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Annuities Before
beginning, please read the following instructions:
Exam
CHAPTER 1: Annuities In General CHAPTER 1: Annuities In General All
annuities have many things in common, so this chapter deals with items
that are generally applicable to all annuities even though there may be
individual exceptions. Terminology may change from company to company as
well as descriptive content, but as a product class, they are similar. An
annuity is basically a contractual agreement between an annuity owner and
an insurance company. The owner makes purchase payments in exchange for
certain benefits and privileges. All annuities are generically known as
tax-deferred annuities. As a product class, there are two general types of
annuities: variable and fixed. Annuities share the following features:
Purposes of Annuities Originally, annuities were created to provide an income stream for a specific period of time or during one’s lifetime. Unlike life insurance, which creates an estate and protects against dying too soon, annuities liquidate an estate and protects against living too long. During the accumulation
phase, the annuity owner would deposit with the insurance company a
one-time or periodic premiums to build up a nest egg and then at a
designated time would annuitize the policy. Annuitization describes the
event when the policy owner basically surrenders the accumulated policy
value in exchange for a calculated amount for a specific timeframe or over
the annuitant’s lifetime. Today, however, it seems times have changed. More people are interested in annuities as savings or investment alternatives as well as the guarantees and tax benefits. Annuities are perceived more as accumulation vehicles instead of income vehicles because less than two percent are annuitized into an income stream while the rest are left to heirs. Safety As with any savings or
investment, safety lies with the issuing entity. For annuities, safety
lies with the strength of the issuing insurance company. One can determine
an insurance company’s financial strength by looking at its rating from
A. M. Best Co., Inc., which has been providing
financial strength ratings and evaluations for insurance companies since
1899. On the default side of things, each state has its own insurance guaranty act that protects, up to a certain dollar amount, each insured of an insurer that becomes insolvent. The dollar limits depend upon the type of policy, for example, net life insurance death benefits ($300,000), net cash values for life insurance ($100,000), and net cash values for annuities ($100,000). Liquidity Liquidity can be perceived from two perspectives. In its purest sense, liquidity refers to the ease and speed in which an asset can be converted into cash. In a general sense, it is the same without incurring loss. Notwithstanding surrender charges and an insurance company’s ability to withhold cash payments for up to six months, which is rarely done, an annuity is fairly liquid. The only real hurdles are completing the insurance company’s required paperwork and going through their logistical process, which can sometimes be slow. Risks There are many types of
risks savers and investors are concerned about; however, some of those
risks are either mitigated or nonexistent in annuities. All annuities,
fixed and variable, have some sort of guarantees. Even variable annuities
have an option whereby the principal and interest is guaranteed, if
available, just like any other fixed annuity, but the annuity owner must
expressly choose that option. Of lesser importance, fixed annuities are subject to interest rate risk. Even variable annuities with a fixed component are subject to interest rate risk. Since annuities are usually very competitive with other interest bearing accounts, this is not a major issue. Fixed annuities are not exposed to investment risk like other investments - which is the risk inherent in the individual investment itself - because the principal and interest are guaranteed by the strength of the insurance company. Variable annuities, on the other hand, are subject to investment risk just like the risks associated with investing in mutual funds. Fixed annuities are also not subject to market risk like other investments. Market risk is the risk of loss associated with a large number of assets like the stock market. Suitability and Switching Some states have enacted legislation pertaining to the suitability of the sale of annuities to seniors and has become such a big issue in the VA market that the NASD is taking a closer look at this practice. How does one determine if a particular VA is more suitable than the next, providing a better cost/benefit scenario? Of course, opinions in the investment industry are fairly diverse. One can only assume, if he dare, that in an efficient market all investments have similar risk-adjusted performance. If this is the case, one may want to go beyond the accumulation phase and look at the annuitization phase. Since risk is tied to suitability, then risk-adjusted performance makes for an inefficient measuring rod for switching purposes. The annuitization phase highlights contractual guarantees, which for purposes of comparison can discount various payout scenarios to present value benefits. From this point, one can include hard costs such as mortality expenses, surrender charges, etc. However, one must realize that annuitization of a VA is a rarity. Anyway, one needs to wisely pick his medicine just in case it comes under NASD scrutiny. Replacements A replacement can sometimes be a confusing and complex topic, especially for potential clients. This has led to the heightened concern of regulators who are more closely monitoring business practices of companies and agents. Most companies have already taken a proactive role in issuing internal guidelines and suggested practice requirements for their agents. Insurance companies do not encourage or condone replacing existing annuities as a mode of doing business if such replacements are not in the best interests of the client. Each state has its own set of insurance regulations dealing with replacement. The following is a generalization of when a replacement occurs:
AND
If all policies currently owned by the client remain as is after the new purchase is made, a replacement has not occurred. In order to comply with
replacement regulations, insurance professionals should generally engage,
at a minimum, in the following procedures:
None of this should lead
one to conclude that all replacements are bad, which can be quite the
contrary. One must look and compare all aspects of the new versus the old,
considering the short-term and long-term benefits to the client. Such
factors to consider may include:
Exam CHAPTER 2: Features and Benefits Annuities have many features and benefits that other alternatives do not. Depending upon one’s risk tolerance, investment objective and planning needs in general, annuities are probably going to have a fit in one’s financial profile to some extent. The following is a list of the common attributes found in annuities but not found in other saving or investment vehicles. Principal Guarantee Unlike investments, annuities have some sort of guarantee for the return of principal or premium payments, less applicable surrender charges, assuming one is past the initial free-look period. Of course, this guarantee lies with the strength of the insurance company that issued the policy; and, is further guaranteed by the insurance company’s state of domicile’s Insurance Guarantee Association (now that’s a mouthful). Annuities are not, however, insured by the FDIC, which will probably not be a point of contention with most annuity buyers. Even though it is uncommon for insurance companies to become insolvent, it has happened in the past and will probably happen again. Nonetheless, because of the protection afforded by each state’s guarantee association, it is unlikely an insured would lose money if he followed through with the association’s claims procedures and stayed the course. Interest Rate Guarantee Fixed annuities have two interest rate guarantees. The first is the minimum interest rate that the contract guarantees to never fall below. The second is the current interest rate that is guaranteed during a specific period, usually one year. Some annuity contracts guarantee a stated interest rate from one contract year to the next. For example, if the date of an annuity contract is July 4, the stated interest rate will be guaranteed until the following July 4 and will be credited to all contributions made during that time. Other companies guarantee the rate for one year per contribution. For contributions made in the month of January, the stated interest rate is guaranteed until the following January. For contributions made in February, the interest rate is guaranteed until the following February, and so on. The source from which the contributions came is irrelevant. The current interest rate is based on the company’s portfolio rate. An insurance company can invest in a wide range of securities, but most are invested heavily in investment grade corporate and government bonds. The weighted yield of this portfolio is what drives the interest rate of a fixed annuity, which is a little below the company’s portfolio rate. This guaranteed interest rate could either be the nemesis or savior of the fixed annuity market. During the bull market of the 90s, investors abandoned traditional fixed products and sought after their sexier cousins, variable annuities, and equity indexed annuities. The bears showed up in 2000-02, so traditional fixed products found favor with investors once again. This was short lived, however, because the Feds drove down interest rates in an attempt to jumpstart the economy. Up through 2005, interest rates have been the lowest in decades, so the likelihood of rates rising and fixed annuities being restored to an honorable position is likely. On the default side of the equation, in 2014 the youngest of the baby boom generation will turn 50. With this being the wealthiest generation of all time, they are sure to restore some of the glamour fixed products have lost to the equities arena. Death Benefit Guarantee All annuities have some sort of death benefit, which is typically defined as the amount that is payable as a result of the death of an owner before the maturity date or annuity date. The amount of the death benefit is usually the accumulated value excluding any surrender charges. Since an annuity is also considered a life insurance product, the amount paid bypasses probate and goes directly to a named beneficiary. If there is more than one owner, ownership passes to the remaining owners. No Fee Structure Unlike variable annuities and many other investments, fixed annuities don’t charge fees. Normal fees from investing can come in the form of administrative fees, operating fees, management fees, etc. This does not mean that insurance companies don’t pass along their costs, they just don’t show up as a fee and one cannot discern otherwise. Fixed annuities also don’t have a mortality expense for death benefit guarantees, as do variable annuities. Policy Loans The general tax rule states that loans from “qualified employer plans,” which includes certain annuities, are considered distributions and therefore taxable. In regards to this rule, qualified employer plans include 401(a), 403(a), 403(b) and government plans. However, there is an exception to the general rule in IRC 72(p)(2), which only applies to certain tax qualified plans. It allows loans that are the lesser of (1) $50,000 or (2) the greater of the annuity’s surrender value or $10,000. Policy loans are to be repaid within five years, per the terms of the loan agreement, unless the loan is for the purchase of a home that is to be used as the principal residence of the borrower within a reasonable time. Tax-Deferral One of the most popular aspects of an annuity is that the earnings grow tax-deferred, whether it is non-qualified or tax-qualified. In performing a comparative analysis, clients and advisors are interested in the bottom line, that is, what are the after tax results of any given investment. For example, if an annuity were earning 6%, what would be the after-tax equivalent for an alternative such as a mutual fund? The quickest measuring tool is to take the annuity yield and divide it by 1 minus the tax bracket. If a client is in the 28% tax bracket and the annuity in consideration is earning 6%, the taxable equivalent would be 8.33% (.06 / (1-.28)). On the other hand, if one had a taxable investment that earns 10%, the equivalent tax-deferred yield would be the taxable yield multiplied by 1 minus the tax bracket. In this case, the tax-deferred equivalent would be 7.2% (.10 x (1-.28)). Of
course, when considering annuities, one is usually more interested in just
the bottom line, such as lifetime income, survivor income, guarantees,
safety of principal, tax planning, etc.
In a manner of speaking, annuities have triple compounding because
they earn interest on (1) the principle, (2) interest on accumulated
interest, and (3) interest on deferred taxes.
Interest bearing investments or saving vehicles earn interest either on a compound or simple basis. Annuities earn compound interest. The difference between compound and simple interest can be staggering, for example, let’s consider the following investment, excluding taxes.
It doesn’t take a rocket scientist to figure out that compound interest is the only way to go. In 30 years, the total difference is $182,194, which is derived solely from the additional interest earnings. Some
folks think that the tax-deferral of annuities is not advantageous because
taxes ultimately have to be paid. It is true that taxes have to be
eventually paid, but because annuities have triple compounding, the net
after-tax result will always be higher. Triple compounding means that
interest is earned upon the principal, deferred interest and deferred
taxes. Let’s use the same scenario as above and compare the taxation of
the results at the end of the 30-year period to paying taxes along the
way.
Now, there needs to be some additional observations. It is very rare for an annuity owner to cash out an annuity upon maturity and pay all the tax at once. If you have heard of such an instance, you may be the first. In fact, less than 2% ever annuitize the contract while the remaining pass on to beneficiaries who have various options depending upon the tax status of the annuity and relationship to the owner/annuitant. Assuming the remote chance that one did cash out, the tax rate would of course be higher than 28% because of the amount involved. Well, let’s move from a tax rate scenario (above), the rate at which the whole amount gets taxed, to a tax bracket scenario. The 2004 IRS table shows that the highest tax bracket is 35% for a taxable income over $319,100. More specifically, the tax is $89,753 plus 35% of the amount over $319,100. Using their formula, and assuming all of the $332,194 in interest is taxable income, the most that one could be taxed is $94,336, which varies little from our tax rate example above ($93,014). In the IRS’ 2004 tax bracket system (Schedule Y-1, Married filing jointly or Qualifying widow(er)), the first $14,300 of taxable income is taxed at 10%. From $14,300 to $58,100, the amount is taxed at 15%. From $58,100 to $117,250, the amount is taxed at 25%, and so on. This ratcheting system continues until it peaks at the 35% bracket. If we convert our result to an equivalent tax rate, it would be 28.4% (94,336 / 332,194). Tax-Free Exchanges The Internal Revenue Code (IRC) allows annuity owners to exchange one annuity for another without suffering any tax consequences. Like the advantages of tax-deferral, annuity owners are not hindered from closing out one annuity in order to open up another that may be more in line with the owner’s objectives. However, in order to not give the perception of being in constructive receipt of the money for other purposes and to stay within allowable time frames, it is best for any exchange to take place between the insurance companies and leave the annuity owner out of the process. Probate Bypass Upon death, all assets of a deceased person are subject to a state’s probate laws unless some provision is made in the titling, ownership or otherwise to bypass probate, which is the default way of settling an estate. Annuities have beneficiaries and any such designation bypasses probate and the death proceeds go straight to the beneficiary regardless of the terms of any will or trust. Even though the death benefit may vary from company to company, generally, it is the accumulated value at the date of death void of any applicable surrender penalties. Premium Bonus For contracts that have these features, an immediate interest rate is credited to any new premium received by the insurance company, is part of the contract guarantees and subject to surrender charges. Premium bonuses and agent commissions have an inverse relationship; that is, the higher the bonus to the annuity owner, the lower the commissions to the agent. Premium bonuses also have a compounding effect. For example, a $100,000 premium with a 6% bonus will start earning interest on $106,000 instead of $100,000. At a 5% crediting rate, the first year annualized return will be 11.3% instead of 11%. Another type of bonus is one that pays a small bonus each contract year such as 1% a year for the next 10 years, which is payable on the contract date and each subsequent policy anniversary. For example, a $100,000 annuity with ABC Annuity Company is credited $1,000 when the contract is issued as well as each policy anniversary up to a maximum number of years. One advantage of a bonus is that it may be used to offset a surrender charge incurred from surrendering an unsuited annuity and exchanging to one more suited to the annuitant’s needs. For example, Client A has received an inheritance and no longer needs his variable annuity. He surrenders his variable annuity from ABC Annuity Company and incurs a 5% surrender charge, but his new fixed annuity pays a 6% bonus. On the downside, one should be aware of the new company’s crediting history. As the bonuses get higher, beware that crediting rates after the first year may be significantly lower than an existing annuity or one with lower or no bonus. As with any perceived freebie, there is always a trade-off. Higher bonuses usually have strings attached such as longer surrender periods, higher surrender charges and forced annuitization to keep the bonus. For equity indexed annuities, an additional tradeoff may be lower participation rates. Consequently, surrendering in the early years with such a scenario can be very costly. For the agent, the trade-off is usually a reduction in commissions. Forced annuitization is an exception to the rule, but a costly feature nonetheless. Of the few annuities that do require annuitization to receive bonus credits, or index credits with EIAs, the penalties for doing otherwise can be very draconian and should be avoided. In order to be deemed compliant, the typical minimum payout is five years but may be longer. Market Value Adjustment (MVA) A MVA is an adjustment made to the annuity’s cash value, depending upon whether interest rates have risen or fallen since the contract’s inception, when the annuity is surrendered or money withdrawn before its guaranteed term or period has expired. For annuities with this feature, they are usually offered with various time periods in which a specific interest rate is guaranteed; and, when they mature, they can automatically be renewed for the same or another guaranteed period. Comparatively speaking, the effect of a market value adjustment is like a bond, which has a principal adjustment as interest rates move up or down. If interest rates have risen since the start date, the adjustment will be negative. If interest rates have fallen since the start date, the adjustment will be positive. When one surrenders an annuity early or makes withdrawals, surrender charges and amounts are known. However, a MVA is the only cost of surrendering or withdrawing early that is an unknown. Surrender Charge All annuities charge a penalty if part or all of the policy is withdrawn during the surrender period, which is a specific number of years in which a penalty would apply. Once the surrender period has passed, no charges apply to any surrender. Of course, surrender charges are inapplicable if the policy is annuitized or cashed in by reason of the owner’s death. Why do annuities have surrender charges and other investments do not? When an insurance company issues an annuity policy, they pay commissions to the underwriting agent, buy securities that will cover the guarantees and have overall operating expenses. In case an owner cashes out early, the insurance company wants to ensure that these costs are recovered. The amount of the penalty is based on the number of years that have elapsed since the receipt of premium payments or the contract date and is typically a percentage of the premium payments or accumulated value. The policy may have a table of surrender charges shown on the data page. If the policy is completely surrendered, the company may require the policy to be returned and reserves the right to defer payment of any surrender for up to six months. In order to forego paying a surrender charge, policies allow an amount to be withdrawn without penalty, called a penalty-free withdrawal. The dollar amount of the surrender charge will be determined by multiplying the applicable surrender charge percentage by the withdrawal amount in excess of the penalty-free withdrawal. For example, if a policy allows up to 10% of the policy’s accumulated value to be withdrawn per contract year, then any amount over 10% will be subject to the surrender charge. Table of Surrender Charges There are typically two different ways in which companies apply surrender charges. The first is based upon policy year. For example, if a withdrawal exceeds the penalty-free withdrawal amount, the applicable surrender charge or percent is determined by the contract year in which the withdrawal takes place. The second is based upon each payment received. For example, every premium submitted, the initial and any subsequent premiums, is subject to a surrender charge.
Nursing Home / Terminal Illness Waivers Many policies allow penalty free withdrawals if the annuity owner is confined in a hospital, hospice facility or nursing facility. Confinement must be for a minimum number of days, say 60 consecutive days, for example. The insurance company will require documentation from a physician that the confinement was medically necessary and due to an injury or sickness. Social Security Not Taxed Social Security (SS) benefits make up a substantial portion of most retirees’ income. Prior to 1984, SS benefits were not taxable, but since SS issues are a political ping-pong, the Social Security Act was amended in 1983 to pave the way for SS taxation. Unless an item is excluded by law from taxation, the IRS says that generally all income is taxable. One of the exclusions is tax-exempt interest from municipal bonds; however, this interest is included in determining whether SS benefits are taxable. The only exception to current taxation and SS taxation is interest earnings from annuities. One just needs to move as much money as reasonably possible from other investments or saving vehicles into annuities to eliminate or mitigate the effects of SS taxation. This topic will be discussed more later. Exam There are many ways to purchase an annuity along with various tax strategies and consequences. Any annuity purchaser must become knowledgeable with each of the options to determine which one best fits his needs. Also note that each of the options below is not applicable to all annuities. Fixed Annuities Generally, there are two types of annuities, fixed, which includes equity indexed annuities, and variable. Fixed annuities are probably the simplest in the annuity arena and are either deferred or immediate as it relates to the timing of annuity payments to the annuitant. In terms of taxation, they are either non-qualified or tax-qualified. Fixed annuities do not have market risk because they are not invested in the stock market. Annuity owners don’t share in any investment risk because the insurance company assumes that as it manages its own investment portfolio. Assuming the definition of interest rate risk includes the loss of principal due to interest rate fluctuations, fixed annuities are not subject to interest rate risk. Variable Annuities (VAs) VAs have many of the same features and guarantees as a fixed annuity by offering an optional fixed account that works the same way. VAs also have features similar to mutual funds with the same risks and opportunities, potential for loss and gain. In fact, many VAs offer multiple investment accounts for investors to choose from and some are exact imitations of existing mutual funds. These investment accounts, known as separate accounts or sub-accounts, appear and operate just like mutual funds. In a VA, it is the annuity owner who bears the investment risk burden, not the insurance company. The introduction of VAs was the insurance industry’s way of crossing over and competing with non-guaranteed investments. Deferred Annuities A deferred annuity is either a fixed or variable annuity that has an accumulation phase of at least one year. This is more of a descriptive term meaning that it is allowed to earn interest and then annuitize at least a year later. Typically, however, annuity owners have their annuities deferred for their whole lifetime. Deferred relates to the postponement of making income payments to an annuitant as well as the deferment of paying taxes on interest. Deferred annuities have withdrawal penalties applicable during the first few years of the contract if one withdraws an amount above a specific percentage, which is the penalty-free withdrawal. Of course, there are exceptions to this rule, such as when the contract is annuitized and the annuitant receives monthly income payments or the owner or annuitant dies. The vast majority of annuities, whether fixed or variable, are deferred annuities. Immediate Annuities (IAs) An IA is either a fixed or variable annuity that generally has no accumulation phase because it is annuitized shortly after a one-time single purchase payment is made. The annuitant may start receiving payments within a month of the issue date or sometime later, generally before the end of the first year. Annuitization is exchanging the initial purchase payment for an income stream for a specific timeframe or as long as the annuitant lives. Since deferred annuities make up the bulk of all annuities, only a small percentage of annuities are considered immediate. Flexible Premium Deferred Annuity (FPDA) A FPDA refers to the manner in which payments are made to a deferred annuity. It can be funded with one or more purchase payments with the most common being periodic payments. They can also receive irregular payments at the whim of the annuity owner. Irregular and one-time payments are subject to minimum dollar amounts; however, if the annuity owner agrees to regular and periodic payments, the minimums are much lower. Generally, an FPDA must be in effect for a year before any penalty free withdrawals can be made. Single Premium Deferred Annuity (SPDA) A SPDA refers to the manner in which payments are made to a deferred annuity. In this case, it is funded with a single one-time purchase payment. Other than that, it is identical to the FPDA. Single Premium Immediate Annuity (SPIA) A SPIA is funded in the same manner as a SPDA, a single one-time purchase payment, and immediately or within the first month, the policy is annuitized and the annuitant starts receiving annuity payments. Non-Qualified Annuity A non-qualified annuity is either (1) a deferred or immediate annuity and either (2) a fixed or variable annuity that is funded with after-tax dollars. A paycheck is the best example of after-tax dollars. A non-qualified annuity gets no special tax treatment other than being tax-deferred just like any other annuity; and, there are no contribution limitations. However, the interest earnings are still subject to the pre-59½ withdrawal penalty, but they are not subject to the required minimum distribution rules. Tax-Qualified Annuity A tax-qualified annuity is either (1) a deferred or immediate annuity and either (2) a fixed or variable annuity that takes advantage of some special taxing privilege found in the Internal Revenue Code. All tax-qualified annuities are funded with pre-tax dollars, usually made from an employee’s personal savings, payroll deduction or an employer’s contribution made of behalf of an employee. There are various types of tax-qualified annuities each with its own set of applicable statutes and contribution limitations. As with any annuity, the earnings grow tax-deferred; and, all money is subject to the pre-59½ withdrawal penalty and required minimum distributions rules. Since contributions to a tax-qualified annuity have never been taxed, any withdrawal or annuity payment is subject to regular income taxation. Exam CHAPTER 4: Parties to the Annuity Contract Owner The owner is any person or entity that purchases an annuity, is named in the application as owner or on record as owner in the most recent change, and has complete or shared ownership rights in the policy. An owner also includes any person or entity that succeeds to ownership as stated under any death of owner provision. If there is more than one owner, the joint owners are usually spouses and exercise ownership rights jointly. The owner may or may not be the annuitant. The owner has exclusivity in exercising the rights given by the policy. The owner may make any changes in a policy by typically sending a written request to the company in compliance with policy provisions. Prior to the maturity date and prior to a death that causes payment of a death benefit, the owner generally has the right to, but is not limited to:
Annuitant The annuitant may also be the owner and is the person on whose life the annuity benefits are based by using age and sex to determine the amount and duration of payments. There may be a secondary, or contingent, annuitant who will receive the benefits of an annuitant if the primary annuitant dies. When annuity payments begin, changing annuitants is disallowed. Upon the death of an annuitant while the owner is living, any surviving joint annuitant will become the annuitant; otherwise, it will fall on the contingent annuitant. If there is no surviving annuitant, the owner will automatically become the annuitant if the owner is an individual. If there is no surviving annuitant and there are joint owners, then the joint owners become joint annuitants. In the event that the owner is an entity and joint annuitants have been named, the joint annuitants are usually spouses. An entity can be any party of an annuity contract except annuitant. Beneficiary The beneficiary is the person(s) designated by the owner to receive death benefits in case the owner or annuitant dies before the annuity date. There may be more than one class of beneficiary, such as primary beneficiary and secondary (contingent) beneficiary. There may also be more than one person in each class. Beneficiary designations can be changed at any time by sending a request to the company in a manner prescribed in the policy provisions. If more than one beneficiary is named, each named beneficiary will share equally in any benefit or rights granted by the policy, unless indicated otherwise under the beneficiary designation or other written instructions. The beneficiary can also be an irrevocable beneficiary in whose interest cannot be changed without his consent. All rights of the beneficiary end if death occurs before the annuitant and his interests pass to the remaining beneficiaries. If the owner dies and there is no joint owner, the beneficiary may become the owner of the policy. If there are multiple beneficiaries of the same class, they may become joint owners. If settlement option payments have begun that guarantees payment for a certain period of time, the beneficiary will receive the death benefits if the annuitant dies before the expiration of the period certain. If no beneficiary is named or surviving, any death benefit will be paid to the owner or the estate(s) of the owner(s). Insurer / Insurance Company The insurer makes a contractual agreement with the owner or investor of an annuity product The insurer designs the contract to meet its needs and there is no haggling between the insurer and owner in determining the contract’s terms. Basically, the insurer allows the owner to pick the annuitant, beneficiary and how his money is to be invested. Of course, this is exclusive of fixed annuities or any other annuity in which the owner invests in a fixed component. Even in those cases where the owner chooses his investment options, his choices are still limited to the options offered by the insurer for the particular product in question. In the annuity contract, the insurer defines all the rights, guarantees, benefits, restrictions and options applicable to the parties of the annuity contract: insurer, owner, annuitant and beneficiary. The insurer is responsible for investing assets, either for their own general account or any special account chosen by the owner. For the general account, the insurer will invest as well as manage this account, which usually consists of investment grade corporate and U.S. Treasury bonds. For the special account, the insurer administers these accounts in conjunction with an investment company that provides the investment expertise. Some insurers perform both tasks. Exam CHAPTER 5: Equity Indexed Annuities Investors have always been in a quandary with their investment options. On the one extreme are guaranteed or insured investments. Since these do not subject the principal to any risk of loss, the returns have always been pretty minimal with no real upside potential. When markets soar, investors kick themselves in the seat of the pants; and, when markets tank, they thank their lucky stars. On the other hand, there are the at-risk investments that attract risk takers and those who just can’t settle for mediocre returns. The tradeoff for putting principal at risk is the significant upside potential. In this case, investor reaction to the market is just the opposite of those in the first group. General Description EIAs are fixed annuities and share the same features as fixed annuities as well as some of those of at-risk investments. Most require a minimum premium of $5,000; $2,000 for qualified funds. Some are flexible pay and will accept initial and additional premiums as low as $50. The maximum age at which one can purchase an index annuity ranges from 75 to 90, depending on the policy. As with all fixed annuities, there are contractual guarantees of principal and interest. The typical investment portfolio of an insurance company consists of investment grade corporate and government bonds. However, for those insurance companies that issue EIAs, options are added to the portfolio. An option basically gives the holder the right, but not the obligation, to buy the underlying security, which in this case is an external index. Even though EIAs may have similar features of a variable product, they are not considered one. On the plus side is that once an EIA is credited with a gain, it is locked in and may not be lost to subsequent market performance. EIAs are attractive to clients who want to participate in the upside of the market and not the downside. EIAs usually outperform certificates of deposit and other short-term interest bearing accounts, but not the stock market over the long haul. Guaranteed Minimum Interest Rate A typical fixed annuity has a minimum interest rate guarantee on 100% of the premium that is credited annually if rates go that low. However, an EIA is atypical in that it may not credit interest until the end of the annuity term. In addition, the actual crediting may be based on less than 100% of the premium, giving an annualized rate less than the declared rate. What makes the EIA a unique fixed annuity is the way in which it credits interest, which is linked to some index. There are several parts to this linking function; each serving a distinct purpose but all interrelated. THE MOVING PARTS The moving parts of an EIA determine the amount and conditions by which interest is credited to the contract. Since market conditions change, an insurance company needs to have the flexibility to change certain aspects of the contract so that they won’t cause undue financial hardship; therefore, one or more of the following are subject to change during the contract period. Participation (Par) Rate The par rate is the percentage of the change in the index that will be credited to the contract at the end of the indexing period. It is declared in advance for each premium and will not change for the related accumulated value unless that value is later transferred. For example, if the beginning index price were 975 and the ending index price were 1125, the index would have gained 150 points or 15.38%. If the par rate were 80%, then the actual crediting rate would be 12.30% (15.38 x .8). Asset Fee (Spread or Yield Spread) The asset fee is a predetermined charge against the change in the index. If the index increases by 10% percent, then a 2% asset fee would be deducted before the contract is credited the remaining 8%. However, this fee would only come into play if the index exceeds the guaranteed minimum interest rate for the same period. For example, if we had a beginning index price of 975 and ending index price of 1125, the index gained 150 points or 15.38%. If the asset fee were 4%, then the actual crediting rate would be 11.38%. Cap Rate The cap rate is the maximum interest an EIA can earn during a specific term period. It can either be applied to the index (Index Cap) increase before adjustments are made for participation rate or asset fee; or, they can be applied after the participation rate or asset fee (Interest Cap). If an EIA has a 10% Index Cap and the index that it is linked to goes up 15.38%, then the contract only gets credited with 10% before the participation rate is applied. On the other hand, if an EIA has a 10% Interest Cap and the index goes up 15.38%, the participation rate is applied then the result is compared to the cap rate. One would have to look at the historical returns for the linked-to Index to see if a capped product or non-capped product would be best. Of course, since past track record is never indicative of future performance, this may be a useless venture. Nevertheless, it may give one some basis for making a decision. The higher the cap, the lesser the chance that the cap will play a significant role in minimizing gains, but serves more as a security blanket for the insurance company. FEATURES Index The index is the measure used for determining the index value and credits. Unlike other investments, indexes do not reflect the reinvestment of dividends. Depending upon one’s perspective, this may not be an attractive sales feature. All mutual funds show the extent of their growth based on the reinvestment of dividends; and, for some funds, this is quite extensive. If the index is discontinued or if the calculation of the index is substantially changed, the insurance company may substitute an alternative index, subject to approval by the state insurance department of the state in which the policy is issued. Probably the most widely used index is the SPX, which is the Standard & Poor’s 500 Stock Index. Index Credit This is the amount earned by each premium/transfer based on the increase in the index. It is the greater of (1) or (2) where:
Indexing Period The indexing period means the period over which the index yield is calculated. Each premium/transfer has an indexing period associated with it. The initial indexing period begins upon the receipt of the initial premium. Subsequent indexing periods begin immediately following the end of the prior indexing period. Index Price This is the published value of an index. Each premium in an index will be assigned an index price that will be the index price as of the close of business on the day before the premium is received. The index price for the start of each indexing period after the first will be the index price as of the close of business on the day before the premium anniversary. If the index price is not published on any day for which a calculation is made, the first preceding published index price will be used. Point-to-Point This refers to a specific time frame to determine the crediting rate. The beginning point is the index price at the start of the period and the ending point is the index price at the end of the period. For example, let’s consider an EIA using the Capital Stock Index (fictitious) and an annual point-to-point. The beginning index price is 975 and the ending price, one year later, is 1125. The gain of 15.38% ((1125-975)/975) is credited to the contract and the process starts all over again with a beginning index price of 1125. Long-Term Point-to-Point (LT P2P) This is one with a term period longer than one year, usually five or more. Let’s consider a seven-year LT P2P with a beginning price of 975 and an ending price, seven years later, of 1550. This results in an index credit of 58.97% ((1550-975)/975). In actual practice, the ending price (1550) is rarely used but rather some sort of averaging for the last year. What happens to the index appreciation if one surrenders the policy before the end of the indexing period? Since Term Point-to-Point annuities don’t credit gains until the end of the indexing period, there would be no interest credited from the indexing function of the policy. There is no annualized crediting of appreciation in the index. If there were any gains, they would come from the minimum interest guarantees of the policy. High Water Mark This is the same as the Long Term Point-to-Point with one major difference. The ending index value is not necessarily the one at the end of the term, but the highest index value on any policy anniversary during the term of the policy. In the prior example, normal indexing would make 1550 the ending index value. However, let’s say the highest index value was 1600 at the end of the sixth year. This will result in an index gain of 64.10% ((1600-975)/975) instead of 58.97%. Low Water Mark Low Water Mark is just the opposite of High Water Mark. In our example above, let’s say the index dropped to 940 in the second year. Using this indexing method means that the starting index price will be 940 instead of 975. Annual Reset Annual Reset refers to the index starting anew after an indexing period has ended and the gain credited to the contract. For example, an annual point-to-point EIA has a beginning index price of 975 and ending price, one year later, of 1125. The gain of 15.38% is credited to the contract, the process starts all over again and the beginning index price is reset at 1125. Averaging This is basically a short version of the annual point-to-point by using a series of shorter points during an indexing period, which may be monthly, weekly or daily. For example, let’s consider monthly averaging, which uses a monthly point-to-point based on the monthly anniversary date. The index price for each month is added and divided by 12 to give an average ending index price from which to calculate the gain/loss. WHAT AFFECTS PERFORMANCE AND PARTICIPATION RATES? Compared to other fixed annuities, why do EIAs differ in providing guarantees? Well, this gives insurers more flexibility in buying index options so that the policy will rely more on index performance than minimum interest guarantees – more upside potential and little or no gain on the downside. Let’s see how this would play out. There are two things that take precedence before an insurance company can buy options. First, it must be able to cover its own expenses; and, second, it must be able to meet its guarantees. An insurance company is no different from any other company in that the cost of doing business must be transferred to the products they sell. For example, High Noon Annuity Company has fixed expenses and variable expenses. Its fixed expenses are from maintaining their administrative offices, salaries, utilities, insurance, depreciation, etc. They also have variable expenses such as agent commissions from selling annuities. Corporate profit would be included in the picture as well. All of these must be passed on to the consumer and recouped in the way they price their products. The actuaries at High Noon have determined that for every $1.00 in annuity premium they receive, $0.10 goes out in the form of fixed and variable expenses and profit. Next, High Noon guarantees that their 7-year term EIA will earn 3% on 90% of the principal when the annuity matures in 7 years. Well, what is the future value of $1.00 at 3% in 7 years? It is $1.23. However, the insurance company is only guaranteeing 90% of that dollar; therefore, we would multiply $1.23 by .90, which equals $1.11. How much will the insurance company have to be spent today to have $1.11 in 7 years? Assuming a current yield for 7-year bonds is 5%, the answer is $0.79. In common terms, it takes seventy-nine cents invested at 5% for 7 years to equal $1.11. This leaves $0.11 out of every dollar available for investing in options. Now, this gives us a pretty clear picture of how the guarantees, interest rates, and the term of the EIA will affect its potential earnings, which are directly affected by how many options can be purchased. More options mean more potential earnings and less options mean less potential earnings. After all the dust settles and at the end of the annuity term, the annuity is credited with the greater of the minimum interest guarantee or index credits. In the interim, however, the typical EIA is credited with index credits if there were gains or zero if the index had no gain or a loss. Note that it may only take one year for the index to gain an amount equal to or greater than the minimum interest guarantee over the whole annuity term making the guarantee feature moot. Even though withdrawals are discussed elsewhere, it is important to make a special note about the consequences of doing so in an EIA. Since an EIA does not generally credit interest until the end of the term, whether an annual reset or long-term point-to-point, one’s withdrawal could be very untimely and costly. Let’s assume we have a 5-year term annuity with no crediting until the end of the surrender period. Let’s also assume that every year’s performance was poor except for one exceptional year. A withdrawal made just prior to this exceptional year will have a severe negative impact on the overall yield, basically killing it. WHAT CUSTOMER PROFILE IS BEST FOR EIAs? Generally, the primary customers are those who want the safety of insured or guaranteed savings products like traditional fixed annuities, certificates of deposit and treasury securities; and, also want higher rates of return similar to at-risk investments like mutual funds. Aside from the general customer profile, one must remember that EIAs fit into one’s financial planning just like any other product. Diversification, risk management and portfolio design will cause one to depart from the general norm to meet one’s specific financial goals. Younger customers will usually seek a higher degree of aggressive and risky investments while seniors are more risk adverse and will have a higher inclination toward buying EIAs. This has to do with the subjective nature of choosing EIAs. Let’s also look from a contrarian perspective. Index annuities provide incentives missing from other alternatives as well as avoiding some of their negatives and pitfalls. One of the biggest reasons why investors choose mutual funds, stocks and bonds is to reap extraordinary gains. However, extraordinary losses are the major reasons investors cut their losses never to return again. This is also the reason some never venture into the investing arena. EIAs take the “loss” factor out the equation by never posting less than a zero return for negative years. EIAs are also a great way to allow one who has never invested before to get exposure and experience without suffering loss. OPTIONS BASICS Since EIAs purchase options, namely index options, it only makes sense to discuss how these options fit in the scheme of things. Please note that for simplicity reasons we will leave out the effects of taxes, commissions and other trading costs. Generally, an option gives the holder of the option the right, but not the obligation, to sell or buy an underlying asset (a stock or index) at a specific price (strike price) on or before a certain date (expiration date). The price that is paid for the “right” is called the option premium. Since insurance companies only purchase call options, those are the only ones we’ll discuss. If the owner has purchased the right to buy a stock or index at a specific price on or before a certain date, that right is called a ‘call’ option. The expiration date is the day on which the option is no longer valid and ceases to exist. Let’s back up just a bit and say we wanted to buy some stock of Starlight Starbright. Its ticker symbol is SS and its current price is $90/share. If the price went up to $99, we would have a $9 or 10% profit. On the other hand, if the price dropped to $81, we would have a $9 or 10% loss. Our maximum loss could be $90 and our maximum profit is unlimited. We’ll assume that instead of buying SS stock, we buy a call option that gives us the right, but not the obligation, to buy SS stock with a strike price of $90. The price we pay for the option is $5.90/share. If the price of SS went from $90 to $99, we could exercise our right to buy the stock at $90, sell it for $99, subtract out the $5.90 we spent for the option and end up with a $3.10 gain. Of course, this is a lot less than the $9 gain we would have had if we bought the stock outright. In the real world, an option contract controls 100 shares of stock so our actual cost would be $9,000 while an option that controls 100 shares of SS would only cost $590. If we owned SS and the price tanked, we could stand to lose $9,000. If we were only holding an option, the most we could lose is $590. Let’s move on to an index instead of a stock or a portfolio of stocks. For example, the Capital Stock Index is the average weighted price of the largest stocks on the New York Stock Exchange. If we wanted to purchase a portfolio of each stock in this index, well, it would cost a lot of money. However, we can do the same thing by purchasing shares in the Capital Stock Index. If the price of the index were $50, a corresponding option to buy the index may be priced around $3. For every $3 spent, we would have the option to purchase one share of Capital Stock Index at the strike price of $50 and sell it for a profit, assuming it rose in price. On the downside, the most we could lose is $3. In reality, shares are not sold individually but in groupings of 100 shares called round lots. So, an option would cost $300 versus $5,000 if one bought one round lot of Capital Stock Index. There is a break-even price for the index, that is, until the price exceeds a certain amount, we would have no profit. In the above example, in order to have a profit, the total amount received must be greater than our $3/share cost. If the price of Capital Stock Index were $50, then the break-even price would be $53 ($50 + $3) or an appreciation of 6% ($3 / $50). If the price of Capital Stock Index never rose above $53 before the option’s expiration date, we would let it expire and lose our $3/share. In summary, the break-even point is equal to the strike price of the call option plus the premium paid for it. An index price higher than the break-even point will be profitable, while a lower price will be unprofitable. WHICH INDEX CREDITING METHOD IS BEST? The best answer is, “It depends.” There are so many ways of crediting interest (over 3 dozen at last count) that the end result can vary greatly from company to company. Here are some general guidelines, but it has more to do with what will happen because the best crediting method won’t be known until after the fact. If the market is bullish, then a term EIA will probably perform the best. If the market is volatile, then one with monthly or annual point-to-point will probably have the best results. If the market goes into a sideways movement with no real sense of direction, then one with a monthly or daily averaging may be best. Of course, you can’t forget about the effects of the moving parts. For example, in a market that moves sideways, a low cap rate with a high participation rate may work best because gains will always be minimum. Exam COMPARATIVE OVERVIEW VAs have many of the same features and guarantees as other annuities, namely, an optional fixed account that works identically to their fixed annuity cousins. They also have features similar to mutual funds with the same risks and opportunities, potential for loss and gain. Since a VA’s design was tailored after mutual funds, we’ll begin first by making a comparative overview between the two. A VA is an annuity contract between and insurer and owner/investor. However, it has multiple investment accounts, referred to as separate or sub-accounts, from which the investor can choose. The pricing of a sub-account is simple – it is given as a price per unit. Comparatively, a mutual fund also has a price per share, but it has additional components of earnings, such as dividends, interest, and capital gains. All earnings are reinvested into the sub-account and become part of account’s total value. One major VA feature is that investors do not have to consider the tax consequences of their investment decisions. Since VAs are tax-deferred like any other annuity and until one takes some sort of distribution, tax consequences are moot. A VA has a family of sub-accounts for the investor to choose from. Other than distributions, any change in investment objective or reallocation can all be done within the family of sub-accounts available in the VA without affecting its tax-deferred status. When one does take a distribution, it is subject to ordinary income taxation, which means there is no preferential tax treatment. In a VA, there are two primary accounts - the account value and death value. The account value, of course, reflects the performance of the sub-accounts, which will either be more or less than the amount invested minus withdrawals. The death value is always at least equal to the amount invested minus withdrawals. There are some VAs that have an increasing death benefit every year. VAs have costs that other annuities do not. Since there are separate investment accounts (sub-accounts) to manage, there are management and administration fees. They also have principal guarantees, mortality expenses to provide for the death benefit guarantees, risk expense charges and deductions for premium taxes. All in all, VAs have expenses that can equal up to 3% of the account value. LONGEVITY AND RETIREMENT What happens when people live longer? Their annuity portfolio must fill the gap, somehow, and perform longer. The insurance industry has long produced tables based on the law of large numbers, which statistically calculate death and longevity. These tables are popularly known as the Commissioner’s Standard Ordinary Mortality Tables, referred to as the CSO Mortality Tables or CSO tables in industry lingo. These tables have been continually updated because the longevity of Americans keeps changing. Accurately predicting claim rates and charging the appropriate premium determines profitability. This is the problem that has created a dilemma for annuity providers - providing a profitable insurance product to compete with other investment alternatives - in a manner of speaking. According to the U.S. Administration on Aging (www.aoa.gov), persons 65 years of age or older numbered 35.0 million in 2000, which represented 12.4% of the population, about one in every eight Americans. By 2030, that number will be about 70.0 million or 20% of the population. In 2000, an estimated 2 percent of the population was age 85 and older. It is projected to increase to almost 5% by 2050. Projections by the U.S. Census Bureau suggest that the population age 85 and older could grow from about 4 million in 2000 to 19 million by 2050. As one can see, this aging of America in growing numbers is posing a major problem for pension planning, social security and investing in general. Most specifically, the annuity industry, which has long been considered a ‘safe harbor’ industry, has had to develop more creative products such as the VA to deal with these issues. Since traditional products such as fixed annuities cannot keep pace with inflation, taxation and longevity, both financial planners and investors are allocating a higher percentage of their retirement dollars in VAs to ensure that one does not outlive his retirement income. KNOWLEDGEABLE INVESTORS Investors have become more investing savvy by default and by the aging of the baby boomers. Employers provided the default mechanism by moving toward profit sharing plans that require more employee participation and responsibility. The end result is that investors are no longer ignorant about investing in general and VAs in particular; and, they are no longer inclined to stick with traditional thinking and invest in fixed annuities or other insured and guaranteed investments. Baby Boomers span a period of twenty years with the oldest of the bunch reaching age 65 in 2011. This generation is unique in that they are inheriting the massive wealth obtained from the prior generation of savers; they are more investment savvy and risk takers; they demand more for their money; and, many are retiring much earlier than the normal retirement age of 65. WHY VARIABLE ANNUITIES? Since VAs have many of the same features as mutual funds, they also possess many of the same reasons for investing. Ease VAs have made it easy for the masses to invest on a small scale and to compete with big investors. In a phrase, they have “equaled the playing field.” Let’s say an investor doesn’t have a large sum of money but can set aside $50-$100 a month. Most VAs have small initial investment requirements; and, they allow monthly bank draft commitments or payroll deductions for IRAs and other plans for as low as $50 a month. Comparatively speaking, they rival the mutual fund industry for similar growth potential for such a small amount. Economies of Scale VAs pool resources, that is, they receive millions of dollars from lots of investors and use this large sum to create and manage a portfolio. It only stands to reason that they have much more purchasing power than an individual investor. With this purchasing power, they are able to go into the mark | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||