Variable Annuities and Retirement Plans Flashcards
Annuities
An annuity is a contract between an individual and an insurance company. Once the contract is entered into, the individual becomes known as the annuitant. There are three basic types of annuities that are designed to meet different objectives. They are: fixed annuity, variable annuity, combination annuity. Although all three types allow the investor’s money to grow tax deferred, the type of investments made and how the money is invested varies according to the type of annuity.
Fixed Annuity
A fixed annuity offers investors a guaranteed rate of return regardless of whether the investment portfolio can produce the guaranteed rate. If the performance of the portfolio falls below the rate that was guaranteed, the insurance company owes investors the difference. Because the purchaser of a fixed annuity does not have any investment risk, a fixed annuity is considered to be an insurance product, not a security. Representatives who sell fixed annuity contracts must have an insurance license. Because fixed annuities offer investors a guaranteed return, the money invested by the insurance company will be used to purchase conservative investments like mortgages and real estate. These are investments whose historical performance is predictable enough so that a guaranteed rate can be offered to investors. All of the money invested into fixed annuity contracts is held in the insurance company’s general account. Because the rate that the insurance company guarantees is not very high, the annuitant may suffer a loss of purchasing power due to inflation risk.
Variable Annuity
An investor seeking to achieve a higher rate of return may elect to purchase a variable annuity. Variable annuities seek to obtain a higher rate of return by investing in stocks, bonds, or mutual fund shares. These securities traditionally offer higher rates of return than more conservative investments. A variable annuity does not offer the investor a guaranteed rate of return and the investor may lose all or part of their principal. Because the annuitant bears the investment risk associated with a variable annuity, the contract is considered to be both a security and an insurance product. Representatives who sell variable annuities must have both their securities license and their insurance license. The money and securities contained in a variable annuity contract are held in the insurance company’s separate account. The separate account was named this because the variable annuity’s portfolio must be kept separate from the insurance company’s general funds. The insurance company must have a net worth of $1,000,000 or the separate account must have a net worth of $1,000,000, in order for the separate account to begin operating. Once the separate account begins operations, it may invest in one of two ways: directly, indirectly.
Direct Investment
If the money in the separate account is invested directly into individual stocks and bonds, the separate account must have an investment adviser to actively manage the portfolio. If the money in the separate account is actively managed and invested directly, then the separate account is considered to be an open-end investment company under the Investment Company Act of 1940 and must register as such.
Indirect Investment
If the separate account uses the money in the portfolio to purchase mutual fund shares, it is investing in the equity and debt markets indirectly and no investment advisor is required to actively manage the portfolio. If the separate account purchases mutual fund shares, then the separate account is considered to be a unit investment trust under the Investment Company Act of 1940 and must register as such.
Combination Annuity
For investors who feel that a fixed annuity is too conservative and that a variable annuity is too risky, a combination annuity offers the annuitant features of both a fixed and variable contract. A combination annuity has a fixed portion that offers a guaranteed rate and a variable portion that tries to achieve a higher rate of return. Most combination annuities will allow the investor to move money between the fixed and variable portions of the contract. The money invested in the fixed portion of the contract is invested in the insurance company’s general account and used to purchase conservative investments like mortgages and real estate. The money invested in the variable side of the contract is invested in the insurance company’s separate account and used to purchase stocks, bonds, or mutual fund shares. Representatives who sell combination annuities must have both their securities license and their insurance license.
Bonus Annuity
An insurance company that issues annuity contracts may offer incentives to investors who purchase their variable annuities. Such incentives are often referred to as bonuses. One type of bonus is known as premium enhancement. Under a premium enhancement option, the insurance company will make an additional contribution to the annuitant’s account based on the premium paid by the annuitant. For example, if the annuitant is contributing $1,000 per month, the insurance company may offer to contribute an additional 5% or $50 per month to the account. Another type of bonus offered to annuitants is the ability to withdraw the greater of the account’s earnings or up to 15% of the total premiums paid without a penalty. Although the annuitant will not have to pay a penalty to the insurance company, there may be income taxes and a 10% penalty tax owed to the IRS. Bonus annuities often have higher expenses and longer surrender periods than other annuities and these additional costs and surrender periods need to be clearly disclosed to prospective purchasers. In order to offer bonus annuities the bonus received must outweigh increased costs and fees associated with the contract. Fixed annuity contracts may not offer bonuses to purchasers.
Recommending Variable Annuities
There are a number of factors that will determine if a variable annuity is a suitable recommendation for an investor. Variable annuities are meant to be used as supplements to other retirement accounts such as IRAs and corporate retirement plans. Variable annuities should not be recommended to investors who are trying to save for a large purchase or expense such as college tuition or a second home. Variable annuity products are more appropriate for an investor who is looking to create an income stream. A deferred annuity contract would be appropriate for someone seeking retirement income at some point in the future. An immediate annuity contract would be more appropriate for someone seeking to generate current income and who is perhaps already retired. Many annuity contracts have complex features and cost structures which may be difficult for both the representative and the investor to understand. The benefits of the contract should outweigh the additional costs of the contract to ensure the contract is suitable for the investor. Illustrations regarding performance of the contract must be approved or denied by a principal based on suitability within 7 business days of receipt. A Series 24 or Series 26 principal may approve or deny a variable annuity application presented by either a Series 6 or Series 7 registered representative.
Annuity Sales Best Practices
1035 exchanges allow investors to move from one annuity contract to another without incurring tax consequences. 1035 exchanges can be a red flag and a cause for concern over abusive sales practices. Because most annuity contracts have surrender charges that may be substantial, 1035 exchanges may result in the investor being worse off and may constitute churning. FINRA is concerned about firms who employ compensation structures for representatives that may incentivize the sale of annuities over other investment products with lower costs and which may be more appropriate for investors. Firms should guard against incentivizing agents to sell annuity products over other investments. Members should ensure proper product training for investment advisers and principals for annuities and they must have adequate supervision to monitor sales practices and to test their product knowledge. The focus should be on detecting problematic and abusive sales practices. L share annuity contracts are designed with shorter surrender periods, but have higher costs to investors. The sale of L share annuity contracts can be a red flag for compliance personnel and may constitute abusive sales practices.
Annuity Purchase Options
Single payment deferred annuity, single payment immediate annuity, periodic payment deferred annuity.
Single Payment Deferred Annuity
With a single payment deferred annuity, the investor funds the contract completely with one payment and defers receiving payments from the contract until some point in the future, usually after retirement. Money being invested in a single payment deferred annuity is used to purchase accumulation units. The number and value of the accumulation units varies as the distributions are reinvested and the value of the separate account’s portfolio changes.
Single Payment Immediate Annuity
With a single payment immediate annuity, the investor funds the contract completely with one payment and beings receiving payments from the contract immediately, normally within 60 days. The money that is invested in a single payment immediate annuity is used to purchase annuity units. The number of annuity units remains fixed and the value changes as the value of the securities in the separate account’s portfolio fluctuates.
Periodic Payment Deferred Annuity
With a periodic payment annuity, the investor purchases the annuity by making regularly scheduled payments into the contract. This is known as the accumulation stage. During the accumulation stage, the terms are flexible and if the investor misses a payment, there’s no penalty. The money invested in a periodic payment deferred annuity is used to purchase accumulation units. The number and value of the accumulation units fluctuate with the securities in the separate account’s portfolio.
