Chapter 9

Question 1

Annuity

Answer 1

main reason for purchasing an annuity is to provide future economic security. an annuity is a mathematical concept that is quite simple in its most basic application. start with a lump sum of money, then pay it out in equal installments over a period of time until the original fund is exhausted.

the sum of money that has not yet been paid out yet is earning interest and that interest is also passed on to the income recipient (the annuitant)

while anyone can set up an annuity and pay income for a state period of time, only life insurance companies can guarantee income for the life of the annuitant.

primary function is to liquidate an estate by the periodic payment of money out of the contract. life insurance is concerned with how soon someone will die will life annuities are concerned with how long one will live.

annuities play a vital role in any situation where a stream of income is needed for only a few years or for a liftetime. an annuity is a cash contract with an insurance company that includes a free-look period as well as nonforfeiture benefits.

individuals purchase or fund annuities with a single-sum amount through a series of periodic payments. the insurer credits the annuity fund with a certain rate of interest which is not currently taxable to the annuitant. in this way, the annuity grows. the ultimate amount that will be able for payout is a reflection of these factors. Most annuities guarantee a death benefit payable in the event the annuitant dies before the payout begins. However, it is usually limited to the amount paid into the contract plus interest credited.

Question 2

survivorship factor

Answer 2

because of their experience in mortality tables, life insurance companies are uniquely qualified to combine an extra factor into the standard annuity calculation. Called a survivorship factor, it is very similar to the mortality factor in a life insurance premium calculated. it provides insurers with means to guarantee annuity payments for life regardless of how long that life lasts.

Question 3

surrender charges

Answer 3

used to discourage withdrawals and exchanges in an annuity

most insurers charge contract owners a back-end load for liquidating deferred annuities early in the years of the contract. these surrender charges cover the costs associated with selling and issuing contracts as well as associated with the insurer’s need to liquidate underlying investments at a possibly inappropriate time. Many deferred annuity contracts waive he surrender charge when the annuitant dies or becomes disabled.

surrender charges for most annuities are of limited duration applying only during the first five to eight years of the contract. For those years where charges are applicable, most annuities provide for an annual “free withdrawal” which allows the annuity owner to a certain percentage, usually 10% of the annuity account with no surrender charge applied. Additional some annuities may offer a “bailout provision” which allows the annuity owner to surrender the annuity without surrender charges if interest rates fall below a stated level within a specified time period.

Question 4

death of annuity contract owner

Answer 4

trigger a payout to the beneficiary. a spouse as a beneficiary may continue the contract with deferred taxation as contingent owner. When filling out an annuity contract application, the owner names his beneficiary and also the annuitant’s beneficiary. The owner and the annuitant can be each other’s beneficiary (which simplifies the matter), no one can be his or her own beneficiary.

Question 5

accumulation period

Answer 5

the time during which funds are being paid into the annuity. the payout or annuity period refers to the point at which the annuity ceases to be an accumulation vehicle and begins to generate benefit payments on a regular basis.

payments are made by the contract holder and interest earnings are credited by the insurer. The accumulation period of an annuity normally may continue after the purchase payments cease. If an annuitant dies during the accumulation, his or her beneficiary will receive the greater of the accumulated cash value of the total premium paid.

Question 6

Payout or liquidation period

Answer 6

refers to the point at which the annuity ceases to be an accumulation vehicle and begins to generate benefit payments at regular intervals. Typically benefits are paid out monthly. quarterly, semi annual or annual payment arrangements can also be structure. the policy owner is the only one who can surrender an annuity during the accumulation period.

Question 7

annuities are flexible in that there are options available to purchasers to which enable them to structure and design the product to best suit their needs. these options include:

Answer 7

funding method - single lump sum payment or periodic payments over time

date annuity benefits begin - immediate or deferred until a future date

investment configuration - a fixed (guaranteed) rate of return or a variable (non-guaranteed) rate of return

payout period - a specified number of years, or for life, or a combination of both

Question 8

funding method

Answer 8

an annuity begins with a sum of money called the principal sum. Annuity principal is created (or funded) in one of two ways: 1. immediately with a single premium or 2. over time with a series of periodic premiums

Question 9

single premium

Answer 9

single lump sum premium. the principal is created immediately.

Question 10

periodic payment (flexible premiums)

Answer 10

annuities can also be funded through a series of periodic premiums that will eventually create the annuity principal fund. today, it is more common to allow annuity owners to make flexible premium payments. a certain minimum premium may be required to purchase the annuity. After that, the owner can make premium deposits as often as is desired. with flexible premium annuities, the benefit is expressed in terms of accumulated value.

Question 11

date annuity income payments begin

Answer 11

annuities can be classified by the date in which the income payments to the annuitant begin. depending on the contract, annuity payments can begin immediately, or they can be deferred to a future date.

Question 12

immediate annuities

Answer 12

designed to make its first benefit payment to the annuitant at one payment interval from the date of purchase. since most annuities make monthly payments, an immediate annuity would typically pay its first payment one month from the purchase date.

an immediate annuity lacks an accumulation period. immediate annuities can only be funded with a single payment and are often called single-premium immediate annuities (SPIAs) and is intended for liquidation of a principal sum. an annuity cannot simultaneously accept periodic funding payments by the annuitant and pay out income to the annuitant.

Question 13

deferred annuities

Answer 13

deferred annuities accumulate interest earnings on a tax-deferred basis and provide income payments at some specified future date (normally within a minimum of 12 months after date of purchase). Unlike immediate annuities, deferred annuities can be funded with period payments over time.

periodic payment annuities are commonly called flexible premium deferred annuities. Deferred annuities can be funded with single premiums in which they are called single-premium deferred annuities.

The accumulation value of a deferred annuity is equal to the sum of premium paid plus interest earned minus expenses and withdrawals. benefit payments are initiated after the contract becomes annuitized.

Question 14

annuity payout options

Answer 14

just as life insurance beneficiaries have various settlement options for the disposition of policy proceeds, so too do annuitants have various income payout options to specify the way in which an annuity fund is to be paid out.

Question 15

fixed amount option

Answer 15

the annuitant receives a fixed payment until the contract value is exhausted, regardless of when that will be. if the annuitant dies before the contract is depleted, the beneficiary receives the remainder.

Question 16

straight life income option

Answer 16

aka life income annuity, pure life annuity, or straight life annuity.

pays the annuitant a guaranteed income for the rest of the annuitants lifetime. when the annuitant dies, no further payments are made to anyone. If the annuitant dies before the annuity fund is depleted, the balance is forfeited to the insurer.

This annuity guarantees protection against exhaustion of savings due to longevity. when a life annuitant outlives life expectancy, the funds for additional benefit payments will be derived primarily from funds that were not distributed to life annuitants who died before life expectancy. The straight life annuity typically pays the largest monthly benefit to a single annuitant because it is based only on life expectancy. however, it creates a risk that the annuitant may die early and forfeit much of the value of the annuity to the insurance company.

Question 17

cash refund option

Answer 17

a cash refund option provides a guaranteed income to the annuitant for life. if the annuitant dies before the annuity fund (principal) is depleted, a lump-sum cash payment of the remaining balance is made to the annuitant’s beneficiary.

thus the beneficiary receives an amount equal to the beginning annuity fund less the amount of income already paid to the deceased annuitant. A cash refund option provides payments to the annuitant for life and if the annuitant dies before the principal fund is depleted, the remainder is to be paid in a single cash payment to the annuitant’s beneficiary. This total annuity fund is guaranteed to be paid out.

Question 18

installment refund option

Answer 18

guarantees that the total annuity fund will be paid to the annuitant or the annuitant’s beneficiary. the difference between this and cash refund is that for this option, the fund remaining at the annuitant’s death is to be paid to the beneficiary is paid to the beneficiary as annuity payments, not as a single lump sum. under the cash refund or installment refund option, if annuitant lives to receive payments equal to the principal amount, no future payments will be made to a beneficiary. The installment refund option guarantees payments to the annuitant for life. if the annuitant dies before the principal fund is depleted, the same annuity payments will continue to the beneficiary until the fund is paid out.

Question 19

life with period certain option

Answer 19

aka life income with term-certain option

this payout approach is designed to pay the annuitant an income for life but guarantees a definite minimum period of payments.

ex. a life and 10-year certain annuity, annuitant is guaranteed payments for life or 10 years, whichever is longer. if the individual dies 6 years in, the beneficiary will get the same payments for four more years. if annuitant dies after 10 years, the annuitants beneficiary would receive nothing.

this option provies income to the annuitant for life but guarantees a minimum period of payments.

Question 20

temporary annuity certain

Answer 20

under a temporary annuity certain the payments are guaranteed to be made for a specified number of years. since the income is guaranteed if the annuitant dies before receiving payments for the full specified period of time, the annuitant’s beneficiary will receive payments for the remaining number of years.

Question 21

joint and survivor option

Answer 21

provides for payment of the annuity to two people. if either person dies, the same income payments continue to the survivor for life. when the surviving annuitant dies, no further payments are made to anyone. A full survivor option pays the same benefit amount to the survivor. Two thirds survivor option pays two thirds of the original joint benefit. A one half survivor option pays one half of the original joint benefit.

Question 22

annuity period

Answer 22

this is the income phase. sometimes referred to as annuitization, this is the period fo time beginning when the contract owner gives up the right to the funds of the contract, in return for a promise of monthly income.

Question 23

period certain option

Answer 23

not based on life contingency. provides a guaranteed minimum total benefit for a minimum number of years (ex. 10, 15, or 20) regardless of when the annuitant dies. at the end of the specified term, payments cease

Question 24

investment configuration

Answer 24

affects the income benefit s annuities pay. the two classifications are fixed annuities and variable annuities.

fixed annuities provide a fixed guaranteed accumulation or payout.

variable annuities attempt to offset inflation by providing a bneefit linked to a variable underlying investment account.

equity indexed annuities, a form of fixed annuity, are fairly new but have become quite popualar

Question 25

fixed annuities

Answer 25

provide a guaranteed rate of return. during the period in which the annuitant is making payments to fund the annuity the insurer invests these payments in conservative long-term securities (typically bonds). this allows for the insurer to credit a steady interest rate to the annuity contract. The interest payable for any given year is declared in advance by the insurer and is guaranteed to be now less than a minimum specified in the contract. In this way, a fixed annuity has two interest rates: a minimum guaranteed rate and a current rate. The current rate is what the insurer credits the annuity on a regular schedule (typically each year). The current rate will never be lower than the minimum rate, which the insurer guarantees.

accumulation of funds is certain in a fixed annuity. the investment risk is borne by the insurer. When converted to a payout mode, fixed annuities provide a guaranteed fixed benefit amount to the annuitant typically in terms of dolars per $1000 of accumulated value.

fixed annuities provide security and financial peace of mind because they provide specified benefit payable for life. however since the benefit amount is fixed, annuitants may see the purchasing power of their income payments decline over the years due to inflation.

Question 26

variable annuities

Answer 26

preferable to many.

these shift the investment risk from the insurer to the contract owner. if the investments supporting the contract perform well (as in a bull market) the owner will probably realize investment growth that exceeds what is possible in a fixed annuity. However, the lack of investment guarantees means that the variable annuity owner can see the value of the annuity decrease in a depressed market or in an economic recession. Variable annuities invest deferred annuity payments in an insurer’s separate accounts, as opposed to an insurer’s general accounts (which allow the insurer to guarantee interest in a fixed annuity).

Because variable annuities are based on non-guaranteed equity investments (such as common stock) a sales rep who wants to sell such contracts must be registered with the financial industry regulatory authority as well as hold a state insurance license. not only can the value of a variable annuity fluctuate in response to movements in the market, so too will the amount of annuity income fluctuate even after the contract has annuitized.

to accommodate the variable concept a new means of accounting for both annuity payments and annuity income was required. The result is the accumulation unit and the annuity unit

Question 27

Accumulation units

Answer 27

during the accumulation period, contributions made by the annuitant (less a deduction for expenses) are converted to accumulation units and credited to the individual’s account. The value of each accumulation unit varies depending on the value of the underlying stock investment.

the value of one accumulation unit is found by dividing the total value of the comapny’s separate account by the total number of accumulation units outstanding.

Question 28

annuity units

Answer 28

once variable annuity benefits are to be paid out to the annuitant, the accumulation units are converted to annuity units. at the time of the initial payout, the annuity unit calculation is made. from then on, the number of annuity units remains the same for the annuitant. The value of one annuity unit can and does vary from month to month, depending on investment results.

the theory has been that the payout from a variable annuity over a period of years will keep pace with the cost of living and thus maintain the annuitant’s purchasing power at or above a constant level. as with fixed annuities, the variable annuity owner has various payout options from which to choose. these options usually include the life annuity, life annuity with period certain, unit refund annuity, and joint and survivor annuity.

Question 29

equity indexed annuities

Answer 29

a type of fixed annuity that offers the potential for higher credited rates of return than traditional counter parts, but also guarantee the owner’s principal. Tied to specific equity or stock index (such as S&P 500) which results in long-term inflation protection. underlying the contract for the duration of its term is a minimum guaranteed rate (ordinarily 3-4%) so a certain rate of growth is guaranteed. When increases in the index to which the annuity is linked produce gains that are greater than the minimum rate, that gain becomes the basis for the amount of interest that will be credited to the annuity. at the end of the contract’s term (usually 5 to 7 years) the annuity will be credited with the greater of the guaranteed minimum value or the indexed value.

Question 30

market value adjusted annuities

Answer 30

instead of having the annuity’s interest rate linked to an index as with equity-indexed annuity, an MVA annuity’s interest rate is guaranteed fixed if the contract is held for the period specified in the policy. The market-value adjustment feature applies only if the contract is surrendered before the contract period expires. otherwise, the annuity functions the same way a fixed annuity does.

Question 31

annuity taxation

Answer 31

annuity benefit payments are a combination of principal interest. accordingly, they are taxed in a manner consistent with other types of income. the portion of the benefit payments that represents a return on principal (ie. the contributions made by the annuitant) are not taxed. However the interest earned on the declining principal is taxed as ordinary income. The result is a tax-free return of the annuitant’s investment and the taxing of the balance.

a simple formula for computing the taxable portion of an annuity payment is called the exclusion ratio, and is used to determine the amount of annual annuity income exempt from federal income taxes. the formula is the investment in the contract divided by expected returns.

Question 32

deferred annuities

Answer 32

accumulate interest earnings on a tax-deferred basis. while no taxes are imposed on the annuity during the accumulation phase, taxes are imposed when the contract begins to pay its benefits.

Question 33

1035 contract exchanges

Answer 33

section 1035 of the Internal revenue code provides for tax-free exchanges of certain kinds of financial products, including annuity contracts. no gain will be recognized (taxed) if an annuity contract is exchanged for another annuity contract. the same applies when a life insurance or endowment policy is exchanged for an annuity contract. an annuity contract cannot be exchanged tax-free for a life insurance contract.

Question 34

qualified annuity plan

Answer 34

tax-deferred arrangement established by an employer to provide benefits for employees. this plan is qualified because of having met government requirements. a qualified annuity is an annuity purchased as a part of a tax-qualified individual or employer-sponsored retirement plan, such as an individual retirement account (IRA). in the accumulation phase a qualified deferred annuity may be used to fund and IRA and permit continued contributions within the maximum limits set by the IRS.

Question 35

tax sheltered annuity (TSA)

Answer 35

special type of annuity plan for nonprofit organizations. 403(b) plan or a 501(c) plan because it was made possible by those sections of the tax code. for years, the federal government, through tax laws, has encouraged specified nonprofit charitable, educational, and religious organizations to set aside funds for their employees’ retirements. regardless of whether the money is actually set aside by the employers for the employees of such organizations or the funds are contributed by the employees through a reduction in salary, such funds may be placed in TSAs and can be excluded from the employees’ current taxable income.

Question 36

structured settlements

Answer 36

annuities are also used to distribute funds from settlement of lawsuits or the winnings of lotteries and other contests. court settlements of lawsuits often require the payment of large sums of money throughout the rest of the life of the injured party. Annuities are perfect vehicles for these settlements becasue they can be tailored to meet the needs of the claimant. Annuities are also suited for distributing the large awards people win in state lotteries. These awards are usually paid out over a period of several years (usually 10 to 20 years). Because of the extended payout period, the state can advertise large awards and then provide for the distribution of the award by purchasing a structured settlement from an insurance company at a discount.

Question 37

education funds

Answer 37

an annuity provides a steady stream of income for retirement but can also be used to fund education for children or family members.

Question 38

two tiered annuities

Answer 38

different values available for distribution at maturity depending on whether the value is taken in a lump sum before annuitization or is left with the insurer in order to receive monthly payments. if an owner/insured keeps the contract for a specific number of years they will have received a higher rate of interest. if the contract is surrendered at an earlier date, the interest credited will be recalculated from the contract’s inception using a lower tier interest rate.

Question 39

long-term care riders

Answer 39

may be attached to an annuity or a life insurance policy and allows for payment of a percentage of the death benefit if an individual is not terminally ill but requires long-term care.

Question 40

guaranteed minimum withdrawal benefit

Answer 40

a rider in an annuity insurance policy. guarantees the policy holder a steady stream of retirement income regardless of market volatility.