Annuities Chapter 6 PDF
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This document discusses annuities, explaining the roles of different parties involved like the owner, annuitant, and beneficiary. It differentiates between immediate and deferred annuities, highlighting the importance of consumer protection and suitability information in choosing an appropriate annuity product.
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Powered by ExamFX - Online Training & Assessment Annuities This chapter includes a discussion about annuities. It is important for you to understand what annuities are and how they differ from life insurance. By the end of this chapter, you...
Powered by ExamFX - Online Training & Assessment Annuities This chapter includes a discussion about annuities. It is important for you to understand what annuities are and how they differ from life insurance. By the end of this chapter, you will be able to describe the different roles of the owner, annuitant, and beneficiary, discuss different classification of annuities such as immediate vs. deferred and fixed vs. variable, and identify proper uses of different types of annuities. TERMS TO KNOW D e fe r re d — withheld or postponed until a specified time or event in the future I R S — Internal Revenue Service: a U.S. Government agency responsible for collecting of taxes, and enforcement of the Internal Revenue Code L i fe c o n t i n ge n c y — dependent upon whether or not the insured is alive L i q u i d a t i o n of a n e s t a te — converting a person's net worth into a cash flow N a t u r a l p e r s o n — a human being Q u a l i fie d p l a n — a retirement plan that meets the IRS guidelines for receiving favorable tax treatment S u i t a b i l i t y — a requirement to determine if an insurance product or an investment is appropriate for a particular customer A. Annuity Principles And Concepts An annuity is a contract that provides income for a specified period of years, or for life. An annuity protects a person against outliving his or her money. Annuities are not life insurance, but rather a vehicle for the accumulation of money and the liquidation of an estateestate. Annuities are marketed by life insurance companies. Licensed life insurance agents are authorized to sell some types of annuities. Annuities do not pay a face amount upon the death of the annuitant. In fact, they do just the opposite. In most cases, the payments stop upon the death of the annuitant. Annuities use mortality tables, but these tables reflect a longer life expectancy than the mortality tables used for life insurance. Mortality tables indicate the number of individuals within a specified group (e.g. males, females, smokers, nonsmokers) starting at a certain age, who are expected to be alive at a succeeding age. 1. Parties to an Annuity Owner – The purchaser of the annuity contract, but not necessarily the one who receives the benefits. The owner of the annuity has all of the rights, such as naming the beneficiary and surrendering the annuity. The owner of an annuity may be a corporation, trust, or other legal entity. Annuitant – The person who receives benefits or payments from the annuity, whose life expectancy is taken into consideration, and for whom the annuity is written. The annuitant and the contract owner do not need to be the same person, but most often are. A corporation, trust or other legal entity may own an annuity, but the annuitant must be a natural person person. Know This! Because annuities are based on the life expectancy of an annuitant, the annuitant must be a natural person, regardless of who owns the policy. Beneficiary – The person who receives annuity assets (either the amount paid into the annuity or the cash value, whichever is greater) if the annuitant dies during the accumulation period, or to whom the balance of annuity benefits is paid out. 2. Accumulation Period vs. Annuity Period The accumulation period period, also known as the pay-in period period, is the period of time over which the owner makes payments (premiums) into an annuity. Furthermore, it is the period of time during which the payments earn interest on a tax-deferred basis. The annuity period period, also known as the annuitization period period, liquidation period period, or pay-out period, is the time during which the sum that has been accumulated during the accumulation period is converted into a stream of income payments to the annuitant. The annuity period may last for the lifetime of the annuitant or for a specified period, which could be longer or shorter. The annuitization date is the time when the annuity benefit payouts begin (trigger for benefits). Know This! During the accumulation period, funds are paid INTO the annuity. During the annuity period, funds are paid OUT to the annuitant. 3. Insurance Aspects of Annuities Annuities are not life insurance; they do not pay a face amount upon the death of the annuitant. In fact, they are just the opposite. In most cases, the payment phase stops upon the death of the annuitant. Annuities do use a mortality table, but this table reflects a longer life expectancy than the table used in life insurance. A deferred annuity does grow tax-deferred. 4. Consumer Protection It is a producer's responsibility to evaluate the consumer's suitability information, which includes the following: Age; Income; Financial situation and financial experience; Needs and objectives; Intended use of annuity; Risk tolerance; and Tax status. B. Immediate Vs. Deferred Annuities 1. Single Premium Immediate Annuities (SPIAs) A Single Premium Immediate Annuity is one that is purchased with a single, lump sum payment and provides income payments that start within 1 year from the date of purchase. Typically, an immediate annuity will make the first payment as early as 1 month from the purchase date. The annuity income amount is based upon the following: The amount of premium paid or cash value accumulated; The frequency of the payment; The interest rate; and The annuitant's age and gender. An annuitant whose life expectancy is longer will have smaller income installments. For example, all other factors being equal, a 65-year-old male will have higher annuity income payments than a 45-year-old male, or than a 65- year-old female. 2. Deferred Annuities A deferred annuity is an annuity that either is purchased with a single lump sum (single premium-deferred annuities) or is purchased through periodic payments (flexible premium-deferred annuities). Deferred annuities are unique in that they grow tax deferred. Under a deferred annuity, the income payments begin sometime after one year from the date of purchase (10 years, 20 years, at age 65, etc.). Deferred annuities are often used to accumulate funds for retirement. In a deferred annuity the owner will receive the current interest rate or the guaranteed interest raterate, whichever is higher. If a deferred annuity is surrendered prior to age 59½, income tax must be paid on the gain, and a 10% penalty will be imposed on the taxable portion. Premium Payment Options Single Premium Deferred Annuities (SPDAs) In a Single Premium Deferred Annuity (SPDA), the annuity is purchased with a single payment, but the benefit is not paid until after one year or more has elapsed. Flexible Premium Deferred Annuities (FPDAs) In a Flexible Premium Deferred Annuity (FPDA), the annuity is purchased with multiple payments that can vary from year to year (e.g. a portion of each paycheck), and the benefit payments begin sometime after one year from the date of purchase (e.g. payouts start at age 65). Nonforfeiture The nonforfeiture law stipulates that a deferred annuity must have a guaranteed surrender value that is available if the owner decides to surrender the annuity prior to annuitization (e.g. 100% of the premium paid, less any prior withdrawals and related surrender charges). However, a 10% penalty will be applied for early withdrawals (prior to age 59 ½). Surrender Charges The purpose of the surrender charge is to help compensate the company for loss of the investment value due to an early surrender of a deferred annuity. A surrender charge is levied against the cash value, and is generally a percentage that reduces over time. A common surrender charge might be 7% the first year, 6% the second year, and 5%, 4%, 3%, 2%, 1%, and 0% respectively thereafter. Therefore, if the annuity is surrendered in the 8th year or after there would be no further surrender charge. At surrender, the owner gets the premium, plus interest (the value of the annuity), minus the surrender charge. Example: Assume that the annuity owner paid $700 in premium, which accumulated a total of $35 of interest, and a surrender charge is $70. If the annuity is surrendered prematurely, what will the annuity value be at surrender? The answer is $665. ($700 Premium + $35 Interest) - $70 Surrender Charge = $665 Value of the Annuity Waiver Annuity contracts provide for a waiver of surrender charges if the annuitant is confined to a Long-term Care facility for at least 30 days. Bail-Out Provision A bail-out provision is found in some annuity contracts. It allows the contract holder, in the event that interest rates drop a specified amount within a specified time frame, to surrender the contract without charge. Death Benefits If an annuitant dies during the accumulation period, the insurer is obligated to return to the beneficiary either the cash value or the total premiums paid paid, whichever is greater. If a beneficiary is not named, the death benefit will be paid to the annuitant's estate. C. Annuity Products - Investment Options Annuities may be classified as fixed or variable based on how the premium payments are invested. 1. Fixed Annuities A fixed annuity provides the following features: Guaranteed minimum rate of interest to be credited to the purchase payment(s); Income (annuity) payments that do not vary from one payment to the next; and The insurance company guarantees the specified dollar amount for each payment and the length of the period of payments as determined by the settlement option chosen by the annuitant. With fixed annuities, the annuitant knows the exact amount of each payment received from the annuity during the annuity period. This is called level benefit payment amount amount. A disadvantage to fixed annuities is that the purchasing power that they afford may be eroded over time due to inflation. General Account Assets Fixed annuity premiums are deposited into the life insurance company's general account. The general account is comprised mostly of conservative investments like bonds. These investments are secure enough to allow the insurance company to guarantee a specified rate of interest, as well as assure the future income payments that the annuity will provide. Know This! In fixed annuities, the premiums are deposited in the company’s general account. Interest Rate Guarantees (Minimum vs. Current) In fixed annuities, the insurer bears the investment risk risk. Future interest rates actually paid by an insurer are based upon the performance of the insurance company's general account. However, the rate may not drop below a policy's guaranteed minimum (typically 3%). Should interest rates drop below this guaranteed rate, the insurer is obligated to pay the guaranteed rate amount. During the accumulation phase, the insurer will invest the principal, or accumulation, and give the annuitant a guaranteed interest rate based on a minimum rate as specified in the annuity, or the current interest rate rate, whichever is higher. The minimum rate is the lowest rate that the principal can contractually earn. Level Benefit Payment Amount During the payout phase of a fixed annuity, the amount of benefit is also guaranteed. With the fixed payment in times of inflation, the benefit payment will have less purchasing power and in time of deflation the benefit payment will have more purchasing power. 2. Equity Indexed Annuities Indexed (or equity indexed) annuities are fixed annuities that invest on a relatively aggressive basis to aim for higher returns. Like a fixed annuity, the indexed annuity has a guaranteed minimum interest rate. The current interest rate that is actually credited is often tied to a familiar index like the Standard and Poor's 500. Generally, the insurance companies reserve the initial returns for themselves but pay the excess to the annuitant. For example, the company may keep the first 4% earned for itself, but any accumulation in excess of 4% is credited to the annuitant's account. So if the interest earned is 12%, the company keeps 4% and credits the client’s account with 8%. Equity indexed annuities are less risky than a variable annuity or mutual fund but are expected to earn a higher interest rate than a fixed annuity. 3. Variable Annuities A variable annuity serves as a hedge against inflation, and is variable from the standpoint that the annuitant may receive different rates of return on the funds that are paid into the annuity. Listed below are the 3 main characteristics of variable annuities: Underlying Investment: the payments that the annuitant makes into the variable annuity are invested in the insurer's separate account, not their general account. The separate account is not part of the insurance company's own investment portfolio, and is not subject to the restrictions that are applicable to the insurer's own general account. Interest Rate: issuing insurance company does not guarantee a minimum interest rate. License Requirements: a variable annuity is considered a security and is regulated by the Securities Exchange Commission (SEC) in addition to state insurance regulations. An agent selling variable annuities must hold a securities license in addition to a life insurance license. Agents or companies that sell variable annuities must also be properly registered with FINRA. Variable premiums purchase accumulation units in the fund, which is similar to buying shares in a Mutual Fund. Accumulation units represent ownership interest in the separate account. Upon annuitization, the accumulation units are converted to annuity units units. The income is then paid to the annuitant based on the value of the annuity units. The number of annuity units received remains level, but the unit values will fluctuate until actually paid out to the annuitant. FEATURES FEATURESFIXED FIXED ANNUITY ANNUITYVARIABLE VARIABLE ANNUITY Interest Rate RateGuaranteed by insurerNo guarantee Underlying Investment General account Separate account (safe, conservative)(equities, no guarantee) License Needed NeededLife insuranceLife insurance PLUS securities Expenses ExpensesGuaranteedGuaranteed Income Payment PaymentGuaranteedNo guarantee D. Annuity (Benefit) Payment Options 1. Life Contingency Options Pure Life vs. Life with Guaranteed Minimum The life annuity will pay a specific amount for the remainder of the annuitant’s life. With pure life life, also known as life-only or straight life life, this payment ceases at the annuitant's death (no matter how soon in the annuitization period that occurs). This option provides the highest monthly benefits for an individual annuitant. Under this option, while the annuity payments are guaranteed for the lifetime of the annuitant, there is no guarantee that all the proceeds will be fully paid out. Under the life with guaranteed minimum settlement option, if the annuitant dies before the principal amount has been paid out, the remainder of the principal amount will be refunded to the beneficiary. This option is also called refund life life. It guarantees that the entire principal amount will be paid out. Know This! Pure life annuity provides the highest monthly benefit, but there is no guarantee that the entire principal will be paid out. Life with Period Certain Life with period (term) certain is another life contingency payout option. Under this option, the annuity payments are guaranteed for the lifetime of the annuitant, and for a specified period of time for the beneficiary. For example, a life income with a 20-year period certain option would provide the annuitant with an income while he is living (for the entire life). If, however, the annuitant dies shortly after payments begin, the payments will be continued to a beneficiary for the remainder of the period (for a total of 20 years). Refund Life Annuities There are two types of refund life annuities: cash refund and installment refund. Installment Refund With the installment refund option, when the annuitant dies, the annuitant’s beneficiary will continue to receive guaranteed installments until the entire principal amount has been paid out. Cash Refund With the cash refund option in annuities, when the annuitant dies, the annuitant’s beneficiary receives a refund of the principal, or the original amount paid into the annuity minus benefit payments already made to the annuitant. This guarantees the return of the amount to purchase the annuity but it does not guarantee to pay any interest. The only difference between cash refund and installment refund is that cash refund is a lump-sum payment. Single Life vs. Multiple Life Single life annuities cover one life life, and annuity payments are made with reference to one life only. Contributions can be made with a single premium or on a periodic premium basis with subsequent values accumulating until the contract is annuitized. Multiple life annuities cover 2 or more liveslives. The most common multiple life annuities are joint life, and joint and survivor. Joint Life Joint life is a payout arrangement where two or more annuitants receive payments until the first death among the annuitants, and then payments stop. Joint and Survivor The joint and survivor arrangement is a modification of the life income option in that it guarantees an income for two recipients that neither can outlive. Although it is possible for the surviving recipient(s) to receive payments in the same amount as the first recipient to die, most contracts provide that the surviving recipients will receive a reduced payment after the first recipient dies. Most commonly, this option is written as “joint and ½ survivor” or "joint and 2/3 survivor,” in which the surviving beneficiary receives ½ or 2/3 of what was received when both beneficiaries were alive. This option is commonly selected by a couple in retirement. As with the life income option, there is no guarantee that all the proceeds will be paid out if both beneficiaries die shortly after the installments begin. 2. Annuities Certain (Types) In contrast with life contingency benefit payment options, annuities certain are short-term annuities that limit the amounts paid to a certain fixed period or until a certain fixed amount is liquidated. Fixed Period With fixed-period installments installments, the annuitant selects the time period for the benefits, and the insurer determines how much each payment will be, based on the value of the account and future earnings projections. This option pays for a specified amount of time only, whether or not the annuitant is living. Know This! The fixed-period option pays for a specific time only, whether or not the annuitant is living. Fixed Amount With fixed-amount installments installments, the annuitant selects how much each payment will be, and the insurer determines how long the benefits will be paid by analyzing the value of the account and future earnings. This option pays a specific amount until funds are exhausted, whether or not the annuitant is living. E. Uses Of Annuities The principal use of an annuity is to provide income for retirement retirement; however, an annuity may be used for any accumulation of cash or simply to liquidate an estate. Because of the various uses of annuities, agents should always assess how well a recommended product will meet the applicant's needs and resources — the suitability of a product. Know This! The main use of annuities is to provide retirement income. 1. Lump-sum Settlements Annuities may serve as an ideal financial vehicle for someone who comes into a large lump sum of money, such as inheritance, lottery, award of damages from a lawsuit, proceeds from a sale of a business, or a lump-sum distribution from a qualified pension plan. In this case, a person may purchase a single premium immediate annuity, which will convert the lump sum into a series of periodic payments, providing a stream of income for the annuitant. 2. Retirement Income Since annuities are a popular means to provide retirement income, they are often used to fund qualified retirement plans plans, which means they meet the IRS guidelines to receive favorable tax treatment. Qualified retirement annuities can be individual (such as individual retirement accounts — IRAs), and group (such as tax-sheltered annuity — TSA, or profit- sharing pension plans). Retirement annuities may offer a Guaranteed Minimum Withdrawal Benefit (GMWB) option to the annuitant. With this option, the annuitant can withdraw a maximum percentage of his or her investment annually until the initial investment has been recovered. This option protects the annuitant against investment losses. 3. Education Funds In addition to providing income for retirement and estate liquidation, annuities can be used to accumulate funds for college education. An annuity can provide savings on a tax-deferred basis for the education expenses of the annuitant. 4. Long-Term Care Needs Under the Pension Protection Act of 2006, annuitants are allowed to transfer money from an annuity to pay for long-term care insurance premiums, tax free. In the past, distributions from nonqualified annuities were taxed; however, now, distributions can be used to pay for long-term care premiums and, in many cases, eliminate the taxes on the annuity gains. As a result, many insurers now offer a hybrid annuity with a long-term care feature. These policies provide for income, long-term care, or both. ANNUITIES Phases Accumulation period - payments in, to insurer Annuitization period - payments out, to insured Parties Annuitant - insured; policy issued on annuitant's life; must be a natural person Beneficiary - will receive any amount contributed to annuity (plus any gain) if annuitant dies during accumulation period Owner - has all rights to policy (usually annuitant); can be corporation or trust Types of Fixed Annuities - guaranteed, fixed payment amount; premiums in Annuities general account Equity Indexed Annuities - interest rate tied to an index. Earn higher rate than fixed annuities, not as risky as variable annuities or mutual funds. Variable Annuities - payment not guaranteed. Premiums are in separate account, and invested in stocks and bonds. Premium Single - ONE lump-sum payment; the principal is created immediately Payments (used for both immediate and deferred annuities). Periodic (Flexible) - multiple payments; the principal is created over time (used for deferred annuity only). Income Immediate - purchased with a single premium; income payments start Payments within one year from the date of purchase Deferred - purchased with either lump-sum or periodic payments premium. Benefits start sometime after one year from the date of purchase (often used to accumulate funds for retirement). Settlement Life Only - insured cannot outlive income. Any monies not paid out are Options retained by company at insured's death. Pays highest monthly amount. Refund Life Annuity - Guaranteed lifetime income. If annuitant dies, balance is "refunded" to beneficiary. Installment option gives beneficiary payments until purchase amount is paid out. Cash refund gives refund of balance of original annuity purchase amount minus payments made to annuitant. Life with Period Certain - specific monthly payment for life and a specific period of time. If annuitant dies before payment period is up, payment goes to beneficiary. Joint Life - 2 or more annuitants receive payments until first death, then payments cease. Joint and Survivor - Income for 2 or more that cannot be outlived. Often used with period certain. When one annuitant dies, the other receives either 1/2 or 2/3 of the original payment amount. Lump-sum - paid at annuitization; all interest accumulated is taxable. Additional 10% penalty imposed prior to annuitant's reaching 59 1/2. Annuities Certain - payment guaranteed for fixed period or until certain fixed amount paid. NO LIFE option. Interest Guaranteed - company must pay this minimum percentage. Typically Rate around 3%. Current - exceeds guaranteed rate. Paid to annuitant when a company's own investment is better than expected. F. Chapter Recap This chapter explained key concepts related to annuities, from the parties to the contract to different annuity classifications. Let’s recap the main concepts you need to know: ANNUITIES Phases Accumulation period - payments in, to insurer Annuitization period - payments out, to insured Parties Annuitant - insured; policy issued on annuitant's life; must be a person Beneficiary - will receive any amount contributed to annuity (plus any gain) if annuitant dies during accumulation period Owner - has all rights to policy (usually annuitant); can be corporation or trust Types of Fixed Annuities - guaranteed, fixed payment amount; premiums Annuities in general account Variable Annuities - payment not guaranteed; premiums are in separate account, and invested in stocks and bonds Indexed Annuities - interest rate tied to an index; earn higher rate than fixed annuities, not as risky as variable annuities or mutual funds Premium Single - ONE lump-sum payment. The principal is created Payments immediately (used for both immediate and deferred annuities). Periodic (Flexible) - multiple payments; annuity principal fund is created over time (used for deferred annuity only) Income Immediate - purchased with a single premium. Income payments Payments start within one year from the date of purchase. Deferred - purchased with either lump sum or periodic- payments premium. Benefits start sometime after one year from the date of purchase (often used to accumulate funds for retirement). Settlement Lump-sum - at annuitization, and all interest accumulated is Options taxable. Additional 10% penalty can be imposed prior to annuitant's reaching 59 1/2. Life Only - insured cannot outlive income. Any monies not paid out are retained by company at insured's death. Pays highest monthly amount. Refund Life Annuity - guaranteed lifetime income. If annuitant dies, balance is "refunded" to beneficiary. Installment option gives beneficiary payments until purchase amount is paid out. Cash refund gives refund of balance of original annuity purchase amount minus payments made to annuitant. Joint Life - 2 or more annuitants receive payments until first death, then payments cease. Joint and Survivor - income for 2 or more that cannot be outlived. Often used with period certain. When one annuitant dies, the other receives either 1/2 or 2/3 of the original payment amount. Life with Period Certain - specific monthly payment for life and a specific period of time (e.g. Life plus 10-year certain). If annuitant dies before payment period is up, payment goes to beneficiary. Annuities Certain - payment guaranteed for fixed period or until certain fixed amount paid. NO LIFE option. Interest Guaranteed - company must pay this minimum percentage. Rate Typically around 3%. Current - exceeds guaranteed rate. Paid to annuitant when a company's own investment is better than expected.