Chapter 5: Annuities

Question 1

Concept of an Annuity

Answer 1

Annuities are primarily used to provide a steady stream of income to an individual, typically upon retirement. An annuity is designed to protect against outliving an individual’s retirement income by providing lifetime income. An annuity can be used to liquidate an estate or pay benefits until the death of an annuitant. When directly compared to life insurance, an annuity can be viewed to as the opposite of a life insurance policy. Annuities are funded and sold through life insurance companies and require at least a life insurance license to sell.

Question 2

Annuity Characteristics

Answer 2

• Provides steady income until the death of the annuitant
• Liquidates an estate
• Pays a LIVING benefit
• Protects against living too long
• Owner, annuitant, beneficiary
• Contract

Question 3

Owner

Answer 3

The individual who controls the contract, is responsible for making payments into the contract, and has all of the contractual rights in the policy.

The owner’s rights begin at the time of purchase. An owner, who may also be the annuitant, may change the annuity date, beneficiary, and payout option.

During the accumulation period, if the contract owner and the annuitant are the same person and the designated beneficiary is the annuitant’s spouse, the IRS code allows the spouse to assume ownership of the annuity once the annuitant dies. The rights of ownership include tax deferment.

Question 4

Annuitant

Answer 4

The individual whose life the contract is based on. Upon a lifetime annuitization, payments will be made to the annuitant based upon the annuitant’s age, gender, settlement option selected, and dollar amount used to fund the income benefit payments.

Question 5

Beneficiary

Answer 5

The individual or person named in the contract to potentially receive benefits if the owner and/or annuitant die prior to annuitization or if the settlement option selected offers any residual benefit after the annuitant’s death.

As with life insurance, annuities may have beneficiaries that are named and designated by the owner prior to annuitization or guaranteed payout period. The beneficiary is named at receipt of the first purchase payment and may ONLY be changed by the owner.

Question 6

Insurance Aspects of an Annuity

Answer 6

Annuities are insurance products based on a mortality table. If a life contingency settlement option is chosen, the insurance company guarantees to provide an income benefit payment as long as the annuitant lives. Actuarial assumptions based off of the law of large numbers allow this to occur. Those who live a shorter life span than expected allow the insurance company to have the reserves in place to be able to pay out guaranteed lifetime income benefit payments to those who live well beyond life expectancy.

Question 7

Death Benefits of an Annunity

Answer 7

In addition to providing a guaranteed income benefit payout for life, an annuity also has another guarantee if the annuitant dies prior to annuitizing the contract. In this case, the policy has a named beneficiary, just like a life insurance policy. The insurer will pay out an amount equal to the total premiums paid or the account value, whichever is greater.

Question 8

Accumulation (Pay-In) Period

Answer 8

The period of time from the first deposit to the selection of a settlement option is considered the accumulation period, during which taxes are deferred. Accumulation periods are found within DEFERRED annuities.

Question 9

Annuity Premium Payout Options

Answer 9

• Single Premium
• Periodic Premium
• Flexible Premium

Question 10

Single Premium

Answer 10

A lump sum payment is made into an annuity

Question 11

Periodic Premium

Answer 11

Continuous premiums paid into the contract. The most common example of a periodic premium is a flexible premium.

Question 12

Flexible Premium

Answer 12

Flexible contributions may be made as often and whatever amount the contract owner desires. However, most insurers set a minimum and a maximum dollar amount they will accept.

Question 13

Immediate Annuity

Answer 13

Does NOT have an accumulation period and is used to generate IMMEDIATE income within a year of the issue date.

Question 14

Deferred Annuity

Answer 14

Will pay periodic benefits starting at a specified time in the future; income benefits must begin MORE THAN 1 year from the issue date.

Question 15

Single Premium Immediate Annuity (SPIA)

Answer 15

A single premium (lump sum) is put into an annuity from which the annuitant may IMMEDIATELY being drawing benefits (within a year of the issue date).

A retirement plan rollover, savings account balances or CDs, mutual funds, deferred annuity values, or the death proceeds of a life insurance policy might be used to purchase a SPIA.

Question 16

Single Premium Deferred Annuity (SPDA)

Answer 16

A single premium (lump sum) is put into an annuity from which the annuitant will draw the benefits at some specified time in the future, MORE THAN 1 year from the issue date.

Question 17

Flexible Premium Deferred Annuity (FPDA)

Answer 17

Flexible contributions may be made as often and in whatever amount the contract owner desires. However, most insurers set a minimum and a maximum amount for contributions. Benefits begin MORE THAN 1 year from the issue date.

Question 18

Deferred Annuity Characteristics

Answer 18

Normally purchased to defer taxes on any contract earnings. They are ideal for accumulating a retirement fund. During the accumulation period, only the contract owner can sign the request for surrender of a deferred annuity. During the early part of the accumulation period, the insurer will normally assess a surrender charge.

Question 19

Tax-Deferred Growth

Answer 19

Since an annuity is an insurance contract, the accumulation value grows tax-deferred. Deferred annuities allow for the named beneficiary to receive any policy values if the annuitant dies prior to annuitizing.

Withdrawals prior to age 59.5 are subject to income tax and, generally, a 10% tax penalty as well. Systematic withdrawals are allowed as a way to access the policy’s values without having to elect a settlement option.

Question 20

Nonforfeiture Provisions

Answer 20

An annuity owner will not lose the value accumulated up to the point where they stopped paying into the contract. Nonforfeiture provisions give the owner the rights to the accumulation in the contract. The owner has the right to surrender the contract during the accumulation period.

Remember, these provisions ONLY apply to deferred annuities since immediate annuities do not have an accumulation period.

Nonforfeiture provisions include:

• Tax Penalty
• Surrender Charges
• Bailout Provision (Escape Clause)
• Waiver

Question 21

Tax Penalty

Answer 21

To discourage the use of annuities as short-term tax shelters, a 10% penalty tax is levied against any premature withdrawals prior to 59.5 years of age. The penalty discourages withdrawals. The tax penalty DOES NOT apply if premature distributions occur due to the death or disability of the contract owner.

Question 22

Surrender Charges

Answer 22

When a contract is fully surrendered, any surrender charges will lessen the contract payout. This is also referred to as a BACK-END LOAD. Surrender charges diminish over a stated number of years, set by the insurer, until they disappear.

Question 23

Bailout Provision (Escape Clause)

Answer 23

During the accumulation period, some contracts also offer a “bailout” provision that allows the owner to withdraw money from the annuity without surrender charges if the crediting rate falls by more than a specific amount. This will enable the policyowner to consider other savings and investment options.

Question 24

Waiver

Answer 24

Annuity surrender charges are generally waived if the annuitant is hospitalized for an extended period, placed in a nursing facility for at least 30 days, becomes disabled, or dies.

Question 25

The Annuity Period (Pay-Out/Liquidation)

Answer 25

The annuitization period begins once the policyowner elects to convert a deferred annuity into an income benefit payment. The settlement option selected can provide a temporary or lifetime payment. If a lifetime benefit is selected, in most cases it is an irrevocable election. The cash values go towards paying for the income benefit.

• Lump Sum
• Annuitization

Question 26

Lump Sum

Answer 26

The annuitant has the option of cashing out the annuity in a lump sum instead of electing to receive a stream of income. There could be tax consequences and tax penalties depending upon when this occurs.

Question 27

Annuitization

Answer 27

The election to receive payments from the annuity for life or for a specified period depending on the settlement options selected.

Question 28

Annuity (Benefit) Payment Options

Answer 28

Once a contract is annuitized, the insurance company takes ownership of funds in the account. In return, the annuitant is entitled to a guaranteed income stream based on the terms of the annuitization. Depending on the option chosen, the annuitant may be able to name a beneficiary to receive any remaining benefits that are payable upon the annuitant’s death. Annuity income is based on annuity tables, which are similar to mortality tables used for life insurance. Other factors that determine the income include the accumulation amount, interest rate return, age and gender of the annuitant, and the payment option selected. The available payment options include:

• Life Income (Pure or Straight Life)
• Life Income Period Certain
• Life Income with Refund (Installment or Cash Refund)
• Life Income Joint & Survivor
• Joint Life
• Annuity Certain

Question 29

Life Income (Pure or Straight Life)

Answer 29

Annuity is payable for as long as the annuitant lives, and upon death all payments cease. This option provides the HIGHEST monthly income compared to any of the other options.

Question 30

Life Income Period Certain

Answer 30

Annuity is payable for life, or for a specified period of time, whichever is longer. If the annuitant lives beyond stated period, benefits continue for lifetime of annuitant. If the annuitant dies prior to the end of the period, a beneficiary receives the balance of the payments for the remaining time period.

Question 31

Life Income with Refund (Installment or Cash Refund)

Answer 31

Annuity is payable for the lifetime of annuitant. Upon death, if an annuitant has not received an amount equal to the total of all payments made into the annuity (not the growth), the balance is refunded to the beneficiary as a lump sum, or cash refund, or in installments, sometimes referred to as the INSTALLMENT REFUND.

Question 32

Life Income Joint & Survivor

Answer 32

Annuity is payable to 2 annuitants (in one check) while both are living. Upon the death of the first annuitant, survivor benefits continue, either paying the full amount or reduced to 2/3 or 1/2 for the survivor’s income until the survivor dies. Depending on which option is selected, these options may be referred to as Joint and full Survivor, Joint and 2/3 Survivor, or Joint and 1/2 Survivor.

Question 33

Joint Life

Answer 33

Annuity is payable to 2 or more named annuitants while both are living. Upon death of the first annuitant, the benefits stop.

Question 34

Annuity Certain

Answer 34

Annuity benefit payments are received for a specified period of time or a specified amount of periodic income. If the annuitant dies with time remaining on the period certain, or a balance is left in the account, the named beneficiary receives the balance of the payments. An annuity guaranteed pay out for a specific number of years (such as a typical, state lottery prize) is called a flex period. If the periodic amount is specified, but not the number of payments needed to pay out, or liquidate, the sum in question, then the annuity certain is called a fixed amount. Both forms are often used in settlement options.

Question 35

Types of Annuities

Answer 35

• Fixed (Guaranteed) Annuity
• Indexed (or Equity Indexed) Annuity
• Market-Value Adjustment (Adjusted) Annuity
• Variable Annuity

Question 36

Fixed (Guaranteed) Annuity

Answer 36

During the accumulation period, the insurer guarantees a minimum interest rate that is fixed. At annuitization, benefits are paid at a minimum level fixed amount.

The fixed amount purchasing power decreases as the cost of living increases. The actual rate of interest created at any one time is based on the earnings rate of the insurer’s general account, and the insurer bears any investment risk.

Only a life insurance license is required in order to sell fixed annuities in most states.

Some fixed annuities offer a base interest rate plus a bonus interest rate which becomes the current rate credited to the annuity. The current rate is set by the insurance company at the time the contract is issued and is guaranteed for a specific time period.

Question 37

Indexed (or Equity Indexed) Annuity

Answer 37

An annuity product with interest rates that are linked to the positive performance of a stock market related (equity) index, such as the Standard & Poor’s 500 Index.

The contract owner enjoys the safety of the principal and some guaranteed minimum returns. The safety of the principal and previously locked-in interest is backed by the insurer’s general account. The minimum guarantee can be as low as 0%, reflecting that the policy will not be adversely affected by negative stock market index performance.

These contracts typically have a fixed account from which funds are transferred into the index selected. They also tend to have higher surrender charges and longer surrender charge periods.

Question 38

Market-Value Adjustment (Adjusted) Annuity

Answer 38

This is an annuity product that features fixed interest rate guarantees combined with an interest rate adjustment factor that can cause the surrender value to fluctuate in response to market conditions. Upon withdrawal, the MVA will add or deduct an amount from the annuity or the withdrawal amount.

If the interest on which the MVA is based are higher than when the annuity was purchased, the MVA will likely be negative, meaning an additional amount may be deducted from either the annuity or the withdrawal amount.

If the interest rates on which if MVA is based are lower than when the annuity was purchased, the MVA will likely be positive, meaning money may be added either to the annuity or to the withdrawal amount.

Question 39

Variable Annuity

Answer 39

• Regulated by the SEC, FINRA and State Insurance departments
• Annuity payments and cash values fluctuate according to the investment experience of the separate account the contract owner has designated
• Payments based on “units” rather than dollars
• While not guaranteed, variable annuities may hedge against inflation - this protects against the purchasing power of the fixed payment annuity by providing income that trends toward keeping pace with inflation
• Contract owner bears investment risk and receives return earned, less any charges assessed by the insurer and investment managers - NO guaranteed return.
• Need FINRA registration to sell

Question 40

Qualified Annuity

Answer 40

Funded with PRE-TAX dollars, meaning the contribution itself could qualify for a tax deduction, lowering taxable income. The entire distribution from a qualified annuity (contributions and earnings) i subject to ordinary income taxes.

Question 41

Non-qualified Annuity

Answer 41

Funded with AFTER-TAX dollars,meaning taxes on the money were paid before it goes into the annuity. Upon distribution, only the earnings are taxable as ordinary income.

Question 42

Annuity Classifications are based on:

Answer 42

• Method of premium payment (single, flexible, and periodic)
• Funding (fixed vs. variable)
• When income benefits are payable (immediate vs. deferred)
• The payout option selected (Life only vs. Annuity certain

Question 43

Annuity Uses

Answer 43

Before determining the use of an annuity, it is important to determine the suitability of the product to the intended purchaser. Suitability describes the steps that must be taken by a producer to ensure that an annuity is addressing a prospective owner’s need and financial objectives at the time of the sale. Additional factors used when determining suitability include the age, income, risk tolerance, and potential use of the annuity.

Question 44

Personal Uses of Annuities

Answer 44

• Purchase other insurance
• Education funding
• Retirement fund accumulation
• Retirement income
• Long-term care benefits
• Lump-sum structured settlements

Question 45

Purchase other insurance

Answer 45

Annuities can be used as a funding vehicle for insurance premiums that consumer may need to have. If any annuity has a large amount of tax deferred earnings then, upon death, the beneficiary will receive the payout and be responsible for paying income taxes according to their tax bracket. This may force them into a higher tax bracket overall. Instead the annuity can e used either through systematic withdrawals or a settlement option to buy life insurance which will pay out a death benefit income tax free to the beneficiary.

Question 46

Education funding

Answer 46

An annuity can provide funds to help offset the costs of a college education. Using a systematic withdrawal or settlement option provides an income stream to help meet or offset some of the expenses incurred.

Question 47

Retirement fund accumulation

Answer 47

A deferred annuity that is held outside an IRA allows for the accumulation of earnings on a tax-deferred basis. The earnings may come from current or guaranteed interest credits, excess interest credits linked to the performance of a stock index, or from separate account investment performance. The premiums paid-in are not eligible for tax deduction. An IRA annuity may allow for all or part of the premiums paid to be tax deductible. Since an annuity is already tax-deferred, having it held inside an IRA account does not provide any additional tax deferral benefit.

Question 48

Retirement income

Answer 48

The funds accumulated inside an annuity can be used to fund all or part of a consumer’s retirement income. The accumulated funds can be used to purchase a settlement option which can provide for a lifetime income stream that can end prior to the annuitant’s death. The income received is tax-free as far as the portion of the payment is counted as a return of premium while the balance is taxable as ordinary income.

If premiums were deductible, then the entire income received would be subject to tax. A Guaranteed Minimum Withdrawal Benefit (GMWB) is an optional benefit that can be purchased to help annuitants protect their retirement income from a down market. This option allows the annuitant to withdraw a maximum percentage each year until the initial investment has been paid out.

Question 49

Long-term care benefits

Answer 49

Today’s annuities may offer riders which help offset some of the costs associated with providing long-term care. As with most riders, there is an additional cost associated with it. A few companies offer a combination deferred annuity and long-term care policy that allows for the leverage of single premiums 3-to-1 or 2-to-1.

For example, a $100,000 single premium deferred annuity could pay up to $200,000-$300,000 in long-term care benefits. Generally, the annuity values must be used then, if needed, the long-term care benefit kicks in. The annuity funds used for long-term care costs are TAX FREE.

Question 50

Lump sum structured settlements

Answer 50

Lump sum payments from lawsuits, lottery winnings, or an inheritance can be used to purchase a structured settlement in the form of an annuity. The annuity can be used to provide guaranteed lifetime income to the annuitant.

Question 51

Business Uses of Annuities: Employer Sponsored Qualified Retirement Plans

Answer 51

Annuities are usually purchased by individuals, but they may also be purchased as part of a structured corporate pension plan referred to as a Group Annuity, which is a contract between the insurer and the employer and is set up for eligible employees. Each employee receives a certificate. This is a defined benefit plan under IRS rules.

Corporations may use annuities to provide mentions for employees, funding nonqualified deferred compensation plans or qualified retirement plans, and event to structure payments from liability settlements, known as structured settlements.

Corporate-owned annuities lose the tax-deferral aspect of the policy and interest or gains are taxable as income in the year earned.

Annuities may be used as a nonqualified savings plan or as a qualified retirement plan. When nonqualified, annuity contributions are limited only to the extent that the insurance company has the right to limit the amount it is willing to accept for deposit at any one time. If used as a qualified or other type of retirement plan, contributions are limited according to the type of plan by the Internal Revenue Code.

Annuities can be used simply as funding vehicles or provide benefits that other investments cannot, such as guaranteed minimum death benefit, a guaranteed minimum interest rate, an income benefits that cannot be outlived, or other various benefits and riders.