Insurance Ch - 8 Flashcards
The two features of an equity indexed annuity contract that have the greatest effect on the amount of additional interest that may be credited to the contract are: ??
- The indexing methods specified in the contract
- The participation rate
ANNUITIES
* One of the common goals for most Americans is to live comfortably
in retirement – generally requires two components: ??
- Annuities are used to: ????
ANNUITIES
* One of the common goals for most Americans is to live comfortably
in retirement – generally requires two components:
- Accumulation of assets
- Reliable source of income
- Annuities are used to:
Provide income streams for retirees
Accumulate assets on a tax-deferred basis
NOTE: most annuities are not annuitized
RETIREMENT ISSUES
- Retirement Life Expectancy: The period between retirement and
death - This period has increased due to: ??
RETIREMENT ISSUES
- Retirement Life Expectancy:
The period between retirement and death - This period has increased due to:
earlier retirement and
extended life expectancy - Inflation: The increase in the general price level of goods and
services
RETIREMENT BENEFITS
- Historically, individuals received Social Security retirement benefits
and a fixed pension during retirement.
RETIREMENT BENEFITS
- Historically, individuals received Social Security retirement benefits
and a fixed pension during retirement. - Pension payments are generally made from retirement plans
known as defined benefit plans.
-Defined benefit plans pay a fixed amount of income to
retirement workers, typically for life. - In 1985, there were about 170,000 defined benefit plans. In 2019,
there were fewer than 47,000 defined benefit plans.
DEFINED CONTRIBUTION VS. DEFINED BENEFIT PLANS
DEFINED CONTRIBUTION VS . DEFINED BENEFIT PLANS
- Defined contribution plans do not promise any particular income
benefit in retirement. - In 1985, there were about 460,000 defined contribution plans. In
2019, there were more than 680,000 defined contribution plans. - With longer life expectancies and less income from defined benefit
plans, it is important for many individuals to mitigate the risk of
superannuation
CHARACTERISTICS OF ANNUITIES (1 OF 2)
CHARACTERISTICS OF ANNUITIES (1 OF 2)
- An annuity is a contract that is designed to provide a specific
income that is payable at stated intervals for a specified period of
time. - Traditionally, individuals receive fixed annuities from:
– Employer defined benefit plans
– Government retirement plans
—Insurance companies - Individuals can purchase commercial annuities; these are not
uniform in any respect.
CHARACTERISTICS OF ANNUITIES (2 OF 2)
- Annuities can be characterized based on several factors: ?
CHARACTERISTICS OF ANNUITIES (2 OF 2)
- Annuities can be characterized based on several factors:
–Type of payout
– Frequency and flexibility of premium
– The timing of when income is payable
– Tax considerations and funding vehicles
- Annuities have two distinct phases:
– Accumulation phase
– Annuitization phase (not all annuities are annuitized)
ANNUITIES: ADVANTAGES AND DISADVANTAGES
ANNUITIES: ADVANTAGES AND DISADVANTAGES
Advantages :_______________________________
Lifetime income
Structure of income can be based on single or multiple lives
Eliminates Superannuation risk and purchasing power
May provide protection from creditors
earnings oare tax -deferred
Disadvantages:______________________________
Complex
Cost and fees reduce returns
once funds are exchanges for annuity they are no longer avaialbe to heirs
Taxable benefits consist of Ordinary Income as opposed to cap gains for qualifying dividends,
PARTIES TO AN ANNUITY CONTRACT
- There are generally four parties to an annuity contract: ?
PARTIES TO AN ANNUITY CONTRACT
- There are generally four parties to an annuity contract:
- Annuitant
- Beneficiary
- Owner
- Insurance company
ANNUITY FEATURES (1 OF 2)
Annuity Payout Period
Immediate vs. Deferred
ANNUITY FEATURES (1 OF 2)
Annuity Payout Period
* May provide payments for a fixed term such as 20 years (term
certain) or for an indefinite term such as the lifetime of the annuitant
(life annuity).
Immediate vs. Deferred
* Immediate Annuity: Created when the contract owner trades a
sum of money in return for a stream of income that begins
immediately.
- Deferred Annuity: Does not begin distributions immediately but
waits until some future time to start payments.
ANNUITY FEATURES (2 OF 2)
Flexible Premium vs. Single Premium
ANNUITY FEATURES (2 OF 2)
Flexible Premium vs. Single Premium
- Flexible: Allows the insured the option to vary premium deposits
over time - Single: Annuity purchased with a single lump sum
Earnings - Fixed: Invest in less risky investments and will guarantee returns
for a period of time - Variable: Have a wider array of investment choices, including
equity investments
ANNUITY BENEFIT OPTIONS (1 OF 2)
- Single life annuities
- Term certain (Guaranteed Minimum Payment)
ANNUITY BENEFIT OPTIONS (1 OF 2)
- Single life annuities
–Straight or pure life annuities
– Installment refund annuities
–Cash refund annuities
–Life with term certain annuities
- Term certain (Guaranteed Minimum Payment)
ANNUITY BENEFIT OPTIONS (2 OF 2)
- ## Joint and survivor life annuities
ANNUITY BENEFIT OPTIONS (2 OF 2)
- Joint and survivor life annuities
–Payments are made over the lives of two or more annuitants
and continue until the last annuitant dies
– Commonly used to provide income for married couples
– Survivor may receive 100%, 75%, or 50% of the joint amount
TYPES OF ANNUITY CONTRACTS
Fixed Annuity
Variable Annuity
Equity Indexed Annuity
TYPES OF ANNUITY CONTRACTS
Fixed Annuity
* Most conservative
* Principal protection
* mitigates the risk of superannuation
Variable Annuity
* Allows for participation in equity markets
* Higher costs and fees
Equity Indexed Annuity
* Guaranteed minimum rate
* Earnings based on some type of index
FIXED ANNUITY
FIXED ANNUITY
- Most conservative
- Provides full principal protection combined with a guaranteed rate of return
– Initial rate
–Renewal rate
VARIABLE ANNUITY (1 OF 2)
Features
VARIABLE ANNUITY (1 OF 2)
Features
* Tax deferred earnings
* Avoid income tax when one investment in the annuity contract is
sold and replaced with another investment (transfer among
subaccounts)
* Death benefit protection options
* Living benefit protection options
* Lifetime income options
VARIABLE ANNUITY (2 OF 2)
Prospectus
VARIABLE ANNUITY (2 OF 2)
Prospectus
* A disclosure document provided to purchasers of variable annuities
that contains important information about the contract, such as:
– Fees and charges
– Investment options and objectives
– Risks
– Death benefit options
–Living benefits
–Annuity income options
VARIABLE ANNUITY FEES ( 1 OF 3)
VARIABLE ANNUITY FEES (1 OF 3)
- Mortality and expense risk charges
* Insurance risks
* Cover the risks of annuitant living too long
* 1.15% to 1.85% (115 to 185 bps) annually - Administrative and Distribution Fees
* Costs associated with servicing and distributing the annuity
* 0% to 0.35% (0 to 35 bps) annually - Annual Fee
* Record keeping and administration
* $30 to $50
* Regularly waived
VARIABLE ANNUITY FEES (2 OF 3)
VARIABLE ANNUITY FEES (2 OF 3)
- Subaccount Fees and Expenses
- Charged to the investment subaccounts inside the annuity
and include investment management fees - $0.7% to 2.5% (70 to 250 bps) annually
- Surrender Charges
* Known as contingent deferred sales charges (CDSCs)
- Typically, a percentage (7% to 9%) of the amount withdrawn in
excess of a 10% free withdrawal amount and declines over time - Does not apply if the annuity is annuitized
VARIABLE ANNUITY FEES ( 3 OF 3)
Variable annuities are offered by share class:
VARIABLE ANNUITY FEES (3 OF 3)
Variable annuities are offered by share class:
- B shares typically have a 6- to 8- year period of surrender charges.
- L shares have a 3- to 4- year surrender charge period for each
contribution. - C shares have no surrender charge.
- B shares typically have slightly lower fees.
Note: There is generally a direct link between the CDSC and the
commission the broker receives as part of the sale
VARIABLE ANNUITY FEES: EXAMPLE
- Elmer purchases a variable annuity contract with a $100,000
purchase payment. The contract has a schedule of surrender
charges, beginning with a 7% charge in the first year, and declining
by 1% each year. In addition, he is allowed to withdraw 10% of the
contract value each year free of surrender charges. In the first year,
Elmer decides to withdraw $50,000, or one-half of his contract value
of $100,000 assuming the contract value has not increased or
decreased because of investment performance).
VARIABLE ANNUITY FEES: EXAMPLE
- Elmer purchases a variable annuity contract with a $100,000
purchase payment. The contract has a schedule of surrender
charges, beginning with a 7% charge in the first year, and declining
by 1% each year. In addition, he is allowed to withdraw 10% of the
contract value each year free of surrender charges. In the first year,
Elmer decides to withdraw $50,000, or one-half of his contract value
of $100,000 assuming the contract value has not increased or
decreased because of investment performance).
In this case, Elmer could withdraw $10,000 (10% of contract value) free of surrender
charges, but he would pay a surrender charge of 7%, or $2,800, on
the other $40,000 withdrawn
GUARANTEED LIVING BENEFIT RIDERS
Basic Types of Living Benefits:
GUARANTEED LIVING BENEFIT RIDERS
Basic Types of Living Benefits:
- The guaranteed minimum accumulation benefit (GMAB)
- The guaranteed minimum income benefit (GMIB)
- The guaranteed minimum withdrawal benefit (GMWB)
EQUITY-INDEXED ANNUITIES
EQUITY-INDEXED ANNUITIES
- Fixed annuities that earn interest or provide benefits that are linked
to an external equity reference or an equity index. - One of the most commonly used indices for annuity products is the
Standard & Poors 500 composite stock price index (S&P 500). - Credit interest using a formula based on changes in the index to
which annuity is linked. - Two Features that affect the amount of interest credited:
1. Indexing methods specified in the contract
2. Participation rate
INDEXING METHOD
I
INDEXING METHOD
Indexing Method
1. The annual reset (ratcheting) method
* Compares the index value at the end of the contract year with
the index value at the beginning of the contract year
- The high watermark method
* Compares the value of the index at various points during the
term (usually on anniversary dates) - The point-to-point method
* Based on the difference between an index value at the end of the
term compared with the index value at the start of the term
EQUITY-INDEXED ANNUITY KEY TERMS
- Index Term:
- Participation Rate:
- Cap Rate:
- Floor Crediting Rate:
EQUITY-INDEXED ANNUITY KEY TERMS
- Index Term: Period over which index-linked interest is calculated,
ranging from 1 to 10 years, with 6 to 7 being the most common. - Participation Rate: Determines how much of the increase in the
index will be used to calculate the index-linked interest. - Cap Rate: Some indexed annuities impose an upper limit on the
index-linked rate. - Floor Crediting Rate: Minimum index-linked interest rate that will
be credited to the contract in a given period.
EQUITY-INDEXED ANNUITY: EXAMPLE
- Homer buys an equity-indexed annuity that has:
–A guaranteed minimum rate of 2%
– A participation rate of 75%
– A maximum rate of 9% - On the day Homer purchases his annuity, the S&P 500 index is
1800.
EQUITY-INDEXED ANNUITY: EXAMPLE
- Homer buys an equity-indexed annuity that has:
– A guaranteed minimum rate of 2%
– A participation rate of 75%
–A maximum rate of 9%
________________________________________________________________ - On the day Homer purchases his annuity, the S&P 500 index is
1800. - One year later the index is 2050, an increase of 13.88%.
- 75% participation rate x 13.88% = 10.42%; however, Homer’s
annuity will be credited with the maximum rate of 9%. - If the S&P 500 instead had a return of -7.3%, Homer would be
credited with the minimum rate of 2%
ADVANTAGES OF ANNUITY CONTRACTS
ADVANTAGES OF ANNUITY CONTRACTS
- Opportunity to defer income taxation
- The ability to rebalance the portfolio inside a variable annuity
contract without incurring any immediate income taxation on asset
sales - Annuities are protected from creditors in some states
DISADVANTAGES OF ANNUITY CONTRACTS
DISADVANTAGES OF ANNUITY CONTRACTS
* Complexity
* Costs and fees
* Tax consequences
TAXATION OF ANNUITIES (1 OF 3)
Income Taxation
TAXATION OF ANNUITIES (1 OF 3)
Income Taxation
- Distributions taken from an annuity BEFORE annuitizing:
– Included in the taxpayer’s gross income until all of the
gain in the contract has been distributed
– Further distributions are treated as tax-free returns of basis
– Follow a LIFO approach to income reporting
– Annuities issued prior to August 14, 1982 receive FIFO
treatment
– Taxable distributions of earnings are subject to 10% early
withdrawal penalty if the account holder is under the age 59½
TAXATION OF ANNUITIES (2 OF 3)
TAXATION OF ANNUITIES (2 OF 3)
- If the annuitant/owner is a high-income taxpayer and the annuity
distribution is not made through an IRA or qualified plan, a 3.8%
Medicare surtax will apply. - Annuities purchased with pre-tax dollars typically do not have any
basis for income tax purposes.
– 401(k) plans and deductible traditional IRAs
– All distributions are taxable as ordinary income
– The 3.8% Medicare surtax does not apply
TAXATION OF ANNUITIES (3 OF 3)
Income Taxation
TAXATION OF ANNUITIES (3 OF 3)
Income Taxation
- Each annuity payment received from a non-qualified annuity uses
an exclusion ratio to split the tax treatment into two pieces:
–A tax-free return of basis
– Taxable income - The exclusion amount for a variable annuity is determined by
dividing the after-tax investment in the contract by the number of
years of expected payout. - Once the investment in the contract has been fully recovered, all
payments will be fully taxable as ordinary income.
TAXATION OF ANNUITIES: EXAMPLE 1
- Hope purchased an annuity contract 10 years ago for $100,000.
The current value of the annuity is $175,000. Hope decides to
withdraw $100,000 from the contract
TAXATION OF ANNUITIES: EXAMPLE 1
- Hope purchased an annuity contract 10 years ago for $100,000.
The current value of the annuity is $175,000. Hope decides to
withdraw $100,000 from the contract
Total Withdrawal = $ 75,0000 GAINS
$ 100,000 BASIS
