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Variable 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:
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. 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 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. 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. 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. 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. Unlike investments, fixed annuities and the fixed component of variable 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. The fixed component of variable annuities has 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 or fixed component of a variable 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. 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. 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. 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. 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 25% tax bracket and the annuity in consideration is earning 6%, the taxable equivalent would be 8.0% (.06 / (1-.25)). 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 7.5% (.10 x (1-.25)). Of
course, when considering variable annuities, one is usually more interested in just
the bottom line, such as total return, instead of items such as lifetime income, survivor income, guarantees,
safety of principal, tax planning, etc. Generally,
fixed annuities and the fixed component of variable 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, whether it is variable annuities or fixed annuities
with 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 slightly lower than 28% (actually 26.74%). 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 2007 IRS table shows that our appropriate tax bracket is 33% for a taxable income between $195,850 and $349,700. More specifically, the tax is $43,830 plus 33% of the amount over $195,859. Using their formula, and assuming all of the $332,194 in interest is taxable income, the most that one could be taxed is $88,824, which varies little from our tax rate example above ($93,014). In the IRS’ 2007 tax bracket system (Schedule Y-1, Married filing jointly or Qualifying widow(er)), the first $15,650 of taxable income is taxed at 10%. From $15,650 to $63,700, the amount is taxed at 15%. From $63,700 to $128,500, the amount is taxed at 25%. From $128,500 to $195,850, the amount is taxed at 28%, and so on. This ratcheting system continues until it peaks at the 35% bracket for amounts over $349,700. If we convert our result to an equivalent tax rate, it would be 26.74% (88,824 / 332,194). 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. 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. 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. 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. 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 (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 CHAPTER
3: Purchase Options 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. 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. 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. 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. 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. 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. 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 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:
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. 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). 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: Variable
Annuities In General Variable Annuities (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. If fact, many VAs are exact imitations of existing mutual funds. In terms of selling a VA, an insurance agent must have a life insurance license and variable products license. 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 from which the investor can choose. These accounts, from the novice's perspective, may appear and operate just like mutual funds, except for the fact that they are referred to as separate accounts, or sub-accounts. The pricing of a sub-account is simple – it is given as a price per unit (share). Comparatively, a mutual fund also has a price per share, but it has additional components of earnings, such as dividends, interest, and capital gains. The pricing of a sub-account does not have an additional or separate accounting for these other components; rather, they are reflected in the price per unit. All earnings are reinvested into the sub-account and become part of account’s total value. A typical investor's portfolio is identified by the number of units that is owned.VAs share many of the same risks as mutual funds, that is, it is the annuity owner who bears the investment risk burden, not the insurance company. A sub-account has a portfolio of securities just like a mutual fund; and, as the price of the underlying securities move up and down, so does the sub-account’s unit price. The number of units that an investor owns is referred to as Accumulation Units. One of the great advantages of owning a VA 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. If one had a stock portfolio and needed to sell part of the portfolio for any reason - whether it were for income needs, reallocation or a change in investment objective - there would be a tax consequence as well as the loss of a stepped-up cost basis. A mutual fund with significant gains may create a similar dilemma. Not so with a VA. It is similar to a family of mutual funds, which has multiple mutual funds for the investor to choose from. 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. These internal transfers are usually unlimited in number but the insurer retains the right to limit them. When one does take a distribution, it is subject to ordinary income taxation, which means there is no preferential tax treatment. From a taxation perspective, this is not necessarily a positive; but, from an investment decision-making perspective, it keeps things simple. 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. Unlike annuitizing a fixed annuity, when one decides to take a monthly income from a VA, the amount of the income stream is not guaranteed. The only exception to this is when the annuitant takes the guaranteed option of annuitization. Otherwise, payments are dependent upon the underlying value of the sub-account. For example, Bill has $50,000 in his VA that is invested in the Growth & Income sub-account. He chooses an initial payout option that will generate $225 a month. Since this payout is determined by using a specific number of units and a variable price, the payout will change each month as the price of the underlying sub-account changes. One concern for insurers is the retention of business, that is, keeping it on the books. Surrenders from switching to the competition is costly so a little creativity can go a long way. Some insurers provide annuitization incentives to policy owners by giving bonus credits to the contract, meaning that the original investment receives an additional interest bonus up front. If the annuitant does not ultimately annuitize the contract, then the additional interest is lost. Other insurers focus on the agent by giving persistency rewards if the contract remains intact for a specific length of time. Still others incorporate freebies to policy owners that have typically cost in the past, such as asset allocation whereby assets are automatically reallocated based on market performance and economic conditions. 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. The first table was just called the CSO table, the second was the 1940 CSO table, the third was the 1958 CSO table, and then there was the 1980 CSO table. 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. When President Roosevelt signed the Social Security Act on August 14, 1935, its purpose was a quick fix to a national dilemma and was never intended to be a major source of retirement income. Original social security legislation only provided retirement benefits to the primary worker (www.ssa.gov). Survivors benefits and benefits for the retiree's spouse and children were added in 1939; and, disability benefits were added in 1956. Since then, social security has become a politically correct legislative nightmare. According to the SSA, the average life expectancy beyond age 65 has only increased an additional five years since 1940. This alone would not seem to put a strain on social security that is constantly purported in the news. So where does the problem really lie? If one couples that fact with the phenomenal numerical growth coming out of the baby boom generation, a real problem is on the horizon. The problem: an inverse numerical relationship between contributors and retirees, that is, the number of contributors per retiree is dwindling. According to the U.S. Administration on Aging (www.aoa.gov), persons 65 years of age or older numbered 37.3 million in 2006, which represented 12.4% of the population, about one in every eight Americans. By 2030, that number will be about 71.5 million or 20% of the population. This is more than a ten-fold increase since 1900 when there were only 3 million Americans older than 65, which represented 4% of the population. In 2006, an estimated 5.3 million of the population were age 85 and older and is projected to increase to 8.9 million in 2030. In 2000, there were about 65,000 people age 100 or older with projections to be as many as 381,000 by 2030. 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. Even though many financial planners still preach the old school philosophy that retirement means a shift to a more conservative portfolio, they soon realize that their philosophy does not always meet the needs of their aging clients. 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. 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. With this shift, employees have taken an active role in the management of their portfolios and moved up the learning curve. 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. Because of these unique circumstances, this generation is investing more in VAs to carry them through til the end. Exam CHAPTER 6: Why Variable
Annuities? Previously, we contrasted variable annuities and fixed annuities. Since VAs have many of the same features as mutual funds, they also possess many of the same reasons for investing, which we’ll discuss here. 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. Even though small-time investors can just as well put their money in a passbook savings, the reality is that people want more for their money. [From a financial planning perspective, a passbook savings plan is not used for the accumulation of wealth but rather serves as a temporary safe haven, a short-term purpose or a limited cash reserve.] If investors really want more bang for their buck, the natural question would be, “Why don’t they just buy a portfolio of stocks and bonds?” One of the best places to look for stock would be on the New York Stock Exchange in the Dow Jones Industrial Average (DOW). It is made up of 30 high quality, well known and established stocks, also known as “blue chips.” For example, part of the portfolio may be in shares of IBM. However, if the price of IBM were $80 a share, our investor above would have a hard time accumulating shares. Since most shares of stock are sold/bought in 100 share increments, called a round lot, it would cost $8,000 plus broker’s commission. This one factor alone would prevent the vast majority of investors from going this route. When one also takes into consideration the principles of diversification and risk (discussed later), this investing technique is out of reach for the masses. What if our investor was more interested in bonds instead of stock? Well, most bonds, depending upon multiple factors, are priced around $1,000. It would take several months to come up with enough money to buy one bond; however, the same problems with diversification and risk still exist. Similar to bonds, some commercial Certificates of Deposit (CDs) and Treasury securities have very high minimum purchase requirements. Other than VAs and mutual funds, an investor would have to have a substantial sum to buy a diversified portfolio of stocks, bonds, CDs, and/or Treasury securities. This is contrary to the spirit and environment in which VAs thrive. 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 market and negotiate a better deal for large purchases of securities. This is similar to what large store chains do; they make volume purchases and sell to the consumer at a price that smaller, local establishments cannot. For this reason alone, VAs can purchase a more cost effective portfolio than individual investors; and, this cost savings is passed along to the individual investor. It takes time and expertise to successfully manage an investment portfolio of individual securities. Working for a living prevents the vast majority of investors from doing this. However, there are many who do manage their own portfolio, but the portfolio already contains a small percentage of VAs. Following are a few of the items a professional money manager for a VA sub-account brings to the table:
It a nutshell, diversification is heralded as one of the foremost rules of investing. However, it is not a new concept. In early history, there are stories of caravans using multiple trade routes and supply trains [camels, not the rail type] to ensure their wares reached their destination. Shipping companies did the same. There is even a scripture verse that says, “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth,” Ecclesiastes 11:2. In modern phraseology, “Don’t put all your eggs in one basket.” Nonetheless, diversification and long-term investing success are two peas in the same pod; one cannot be done without the other. The primary purpose of diversification is to reduce risk. Even though maximum statistical diversification is reached around 30 securities, VA sub-accounts have gone beyond that by having up to hundreds of securities within a portfolio. Diversification in its general sense refers to encompassing all securities such as stocks, bonds, money markets, etc. A ‘Balanced’ sub-account probably meets this general definition best. From there, market segmentation has given new meaning to diversification. There are sub-accounts that specialize in particular securities, industries and technologies as well as specific parts of the world, e.g., sector sub-accounts, technology sub-accounts, international sub-accounts, small cap sub-accounts, etc. All of these sub-accounts have some degree of ‘specialized’ diversification where risk is much higher and narrowly defined. Acquiring 30 securities for maximum diversification is financially impossible for most investors. That is why VAs are so popular. Even though VAs are already well diversified, specialized diversification has become a problem. As a result, financial planners are now recommending that their clients hold multiple VAs or multiple sub-accounts within a VA to obtain general diversification. Multiple Investment Opportunities A VA sub-account is part of a family of sub-accounts held under one umbrella, the VA, which is similar to a family of mutual funds. There is probably a VA that will meet the need of any investor no matter his risk tolerance or investment objective. While some VAs have only a few sub-accounts, others have many. If one sub-account proves unsatisfactory for whatever reason, the investor can make a switch to another sub-account within the same VA, typically with just a phone call. As with any annuity, there are no tax consequences when switching from one sub-account to another. Since investors can make small investments on a regular basis, new units are continually added to the investor’s account. Market conditions dictate whether a constant dollar investment will purchase more or less units over a period of time. Let’s assume we have an investor that invests $100 the first day of every month. This month’s unit price was $10.99 and last month’s was $11.21. For the same dollar investment, our investor would be able to acquire more units this month than last. For the moment, we’ll set aside the fact that the sub-account’s value has declined. We already know the price fluctuates up and down every day. DCA is the process of investing at regular intervals, making price swings advantageous over the long-term. For example:
Exam CHAPTER 7:
Sub-Account Design A VA sub-account is a portfolio of various securities, gargantuan style. It’s like an investor developing a personal portfolio of stocks, bonds, money market securities, etc. and multiplying the results several thousand times. The diversity of a sub-account can range from the very broad to include just about every type of security to one of narrowly defined specialization. Investors have to work their way through the maze of offerings to find the VA and sub-account(s) that fit them. Fortunately, VAs have provided a hint as to what they are going to try and accomplish through a published investment objective. When one becomes familiar with the various investment objectives and the underlying securities needed to support that objective, then making the right choice is not far away. The first step for investors is, of course, to have some understanding of the various types of securities that can be found in VA sub-accounts. Many people do not understand the “money market” concept. Follow these illustrations if you will. Real estate agents work in the ‘real estate market.’ Insurance agents work in the ‘insurance market.’ There is also the ‘stock market’ and ‘bond market;’ therefore, the ‘money market’ is a market where money is bought and sold. This is not money in the ‘currency’ sense but rather ‘currency equivalent’ sense by having the same characteristics and liquidity as currency. Well, the next question would be, “What is a currency equivalent?” They are things such as short-term Treasury securities (Treasury Bills), Repurchase Agreements, Banker’s Acceptances, Certificates of Deposit, Commercial Paper, etc. Since all of these securities have short-term maturities, are considered very secure and almost risk-less, they are given the same standing as currency. In summary, many sub-accounts hold money market securities in their portfolio for purposes of diversification and asset allocation. A bond is a debt certificate and is issued by corporations and government agencies or organizations. We’ll refer to both as ‘entities.’ For example, ABC Corporation, Podunck County, or the Transatlantic Toll Bridge can raise money by issuing bonds. Even though some entities can raise money through stock offerings and bank loans, bonds represent another source. When a VA buys bonds, it is making a loan to the issuing entity and becomes its creditor; the issuing entity becomes the debtor of the VA. Most VAs buy bonds because of the interest, which is paid semi-annually. Even though there are no time restrictions, most bonds are designed to mature between 2 to 30 years. Upon maturity, the principal is returned to the VA. The interest rate that bonds pay is set when they are originally issued and do not change for the life of the bond. Since bonds have a set interest rate, the underlying principal value fluctuates until it matures. For example, a VA buys a newly issued bond for one of its sub-accounts. The amount paid for the bond is $1,000, aka par value or face amount, which pays 6%. This means that the sub-account will derive $30 every six months. Two years down the road, interest rates on new bonds are 8%. Our VA can spend $1,000 on a new bond and earn $40 every six months. Could the VA sell the old bond for the original amount of $1,000? No! For bonds, there is an inverse | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||