Annuities

1
Annuities

• Objectives
• Identify the characteristics, features, and usage
  of deferred annuities
• Identify the characteristics, features, and usage
  of immediate annuities
• Understand how to calculate immediate annuity
  payments.
• Understand how to calculate the exclusion ratio
  for immediate annuity payments.

2
Annuities Introduction

• What is the risk that you insure with an
  annuity?
• Risk Of Old Age
• basically, the risk of outliving income/wealth
• The annuity product transfers this risk to an
  insurer

3
What is an annuity?

• Financial Definition A Stream Of Payments
  Through Time
• Contracts providing for the systematic
  liquidation principal and interest in the form of
  a series of payments over a period of time

4
Insurers separate an annuity into two phases

• Annuities may be deferred or immediate
• An immediate annuity has no accumulation phase

Investor makes cash payments to the insurance
company. The money remains invested with the
insurance company and is periodically credited
with some growth factor
The insurance company agrees to pay the owner a
specified amount periodically, beginning on a
specified date.
5
Types of Annuities just the basics

• Immediate annuity Payout begins within one year
  of the date the contract is established
• Deferred annuity Payout begins more than one
  year of the date the contract is established
• Life annuity Payouts will continue as long as
  the annuitant lives
• Fixed period annuity Company promises a payout
  for a fixed or guaranteed period of time,
  independent of the survival of the annuitant
• Combination of life and fixed period payout for
  example, the greater of ten years for the life of
  the annuitant
• Fixed annuity Invested in the general fixed
  account of the insurance company
• Variable annuity Invested in the separately
  managed sub-accounts selected by the annuity
  owner
• Additional features
• Guaranteed death benefits
• Living benefits - company guaranteed benefits
  for owners or beneficiaries
• That would be higher than actual investment
  performance would provide for
• Variable annuitization
• Payments fluctuate depending on the investment
  performance of the underlying sub-accounts

6
Taxation of Annuities

• Taxation is governed by IRC section 72
• Accumulation phase
• Growth is tax deferred
• Withdrawals during this phase are taxed on a LIFO
  basis
• Withdrawals are considered to be withdrawals of
  growth first and principal second
• Payout phase
• A portion of each payout is considered a return
  of principal
• A portion of each payout is considered interest
  or growth
• Calculation of those portions (the exclusion
  ratio) depends on the principal invested, the
  period of the payout and an internal growth
  factor for the payout period

7
Taxation - Details

• An exclusion ratio is used to determine the
  amount that is taxed vs. the amount that is
  exempt from taxation.
• Applies to each annuity payment equally
  throughout the payout phase
• Example Male aged 70 pays 12,000 for the
  annuity. His expected return throughout the
  payout phase is 19,200.
• The exclusion ratio is 62.50
• If the monthly payment is 100, then
• 62.50 is considered a return of principal
• 37.50 is considered taxable income
• Once the entire investment in the contract has
  been recovered, then 100 of each annuity payment
  received is taxable income

8
Taxation - Details

• The expected return is the total amount the
  annuity owner should receive
• Payments specified x life expectancy (or term
  certain if elected)
• Life expectancy based on IRS Table V (single
  lives) or Table VI ( joint lives)
• If annuitant dies before receiving the full
  amount guaranteed under a refund or period
  certain annuity
• Balanced received will not be taxed (unless it
  exceeds the investment in the contract)
• For joint and survivor annuities
• Surviving owner excludes from income the same
  percentage of each payment that was excludible by
  the first annuitant
• An income tax deduction may be available to the
  survivor owner to the extent inclusion of the
  annuity in the estate of the first annuitant
  generated an estate tax (IRD)

9
Taxation - Details

• Partial withdrawals are subject to income tax,
  e.g., if the owner makes a partial withdrawal and
  takes a reduced annuity
• If the owner takes a partial withdrawal chooses
  same payments for different term
• To the extent cash value exceeds investment in
  the contract, gain will be realized in the form
  of a taxable withdrawal of interest
• Variable Annuities
• No tax will be paid until the earlier of
• Surrender of the contract
• Withdrawals from the contract
• Time that payments commence from the annuity
• To obtain annuity treatment the underlying
  investments must be adequately diversified under
  IRS regulations

10
Taxation - Details

• A different exclusion ratio is applied to
  variable annuities
• Example
• Male aged 65 purchases variable annuity for
  20,000
• Life expectancy of 20 years (Based on Table V)
• He can exclude 1,000 from each payment (20,000
  / 20)
• Assume at age 70 he receives only 200 (800 less
  than his excludible amount)
• Assume at age 70 his life expectancy is 16 years
• He can add 50 (800/16) to his 1,000 excludible
  amount

11
Taxation - Details

• If the annuitant dies before payments received
  equal cost
• A loss deduction allowed for the amount of
  un-recovered investment, as an itemized deduction
• Amounts payable under a deferred annuity at the
  death of annuitant
• Partially taxable as ordinary income to the
  beneficiary
• Equal to excess of death benefit over gross
  premiums
• Dividends, loans, cash withdrawals and other
  amounts that are taken out before the annuity
  starting date are taxed as ordinary income to
  extend the cash value exceeds the investment in
  the contract
• LIFO basis

12
Taxation - Details

• Premature Distributions are subject to ordinary
  income tax plus a 10 penalty tax
• Tax applies to amount of distribution included in
  income
• Penalty for premature distributions does not
  apply to
• Payments that are part of a substantial equal
  periodic payments made for life
• Payments on or after age 59½
• Payments made on account of contracts owner
  disability
• Payments from qualified retirement plans and
  IRAs
• Payments to beneficiary after death of annuitant
• Distributions under an immediate annuity contract
• Annuity purchased on the termination of certain
  qualified employer retirement plans
• Payments allocable to investment in the contract
  before August 14th, 1982

13
Taxation - Details

• If annuitant dies before annuity starting date
• Cash value must be distributed within 5 years of
  death or
• Used within one year to provide for a life
  annuity or installments payments not longer than
  the beneficiaries life expectancy
• If spouse is the beneficiary, spouse can elect to
  become the new owner of the contract instead
• If an annuity contract is transferred by gift,
  tax deferral allowed on the inside build-up is
  terminated
• Tax-free build-up is allowed only to natural
  persons
• For non-natural persons income is treated as
  ordinary income in the year received
• Some exceptions include annuities received by the
  executor of a decedent, annuities held by a
  qualified retirement plan or IRA, Annuities
  purchased by an employer on termination of a
  qualified plan

14
When should one consider using an annuity?

• When a person wants a retirement income that
  cannot be outlived
• When an individual wants a retirement income
  higher than their other conservative investments
  and is willing to have principal liquidated
• To avoid probate and pass a large sum of money by
  contract to an heir and reduce the possibility of
  a will contest
• When tax deferred growth is desired for an
  investment
• When an investor wants to be free of the
  responsibility of investing and managing assets
• As a supplement to an IRA

15
Fixed or Variable?

• Variable
• Investor wants more control over the investments
  and is willing to bear the risk
• Investor is looking for potentially increasing
  retirement income
• Investor wants to be invested in variable
  sub-accounts, but also desires some aspect of
  risk management
• Guaranteed death benefits / living benefits

• Fixed
• Safety of principal is paramount
• Investor wants to guarantee a level of interest
• Investor desires a conservative complement to
  other investments

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Advantages of Annuities

• Guarantees of safety, interest rates and lifelong
  income
• Protects and preserves persons cash reserves
• Allows investment in the market while moderating
  risk
• Client can time the receipt of income and shift
  it into lower tax bracket years
• An annuity paying the same rate of interest as a
  taxable investment will result in a higher
  effective yield
• Underlying guarantees in variable annuities allow
  client to take on greater risk in the underlying
  investment options (equities, small market
  capitalizations, high yield bonds etc.) while
  still maintaining a reasonable risk exposure
• Adjusted Gross Income (AGI) may be reduced in
  years where the annuity is held without
  withdrawals
• Lower taxable income may be recognized during the
  payout phase, due to partial recovery of basis
  associated with each payment

17
Disadvantages of Annuities

• Receipt of lump sum could result in a significant
  tax burden
• Income averaging may not be available
• Cash flow received may not keep pace with
  inflation
• A 10 penalty tax imposed on withdrawals prior to
  age 59 ½
• Growth in corporate-owned annuities is subject to
  taxation
• Liquidation in the early years
• Management, maintenance fees could prove
  expensive
• Management fees and mortality charges could run
  from 1 to 21/2 of the value of the contract
• Back end surrender charges
• Investment earnings are taxed at owners ordinary
  income tax rate
• Regardless of the source or nature of the return
• Returns associated with long term capital
  appreciation do not enjoy the capital gains tax
  rate

18
Deferred Annuities

• Goal Long-Term, Tax-Deferred Savings 
• Premium types
• Investment
• Single (SPDA)
• Ongoing (FPA)
• Regular
• Flexible 

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Timely Advice from Consumer Reports

• The fixed-dollar, deferred annuity offers safety
  of principal and, often, outstanding long-term
  guaranteed rates that could be very valuable over
  15 or 20 years, should market-interest rates go
  down. (If market-interest rates go up, the
  insurance company would probably credit higher
  rates.)
• It is the only investment that can provide, at
  your option, the security of a monthly payment
  for life, regardless of how long you live. These
  features make annuities a good way to save for
  retirement.

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Types Of Deferred Annuities

• Fixed
• No Acquisition Charge
• Investment growth based on interest earnings
• Mortality Charge
• Other Charges
• Variable
• No Acquisition Charge
• Multiple investment options
• Investment growth based on investment choices and
  performance
• Mortality Charge
• Other Charges

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Deferred Sales Charges
22
The Life Insurance Business (Sources of Income
in 1975)
23
The Life Insurance Business (Sources of Income
in 2004)
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Sales Of Individual Annuities By Distribution
Channels
Source LIMRA International and the Insurance
Information Institute
25
Variable Annuity Net Assets by Investment
Objective
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Sales of Variable Annuities, by producer type
27
Net Assets of Variable Annuities, (1997-2006), in
billions
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Individual Annuity Considerations (1997-2003)
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Life Expectancy and the Need to Save
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Retirement Supports 3 Legged Stool (U.S. Model)
33
Tax-Deferred Savings Benefits
Investment 25,000 I6 Tax Rate 28

• Two Options
• Pay yearly tax on investment gain
• FV71,966
• Defer tax on investment gain
• FV107,297-
• 23,043 84,254

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Examples of Surrender Charge and Rate Differences
Source http//www.annuityadvantage.com
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Withdrawals

• Partial Surrender
• Cash Out
• Annuitize
• Purchase Immediate Annuity
• Taxation
• Prior To 59 ½
• After 59 ½
• Partial Surrender
• Full Surrender

36
Flexible Premium Deferred Annuity Constant
Funding
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Immediate Annuities

• Payment For Life
• Types
• Single Life, No Refund
• Period Certain
• Joint Survivor
• Variable Payout Based On Earnings 

38
Effect of Gender and Age on Immediate Annuity
Payments
Monthly income per 1000 of deposit Can
you explain these patterns?
39
Nonparticipating Immediate Annuity Rates (Male)
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How are Immediate Annuities Used?

• Retirement Benefits
• Supplemental Benefits
• Legal Awards (Structured Settlements)
• Parent/Handicapped Child
• Private Annuities

41
Using Deferred Annuities in Retirement Plans
Deferred Annuity
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Alternatives to Annuities

• Municipal bond funds
• Income exempt from federal and some state income
  taxes
• Money can be withdrawn without tax penalty
• Disadvantage
• Lack of guaranteed return
• Potential for capital losses if interest rates
  rise and bonds sold before maturity
• Single Premium Life Insurance
• Tax free death benefit
• Tax deferred growth of cash surrender values
• Withdrawals loans subject to LIFO taxation and
  10 penalty if distribution occurred before age
  59 ½

43
Annuity Fees and Acquisition Costs

• Fees and acquisition costs
• Investment management fees
• Typically from .25 to about 1
• Administrative expense and mortality risk charge
• Typically from a low of about .5 to as high as
  2
• Annual maintenance charge
• Typically 25 to 100
• Charges per fund exchange
• Usually less than 10
• Some companies permit a limited number of
  charge-free exchanges per year
• Maximum surrender charge
• Varies from company to company
• Generally phases out over a number of years

44
Selecting the Best Annuity

• Compare costs and features in a spreadsheet
• Fixed annuities compare the total outlay with
  the total annual annuity payments
• Variable annuities evaluate the total returns
  for the variable annuity sub-accounts over
  multiple time periods
• Morningstar and Lipper Analytical Services Inc.
• Compare the relative financial strength of the
  company to other similar companies
• Rating agencies - A.M. Best / Moodys/ Standard
  Poors

45
Suitability

• In June 2008, Florida passed into law the John
  and Patricia Seibel Act.
• The Act amends state laws with regard to the sale
  of annuities to senior consumers.
• The Act outlines standards agents must meet to
  evaluate and determine suitability
• Objective measures, vs. previous reasonable
  standard
• More details in writing comparisons and
  disclosures
• New Requirements for corrective action and
  penalties