity contract:

· Owner

· Annuitant

· Beneficiary

· Issuing insurance company

The rights and duties of each of these entities are discussed in this session.



Here is a general overview of the four potential parties to a nonqualified annuity contract:

Owner – the person who purchases the annuity

Annuitant – the individual whose life will be used in determining how payments under the contract will be made

Beneficiary – the individual or entity that will receive any death benefits that become payable under the annuity contract

Issuing insurance company – the organization that accepts the owner’s premium and promises to pay the benefits spelled out in the contract



Although there are four potential parties to each annuity contract, the most common situation involves only three parties since the owner and the annuitant are usually the same individual.

As an example of this commonly used arrangement, consider Ms. Jackson. She has just attended her youngest child’s college graduation ceremony, and is now turning her attention to seriously planning for her retirement years.

Her insurance agent gives her a tip: she can purchase a nonqualified deferred annuity from an insurance company, placing $200 each month into the annuity. When she retires, the contract will move from the accumulation phase to the payout phase, and will begin providing her with a monthly benefit.


Question 2-1

PROPERTIES



In setting up the annuity, Ms. Jackson will be named as both the contract owner and the annuitant. She will name a beneficiary for any death benefits that are paid from the contract should she die before reaching retirement age.

Most likely, Ms. Jackson will name one of her children as the beneficiary. The third party, the insurance company, will be the party from which Ms. Jackson purchases the annuity.


Four potential parties to a nonqualified annuity contract:

• Owner• Annuitant• Beneficiary• Issuing insurance

company

The Owner

Every annuity contract must have an owner. This party is referred to as:

· The owner

· The annuity holder

· The annuity owner

With a nonqualified annuity contract, the owner is usually a real person, someone who has decided to purchase the annuity as part of a financial plan for retirement or for some other purpose. But there is no requirement that the owner be a real person. An annuity contract might be owned by various types of trusts, or by a business that is organized as a corporation or a partnership.

In the most common instance, where the owner and the annuitant are the same person, the owner pays premiums into the annuity during the accumulation phase. At the end of this phase, the owner-annuitant begins to receive the annuity benefit payments from the insurance company.


Question 2-2

PROPERTIES


The Owner

As the term “owner” implies, the owner of the annuity contract holds a number of rights under the contract. The owner decides who will serve as the annuitant and who will be the beneficiary under the contract. Also, it is the owner who determines when the annuity contract will move from the accumulation phase into the payout (or annuitization) phase and begin to pay benefits.

If Ms. Gulden purchased a single premium annuity twenty years ago, as owner of the annuity contract, she can choose to begin receiving annuity payments today, or she can wait until some point in the future. Most annuity contracts do specify a maximum age past, which annuity payouts cannot be deferred, but in most contracts this age is well past the usual retirement age.


The Owner

Under a typical annuity contract, Ms. Gulden also has the right to make a partial surrender and receive a portion of the funds accumulated inside the contract. She can also choose to end the contract completely by fully surrendering the contract.

To illustrate Ms. Gulden’s options in this respect, assume that the contract value today is $50,000. As owner of the contract, Ms. Gulden may make a partial surrender of an amount less than the full $50,000 value. If she chooses to receive $20,000 from the contract, the annuity contract will continue in force but with a value of only $30,000. When she chooses to begin receiving the annuity benefit payments, she will be entitled to benefits calculated on the remaining $30,000 value in the contract.


The Owner

As owner of the contract, Ms. Gulden can also choose to fully surrender the contract, receiving the entire $50,000 value today. Should she decide to do this, the annuity contract will be at an end, and neither Ms. Gulden nor the insurance company will have any further rights or obligations relating to the annuity.


The annuity owners rights:

• Decides who is the annuitant

• Decides who is the beneficiary

• Determines when to receive payments

• Can choose to make a partial surrender

• Can choose to make a full surrender

The Annuitant

As mentioned above, the annuitant is the individual whose life will serve as the measuring stick to determine benefits to be paid out under the contract. According to the Internal Revenue Code, the annuitant is the individual whose life is of primary importance in affecting the timing or amount of the payout under the contract.

In other words the annuitant’s life is the measuring life. Thus, the annuitant, unlike the owner or the beneficiary of the annuity contract, must be a real flesh-and-blood person.


The Annuitant

Although it is the most common arrangement, there is no requirement that the owner of the annuity contract and the annuitant be the same individual. A father, age 50, buys an annuity contract and is the owner. He names his son, age 25, as the annuitant, with annuity payments to begin when his son reaches age 45.

When the accumulation phase of the annuity draws to a close and the owner wishes to annuitize the contract and begin receiving annuity benefit payments, the life expectancy of the annuitant can come into play. The method by which benefits are paid depends upon which annuity payout or settlement option is elected.


Question 2-3

PROPERTIES


The Annuitant

For example, if Mr. Laurie is both the owner and annuitant of a contract that will begin paying benefits when he is age 65, and he elects a life only payout option, the fact that Mr. Laurie has a life expectancy of 20 years will be used in calculating the portion of the benefit payout that will be taxed to him. For income tax purposes, the 20-year life expectancy figure is taken from the applicable annuity table issued by the Internal Revenue Service.

In addition, a similar life expectancy figure will be used by the insurance company that sold the annuity to Mr. Laurie in calculating the amount of his monthly annuity benefit. Thus, the annuitant’s age (and therefore his or her life expectancy) at the time the benefit payout begins will affect this monthly benefit amount.


The Annuitant

Consider the example of three owner-annuitants who each hold contracts with an accumulation value of $50,000. Mr. Gray is 65 years old; if he decides to begin receiving annuity benefits now, his benefit will be about $334 per month under a life only settlement option. Mr. Davis is 75; if he begins to receive benefits from his $50,000 annuity, his monthly payout amount under a life only settlement option will be about $471 per month. Mr. Tarvin, who retires early, annuitizing his contract at 55, will receive only $265 per month.


The Beneficiary

Similar to the beneficiary of a life insurance policy, the beneficiary of an annuity contract receives a death benefit when another party to the contract dies prior to the time of annuitization.

The death benefit payment allows an owner to recover his or her investment and pass it along to his or her beneficiary if he or she does not live long enough to begin receiving annuity contract benefits. The death benefit amount is equal generally to the value of the annuity contract at the time of death.


Question 2-4

PROPERTIES


The Beneficiary

As an example, assume that Mrs. Smith purchased an annuity, naming herself as both owner and annuitant, and naming her nephew, her only living relative, as the beneficiary. Mrs. Smith purchased this deferred annuity contract when she was 50 years old, and she does not plan to annuitize it (that is, to begin receiving benefits) until she retires at age 65.

If she dies prior to retirement, the typical annuity contract will pay a death benefit to her nephew approximately equal to the premiums that Mrs. Smith paid into the annuity, plus the interest earned on those premiums.


The Beneficiary

But if Mrs. Smith survives until she retires at age 65, and begins receiving annuity benefits under a life only income option, and then dies at age 67, there will be no death benefit payable to the beneficiary or any other party. This will be true even though Mrs. Smith had not received in two years time benefit payments anywhere close to the amount of premiums she paid into the annuity.

Had Mrs. Smith had elected a method of benefit payout that offered a refund or a guarantee instead of the life only income option, some further benefit payments would be made to her nephew. Most annuity contracts offer a variety of benefit payout or settlement options.


The Beneficiary

The beneficiary has no rights under the annuity contract, other than the right to receive payment of the death benefit. He or she cannot change the payout settlement option. He or she cannot alter the starting date for benefit payments. He or she cannot make any withdrawals or partial surrenders against the contract. The owner has the sole right, under most contracts, to change the beneficiary designation at any time.

There is no requirement that the beneficiary be a flesh-and-blood individual. Often, a trust or other entity—such as a charitable organization—is named as the annuity contract beneficiary.


Question 2-5

PROPERTIES


The Insurance Company

It is the insurance company, which issues the annuity contract and, in doing so, assumes a number of financial obligations to the owner, the annuitant, and the beneficiary.

In a very general sense, the insurance company that issues an annuity contract promises to invest the owner’s premium payments responsibly and credit interest to the funds placed in the annuity. How the premium payments are invested and how much control the owner retains over the investment decisions, if any, varies depending upon which type of nonqualified annuity is purchased.

The insurance company also promises to pay the contract death benefit in the event of the death of the owner prior to annuitization and to make benefit payouts according to the contract settlement option.



Annuity contracts differ from one company to the next. The Internal Revenue Code requires that all annuities contain certain provisions in order to be eligible for the tax benefits associated with the annuity contract, but much room remains for variation between companies.

The best source of information on the specific provisions of an annuity contract is, of course, the issuing insurance company itself. Many agents and financial planners request a sample contract for each of the annuity products they work with to enhance their understanding of each contract.



The purchaser of an annuity contract should be knowledgeable about and comfortable with the financial strength and investment philosophy of the company that is issuing the contract.

To evaluate the company’s financial strength, several rating services are available. These services are often used by agents, financial planners, and consumers. Well known rating services include those from the A.M. Best Company, Moody’s, Standard & Poor’s, and Duff & Phelps. Ratings take into account a company’s investment strategy, marketing philosophy, profitability, and history.


Lesson 2 Quiz

PROPERTIES



Lesson 3Standard Contract Provisions

Lesson 3 Objectives


1. Generalize about charges typically assessed variable and fixed annuity.

2. Explain the two interests rates, which pertain to fixed annuities.

3. Describe provisions that offer the owner a hedge losing most of the value of the unity by dying too soon.

4. Understand, in a general sense, how surrender charges are levied.

Lesson 3: Standard Contract Provisions

Bailout Provisions and Rates

While all annuity contracts are not the same, there are certain standard provisions common to many. The Internal Revenue Code requires certain provisions to be included in an annuity contract.

Generally, if the current interest rate drops below a certain level, a bailout provision allows the contract holder to fully surrender the annuity contract without incurring any of the surrender charges that are typically imposed. A bailout provision is sometimes called an escape clause.

Charges And Fees

Many, if not most annuities assess administrative charges—sometimes several different charges. The dollar amount of each charge may seem small, but the cumulative effect can take its toll.


Charges: Fixed Annuities

For instance, an annuity may charge an administration fee of $30 or $35 annually, to cover the company’s cost of preparing the annuity holder’s statement, making ownership or beneficiary changes, and other tasks.

Typically, the fees associated with a fixed annuity are lower and fewer than those of a variable annuity. At first glance, then, it may seem that the variable annuity is more expensive than the fixed annuity.

Keep in mind, though, that with a fixed annuity, the insurance company declares the current interest rate, and thus can set the rate it will pay lower than the rate it expects to earn on investments. This difference in rates, sometimes called the “spread” or “haircut,” allows the insurance company more leeway to recover its administrative costs than it has with a variable annuity.


Charges: Variable Annuities

The annual administration fee mentioned above in relation to the fixed annuity often is also applied to a variable annuity contract. But other fees and charges levied under variable annuity contracts – while somewhat similar to those charged by fixed annuities – are subject to a greater degree of regulation. This is because variable annuities are considered securities.

In order to sell variable annuities, an agent must have a securities license in addition to the one required to sell fixed annuities; further, the purchaser of a variable annuity must always be given a prospectus.

With a variable annuity, the insurance company does not set the interest rate itself, but credits the rate earned on funds in the separate investment account. Some variable annuities charge a fee for the transfer of funds between investment accounts.


Question 3-1

PROPERTIES


Interest Rates: Fixed Annuities

Typically, a fixed annuity contract will offer two interest rates: a guaranteed rate and a current rate.

The guaranteed rate is the minimum rate that will be credited to funds in the annuity contract. This is true regardless of how low the current rate sinks or how poorly the issuing insurance company fares with its investment returns. Typically, the guaranteed rate is 3% to 4%.

The current interest rate varies with the insurance company’s degree of success with its investment program. Some annuity contracts revise the current rate each month, while others change the current interest rate only once a year.


Interest Rates: Variable Annuities

Understanding how returns are credited on money invested within the framework of a variable annuity can be a bit complicated. The variable annuity holder may allocate his or her premium dollars among a number of investment choices. These usually include a guaranteed account, a stock fund, a bond fund, an income fund, and a growth fund.

It is the annuity holder, not the insurance company, who assumes the investment risk for funds placed in the variable accounts of a variable annuity.

The portion of an annuity holder’s premiums that are allocated to a particular stock or bond fund, for example, will earn the rate of return that is credited to the stock or bond fund generally.


Question 3-2

PROPERTIES


Maximum Ages and Minimum Amounts

A maximum issue age is the age at which an insurance company will sell an annuity to an individual. Some companies specify a maximum issue age while others don’t.

Most annuity contracts require that each premium payment be at least a certain minimum amount – primarily to make the administration of the contract easier.

Most insurance companies specify a maximum age at which the annuity holder must begin receiving benefit payouts from the annuity. Like other annuity provisions, this maximum age varies, and indeed, in recent years, has generally been set at increasingly advanced ages. Many contracts require payout to begin when the annuitant reaches age 80 or 85.


Settlement Options

Settlement options in the annuity contract are the provisions by which the annuity owner can elect to receive payment of benefits under the annuity contract. Other terms that are used to refer to settlement options are payout options or benefit options.

Generally, it is the annuity owner who selects the settlement option. This selection can be made when the contract is purchased, or delayed until the time that benefit payments are to commence. Most annuity contracts allow the chosen settlement option to be changed with proper notice to the insurance company.


Question 3-3

PROPERTIES


Settlement Options

Although not an exhaustive list, the following are common settlement options:

Life Annuity

If the life annuity settlement option is elected, the annuitant will receive payments from the annuity until his or her death. This is true whether the annuitant dies two years after payments begin or 25 years after payments begin. This settlement option is the purest form of ensuring that the annuitant does not outlive his or her financial means.


Common Settlement Options:

• Life Annuity• Life with Period Certain

Guarantee• Refund Life Annuity• Joint and One-Half

Survivor Life Annuity• Joint and Two-Thirds

Survivor Annuity• Fixed Period Annuity• Fixed Amount Annuity

Settlement Options

Life With Period Certain Guarantee

This settlement option is frequently selected since it provides a hedge against loss of much of the value in the annuity should the annuitant die shortly after annuitization.

Under this option, the insurance company agrees to pay the annuity benefit for the longer of the annuitant’s lifetime or a certain period of years. Most annuity contracts offer a choice of the time frame – often 5, 10, 15 or 20 years. Some insurance companies qualify this election, though, by stating that the guarantee period may not exceed the annuitant’s life expectancy.


Settlement Options

Refund Life Annuity

Like the life with period certain guarantee option discussed earlier, the refund life settlement option offers a hedge against the possibility of an early death.

Under this option, the insurance company will pay the monthly benefit for the life of the annuitant. At the annuitant’s death, if the accumulation amount is more than the total of installment payments already received by the annuitant during his or her life, the difference is paid in a lump sum to the beneficiary.


Question 3-4

PROPERTIES


Settlement Options

Joint And Survivor Life Annuity

This settlement option involves two persons and their lifetimes. The insurance company pays benefits during the joint lifetimes of two individuals. Often the two persons are husband and wife, although there is no requirement that this be the case.

Under the joint and one-half survivor annuity settlement option, payments are made in full until the death of one of the annuitants. But then reduced to one half the full amount until the death of the survivor. Many companies offer a joint and two-thirds survivor annuity, under which the payments to the surviving annuitant are equal to two-thirds the original full payment amount.


Settlement Options

Fixed Period Annuity

Probably the easiest of the settlement options to understand are the fixed period and fixed amount options. The fixed period settlement option allows the annuitant to receive the accumulation value in the annuity over a set number of years.

For example, an owner-annuitant who is 60 years old may choose to annuitize his or her contract and elect to receive the benefits over a five year period which would end when he or she reaches age 65—an age when he or she may begin receiving benefits from other retirement plans. Most companies offer the fixed period settlement option for any period from a few years to 25 or 30 years.


Settlement Options

Fixed Amount Annuity

Under this settlement option, the annuitant receives benefit payments of a set amount for as long as the annuity’s accumulation value plus interest lasts. If Mrs. Weaver has an accumulation value of $200,000, under this settlement option she could elect to receive a monthly benefit payment of $3,000 (or any other amount she preferred).

The insurance company would send her a check each month for as long as the accumulation value and interest would support the benefit. After the funds in the annuity were exhausted, Mrs. Weaver would receive no further benefits from the contract.


Question 3-5

PROPERTIES


Surrender Charges

Most annuity contracts levy a “charge” against partial and full surrenders from the contract for a period of years after the annuity is purchased. This charge, usually referred to as a “surrender charge” or a “deferred sales charge,” is intended to make it less attractive for annuity owners to move funds in and out of the annuity. This allows the insurance company to recover its costs if the contract does not remain in force over the long run.

The surrender charge is usually applicable to surrenders made from the annuity for a certain number of years. Although this period varies from one annuity to another, it usually runs anywhere between 5 and 10 years.


Surrender Charges

The surrender charge is usually a percentage that is applied to the funds received as a result of the surrender. Typically, the surrender charge percentage decreases with each passing year.

For example, a nonqualified annuity contract might provide this surrender charge schedule:

· Any surrender made in the second contract year under this schedule will incur a surrender charge of 7%.

· A surrender made in the fifth year will incur a charge of 4%.

· After the contract has been in force for more than 8 years, no surrender charge will apply.


Withdrawals

Partial Surrender

Almost all nonqualified annuity contracts permit the owner to surrender a portion of the values accumulated in the annuity prior to the payout phase. Some contracts limit the frequency with which partial surrenders may be made, and some require that a minimum amount remain in the annuity after any surrender is made.

Full Surrender

An annuity can be surrendered in full at any time prior to annuitization. In addition to the income tax ramifications, contract surrender charges and income tax penalty taxes may be applicable. After a full surrender, the annuity contract is no longer in existence and, of course, will not pay any benefits to the annuitant, owner, or beneficiary.


Lesson 3 Quiz

PROPERTIES



Lesson 4Various Types of Annuities

Lesson 4 Objectives


1. Describe the most common types of annuities and explain how they are interrelated.

2. Distinguish how annuities are categorized by:

Investment options

Timing of annuity payments

Timing of premium payments

3. Compare the advantage and disadvantages of fixed, variable, and equity-indexed annuities.

4. Identify the most common usage associated with each particular type of annuity.

Lesson 4: Various Types of Annuities

Types of Annuities

Annuities come in many different shapes and sizes. The primary types of annuities can be classified by the following 3 criteria:

1. The method of premium payment (single or flexible)

2. How the annuity funds are invested (fixed, equity-indexed or variable)

3. When the annuity payments begin (immediate or deferred)

To make matters even more complicated, a single annuity can combine a number of these different features.

For example, one annuity can be a single premium – fixed – immediate annuity. Another might be a flexible premium – variable – deferred annuity. Let’s start with the types related to premium payment.


Single Premium Annuity

A single premium annuity is what its name implies: an annuity that is purchased with only one premium. This lone premium is usually fairly large. From the standpoint of investment options, a single premium annuity might be a fixed annuity, an equity-indexed annuity, or a variable annuity. From the standpoint of payout timing, a single premium annuity might be immediate or deferred.

Flexible Premium Annuities

The flexible premium annuity allows premium payments to be made at varying intervals and in varying amounts. This type of annuity is a useful tool for accumulating a sum of money at intervals and in amounts that cannot be predicted in advance. As with a single premium annuity, a flexible premium annuity can be a fixed, equity-indexed or variable annuity.


Fixed Annuities

Let’s move on and discuss these investment-related categories:

In the realm of annuities, the term “fixed” refers to the interest rate paid by the issuing insurance company on the funds in the annuity. When an individual purchases a fixed annuity, he or she knows what the current and guaranteed interest rates are. Barring the insolvency of the insurance company, he or she knows that these rates of interest will be credited to the funds in his or her annuity.


Fixed Annuities

Fixed annuities offer security, because the rate of return is certain. They also offer security since the annuity holder is not responsible for making any decisions about where or in what amount the funds in his or her annuity are invested.

Another aspect of the fixed annuity that is “fixed” is the amount of the benefit that will be paid out when the contract is annuitized. The downside of the “fixed” aspect is that, over time, such an approach may fall behind the cumulative effect of inflation.


Question 4-1

PROPERTIES


Equity-Indexed Annuities

An equity-indexed annuity credits earnings based on the movement in an equity index – yet guarantees a certain minimum return. In other words, an equity-indexed annuity allows the annuity holder to participate in stock market gains without risking severe losses when the market declines.

In a financial environment where interest rates on fixed annuities are relatively low, this ability to share in stock market gains while limiting potential loss clearly appeals to prospective annuity buyers.


Equity-Indexed Annuities

One of the disadvantages of the equity-indexed annuity is that because of its link to the equity index, it is considerably more complex than the “plain vanilla” fixed annuity. Also, different life insurance companies calculate the rate payable on their equity-indexed annuities in diverse ways. The debate continues as to whether equity-indexed annuities are fixed insurance products or variable products subject to securities regulations. Currently, they are considered a type of fixed annuity.


Variable Annuities

With a variable annuity, the annuity holder receives varying rates of interest on the funds placed inside the annuity. Depending upon the investment options chosen at the time of annuitization, the holder might receive benefit payments that vary in amount from month to month or from year to year.

In addition, the holder of a variable annuity assumes the risk associated with investment decisions that may not turn out as well as the investor hopes.


Variable Annuities

One major difference between the fixed and variable annuities is that a variable annuity is considered a “security” under federal law, and is therefore subject to a greater degree of regulation. Anyone selling a variable annuity must have the required securities licenses.

Any potential buyer of a variable annuity must be provided a prospectus—which is a detailed document providing information on the variable annuity and the investment options available. With any sale of a variable annuity, the person making the sale must ascertain that the variable annuity is a suitable choice for the individual purchaser.

The assumption of risk by the holder of the annuity is a key element of the variable annuity; it is the product’s most distinguishing characteristic.


Question 4-2

PROPERTIES


Variable Annuities

Let’s compare the assumption of risk with a typical fixed annuity versus a variable one.

First, consider the risk assumed by Mr. Garcia, who has just purchased a fixed annuity. The insurance company has promised to credit the funds in Mr. Garcia’s annuity with a current interest rate of 6.5% for the next contract year. After that, the funds will be credited with the new current rate declared by the insurance company - unless the current rate is less than the guaranteed rate of 4.5%.

In any event, Mr. Garcia will receive at least the guaranteed rate on his funds; regardless of how well or how poorly the insurance company’s investments perform. It is the insurance company, which assumes the risk that investment returns may be less than expected.


Variable Annuities

In contrast, with a variable annuity, it is the annuity holder who assumes this risk. To illustrate, assume that Mr. Mason is concerned that the return on his annuity premium dollars not be outpaced by the inflation rate over a period of time.

To combat this possibility, Mr. Mason decides to purchase a variable annuity, which offers investment choices of a guaranteed account, a stock fund emphasizing growth potential, a stock fund emphasizing income potential, a money market fund, and a bond fund.


Variable Annuities

With the inflation factor in mind, Mr. Mason allocated 75% of his premiums to the stock fund emphasizing growth potential and the remaining 25% to the variable annuity’s guaranteed fund. On the funds in the guaranteed account, which functions similarly to a fixed annuity, Mr. Mason will receive the current interest rate of 6.5%.

On the funds in the stock fund, however, Mr. Mason has no guarantee from the insurance company or any other party that he will receive a certain rate of return. In fact, he has no guarantee that he will not lose part of the premium dollars that he has allocated to the variable investment account.


Question 4-3

PROPERTIES


Investment Options – The Variable Accounts

Typically, a variable annuity offers an annuity holder subaccount options in which to invest all or a portion of the annuity premiums. Typically, a variable annuity offers between seven and ten variable such accounts. These variable accounts are sometimes known as flexible accounts or flexible subaccounts.

When an annuity holder purchases a variable annuity, he or she determines which portion of his or her premium payments, usually on a percentage basis, will be allocated to the different variable accounts. Once this percentage is determined, it remains in effect until the annuity holder notifies the insurance company that he or she wishes to alter his or her allocation arrangement.


Investment Options – The Variable Accounts

In addition, most variable annuities allow an annuity holder to transfer funds between accounts, subject to certain dollar amount and timing limitations. Many variable annuities offer an option called “dollar cost averaging,” which provides a method for systematically transferring sums inside the variable annuity from one fund to another. A typical variable annuity might offer the following investment options:

· Money Market Fund

· Government Securities Fund

· Bond Fund

· Total Return (or Balanced) Fund

· Growth (or Common Stock) Fund

· Growth with Income (Stock) Fund

· Guaranteed Account


Investment Options – The Guaranteed Account

Remember that most variable annuity contracts offer as an investment option a guaranteed account, or a fixed account. This type of account receives a fixed or guaranteed rate of interest.

For example, if Mr. Reese places $5,000 in the guaranteed account of his variable annuity when the current interest rate is 7%, Mr. Reese knows that he will be paid 7% on the funds in this account for the current interest rate period.


Question 4-4

PROPERTIES


Transfers Among Investment Accounts

As mentioned earlier, a variable annuity will allow the annuity holder to transfer funds from one investment account to another. This flexibility to reposition investments offers the variable annuity holder the opportunity to change his or her investment focus in response to changes in the market generally.

It also allows an annuity holder to change the level of risk that he or she is willing to accept as his or her tolerance or desire for risk increases or decreases.


Variable Annuity Death Benefit

Most nonqualified annuity contracts, including variable annuities, provide that if the annuitant dies before the contract has starting paying out benefits, the beneficiary named in the annuity contract will be paid a death benefit.

This offers the annuity holder a guarantee that he or she will not lose all of the funds he or she has paid into the annuity if he or she should die before he or she begins to receive annuity benefit payments.


Question 4-5

PROPERTIES


Immediate Annuities

An immediate annuity is one, which begins paying benefits very quickly, usually within one year of the time it is purchased. By its nature, an immediate annuity is almost always purchased with a single premium.

The immediate annuity can be useful for an individual who has received a large sum of money or must count on these funds to pay expenses over a period of time.

Examples might include someone who has received substantial life insurance proceeds, or a businessperson receiving a large payment from a long-term project.


Deferred Annuities

A deferred annuity is one under which the annuity holder defers or delays the receipt of the benefit payouts until a later date. Most deferred annuity contracts provide considerable flexibility in the timing of premium payments and benefit payouts.

The accumulation phase—the phase when premium payments are made—may last only a few years or it may continue for many years. Likewise, the annuitization phase—the phase when benefits are paid out—might last only a few years, or could last for decades.


Lesson 4 Quiz

PROPERTIES



Lesson 5Income Taxation

Lesson 5 Objectives


1. Describe in a general way the tax implications of premium payments.

2. Distinguish a natural person from a nonnatural person.

3. Describe, broadly, the tax implications of loans and partial withdrawals.

4. Explain the general rule of taxing annuity benefit payments.

5. Explain the exclusion ratio.

Lesson 5: Income Taxation

Premiums

As with all financial products, the individual features of the annuity must be considered against the backdrop of income tax implications.

With any given annuity contract, these tax implications are:

· Multiple

· Impacting premium payments

· Cash value build-up

· Loans and assignments

· Withdrawals

· Benefit payments

· Exchanges

Generally, premiums (or deposits) paid into an annuity are not deductible from the annuity holder’s income. This general rule of non-deductibility applies whether the premium is a single payment, or is paid in installments over many years.


Cash Value Build-Up

If an annuity contract meets certain requirements of the Internal Revenue Code, the interest earned on the funds inside the annuity contract will not be taxed when it is credited. This is true only if the owner of the annuity is a natural person—a living, breathing individual, as opposed to a trust, corporation, or other entity. However, when benefit payments are received from the annuity, they are taxable as income.

A nonnatural person is a corporation, trust, or other entity. Prior to 1986, interest earned within an annuity was tax deferred, whether the annuity was owned by a natural person or a nonnatural person.


In 1986, Congress enacted legislation to prevent corporations from taking advantage of this provision. Since that year, interest credited within a deferred annuity contract owned by a corporation or other entity is taxable each year. As with most taxation rules, there is an exception to this general rule. When an annuity contract is held by a nonnatural person as an agent for a natural person, the interest earned will be income tax deferred.

Cash Value Build-Up


Question 5-1

PROPERTIES


Loans and Assignments

The questions of loans and assignments are somewhat of a confusing area of annuity taxation. It can cause some unexpected and unfortunate income tax results.

Generally, loans made from annuity contracts have been taxable since 1982. The taxable amount, that is the sum included in income – is calculated by subtracting the total of the premiums paid into the annuity from the cash value of the contract.


Partial Withdrawals

The taxation of an amount received from an annuity that can be categorized as a partial withdrawal or partial surrender has been complicated by changes in the tax law over the last several decades. Looking at the date the annuity contract was entered into is the first step in determining the income tax treatment of a partial surrender.

If the annuity was entered into after August 13, 1982 and the owner is making a partial surrender then the “interest first” rule applies.

The purpose behind the “interest first” rule is to limit the tax advantages of deferred annuity contracts to long term investment goals and to prevent the use of tax deferred inside build-up as a method of sheltering income on freely withdrawable short term investments.


Question 5-2

PROPERTIES


Partial Withdrawals

Under the “interest first” rule the annuity holder is deemed to receive the interest earned on the annuity contract before he or she recovers his or her cost in the contract. This means the owner is receiving taxable income earlier rather than later.

More specifically, an amount received as a partial surrender that is taxed under the interest first rule is treated as a distribution of the interest earned in the annuity to the extent that the cash value of the annuity is greater than the contract owner's investment in the annuity. Any remaining amount of the partial surrender is treated as a return of the contract holder's investment. The interest portion of the partial surrender is taxable. The return of investment portion is not.


Partial Withdrawals

Consider the example of Mrs. Green who purchased an annuity for a single premium of $50,000. The value of her annuity today is $80,000. Therefore, Mrs. Green has earned interest of $30,000 in her annuity. This $30,000 figure is arrived at by subtracting Mrs. Green's investment of $50,000 from the annuity's current value of $80,000.

If Mrs. Green decides to make a partial withdrawal of $20,000 from her annuity, under the interest first rule Mrs. Green will pay income tax on the full $20,000. This is so because Mrs. Green has earned, to date, $30,000 in interest on her annuity and until her withdrawals exceed this amount of interest earned she must pay income tax on the withdrawals. If Mrs. Green makes a $40,000 withdrawal, she pays income tax on $30,000 and receives the remaining $10,000 as a tax-free return of her investment.


Partial Withdrawals

If the annuity was entered into before August 14, 1982, then the “cost recovery” rule dictates the income tax treatment of a partial surrender. Under “the cost recovery” rule, the owner is deemed to have received the cost of the annuity before he or she receives any interest that has accumulated within the contract.

The taxpayer may receive all such amounts tax-free until he or she has received tax-free amounts equal to his or her pre-August 14,1982 investment in the contract. The distribution amounts are taxable only after such basis has been fully recovered.

If Mrs. Green's $20,000 partial surrender mentioned earlier was taxed under the cost recovery rule, she would not pay income tax on any portion of the $20,000. This is because the $20,000 she received does not exceed her cost basis in the annuity contract of $50,000. Under the cost recovery rule, Mrs. Green's first partial withdrawal would be tax free to her unless the surrendered amount was more than $50,000.


Question 5-3

PROPERTIES


Partial Withdrawals

For annuity contracts that were entered into before the 1982 cut-off date but received premiums or interest after this date, the rules governing the income taxation of a partial surrender can be complex.

Generally if premiums were paid into a pre-cutoff date annuity after the cutoff date, a partial surrender of these premiums is taxed under the interest first rule. For annuity contracts with interest allocable to both pre- and post-cutoff date investments, a combination of the interest first and cost recovery rules applies.

Please keep in mind that for the taxation of withdrawals from annuity contracts, as with other taxation issues, different rules apply to amounts received under qualified retirement plans, Section 403(b) annuities, and Individual Retirement Arrangements.


“Interest first” rule:

• Taxes paid on interest earned

• On or after August 15, 1982

“Cost of recovery” rule:

• Taxes paid on the amount over and above premium investments

• Before August 14, 1982

Contract Surrender Charges

Most annuity contracts impose a surrender charge if funds are removed either fully or partially within a specified time frame after the annuity contract is purchased. Often, the charges decline slightly each year and eventually no longer apply.

10% Premature Distribution Penalty Tax

In order to discourage the use of annuity contracts as short-term tax sheltered investments, a 10% tax is imposed on certain “premature” payments under annuity contracts. The 10% tax applies to the portion of any payment that is taxable.


Question 5-4

PROPERTIES


Taxation of Withdrawals

The Basic Rule

The basic rule for the income taxation of payments received from an annuity contract is designed to return the purchaser’s investment in equal tax-free amounts over the payment period. The total of premium payments is returned tax-free, while interest or dividends are taxed in the year they are received. Each payment, therefore, is generally part nontaxable and part taxable income.

The Exclusion Ratio

To determine what portion of the annuity payment is taxed and what portion is not, an exclusion ratio must be determined for the contract. The exclusion ratio is a fraction or a percentage. It is arrived at, by dividing the investment in the contract by the expected return. This exclusion ratio is applied to each annuity payment to find the portion of the payment excludable from gross income.


Tax Free Exchange

On occasion, an annuity holder may wish to trade or exchange one annuity contract for a new annuity issued by another company. There are several reasons why an annuity holder might be interested in such an exchange, including the solvency of the current company, the interest rates offered by competitors, or the desire for investment alternatives not available under the current contract.

The Internal Revenue Code does provide for an exchange of one annuity contract for another, subject to certain requirements, in Code section 1035. If the requirements are met, the annuity holder may exchange one annuity contract for another without incurring any current income taxation.


Lesson 5 Quiz

PROPERTIES



Lesson 6Uses of Annuities

Lesson 6 Objectives


1. Identify the best and most frequent use of annuities.

2. Describe a qualified retirement plan and explain its relationship to nonqualified annuity.

3. Define a tax-sheltered annuity.

4. Explain the possible role of annuities in the plans of a self-employed individual.

5. Give an account of the role of annuities in charitable planning.

6. Give an account of the role of annuities in college planning.

Lesson 6: Uses of Annuities

Retirement Planning

Although, the nonqualified annuity can be used for many purposes, probably its best and most frequent use is retirement planning. Retirement has been the focus of much attention in recent years.

Since people are living longer than at any prior time in history, there are more retirement years to be planned for and paid for. The baby boomer generation of Americans, those born between 1945 and 1964 – are now entering their forties and fifties. They are now planning seriously for their retirement years. Further, the downsizing of major American corporations is symptomatic of a climate in which employees cannot rely on their employers to finance their retirement.


Retirement Planning

As a result of these and other factors, there has been a steadily increasing interest in the financial aspects of retirement. Most Americans expect to receive Social Security benefits at retirement, and many are participants in qualified retirement plans provided by their employers.

Experts warn, though, that if baby boomers are to afford the retirement lifestyle they seem to want, these two sources of retirement income will not suffice. Personal savings must make up the difference.

To make the best use of the nonqualified annuity in retirement planning, one should understand alternate retirement planning techniques and grasp how these options interact with nonqualified annuities. A brief discussion of the more commonly encountered types of retirement plan follows.


Individual Retirement Arrangements

An Individual Retirement Arrangement or IRA offers several advantages. First, an IRA contribution may result in an income tax deduction in the year the contribution is made. This deduction depends on income levels and on participation in other employer-provided plans.

Second, the interest earned within a traditional IRA is taxed on a deferred basis. That is, the interest is not taxed until funds are withdrawn from the IRA.

In 1998, another form of IRA, the Roth IRA, became available. While contributions made to a Roth IRA are not deductible, funds distributed from a Roth IRA may be received completely free of any income tax, provided certain conditions are satisfied.


Question 6-1

PROPERTIES


Nonqualified Annuity

From a financial planning perspective, it is important to note that for high-income taxpayers who, because of their income levels, cannot take advantage of IRAs, the use of a nonqualified annuity to accumulate funds for retirement purposes can be attractive.

While it is true that premiums paid into a nonqualified annuity are not income tax deductible and benefit payments from such an annuity will be partially taxable, there is no limit on the amount of funds that may be placed in a nonqualified annuity. And, of course, the interest earned on the funds inside the annuity is tax deferred.


Qualified Retirement Plans

Generally, a qualified retirement plan is an employee benefit arrangement, which an employer offers the employee. There are several different types of qualified plans, such as profit-sharing plans, 401(k) plans and employer stock ownership plans. A detailed explanation of these is beyond the scope of this course.

However, it is important to understand that while these plans are designed to provide an employee with some type of retirement benefit, most employees have little control over the type of plan offered by their employer or how the plan’s funds are invested. The nonqualified annuity offers a method of retirement planning over which the employee retains a much greater degree of control.


Tax Sheltered Annuities

A Tax Sheltered Annuity (TSA) is a special type of annuity that is available only to individuals employed in public schools and nonprofit organizations that are operated exclusively for religious, literary, charitable, scientific, or educational purposes. Included here are churches, synagogues, hospitals, and colleges.

A TSA is usually issued by an insurance company. It may be either a fixed or a variable annuity contract.

Small Business Retirement Planning

For a self-employed individual, the use of a nonqualified annuity may provide the only source of retirement income, other than government benefits such as Social Security. Many agents and financial planners find that a business owner who has just purchased an individual disability income policy is interested in beginning his retirement planning also.


Question 6-2

PROPERTIES


Charitable Planning

There are occasions when an individual who has purchased an annuity finds that he or she would like to make a gift of either the contract itself or the funds held in the contract.

There is no reason that an individual cannot make a gift of a nonqualified annuity contract, if that is his or her wish. However, there may be some unanticipated tax results. As opposed to making a gift of an existing annuity, an individual can purchase an annuity as a method of making regular ongoing payments to a charitable organization.


College Planning

Even before planning for their own retirement, the expense of providing their children with a college education is a primary concern for parents. The cost of a college education has increased rapidly in the last few years. Currently, the cost to attend four years at a private college can run as high as $120,000 while the cost of four years at a state university runs about $30,000.

Over recent years, as annuity sales have increased rapidly, there has been much debate over the use of nonqualified annuities as a college-planning vehicle. In some instances, the annuity can be a useful tool. However, it is not always the best answer to the college-funding dilemma.

The major advantage in using an annuity for college planning is that the funds accumulate on a tax-deferred basis. Since all the interest stays in the contract to accumulate even more interest, the tax-deferred annuity generally provides a greater rate of return than a financial vehicle that is taxed on a regular basis.


College Planning

The primary drawback to using the annuity for college funding appears when it is time to take the funds out of the contract. There are several ways that an annuity holder can withdraw funds from an annuity.

These include:

· A full surrender

· A partial surrender

· Annuitization of the contract

If the annuity holder decides on either full or partial, to withdraw the college funds, he or she will incur the 10% premature distribution penalty tax unless he or she is at least age 59 1/2.


Question 6-3

PROPERTIES


College Planning

By the time that the parent pays the regular income tax due on the surrender and then the penalty tax, the advantage gained by using the tax-deferred funding vehicle is often eliminated.

Of course, there is no requirement that the parent be the owner and annuitant of the annuity contract.

One logical alternative that eliminates the age 59 1/2 problem is for a grandparent to be the owner and annuitant of the contract that will be used for funding a grandchild’s college education.


Lesson 6 Quiz

PROPERTIES


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