Annuities - An Investment Tool 2024 PDF

Annuities – an Investment Tool United Insurance Educators, Inc. (253) 846-1155 2024  Annuities - An Investment Tool Welcome This course is designed to provide accurate credit hours for your...

Annuities – an Investment Tool United Insurance Educators, Inc. (253) 846-1155 2024  Annuities - An Investment Tool Welcome This course is designed to provide accurate credit hours for your state. It is not intended to be used as selling material or to give any type of professional or legal advice to either the insurance agent or the client. Since this material is gathered from multiple sources, there may be differences of opinion expressed or implied. The material enclosed is subject to change as laws or customs may change. It is understood by those who read this course that this material is not to be copied or used in any manner without written authorization from United Insurance Educators, Inc. All courses offered are the sole property of United Insurance Educators, Inc. It is further understood that the agent requesting the credit hours must have personally read the text and personally taken the test. No certificate of completion may be given under any other circumstances Annuities - an Investment Tool is a course designed to help the field agent better understand how annuities work, including annuitization. This course will cover a wide range of subjects which includes the different annuities on the market, using them to plan for a retirement, the advantages and disadvantages of owning an annuity, and the use of annuities to plan for the expenses of col- lege. While it is our intention that this course be well rounded, there may be subjects that the reader feels should be included that is not. Others may feel that certain subjects do not merit inclusion. Regarding the examples expressed in this course, past what is legal or illegal, everything else is opinion. What one agent thinks is right, another may think is wrong. Those who compile these courses, as well as information sources used, experience constant revi- sion problems. Changes continue to occur at regular intervals; as a result, no book or manual is ever completely "up to date." However, little is lost or left out. Generally speaking, the principles of insurance remain fairly stable. We also find it nearly impossible to catch every statement that may seem ambiguous or awkward to the reader. The same may be said for punctuation and spelling. Our computers are in charge of spelling, but errors may still sneak through. Our punctuation people are dedicated to their craft, but with constant and numerous revisions, it is a difficult job. Perhaps it could be said that the authors and proofreaders, like the agents who read this, have not yet reached perfection. Author and educator, Robert Mehr, has said "criticism is the disapproval not of those having faults, but for having faults different from those of the critic." Thank you, United Insurance Educators, Inc.  Annuities - An Investment Tool Table of Contents Table of Contents Welcome Chapter 1: Introduction to the Annuity 1 Mortality tables 1 The insurer, contract owner 2 The annuitant, the beneficiary 3 Annuity Development 4 Reinsurance Network 4 Two-Tiered Annuities 5 How an Annuity Operates 6 Investment Options 6 Immediate Fixed Annuities 6 Immediate Variable Annuities 8 Deferred Annuities 9 Accumulation Annuities 10 Which annuity is best? 10 Chapter 2: Variations of the Annuity 12 Single-Pay Deferred Fixed Annuity 12 Accumulation Annuity 12 Straight-Life Annuity 12 Lifetime With Period Certain Annuity 12 Refund Annuity 12 Two-Tier Annuity 13 Joint-and-Survivor Annuities 13 Pre-Retirement Survivor Annuity 14 Wrap-Around Annuity 14 CD-like Annuity 14 Split Annuities 15 Reverse Annuity Mortgage (RAM) 16 Private Annuity 17 Equity Indexed Annuities (EIAs) 17 Qualified Annuities 19 Tax-sheltered Annuities (TSAs) 21 Accumulation & Payout Period 22 Assumed Interest Rate (AIR) 22 Maximum Exclusion Allowance (MEA) 23 Explicit & Implicit Fees 24 Non-Qualified Annuities 25 United Insurance Educators, Inc.  Annuities - An Investment Tool Table of Contents Chapter 3: Annuitization 26 Seven-Pay Life Insurance 27 Why would a policyholder want to annuitize? 29 Exclusion Ratio 30 Bailout Provision 31 Chapter 4: Rating Systems 32 Introduction to A.M. Best Rating System 32 A.M. Best's Company Rating System 33 Financial Strength Ratings (FSR) 35 Rating Modifiers 35 S&P Global (Formerly Standard & Poor's Corporation) Rating System 36 Moody's Rating System 37 Chart 38 Fitch Rating System 39 Fitch Rating Actions 40 International Long-Term IFS Rating Scale 42 National Long-Term IFS Rating Scale 44 International Short-Term IFS Scale 46 Weiss Research, Inc. Rating System 47 Additional Notations 48 State Ratings 48 Chapter 5: Advantages of the Annuity 50 Safety Record 50 FDIC, BIF 50 Pass-through Insurance 51 The Uniform Gifts to Minors Act 51 Reserve Requirements 52 Financial Clout 52 Rating Services 53 Performance 53 Professional Manager / Investment Team 54 Commission Charges 54 Withdrawal Options 55 Guaranteed Death Benefit 55 Avoidance of Probate 55 “Per stirpes” 56 Exempt from creditors 56 United Insurance Educators, Inc.  Annuities - An Investment Tool Table of Contents Chapter 6: Disadvantages of the Annuity 58 IRS Tax Penalty 58 Surrender Charges 59 Mortality & Expense Fees 59 Contract Maintenance Charge 60 Chapter 7: Annuities verses other Investments 61 Annuities verses the IRA 61 Why does the IRS use the MAGI as a basis instead of the AGI? 61 IRA Tax Rules 62 Annuities verses Mutual Funds 64 SEC 65 Chapter 8: Variable or Fixed Rate 67 Which is better, variable or fixed rate? 67 Fixed Rate 67 Variable Rate 69 Aggressive Growth 70 Growth Object 71 Growth and Income 71 International Stocks 72 Balanced or Total Return 73 Corporate Bonds 73 Government Bonds 74 High-Yield Bonds 74 Global and International Bonds 75 Sector or "Specialty" Portfolios 76 Besides calling the insurer for performance results, are there any other sources that a 76 person can go to? What is DCA? 77 Is DCA similar to SWP? 77 What is an allocation portfolio in a variable annuity? 77 Chapter 9: Annuity Producer Ethics 79 Defining Ethics 80 Greek Word ethos 81 Moral Excellence 81 Virtues 81 EXAMPLE #1 82 EXAMPLE #2 83 EXAMPLE #3 84 EXAMPLE #4 86 United Insurance Educators, Inc.  Annuities - An Investment Tool Table of Contents EXAMPLE #5 86 Why Be Ethical? 87 Public Interest 87 Psychological Egoism 89 Egoists & Egotism 89 Is it possible to teach ethical behavior to others? 90 What is the scope of Ethics? 90 What does it take to be a moral person? 92 EXAMPLE #1 95 EXAMPLE #2 95 EXAMPLE #3 96 EXAMPLE #4 97 What are our responsibilities to other moral persons? 98 Ethics in Action 99 Objectivist Ethics 99 What does ethics in action mean? 100 Human Nature 101 Example 101 Example 102 Example 104 Example 108 Can ethics and promotional campaigns be integrated? 109 Sympathy & Empathy 110 Example 111 Learning to be Ourselves 114 Due Diligence 115 What does the term actually mean? 115 Suitability Standards 119 Determining Suitability 119 Sales Practices 121 Product Replacement 121 Deceptive Sales Practices 121 Full Disclosure 121 Product Knowledge 122 Identifying Suitability Issues 122 It is Not a Liquidity Issue but Rather a Suitability Issue 124 Churning 124 Twisting 125 United Insurance Educators, Inc. (253) 846-1155 United Insurance Educators, Inc.  Annuities - An Investment Tool Chapter 1 - Introduction Introduction to the Annuity Before an insurance producer can sell these products, a basic understanding must be had. There are so many products on the market today for policy owners to invest in that we must know what the best products are so we can pass this on to our clients. What is an Annuity? An annuity is an investment that is made through an insurance company. Annuities do not have anything to do with life insurance or any other type of insurance coverage, even though they are offered by the insurance companies. Annuities are sold (marketed) by a variety of means, from an insurance producer to a bank to a brokerage firm. An annuity contract could be defined as a life insurance policy without the mortality charges because there is no "net amount at risk." Life insurance companies rate prospective policyholders with what is called mortality tables. These are a base for calculating cost per thousand dollars of a life insurance policy. Each year people grow older, so the chances of dying become larger. The first table used by insurance com- panies was the American Experience Table. It was based on statistics gathered between 1843 and 1858. During that time, out of 1000 men age 35, statistically 8.95 died during that year. The second table the insurance companies utilized was the Commissioners' 1941 Standard Ordinary Table based on death statistics between 1930 and 1940. During this period of time the death rate for men at age 35 was 4.59 per thousand. In 1966, the insurance companies were required to use the Commissioners' 1958 Standard Ordinary Table based on death statistics between 1950 and 1954. Obviously, this would be an outdated table, however, in 2001 the Commissioners Standard Ordinary (2001 CSO) Mortality Table was the legally required table for calculating life insurance company reserves and nonforfeitures values as of Jan. 1, 2009. When a Table is required, it means life insurance companies must look at their policyholders' ages and then calculate how much money they must hold in reserves to pay future policy benefits using the mortality rates of the required table. Some Tables have been released and not been required. These required tables would also mean that it is used as the basis for determining guaranteed cash values and other nonforfeiture benefits. These cash values and other nonforfeiture benefits are the amounts that are available to a policy holders if they surrender the life insurance contracts. In 2015 the National Association of Insurance Commissioners (NAIC) adopted the 2017 Commissioners Standard Ordinary Table (2017 CSO). When the NAIC adopted the 2017 Commissioners Standard Ordinary Table, they allowed a three year phase-in period. This means that insurance companies could continue to use the 2001 Commissioners Standard Ordinary Table or implement the 2017 Commissioners Standard Ordinary Table, but once the three-year phase-in period was over, life insurance companies are required to use only the 2017 United Insurance Educators, Inc. Page 1  Annuities - An Investment Tool Chapter 1 - Introduction Commissioners Standard Ordinary Table for new business purposes. Every year, Americans tend to live longer because of many reasons, one of them being the advance of medical technology. Choosing an insurance company that uses the most current mortality tables, when others are available to use, will ensure that your clients are receiving the cheapest premium rates. Insurance companies are not required to go back to old policyholders when new mortality tables come which would reduce their premiums. They will continue year after year to charge at the old mortality table. An annuity is allowed to grow within a contract without current taxation. It includes the charges for expenses. Life insurance, the investment aspect, is also allowed to do this. The major differ- ence between the two is the mortality charges. There are three different types of annuities. They are: 1. Immediate annuities, either variable or fixed rate 2. Deferred annuities, either variable or fixed rate 3. Accumulation annuities, which is a deferred type and can be either variable or fixed With the fixed annuity there is a set rate of return. The variable annuity lets the investor choose from a series of portfolios that can be aggressive or conservative. Thus, the rate of return can fluctuate. The insurance company gives the policyholder certain assurances when they invest in the annuity. The four parties to an annuity contract are: the insurer, the contract owner, the annuitant and the beneficiary. There are always four parties, although one person may fulfill more than one role. The insurer: No matter who sold the annuity, the contract agreement is always between the policyholder and the insurance company. The insurance company is the insurer. The annuity contract contains assurances and the terms of agreement. It also stipulates what can and cannot be done. These would include additional investing, withdrawals, cancellations, penalties, and of course, the guarantees. An insurance producer will need to understand each annuity contract sold by the different insurance companies. Products differ and the need to understand those differences are important for the insurance producer as well as the policyholder. The contract owner: The policy owner is the contract owner. It is their money; they decide among the different options offered. An insurance producer needs to be aware of the options offered so as to give a well-rounded view of what is available. The policyholder has the right and the ability to add more money (if this is allowed by the insurer or the annuity contract selected), terminate the annuity, withdraw a portion or all the money and to change beneficiaries or the an- nuitant. The changing of beneficiaries and/or annuitants requires an approval from the insurer along with the required papers to be filled out. The contract owner can be an individual, a couple, a trust or a corporation. The one requirement is that the owner must be an adult. A minor can be named as long as there is a guardian or custodian listed. The contract owner (policyholder) United Insurance Educators, Inc. Page 2  Annuities - An Investment Tool Chapter 1 - Introduction controls the investment. They can decide to gift or will a partial amount of the entire sum to anyone or any entity at any time. The annuitant: The person named by the contract owner as the annuitant can be anyone cur- rently living and only one person can be named. It does have to be a person though, not a living trust, corporation or partnership. The annuitant is similar to the insured of a life insurance policy. If the annuitant is not also the policy owner, they have no say in the contract, cannot make with- drawals, change names or terminate the contract. The annuity will remain in force until the con- tract owner makes a change or the annuitant dies. Like an insurance policy, when you purchase it on someone else, which is the insured, the annuitant must also sign the annuity contract. Some annuity applications do not require the annuitant's signature. In selecting an annuitant, there is normally an age requirement imposed by the insurance com- pany. While most companies require the annuitant to be under the age of 75, that age does vary among companies. Most companies allow the contract owner to change the annuitant at any time with a stipulation that the new annuitant have been alive when the contract was first written. Changing the annuitant is not as easy as changing a beneficiary. The insurance company must approve of the change first. If the new annuitant is young, the change may be made quite easily. If the new annuitant is older, mortality risks come in to play and the change may not be as easy. In any case, a contract owner who wants to change annuitants must follow the procedures the insurance company indicates. The beneficiary: Simply stated, the beneficiary is waiting for the death of the annuitant. This is the only way the beneficiary can prosper. Like the annuitant, (if not also the policyholder) the beneficiary has no say or control in the management of the policy. Whereas the annuitant must be a person, not an organization; the beneficiaries can be trusts, corporations or partnerships as the beneficiaries, as well as friends, children, relatives or spouses. The annuity contract can name multiple beneficiaries. For instance, Alan, the annuity contract owner, could specify that his wife receives 50 percent of the proceeds. The Humane Society might receive 30 percent and the remaining 20 percent could go to a beloved cousin. One owner must be "primary" and the other "contingent" unless the insurer will permit co-own- ership. Many companies no longer permit co-ownerships as they used to. This is because of so many legal problems - especially in divorces. Companies do not want to get dragged into such things. The same is also true for annuitants. While it is still possible to find insurers that allow co-annuitants, most prefer a single annuitant due to legal problems. Most applications do not even show a line for co-annuitants, but insurers may still allow it if asked to do so. The annuity contract can have two contract owners, such as a husband and wife. Then the annu- itant can be either the husband or wife or both. This would protect the couple's assets in case one of them died. This is one area where total understanding of how the annuity works is crucial. If any other beneficiary was listed, for instance, a child or charity, the surviving spouse would not receive the money. The contract owners need to have this well thought out so the annuity will meet the goals intended. Beneficiary designations may be set up with a primary beneficiary (the spouse) and a contingent beneficiary - the children. United Insurance Educators, Inc. Page 3  Annuities - An Investment Tool Chapter 1 - Introduction A single person can thus hold multiple titles. Alan could name himself as the annuitant and beneficiary as well as being the contract owner. If Alan elected to name himself as the contract owner and the annuitant, and then a loved one or entity as the beneficiary, he would still have complete control of the annuity. Upon Alan's death, the proceeds would pass on to the intended beneficiaries or heirs. Alan would also retain the capability of changing the beneficiaries if he elected to. It must be noted that while Alan would have the right to name himself as the annuitant and the beneficiary, it would not make sense to do so in any way. One of the advantages of the annuity is avoiding probate. Naming himself as the annuitant and the beneficiary would nullify this advantage by reverting the money to the estate which would pass through probate and all the expenses incurred or go to a contingent beneficiary. Annuity Development: The word annuity comes from the Latin word annua, which means “year” and in its simplest form means "a payment of money yearly." The insurance industry designed them to do just that. The annuity is simply a periodic fixed payment for life or for a specified period of time, made to the individual by the insurance company. One of the most notable industries to go into the insur- ance world is the banks and savings and loan institutions. In the early 1920's, the United States government began using annuities to fund government re- tirement accounts, as did the labor unions. Due to the requirements the government mandated, the insurance industry came up with two safety features: 1. A guaranteed minimum interest rate built into the annuity contract. 2. The reinsurance network. Backed by the insurance companies' reserves, a reserve system for annuities was first introduced during the 1920s. The legal reserve system required then and still requires now that insurance companies keep enough surplus cash on hand to cover all cash values and annuity values that may come due at any given time. It is these reserves that enable the minimum interest rate guarantees to exist. The reinsurance network was designed so that if there was a large run on the money in the insurance industry, no one company would be required to take the brunt of the loss. The insurance companies spread the risk out among all of the companies that are offering similar products. On October 19, 1987, the stock market crashed and since that day it has been known as "Black Monday." Annuities were primarily unaffected by this event. When the Great Depression hit the country in the 1920's, over 9,000 banks failed. Stocks and bonds were not worth anything. The exception to the utter economic disaster the country experienced was insurance companies. They had enough cash on hand to pay their policyholders. This was required by the government as already mentioned. The companies continued to pay their guaranteed minimum interest rates that had been established years earlier. After the depression hit, new laws were passed by congress United Insurance Educators, Inc. Page 4  Annuities - An Investment Tool Chapter 1 - Introduction requiring many of the other financial industries to provide some of the same safety features on their products that insurance companies were already required to have. Variable annuities were first introduced in the US in the early 1950s. One of the best known variable annuities is the College Retirement and Equities Fund (CREF). At the end of 1991 it was estimated that over $200 billion was invested in variable annuities and there were well over eight billion contract owners. From 1973 to 1978 the most popular annuity products carried a permanent seven percent surren- der charge. The only way to avoid this charge was to annuitize. Then, as time went on, a few companies began to offer bailout options and limited surrender penalties. Bailouts allowed the client to withdraw their money without penalty charges if the interest rate on their annuity fell below the initial rate. Once this bailout option hit the market, a new generation of products devel- oped. In the 1980s The New York Stock Exchange member firms began aggressively marketing bailout annuities. As interest rates hit all-time highs, insurance companies quickly had to become superb asset managers rather than just good risk managers. The early 1980s saw the introduction of indices and two-tiered annuities. The index rate an- nuity is a fixed annuity whose renewal rate fluctuates during the surrender charge period based upon some independent market indicators. It might be Treasury Bills or any variety of bond indi- ces. This type of indexing is designed to protect the consumer in a low interest rate environment. These products do not tend to have bailout options since they are designed to accurately reflect the changing financial climate. Two-tiered annuities were designed to reward the policyholder who decides not to surrender their annuity by offering a higher first tier interest rate. If the policyholder surrendered or trans- ferred to another carrier, a lower interest rate was retroactively applied; this was the second tier. The two-tier has a second and permanent surrender charge in the form of the lower interest rate. The annuity may have a substantial charge for withdrawals; a charge that may never disappear. This may make it look as if the company is paying competitive rates, but if the policyholder elects to withdraw, they may be credited with an extremely low interest rate. The interest rate is only realized if annuitization is utilized through the initial insurer. This, then, locks the policyholder into the same company for life. When a person is comparing two-tier rates with other annuities and/or companies one should keep in mind these limitations between contracts. Two companies that suffered setbacks that we can learn from are Baldwin United and Charter Oil. Baldwin United experienced a setback in the 1980s when interest rates fueled uncontrolled growth. This resulted in significant setbacks in the insurance industry. Baldwin United's internal investments and questionable accounting procedures eventually resulted in their block of annuity business being sold to Metropolitan Life. Charter Oil suffered from the 1981-1982 over supply of oil and gas that crippled the entire industry. This resulted in Charter Oil selling their annuity block to Metropolitan Life also. United Insurance Educators, Inc. Page 5  Annuities - An Investment Tool Chapter 1 - Introduction One very important point to make note of: in both cases, the contract owners did not lose any of their investment. Policyholders continued to earn tax-deferred interest in the seven to eight percent range. Not all industries can say the same thing. The two problem companies previously mentioned and the passage of TEFRA (The Tax Equity and Fiscal Responsibility Act of 1982), caused annuity sales to drop. During this time, new annuity products emerged. Surrender periods reduced, bailout provisions improved and a move towards multiple year guarantees developed. Many of these new annuities were designed to compete with Certificates of Deposit (CDs). How an Annuity Operates Once an individual decides to invest in an annuity, the insurance producer gives the person an application. The application asks for basic information such as name, address, social security number, etc. The social security number is, of course, asked for income tax purposes if a distribu- tion is ever made. The application also asks for information on the chosen annuitant. The birth date of the annuitant is a requirement so that the insurer can see that they are within the age limi- tations. The application also covers investment options, the type of money (whether it is a roll- over from another source, a retirement plan or a regular investment) and the signature of the con- tract owner and the annuitant. After all the information is completed and signed, the insurance producer submits the application to the insurance company with funds accompanying it. A contract will be sent or delivered to the policyholder. The annuity contract will include a cover sheet that summarizes parts of the application and will point out what type of return or what type of investment portfolio has been chosen. As already discussed, the contract owner has the power to add money, change beneficiaries and/or annuitants, make withdrawals or cancel the entire con- tract. Investment Options As stated in the introduction there are two basic types of annuities (immediate and deferred which includes the accumulation annuity) and options within those types. Within these, there are the options of either a variable or fixed period/amount. We will first be discussing Immediate Annu- ities and the options within. Immediate Fixed Annuities: The immediate annuity is just as it sounds; checks are issued by the insurance company to the policyholder immediately upon investment. Immediate annuities are designed for people who rely on receiving a specific amount of money. One of the first decisions to be made once the policy- holder has chosen the annuity as an investment option is to choose whether it is to be fixed or variable. The second decision involves how long of a payout period the policyholder wants. The periodic check issued under the fixed annuity to the annuitant will be a fixed amount for the United Insurance Educators, Inc. Page 6  Annuities - An Investment Tool Chapter 1 - Introduction duration of the payout period. The duration of the payout period may be determined by stipulating to the insurance company the period of time during which the policyholder wishes to receive the checks. The period of time, which is chosen by the policyholder, could be, for example, five, ten or 20 years. This depends upon the amount of money invested, prevailing levels of interest rates and the period of time the policyholder selects. If Alan invested $80,000 and wanted $1,000 a month for five years, not adding in interest, Alan would be taking out a total of $60,000. Alan could not, of course, choose to take out $2,000 a month for five years. This is because the funds, the base invested amount, would not be there even if the interest rates were sky high. The insurance company will determine how many months they would be able to pay the amount requested by the policyholder in the time period also requested. Immediate annuity checks can be sent out monthly, quarterly or annually. The amount of each check will not fluctuate; the specific dollar amount of the check, of course, would depend upon the initial investment made. A chief consideration for the policyholder is the amount of return (%) being offered on the annuity. When considering which company to suggest to clients, an insurance producer should factor in how much money the company is offering to give the policyholders each month. Telling the policyholders of all the choices available will allow them to make the most informed choice. If Alan was told that an insurance company would give him $275 each month for five years with an initial $10,000 investment he would want to then shop around. Of course, an insurance producer would want to shop around for the policyholder so the commission may not be lost. One difference between companies is the rate of return that each company is willing to offer. However, the rate of return should never be the primary concern. Company stability is much more important. From the aspect of policyholder service, it pays to shop around before an insurance producer recommends certain companies. Both the insurance producer and the policyholder will want the best possible service. Companies are often very competitive even in the service area. A policyholder may be concerned that the money invested, and then paid out during the payout period, may run out before they die. It is possible to select payment for life, although they may be a lesser monthly dollar amount. This is called a Life Annuity payout option. It also may be referred to as a Straight Life Annuity. Under the Life Annuity payout option, the insurance company keeps all funds that remain when the annuitant dies. Nothing more would go to a bene- ficiary. The policyholder, the annuitant, would be taking the risk. All Life Annuities share a common characteristic: The insurer (the insurance company) is betting that one or both of the annuitants will die prematurely. The contract owner, investor, hopes to live for another 100 years. So the policyholder can either win by living longer, or lose by dying earlier than the company estimates. Of course, winning or losing doesn't count for much when you're pushing up daisies. For example, if Alan was to invest in a life annuity he would be betting that he would outlive the amount invested or at the least break even. If a few months down the road after the life annuity was taken out, Alan were to die, his beneficiaries would not see any of the money invested in the annuity. The insurance company would then take control of the money. If though, Alan lived 100 years after the annuity contract was taken out, he would come out on top. United Insurance Educators, Inc. Page 7  Annuities - An Investment Tool Chapter 1 - Introduction The alternative to this is the Refund Annuity. This may also be referred to as Lifetime with Period Certain Annuity. The policyholder can request that the insurance company make pay- ments for life, but to continue those payments for a stipulated period of time if the policyholder should die prematurely. The policyholder could, for example, insist the insurance company make payments for life with a minimum of at least ten, 15, or 20 years or until the beneficiaries receive back at least the entire invested amount that was originally put into the annuity contract. If Alan did not want to take a chance with his hard earned money, he may opt for a refund annuity. Alan could then stipulate that if he were to die prematurely, the balance of the annuity funds would continue to be paid to his beneficiaries. There is also the Joint-and-Survivor Annuities. With this type of annuity the insurance com- pany can guarantee payments for the lives of two people. These are used most frequently by married couples. As with Immediate Fixed Annuities, Joint-and-Survivor Annuities can also be issued with minimum guarantee periods or the refund-certain variety. Immediate Variable Annuities: Any policyholder depending on a fixed annuity income can expect to have an ever decreasing standard of living because the economy is always experiencing inflation. The variable annuity was designed to overcome the decrease in purchasing power of the fixed annuity. The basic idea behind the variable annuity is to invest the capital sum of the annuity into an investment portfolio of stocks and/or mutual funds and anticipating that inflation will cause the stocks to appreciate. That appreciation will provide increasing income to the annuitant. Though this sounds very good, annuitants have not found the variable annuities attractive as investments. The most obvious rea- son is that there is a measure of risk. A policyholder does not have a guarantee which way the stock market will go. There is no promise made that the annuity will increase in value as inflation increases. Another drawback of the variable annuity is that it does not satisfy the annuitants de- mand for a consistent monthly income that most people who annuitize (this will be discussed in chapter four) are wanting. Because of the risks involved, many are not willing to gamble their future standard of living. A variable rate option, whether it is an immediate or deferred annuity, does not guarantee any returns. The insurance company that the variable annuity is purchased from does not tell the pol- icyholder how to invest their money. The company does not share in the profits, nor does it share in the losses. The same thing is true if the policyholder was to buy a stock, bond or mutual fund. If the investment goes up 25 percent in one year, the policyholder receives the entire gain. On the other hand, if the investment goes down 25 percent, no one comes to the rescue. The investor may know the risks involved in a variable rate, and still want it for its flexibility. In the New Century Family Money Book by Jonathan D. Pond, he suggests that a policyholder "divide the deferred or immediate-pay annuity purchases between fixed and variable annuities. The net result will be the holding of balanced annuities." United Insurance Educators, Inc. Page 8  Annuities - An Investment Tool Chapter 1 - Introduction Lipper Analytical Service of Denver that monitors mutual fund and variable annuity performance, stated that a review of fixed income mutual funds and equity mutual funds show that they have under-performed when compared to similar group in variable annuities. Almost every major mu- tual fund complex is now in the variable annuity business. If Alan and Cathy opted for the immediate variable annuity because they wanted their income to keep up with inflation, they are betting that the invested capital will also grow so that their income will grow and keep up with inflation. This, again, is a gamble. There are no assurances that the stock market will keep up with inflation, nor do mutual funds give this sort of assurance. Deferred Annuities: A deferred annuity is normally used as a way to accumulate a retirement savings. A policyholder purchases it, and then watches their money grow. Only a few deferred annuities allow the policy- holder the option of taking a lump-sum when they retire rather than forcing them to annuitize. Even though a deferred annuity is essentially a tax deferred saving plan, it does not mean tax free. Eventually the policyholder will pay taxes on the money withdrawn for retirement. The policy- holder also receives no tax deduction on the amount of money that is initially invested to establish the annuity. An Individual Retirement Account (IRA) will let the policyholder deduct the con- tributions made to the account, although restrictions do apply. There are two types of deferred annuities: 1. Single-premium Annuities 2. Flexible-payment Annuities Simply speaking, the single premium annuity is purchased with one lump sum. The flexible payment annuity lets the policyholder purchase it with installments over a set period of years. If the policyholder chooses, they can receive the interest income from the annuity either through sporadic or scheduled withdrawals, if the deferred annuity plan will let them do so. Deferred annuities can be constructed so that the policyholder can request a portion of the income be given to them annually while the rest is reinvested, much like a Certificate of Deposit (CD). In most cases, though, the policyholder has the principal (the amount initially invested) and any earned interest reinvested automatically. The policyholder could, however, choose to terminate the investment or simply withdraw a por- tion of the principal. This is subject to applicable fees, if any apply. These would be stipulated in the contract. As with the immediate annuities, a deferred annuity has the option of choosing either a fixed or variable interest rate. Investors who purchase CDs do so because they want the interest income or because they plan on rolling over the CD into another CD or investment. The deferred annuities can be constructed to do the same things, accomplishing the same goals. The owner of the annuity can request that a certain amount be sent to them annually or reinvested so a larger amount of United Insurance Educators, Inc. Page 9  Annuities - An Investment Tool Chapter 1 - Introduction money is earning interest; a concept known as compound interest, which is interest earning in- terest. The deferred annuity can offer a great deal of flexibility. Besides automatically reinvesting, the contract owner has the ability to terminate the annuity or withdraw part of the principal, subject to possible costs. Deferred annuity contracts are not as efficient as single premium life insurance policies in accomplishing the transfer of wealth on to a beneficiary. The annuity contract, while deferring taxation on earnings within the contract until future use, never escapes that pent-up in- come tax liability. Accumulation Annuity The Accumulation Annuity is a type of annuity that is similar to the deferred annuity. Whereas the deferred annuity can either be started by putting one lump sum in or making payments to the annuity to build up the principal. The Accumulation Annuity is strictly offered so that one can make systematic payments to the annuity for a period of time. Then, at some later date, the poli- cyholder can annuitize (shift from accumulation to a monthly payout) when they are ready to retire. Which annuity is best? The type of annuity that is chosen by the policyholder should depend on the following four fac- tors: Time Horizon Other Owned Investments Goals & Objectives Risk Level Time Horizon is when the policyholder plans on using the investment proceeds. The longer the policyholder is willing to live with an investment, the more they should concentrate on equity building products. Though not an insurance product, it has been proven that stocks have outper- formed bonds in every decade. Other Investments should be considered when looking at annuity investing. If the policyholders have no other investments, a variable annuity may be too risky for them and their future income levels. On the other hand, they may feel they can invest well enough to better their income. One thing to keep in mind is that things can change in the marketplace -- suddenly. Diversification has always been a fundamental in successful investing. If the policyholders' investments are tied up in debt instruments, they should look at equity options within a variable annuity. Goal and Objectives would include how much the policyholder wants for retirement, sending a child or children through college or just to buy a house in a few years. Whatever the policyholder's goal may be, it is important to turn these into dollar objectives - something that can be attained. We can all dream, but once a goal is set, it may be easier for one to plan and meet that goal. Once United Insurance Educators, Inc. Page 10  Annuities - An Investment Tool Chapter 1 - Introduction this has been established, and the policyholder knows their existing holdings, then comes the steps of calculating how to attain that figure (goal). Risk Level is what the policyholders accept in certain investments. This level can go up or down depending on the investment chosen. A policyholder needs to be comfortable with the risk levels of the investments they choose. This means they need to be aware of them to begin with. United Insurance Educators, Inc. Page 11  Annuities - An Investment Tool Chapter 2 - Variations Variations of the Annuity The oldest type of annuity is the Single-Pay Deferred Fixed Annuity. The contract owner pays the insurance company the intended investment. Generally, the insurance companies require that it be no less than $5,000. The owner could add to the initial amount that was invested any time prior to annuitization. The insurance company guarantees that when the annuitant reaches an age of their choice, he or she will receive a fixed dollar amounts for as long as the person lives. The Accumulation Annuity is similar to the deferred annuity. Whereas the deferred annuity can either be started by putting one lump sum in or making payments to the annuity to build up the principal. The Accumulation Annuity is strictly funded by systematic payments to the annuity for a period of time. Then, at some later date, the policyholder can annuitize (shift from accumulation to a monthly payout) when they are ready to retire. We have already briefly gone over some variations of the annuity in the first chapter, but for a review let's recap what those were. A Life Annuity, also referred to as a Straight Life Annuity, is used when a policyholder wants to maintain a lifetime income. If, however, the annuitant dies prematurely, the insurance company retains all funds remaining. Lifetime with Period Certain Annuity or Life and Installments Certain Annuities is used for those who choose to receive income for life with a guaranteed payment period even if they die prematurely. A typical choice may be a "life or ten years certain." The key word here is certain. The "certain" period of time is usually either ten or twenty years, this can be any number of years depending on the annuity contract. This type of contract states that should the annuitant die prior to the stated "certain" time period, payments would then continue to the beneficiary until that specified number of years has been met. On the other hand, the annuitant may receive payments longer than the "certain" period stated, depending on how long their life extends. That is where the "life" part comes in. The Lifetime with Period Certain Annuity, also referred to as a Refund Annuity, can be used when the policyholder wants to avoid the risk of a Straight Life annuity. The policyholder can request that the insurance company make payments for life, but to continue those payments for a stipulated period of time, 10, 15, or 20 years, if the policyholder should die prematurely. The annuity could also be constructed to pay the beneficiaries until they receive back at least the entire invested amount that was originally put into the annuity contract. A Refund Annuity may pay out less in monthly installments than would a Straight Life Annuity. Even so, an individual may not want a Straight Life Annuity because the beneficiaries could lose the funds remaining if the policy owner died prematurely. An insurance producer may want to point out that annuities are not designed for beneficiaries. They may want to provide for their United Insurance Educators, Inc. Page 12  Annuities - An Investment Tool Chapter 2 - Variations dependents separately (through life insurance, for instance), and consider the Immediate Straight Life which gives them a larger monthly check. Two variants of the "period certain" options are: 1. Cash Refund Annuity 2. Installment Refund Annuity Both the Cash Refund and the Installment Refund Annuity options guarantee enough pay- ments to the policyholder or the beneficiary to match the full and original investment. The Cash Refund pays the beneficiary in a lump sum. The Installment Refund does exactly as the name implies, making installment payments. These contracts can reduce the size of the policyholder's monthly income. This is because the Cash Refund option means that any money left over in the annuity would go to the beneficiary if the annuitant dies prior to a complete liquidation. Two-tiered annuities allow the policyholder to be either rewarded or penalized depending on the avenue they select. They are rewarded if they stay with one company by receiving a higher interest rate. If the policyholder surrenders or transfers to another carrier, they are penalized with a lower interest rate that is retroactively applied. This is the second tier. The two-tier has a second and permanent surrender charge in the form of the lower interest rate. The annuity may have a substantial charge for withdrawals; a charge that may never disappear. It is important to under- stand that the insurer may seem to be paying competitive rates, but if the policyholder elects to withdraw, they may be credited with an extremely low interest rate. The first-tier interest rate is only realized if annuitization is utilized through the initial insurer. This, then, locks the policy- holder into the same company for life. Comparing two-tier rates with other annuity plans can be very misleading. Joint-and-Survivor Annuities allow the insurance company to guarantee payments for the lives of two people. These are used most frequently by married couples. As with Immediate Fixed Annuities, Joint-and-Survivor Annuities can also be issued with minimum guarantee periods or the refund-certain variety. The joint-and-survivor annuity provides payments to a surviving spouse. This may be a wiser choice for a married couple instead of something like the straight life annuity because a straight life annuity is setting aside less money to cover the spouse, though it is providing a higher monthly payment. It has been argued that the higher monthly payment the straight life annuity provides could go towards premium on a life insurance policy. The other side of the coin is that the couple could run out of money and let the life insurance policy lapse. The life insurance proceeds, once one of the spouses dies, would have to be managed effectively so that they would have enough to live on for the rest of their own life. If the surviving spouse is older and their health is failing when death occurs to the other, how would they manage the funds then? One important bit of advice for any insurance producer dealing with the retirement savings or life savings of a couple: Choose an A+ company (A.M. BEST rating. This will be discussed in chapter five along with other rating systems). It doesn't matter how good the annuity contract is if the company selected fails. Some professionals suggest using an insurance company that has been rated highly by two or three dif- ferent rating services. United Insurance Educators, Inc. Page 13  Annuities - An Investment Tool Chapter 2 - Variations The Retirement Equity Act of 1984 gives spouses of employees more protection. Under this bill, the normal way for a married person's pension to be paid out is through the use of a joint-and- survivor annuity. This means that the spouse will not be left without a pension income when the breadwinner dies. The employer's responsibility to pay benefits over a longer period of time means that the initial benefit checks will be smaller. The employer is not allowed, however, to reduce the joint-and-survivor annuity below 50 percent of the benefit for the worker's life alone. The normal provisions must also include a Preretirement Survivor Annuity. This is similar to the joint-and-survivor annuity in that the survivor is guaranteed the income of the pension even if the vested employee dies before retiring. Vesting is when an employee benefit plan participant has the rights of ownership to the employer contributions made on their behalf, plus earnings on those contributions. The Wrap-Around Annuity, also referred to as a Switch-Fund Annuity, is the joining of a life insurance company and a mutual fund organization which manages several mutual funds with different goals and different investment policies. The insurance company provides the annuity contract and the mutual fund company provides the investments. This type of annuity allows the policyholder the freedom to specify which of the mutual funds to invest in. In 1982, the IRS issued a tax restrictive ruling on Wrap-Around Annuities. The IRS may refer to the Wrap-Around Annuity as an "Investment Annuity." The Investment Annuity and the Wrap-Around Annuity are both terms for arrangements under which an insurance company agrees to provide an annuity funded by investment assets placed by or for the policyholder with a financial custodian with assets placed in a specifically identified investment (mutual fund). It is normally held in a segregated account of the insurer. The IRS has ruled that, under such arrangements, sufficient control over the investment assets is retained by the policyholder so that income on the assets prior to the annuity starting date is currently taxable to the policyholder rather than to the insurance company, with the exception of certain contracts grandfathered under Rev. Rule. 77-85 and Rev. Rule. 81-225, the underlying investments of the segregated asset accounts of variable contracts must meet diversification requirements set forth in the regulations. (IRS Sec. 817 {h}) CD-like Annuities are a hybrid of the Single Premium Deferred Annuities (SPDA). However, the CD-like Annuities give the policyholder the liquidity and rate of return most often seen with traditional Certificates of Deposit that are marketed by the banks. Unlike CDs, these annuities have all the advantages of the SPDAs which includes tax-deferred growth, guarantees of principal and the opportunity to convert the account value to a guaranteed income for life or specified period of time. Whereas SPDAs are designed to be used as tax-deferred investments for the long-term, CD-like Annuities are geared for the short term. They normally offer longer guaranteed interest periods as well. Some CD-like Annuities may allow additional deposits, depending on the con- tract, and allow partial penalty-free withdrawals from the account during a specified option period. The additional deposits and the withdrawal options are often referred to as "windows of oppor- tunity." The most common CD-like Annuities run for periods of either one, three or five years. The window of opportunity generally lasts for 30 days after each guaranteed interest period. United Insurance Educators, Inc. Page 14  Annuities - An Investment Tool Chapter 2 - Variations Certainly, the largest selling point of the CD-like Annuity is the tax-deferred growth with liquid- ity coming after a relatively short period of time. A definite advantage of the CD-like Annuity is the ability after the term of the annuity is up, to take the money out, principal and interest, without any insurance company penalty, cost or fee. The partial or complete withdrawal can be sent to the policyholder or to another insurer. If the policyholder uses a 1035 tax-free exchange, the policyholder will not incur any tax events. A 1035 Exchange enables a policyholder to move their money from one company to another without tax consequences. Not all investments allow this change from one investment to another without tax implications. Such a move is known as a 1035 Exchange by the IRS. It is known as a tax-free exchange since the policyholder does not pay any taxes. The policyholder would pay taxes only if they started to make partial withdrawals or completely withdrew their money. This transfer is tax free because the policyholder cannot touch the money being transferred. The money must go directly to the new company or annuity. The actual tax-free exchange is quite easy. Once the policyholder has chosen the new company or annuity, a new application is filled out along with a separate form identified as the 1035 ex- change request. The forms are sent along with the existing contract. The new insurance company will take care of the rest. If the policy owner cannot find the existing contract, another form can be filled out to turn in with the application. The policyholder can make the 1035 exchange at any time, although they would be subject to any penalties incurred by the current insurance company holding the contract. The penalties incurred depend on the specifics of the contract. Normally, though, if the policyholder has stayed with the current insurance company for a certain number of years, there will be no penalty. Penalty sched- ules can range from five to ten years, with some annuities having penalties that never leave. Though there may be penalties imposed by the insurance companies, they are not limited by the number of 1035 Exchanges per year. If the policyholder does not reinvest in an annuity and deposits it in some other type of invest- ment, the policyholder could then incur a tax event. They would be subject to a ten percent IRS penalty if the policyholder was not 59½ or disabled or dead. This potential of a ten percent penalty can be avoided under the provisions of the 1035 exchange. The policyholder is, of course, going to want the highest interest rate possible. They will stay with the same company if the new rates offered are still competitive with other companies. Split Annuities are contracts that are divided into two parts. One part is distributed while the other remains intact earning interest. While the annuity can have either a fixed or variable rate, the fixed rate can make the guarantee of complete restoration within a set period of time. A Split Annuity is for anyone who needs current income, needs a tax break, and wants the guarantee at the end of a specific period of time. The amount received each month will change with the secu- rities investments that the policyholder selected. It is possible to choose a fixed rate annuity if a person desires a specific amount payable. United Insurance Educators, Inc. Page 15  Annuities - An Investment Tool Chapter 2 - Variations The chief difference between a split annuity and an immediate annuity is that the split annuity is designed to restore principal. The immediate annuity only capitalizes on the short-term perfor- mance. Split annuities can be used as long-term investments, whereas immediate annuities vary from a few years to a lifetime. Split annuities can offer the policyholder guarantees in terms of performance that the immediate annuity cannot unless a fixed rate option is used. In choosing a variable or fixed rate, one should consider the market and the policy owner's goals. The variable rate cannot offer any guarantees like the fixed rate ones. However, the potential for return is greater on the variable rate options. As with all annuities, the distribution amount is flexible prior to annuitization. If the policyholder does not need as much income, the contract can be changed. The same is true if the policyholder decides they need more income. They would then be weighing down the split annuity more heavily for income as opposed to growth. Remember, the policyholders only become locked in for the portion they annuitize. Reverse Annuity Mortgages (RAM) is similar to the reverse mortgage. The difference is that with a Reverse Annuity Mortgage the policyholder is guaranteed a home and an income for life. Consequently, the income generated is almost always smaller than that from a reverse mortgage. Consider the Reverse Annuity Mortgage as an income supplement, not an income generator. A Reverse Annuity Mortgage works like this: The policyholder first takes out a mortgage. With the mortgage proceeds, they purchase an annuity from the insurance company of their choice. The insurance company would then subtract the interest due on the mortgage, send it to the lending institution and send the policyholders the net amount back. When the policy owner dies, the home is sold and the mortgage principal is repaid and any remaining proceeds go their estate. The amount of the annuity payments depends upon several things; including interest rates, the property value, the policyholder's age and marital status. Because the insurance company is taking on the mortality risks, they want to insure a profit for themselves. This means that the annuity payment is going to be smaller than a straight reverse mortgage payment over a fixed term. The tax requirements on a Reverse Annuity Mortgage can have a very negative impact. The guidelines for determining the amount of the monthly annuity that must be declared as taxable income is prescribed by the Internal Revenue Service (IRS). This means they are very compli- cated. While regular loan advances from a home equity line of credit are not taxable, the interest portion of the reverse mortgage annuity will be treated as taxable income. As interest accrues, it will essentially accumulate interest upon interest (compound interest). The loan could conceiva- bly outgrow the equity left in the home so it would be left with no assets in the property when death occurs. United Insurance Educators, Inc. Page 16  Annuities - An Investment Tool Chapter 2 - Variations A Private Annuity, also referred to as a Family Annuity, is another option for a couple inter- ested in the Reverse Annuity Mortgage options. The policyholder would sell their home to a pri- vate party, like their children, and in turn receive an annuity income for life. The policyholder would execute a separate agreement that would guarantee the policyholder a lifetime tenancy in their home. As with any annuity, one must consider the tax ramifications and the estate planning choices it offers. The Private Annuity removes the home, considered an asset, from their estate. Assuming the policy owners would spend the income from the annuity; the transfer would have the effect of lowering the total value of the estate. The IRS has published tables for valuing Private Annuities since there is certainly not the same assurance that the private annuities will be paid. A loss under a private annuity is disallowed for federal income tax purposes where the other party is spouse, brother, sister, ancestor or lineal de- scendant. Various fiduciary relationships between the parties also can result in automatic disal- lowance of any loss. The Private Annuity may be hard to get started since there can be multiple obstacles to overcome. The children may be reluctant to assume ownership, they may not be able to agree with their sib- lings, or they may simply not have the funds to do so. One of the biggest advantages may be that the home stays in the family. If a person transfers property to a private party in return for the promise of payment of a stipulated annual payment for life, the annuitant may be parting with property worth more than the value of the of the annuity. In that case, he or she has made a taxable gift. Equity Indexed Annuities Most equity-indexed annuities are declared rate fixed annuities, meaning the annuity’s rate of interest is re-set each anniversary date. For example, the first year might guarantee an interest rate of no less than 3 percent; the second year could adjust down or up, depending on current markets. Whatever subsequent years might be, the declared interest rate can never be a negative number. Like all annuities, as long as the investor holds the product to maturity, he or she will receive at least all they paid in; the investor will never lose principal, as can happen in stocks and mutual funds. For many investors, the absolute guarantee of principal is the major reason annuities are chosen for retirement investing. This might especially be true for those with past experience in the stock market. While annuity contracts are not all the same, generally EIAs do not have internal expenses, mean- ing there are no fees, or front-end or back-end loads that could retard the product’s performance. While we must always stress that contracts can and often do vary, most equity indexed annuities have clarity in that what is presented by the insurer is what is actually charged. This is different than variable annuities, mutual funds, and managed accounts that typically have various manage- ment fees and expenses. Typically, equity-indexed annuities are deferred annuity vehicles because they do not begin providing income for several years. An annuity that begins paying income within a year of contract United Insurance Educators, Inc. Page 17  Annuities - An Investment Tool Chapter 2 - Variations origin is considered an immediate annuity. The insurance companies need a period of time to earn a profit and the annuity needs a period of time to earn enough interest to adequately perform. The period of time during which the annuity is growing, earning interest, and perhaps receiving addi- tional deposits from the investor is called the accumulation phase. Once systematic payments begin (upon annuitization), the contract moves into the distribution phase. Equity-indexed annuities often allow free withdrawals during the accumulation phase without charging surrender penalties, but it is always necessary to read the contract for details. Depending on the contract, it may be possible to withdraw up to 10 or 15 percent of the account value during the accumulation phase. However, it is important that contract owners realize that any time funds are withdrawn there is less money in the account earning interest. Even so, this can help with occasional financial needs of the investor. If the investor is not yet age 59½ any withdrawals are probably subject to the 10 percent Internal Revenue Service early withdrawal penalty. Once the distribution phase begins, the annuity’s account value will be declining steadily, as monthly or quarterly payments are made. Investors typically take distribution payments monthly or quarterly, but many contracts allow semi-annual or even annual payments through the annuiti- zation process. What we have been discussing is true of all fixed rate annuities so why would an indexed annuity be better than any other fixed rate annuity? If the stock market crashed or simply underperformed the equity-indexed annuity, like other fixed rate annuities, would simply continue to operate as they always do, paying the pre-set rate of interest on the investment exactly as the contract prom- ises. However, with an indexed annuity, if the stock market is performing well, the fixed equity- indexed annuity will earn more than it otherwise would. All equity-indexed annuities track some specified stock market index; commonly it is Standard & Poor’s index of the stock values in 500 of the largest corporations known as the S&P 500. The S&P 500 is a registered trademark of McGraw-Hill & Company. Whatever index is used if it substantially increases during the term of the equity-indexed annuity, the annuity’s value will in- crease to the extent specified in the annuity contract. It would be unusual for the equity-indexed annuity to grow exactly as the index it is based upon grows. Most do not track the index exactly and there are various methods used to correlate gains. It should surprise no one that some contracts are more generous to the investor than others. It is important to realize that this added value should be considered a “bonus” since there is no loss if the markets perform poorly. No investor should buy with the expectation that there will always be bonus earnings either. Equity-indexed annuities are first and foremost a fixed annuity product, but there may be additional earnings if the markets are favorable. While it may not be so prevalent today, at least initially, equity-indexed annuities were constantly compared to variable annuities. They are not and never were variable annuities. Critics of equity- indexed annuities may still try to compare them and that does a disservice to the product. More importantly, it confuses investors. A variable annuity tracks the stock market directly so its values go up and down with the stock market. That is not the case with an equity-indexed annuity. Just like all fixed rate annuities they United Insurance Educators, Inc. Page 18  Annuities - An Investment Tool Chapter 2 - Variations perform based on the contract with a bonus earning if the index it is based upon performs favora- bly. Variable annuity values are determined by a separate account that holds various investments, often similar to mutual funds, for each contract owner. Many allow contract owners to choose their own funds but, in most cases, it is important that the portfolio be well managed for maximum performance. Variable annuities experience full stock market risk while equity-indexed annuities do not. This distinction should not be taken lightly since it is a tremendous difference in product types. Just as stock market managers are unable to provide long-term financial guarantees variable annuities cannot give long term performance guarantees either. Experienced money managers may be able to forecast but it is just that: a forecast – not a guarantee. Some variable annuities do guarantee the investor’s return of principal in the case of premature death or during a specified time following the contract’s issue date. A variable annuity has the potential of total loss; that is, the investor could lose the entire amount he or she invested if the market takes a dive and remains down. A fixed equity indexed annuity would not be affected by a market dive; the investor simply would not earn any “bonus” earnings. As long as the investor holds the annuity contract past the surrender period (maturity date) he or she would receive all principal sums and any guaranteed interest earnings. Another important difference between variable annuities and fixed equity-indexed annuities are the fees charged. While every contract can vary, typically variable annuities have several types of fees and expenses, many of which are tied to the buying and selling of stocks. Obviously, fees and expenses (often referred to in the contracts as management fees) will retard potential earnings. Equity-indexed annuities generally do not have internal fees and expenses beyond what is promi- nently stated in the contract. Any fees that do exist would be minimal, so the investor knows exactly what his or her contract earnings are. Qualified Annuities are purchased with funds generated from qualified retirement plans. Gen- erally, contributions made to qualified plans are not subject to current taxation. Simplified Em- ployee Pension plans (SEPs), tax-sheltered or tax deferred annuities (TSAs), 401(k) plans, profit- sharing plans, pension plans and IRAs that qualify for income tax deductions are some other ex- amples of qualified plans. These qualified plans are unique in that, in addition to enjoying the deferral on the earnings, they also let the employer or policyholders make capital investments into these plans without having to pay taxes in the investment year on the amount invested. Since the policyholder never paid taxes on the amount contributed to the plan, they did not establish a cost basis. In many circumstances, there is nothing to return to the policyholder from the tax deductible qualified plans that are not taxable. All payments from such contracts are subject to ordinary income tax at the time these funds are withdrawn, unless reinvested in a similar plan. These qualified plans are usually among the best investment opportunities available. If a policy- holder falls into a 30 percent marginal tax bracket and they qualify for one of the qualified plans, a $100 contribution would reduce their income taxes by $30. With the $30 reduction on the income tax, a $100 investment into the qualified plan means the policyholder actually only gave up $70 of spendable cash. Even so, the policyholder would still have a $100 net worth. This does not even count the actual investment return that the policyholder's $100 is earning inside the plan. The return also is sheltered from current taxation. Some employers may encourage policyholders to invest by offering to contribute a portion of their contribution. The percentage could be as high as United Insurance Educators, Inc. Page 19  Annuities - An Investment Tool Chapter 2 - Variations 50 percent or more. Therefore, a $100 investment could be increased by the employer with $50, the $30 income tax reduction and the net worth have now equaled $150 for a $70 total investment. The government has restrictions on using this money before age 59½. Even so, the policyholder still has the advantage of having a strong net worth which would allow them to pursue more op- portunities than would a weak net worth. For policyholders to retire without taking a cut in their standard of living, it should be strongly urged to take advantage of the employer's qualified retirement plans. Participation in the em- ployer-provided plan at the maximum level available is an ideal start on personal accumulation. Doing so allows the policyholder to invest with pretax dollars. A person would have to do three things to retire without taking a cut in their standard of living. They are: 1. Take advantage of Social Security, 2. Take advantage of the employer's qualified pension plan, and 3. Save 20% of their gross yearly income, each and every year. A unique feature of the qualified plans is that the policy owner is required to begin payouts (or required minimum distributions RMDs) from these plans, or the annuities that hold the cash in these qualified plans, in the year in which the policyholder reaches age 72 (73 if you reached age 72 after Dec. 31, 2022). Currently the IRS regulations require the policyholder to start making withdrawals from all the qualified plans at 73, though this does not change the basic strategy. (SECURE 2.0 also pushes the age at which RMDs must start to 75 starting in 2033). In order for the policyholder to comply, they must begin withdrawing funds. The policyholder does not have to annuitize the entire contract, only a percentage. The policyholder will want to contact a Certi- fied Public Accountant (CPA) to figure the amount that should be annuitized to meet the require- ments, while still leaving enough principal in the annuity to continue earning interest. In some cases, the percentage annuitized may be less than the interest earned which means the contract could continue to increase in size while meeting IRS requirements. It may work out even better for those who have qualified plans who choose to make withdrawals from the plans on a joint-and-survivor basis because the percentage table for this type of distribu- tion requires an even smaller amount to be distributed. Failure to make the required withdrawals will expose the policy- holders to substantial penalties from the IRS, so again, it must be stressed to check with a CPA or tax advisor so that enough money is taken out. If the policyholder waits until after January first of the following year in which they attained age 73 to take their distribution, they will increase their income tax liability if this put them into a higher tax bracket because they are taking two distributions that same year. This increase in tax liability can be avoided if the policyholder takes the distribution before December 31 of the year in which they attain the age of 73 (75 in 2033). Deferral to April 1 is available only in the year of distribution. All years after that will be required to have distributions made within the calendar year. The Rollover IRA is an option for the disposition of retirement plan funds. One of the main reasons is that puts the policyholder in control of the funds instead of the ex-employer. It avoids United Insurance Educators, Inc. Page 20  Annuities - An Investment Tool Chapter 2 - Variations current income taxation entirely and provides continuation of tax-deferred earnings. The funds the policyholder has accumulated over a lifetime are likely considered a core asset, which means they should be managed very carefully. A Tax-sheltered Annuity (TSA) is a retirement plan that members of nonprofit organizations, school personnel and hospital employees are eligible to participate in. As stated before, this is a qualified program that is authorized under Section 403(b) of the Internal Revenue Code (IRC). Tax-sheltered annuities can offer advantages not found in other types of annuities or retirement plans. The insurance company receives contributions directly from the employer. Tax-sheltered annu- ities are annuity contracts purchased from the insurer (insurance company). They can choose be- tween a fixed and variable account. Contracts can be issued on an individual or group basis, but only apply to the members. The participant's contributions can vary yearly. The contributions are spelled out in the salary reduction agreement and made from payroll deductions on a pretax basis. Despite the deductibility, social security taxes are still withheld on the employee salary reduction amounts. Tax-sheltered annuities are intended to be used as retirement plans. Under some circumstances, money can be withdrawn without penalty before retirement. Such distributions are allowed when: 1. financial hardship hits, 2. death occurs, 3. a disability happens, or 4. termination of employment. An individual contract means that each person that is participating in the retirement plan receives an actual contract. A group contract means that each person participating receives a certificate verifying participation and indicating that the contract is between the insurance company and the employer. A major difference between individual and group contracts is the flexibility. Individual contracts are portable. This means that if the person changes jobs, there are several options that can be exercised. All of the following options allow the account to continue to grow and compound tax deferred and, if the changes are made properly, no tax event will happen. The options are: 1. freezing the account 2. transferring part or all of the account into a program offered by the new employer (assum- ing the new employer has an existing tax-sheltered annuity program), or 3. placing part or all of the money in an Individual Retirement Account (IRA) Like the 1035 Exchange, movement from one TSA to another plan can avoid IRS penalties and taxes but it may not avoid withdrawal charges from the previous insurance company. Normally, United Insurance Educators, Inc. Page 21  Annuities - An Investment Tool Chapter 2 - Variations group contracts do include some type of transfer fee. Individual contracts can normally be moved from one employer to another without these charges. One of the major attractions to Tax-sheltered Annuities is their income tax implications: 1. contributions reduce the policyholder's taxable income 2. once invested, the money will grow and compound tax deferred and 3. when withdrawals are made, the policyholder may be in a lower tax bracket thereby mini- mizing the taxes incurred. The Accumulation Period is when the employer is putting money in the TSA for the employee (participant). These contributions are, again, made with pretax dollars on either a biweekly (every two weeks), semimonthly or monthly basis. Most common is the monthly basis. The insurance company then deposits most or all of the contribution into the participant's account. Transaction charges may occur when deposits are made on the participant's behalf. In addition to that charge, either a quarterly or annual maintenance fee may be deducted from the account's balance. Some insurance companies recover their expenses by charging a negligible amount during the accumu- lation period and a larger fee when money is withdrawn. The Payout Period occurs when funds begin to be distributed or "paid out" to the participant from the annuity contract; usually at retirement with several options available. The participant can take it all out as a lump sum, make a partial withdrawal, roll over the account into an IRA or a different TSA, or annuitize the contract and start receiving a series of payments monthly, quarterly or an- nually. If the participant chooses to annuitize, the payments will depend on the rate offered by the insur- ance company, the annuity option selected, and the amount being annuitized. Annuity rates are stated as the amount of monthly income that will be paid by the insurance company for each $1,000 accumulated. Some insurance companies allow the contract owner, the participant, to select either a fixed or variable account during the payout period, regardless of the type of contract used during the accumulation period. If the variable account is chosen during annuitization, no guarantees can be made regarding the monthly payment. If the portfolio does well, the monthly benefits will increase and if the portfolio fares poorly, this will be reflected in a decrease of the monthly benefits received. When the insurance company determines the monthly benefit for the contract owner, it must select an assumed interest rate (AIR) of return. The two most common methods used to determine the current interest rate to be credited to the participants; account is the portfolio average and the banding method. The portfolio average method reflects the insurer's earnings on its entire portfolio during the given year. All policy owners are credited with a single composite rate. The banding method uses a year-by-year means of crediting accounts. Employee contributions are banded together for that particular year. Each account is then credited with the yield the account earns. The banding method is an advantageous one to the investor if interest rates are rising. In a declining interest rate environment, the portfolio method is better. United Insurance Educators, Inc. Page 22  Annuities - An Investment Tool Chapter 2 - Variations As discussed earlier, an employee could also choose a two-tiered method of crediting interest, but remember, this could be misleading. The first tier has the higher interest rate and the second tier has the lower interest rate. The lower interest rate is credited to the account if the participant takes a partial or total liquidation. This allows the insurance company to seem as if they are paying a competitive rate, although the first tier's rate is only realized if annuitization through the initial insurance company is utilized. This locks the investor into one company for life if they want to have the higher interest rates applied to the annuity contract. The two-tier approach discourages 1035 exchanges because the second tier's interest rates would be applied to the annuity, which can be substantially lower. The two-tiered approach could be considered unfair and has been outlawed in some states. Several companies no longer use a calendar year in evaluating the rate of interest to be credited to annuity accounts. These companies use quarterly, monthly or even a daily method. This may allow the insurance company to be more competitive and move more quickly to alter the credited rate if it is too high in relation to the actual yield on the company's portfolio. A small number of insurance companies have adopted a provision called market value adjustment. This provision adjusts the accumulated fund balance, not the yield, upward or downward. The adjustment is in the opposite direction of the rise or fall of interest rates. If the current rate is higher for new contributions than other monies, the value of the investor's account will decrease. On the other hand, a decrease occurs in the current rate, this results in an increase in fund value. With this option, accumulated amounts can constantly change in value, even though it is invested in a fixed rate portfolio. The majority of tax-sheltered annuity contributions are made by the employee, which is outlined in the salary reduction agreement. Contribution parameters are set by the insurance company. Total annual contributions cannot exceed IRS limitations. The amount by which the employee's paycheck is reduced may be an exact dollar amount or a percentage of pay. The investments are generally sent to the annuity biweekly, semimonthly or monthly. However, there is another way to make contributions. An employee can transfer funds from one insurance company to another or from one subaccount to another portfolio offered by the same insurance company. Transfers may be made for the following reasons:  dissatisfaction with the current portfolio,  changing employers,  a change in the employee's ability to take a risk,  a change in the investor's retirement date, or  new employment with someone who does not offer TSAs. Guidelines are provided in IRS Publication 571 by which an individual participant calculates their maximum exclusion allowance (MEA). If the contributions exceeds 20 percent or exceeds $9,500, an audit could occur. When retirement is chosen, there are several options that can be exercised with a TSA: United Insurance Educators, Inc. Page 23  Annuities - An Investment Tool Chapter 2 - Variations  leave the money where it is and let it continue to grow,  withdraw the money all or in part,  take out the account balance in a series of payments over a period of years,  select a fixed rate or variable contract and annuitize,  transfer the balance to another insurance company, or  move the account to an IRA Rollover that is invested in another annuity or mutual fund family. A creative retirement approach would be to use an assumed interest rate (AIR); this is only found in variable annuities. All variable accounts require an AIR as the basis for initial and subsequent payments. Any variable annuity allows the participant to select their own AIR in calculating the initial payment level. The higher the AIR used, the higher the initial checks will be. Some insurance companies will allow loans from a TSA. Some, however, may not since the IRS has restrictions on the amounts and the period of any loan. A consumer interested in doing this will want to talk with a tax expert. Every TSA has expenses. There are two basic approaches used by insurance companies in ob- taining fees, though some are more identifiable than others. There are Explicit and Implicit fees. Explicit charges are clearly indicated. They may be applied regularly throughout the year, such as when the account is valued, when a contribution is received, a loan is made or a withdrawal occurs. Implicit charges are made indirectly and can often be much higher than the explicit charges. An implicit charge might be the difference between the returns the insurance company actually earns versus the amount credited to the account. Another hidden cost may take place if the contract is annuitized. The cost will include a profit margin and expense charges. Profit margins are the spread between what is actually received and what the account actually earns. It is not unusual for a participant to ignore or underestimate the number and magnitude of implicit charges. Insurance companies have the right to alter or amend tax-sheltered annuity contracts. This is a privilege that is usually quite broad. These alterations can affect the amount of any charges made. Interest credited to the account in the future, annuity rates per $1,000 annuitized and other provi- sions described in the contract. For the most part, though, only group contracts can be altered without permission. Individual TSAs can be changed only with the permission of the investor. The only difference between TSAs and other types of annuities is that TSAs are funded with pretax dollars. Other annuities, which are non-qualified, are funded with after tax dollars. A person can have both a TSA and a regular, non-qualified annuity. It may be more advantageous, though, to contribute to the TSA. By doing this the expenses and fees are kept to a minimum. The returns of a TSA are different from other annuities because TSA's are group contracts. They have different expenses and rates of return calculations. United Insurance Educators, Inc. Page 24  Annuities - An Investment Tool Chapter 2 - Variations Non-Qualified Annuities are contracts that the policyholder purchases with the after-tax income or capital. The investment in these contracts constitutes the cost basis. A non-qualified annuity can be any annuity. Non-qualified just means that it is not pension related, and the income paid towards the non-qualified annuity is not deducted off one's yearly income. Interest earnings that have been entirely withdrawn and taxed as ordinary income at the time of withdrawal, the remaining funds (the cost basis) will not be re-taxed at the time when they are withdrawn. The exception to this rule is pre-August 14, 1982 annuity contracts that are taxed in just the opposite way. The basic objective with the non-qualified annuities is to continue deferral of annuitization as long as possible to maintain flexibility and to continue to compound the earnings (interest) within the contract without current taxation. United Insurance Educators, Inc. Page 25  Annuities - An Investment Tool Chapter 3 - Annuitization Annuitization In this chapter we are going to be discussing annuitization options, when a policyholder should annuitize, bailout clauses and the exclusion ratio. Annuitizing may be simply defined as "contracting for a series of payments from an annuity." It provides an even distribution of both principal and interest over a period of time. Annuitization only subjects a portion of the amount withdrawn for that year for taxation. There are three risks involved: 1. That the annuitan