CALIFORNIA 4-HOUR
ANNUITY TRAINING COURSE
HOW FIXED, VARIABLE AND INDEX ANNUITY
CONTRACT PROVISIONS
AFFECT CONSUMERS
(2015 EDITION)
Researched and Written by:
Edward J. Barrett


CFP , ChFC , CLU, CEBS, RPA, CRPS, CRPC
Disclaimer
This course is designed as an educational program for financial advisors and insurance
professionals. EJB Financial Press is not engaged in rendering legal or other professional
advice and the reader should consult legal counsel as appropriate.
We have tried to provide you with the most accurate and useful information possible.
However, one thing is certain and that is change. The content of this publication may be
affected by changes in law and in industry practice, and as a result, information contained
in this publication may become outdated. This material should in no way be used as an
original source of authority on legal and/or tax matters.
Laws and regulations cited in this publication have been edited and summarized for the
sake of clarity.
Names used in this publication are fictional and have no relationship to any person living
or dead.
This presentation is for educational purposes only. The information contained within this
presentation is for internal use only and is not intended for you to discuss or share with
clients or prospects. Financial advisors are reminded that they cannot provide clients with
tax advice and should have clients consult their tax advisor before making tax-related
investment decisions.
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© 2015 EJB Financial Press Inc., Printed in U.S.A. All rights reserved
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ABOUT THE AUTHOR
Edward J. Barrett CFP®, ChFC®, CLU, CEBS®, RPA, CRPS, CRPC®, began his
career in the financial and insurance services back in 1978 with IDS Financial Services,
becoming a leading financial advisor and top district sales manager in Boston,
Massachusetts. In 1986, Mr. Barrett joined Merrill Lynch in Boston as an estate and
business-planning specialist working with over 400 financial advisors and their clients
throughout the New England region assisting in the sale of insurance products.
In 1992, after leaving Merrill Lynch and moving to Florida, Mr. Barrett founded The
Barrett Companies Inc., Broker Educational Sales & Training Inc., Wealth Preservation
Planning Associates and The Life Settlement Advisory Group Inc.
Mr. Barrett is a qualifying member of the Million Dollar Round Table, Qualifying
Member Court of the Table® and Top of the Table® producer. He holds the Certified
Financial Planner designation CFP®, Chartered Financial Consultant (ChFC), Chartered
Life Underwriter (CLU), Certified Employee Benefit Specialist (CEBS), Retirement
Planning Associate (RPA), Chartered Retirement Planning Counselor (CRPC) and the
Chartered Retirement Plans Specialist (CRPS).
About EJB Financial Press
EJB Financial Press, Inc. (www.ejbfinpress.com) was founded in 2004, by Mr. Barrett to
provide advanced educational and training manuals approved for correspondence
continuing education credits for insurance agents, financial advisors, accountants and
attorneys throughout the country.
About Broker Educational Sales & Training Inc.
Broker Educational Sales & Training Inc. (BEST) is a nationally approved provider of
continuing education and advanced training programs to the mutual fund, insurance and
financial services industry.
For more information visit our website at: www.bestonlinecourses.com or call us at 800345-5669.
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BACKGROUND
Section 1749.8 of the California Insurance Code which took effect on January 1, 2005,
pursuant to subdivision (a) it requires that California resident and non-resident life agents
who sell annuity products must first complete eight (8) hours of annuity training that is
approved by the California Department of Insurance (CDI). In addition, pursuant to
subdivision (b), the law also requires life agents who sell annuity products to
satisfactorily complete an additional four hours of annuity training every two years prior
to their license renewal. For resident agents, this requirement is part of, and not in
addition to, their continuing education requirements.
On September 20, 2011, the governor signed into law, Assembly Bill (AB) 689 (Chapter
295, Statutes of 2011), an act to add Article 9 (commencing with Section 10509.910) to
Chapter 5 of Part 2 of Division 2 of the Insurance Code, relating to annuity transaction.
This act became effective January 2, 2012. AB 689 adds Section 10509.915(a) to the
California Insurance Code which states that an insurance producer shall not solicit the
sale of an annuity product unless the insurance producer has adequate knowledge of the
product to recommend the annuity and the insurance producer is in compliance with the
insurer’s standards for product training. Insurance producers may rely on insurerprovided product-specific training standards and materials to comply with the productspecific training requirement. Please note that AB 689 does not change the annuity
training requirements which are stated above in Section 1749.8 (a)(b) of the
California Insurance Code.
To assist California resident and non-resident agents meet Section 1749.8 (b), the fourhour ongoing annuity training requirement, this course has been filed an approved by the
California Department of Insurance (CDI). To receive continuing education credit for
this course you must complete either a paper exam or an online exam with a total of 50
questions and receive a passing grade of 70% or higher.
Disclaimer - The California Department of Insurance is released of responsibility for
approved course materials that may have a copyright infringement. In addition, no course
approved for either pre-licensing or continuing education hours or any designation
resulting from completion of such courses should be construed to be endorsed by the
Commissioner.
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TABLE OF CONTENTS
ABOUT THE AUTHOR .................................................................................................. 3 BACKGROUND ............................................................................................................... 5 CHAPTER 1 INTRODUCTION ................................................................................ 13 Overview ........................................................................................................................... 13 Learning Objectives .......................................................................................................... 13 Annuity Defined................................................................................................................ 13 History of Annuities .......................................................................................................... 14 Annuities in the U.S ...................................................................................................... 15 U.S. Individual Annuity Sales ...................................................................................... 16 Annuity Buyers ................................................................................................................. 17 Primary Uses of Annuities ................................................................................................ 17 Annuity Outlook ............................................................................................................... 18 Chapter 1 Review Questions ........................................................................................... 19 CHAPTER 2 CLASSIFICATION OF ANNUITIES ................................................ 21 Overview ........................................................................................................................... 21 Learning Objectives .......................................................................................................... 21 Classification of Annuities................................................................................................ 21 Purchase Option ................................................................................................................ 22 Single Premium ............................................................................................................. 22 Periodic (Flexible) Payment ......................................................................................... 22 Date Benefit Payments Begin ........................................................................................... 22 Deferred Annuities ........................................................................................................ 23 Immediate Annuities ..................................................................................................... 24 Deferred Income Annuity ............................................................................................. 25 Investment Options ........................................................................................................... 26 Fixed Annuity ............................................................................................................... 26 Variable Annuity ........................................................................................................... 26 Sales of Annuities ......................................................................................................... 27 Payout Options .................................................................................................................. 27 Chapter 2 Review Questions ........................................................................................... 30 CHAPTER 3 FIXED ANNUITIES ........................................................................... 31 Overview ........................................................................................................................... 31 Learning Objectives .......................................................................................................... 31 Advantages of Fixed Annuities......................................................................................... 31 Disadvantages of Fixed Annuities .................................................................................... 32 Fixed Annuity Fees and Expenses .................................................................................... 32 Contract Charge ............................................................................................................ 32 Interest Spread .............................................................................................................. 32 Surrender Charges ......................................................................................................... 32 Fixed Annuity Sales .......................................................................................................... 33 Types of Fixed Annuities .................................................................................................. 33 Crediting Rates of Interest ................................................................................................ 34 Non-forfeiture Interest Rate .......................................................................................... 35 7
Current Rate of Interest ................................................................................................. 35 Portfolio Rate ................................................................................................................ 35 New Money Rate .......................................................................................................... 36 Calculating the Rate ...................................................................................................... 37 Interest Rate Trends ...................................................................................................... 38 Interest Rate Projections ............................................................................................... 38 Bonus Annuities ............................................................................................................ 38 Two-Tiered Annuities ................................................................................................... 39 Fixed Annuitization: Calculating Fixed Annuity Payments ............................................ 39 Chapter 3 Review Questions ........................................................................................... 40 CHAPTER 4 VARIABLE ANNUITIES................................................................... 41 Overview ........................................................................................................................... 41 Learning Objectives .......................................................................................................... 41 VA Defined ....................................................................................................................... 42 The VA Market ............................................................................................................. 42 VA Product Features ..................................................................................................... 44 Separate Accounts ............................................................................................................. 44 Investment Options ....................................................................................................... 44 Accumulation Units ...................................................................................................... 45 VA Charges and Fees........................................................................................................ 46 Mortality and Expense (M&E) Charge ......................................................................... 47 Management (Fund Expense) Fees ............................................................................... 47 Contract (Account) Maintenance Fees.......................................................................... 48 Summary of Above Fees ............................................................................................... 48 Surrender Fees .............................................................................................................. 49 VA Sales Charges ......................................................................................................... 49 Premium Tax ..................................................................................................................... 50 Investment Features .......................................................................................................... 51 Dollar Cost Averaging .................................................................................................. 51 Enhanced Dollar Cost Averaging ................................................................................. 52 Fund Transfers .............................................................................................................. 52 Asset Allocation ............................................................................................................ 53 Asset Rebalancing ......................................................................................................... 53 Guaranteed Minimum Death Benefit ................................................................................ 53 Enhanced GMDB Features ........................................................................................... 54 Initial Purchase Payment with Interest or Rising Floor ................................................ 54 Contract Anniversary, Or “Ratchet” ............................................................................. 55 Reset Option.................................................................................................................. 55 Enhanced Earnings Benefits ......................................................................................... 55 Guaranteed Living Benefit (GLB) Riders......................................................................... 55 Types of GLB Riders .................................................................................................... 56 Guaranteed Minimum Income Benefit (GMIB) ............................................................... 56 GMIB Features and Benefits ........................................................................................ 56 GMIB Caveats .............................................................................................................. 57 GMIB Client Suitability................................................................................................ 58 Guaranteed Minimum Account Balance (GMAB) ........................................................... 58 8
GMAB Example ........................................................................................................... 58 GMAB Caveats ............................................................................................................. 58 GMAB Client Suitability .............................................................................................. 59 Guaranteed Minimum Withdrawal Benefit (GMWB) ...................................................... 59 GMWB Example .......................................................................................................... 59 GMWB Caveats ............................................................................................................ 59 GMWB Client Suitability ............................................................................................. 60 Guaranteed Minimum Withdrawal Benefit for Lifetime .................................................. 60 GMWBL Features and Benefits.................................................................................... 61 GMWBL Client Suitability ........................................................................................... 61 Treatment of Withdrawals from GLB Riders ................................................................... 62 Dollar-for-Dollar ........................................................................................................... 62 Pro-Rata ........................................................................................................................ 62 Variable Annuitization: Calculating Variable Annuity Income Payouts ......................... 63 Annuity Units ................................................................................................................ 63 Assumed Interest Rate (AIR) ........................................................................................ 64 VA Regulation under the Federal Securities Laws ........................................................... 65 Securities Act of 1933 ................................................................................................... 65 Securities Act of 1934 ................................................................................................... 66 Investment Company Act of 1940 ................................................................................ 67 Regulation of Fees and Charges ................................................................................... 67 Outlook for Variable Annuities ........................................................................................ 67 Chapter 4 Review Questions ........................................................................................... 69 CHAPTER 5 INDEX ANNUITIES ........................................................................... 71 Overview ........................................................................................................................... 71 Learning Objectives .......................................................................................................... 71 Index Annuity Defined ..................................................................................................... 71 Index Annuity Market ....................................................................................................... 72 Profile of an IA Buyer....................................................................................................... 72 IA Basic Terms and Provisions......................................................................................... 73 Tied Index ..................................................................................................................... 73 Index (Term) Period ...................................................................................................... 74 Participation Rate .......................................................................................................... 74 Spreads or Margins ....................................................................................................... 75 Cap Rate ........................................................................................................................ 76 No-Loss Provision ........................................................................................................ 77 Guaranteed Minimum Account Value .......................................................................... 77 Liquidity ........................................................................................................................ 77 Fees and Expenses ........................................................................................................ 78 Surrender Charges ......................................................................................................... 78 Interest Calculation ....................................................................................................... 79 Exclusion of Dividends ................................................................................................. 79 Index-Linked Interest Crediting Methods ......................................................................... 79 Annual Reset (Ratchet) Method.................................................................................... 79 High-Water Mark Method ............................................................................................ 81 Point-to-Point Method .................................................................................................. 81 9
Interest Crediting Method Comparison ........................................................................ 84 Averaging ...................................................................................................................... 85 Other Interest Crediting Methods ..................................................................................... 85 Multiple (Blended) Indices ........................................................................................... 85 Monthly Cap (Monthly Point-to-Point) ........................................................................ 85 Binary, Non-Negative (Trigger) Annual Reset ............................................................. 86 Bond-Linked Interest with Base ................................................................................... 86 Hurdle ........................................................................................................................... 86 Annual Fixed Rate with Equity Component ................................................................. 86 Rainbow Method ........................................................................................................... 87 Index Annuity Waivers and Riders ................................................................................... 88 Types of Riders ............................................................................................................. 89 IA’s with Bonuses ............................................................................................................. 89 Regulation of IA’s............................................................................................................. 90 FINRA Investor Alerts .................................................................................................. 91 Chapter 5 Review Questions ........................................................................................... 92 CHAPTER 6 ANNUITY CONTRACT STRUCTURE ........................................... 93 Overview ........................................................................................................................... 93 Learning Objectives .......................................................................................................... 93 Background ....................................................................................................................... 93 Structuring the Contract .................................................................................................... 94 Annuity Contract Forms ................................................................................................... 94 Owner-Driven ............................................................................................................... 95 Annuitant-Driven Contract ........................................................................................... 95 Parties to the Annuity Contract ......................................................................................... 95 The Owner ........................................................................................................................ 95 Rights of the Owner ...................................................................................................... 96 Changing the Annuitant ................................................................................................ 96 Duration of Ownership ................................................................................................. 96 Purchaser, Others as Owner .......................................................................................... 97 Taxation of Owner ........................................................................................................ 97 Death of Owner: Required Distribution ....................................................................... 97 Spousal Exception ......................................................................................................... 98 The Annuitant ................................................................................................................... 98 A Natural Person ........................................................................................................... 98 Role of the Annuitant .................................................................................................... 98 Naming Joint Annuitants/Co-Annuitants...................................................................... 98 Taxation of Annuitant ................................................................................................... 99 Death of Annuitant ........................................................................................................ 99 The Beneficiary ............................................................................................................... 100 Death Benefit .............................................................................................................. 100 Whose Death Triggers the Death Benefit ................................................................... 100 Changing the Beneficiary ........................................................................................... 101 Designated Beneficiary ............................................................................................... 101 Spouse or Children as Beneficiaries ........................................................................... 101 Non-Natural Person as Beneficiary ............................................................................ 101 10
Multiple Beneficiaries................................................................................................. 101 Taxation of Beneficiary .............................................................................................. 101 Death of Beneficiary ................................................................................................... 102 Maximum Ages for Benefits to Begin ............................................................................ 103 Chapter 6 Review Questions ......................................................................................... 104 CHAPTER 7 SUITABILITY OF ANNUITIES ..................................................... 105 Learning Objectives ........................................................................................................ 105 Licensing and Training Requirements ............................................................................ 105 CIC 1749.8 .................................................................................................................. 106 California Suitability Law............................................................................................... 106 CIC § 10509.910 ......................................................................................................... 106 CIC § 10509.911 ......................................................................................................... 107 CIC § 10509.912 ......................................................................................................... 107 CIC § 10509.914 ......................................................................................................... 107 CIC § 10509.914(i) ..................................................................................................... 108 CIC § 10509.914(e) .................................................................................................... 109 CIC § 10509.914(f)(D)(E) .......................................................................................... 109 CIC § 10509.916 ......................................................................................................... 110 CIC § 10509.917 ......................................................................................................... 110 CIC § 10509.918 ......................................................................................................... 111 The Wall Street Reform and Consumer Protection Act of 2010 .................................... 111 Chapter 7 Review Questions .......................................................................................... 113 CHAPTER 8 CIC CONTRACT PROVISIONS, RIDERS AND PENALTIES . 115 Overview ......................................................................................................................... 115 Learning Objectives ........................................................................................................ 115 CIC Contract Provisions ................................................................................................. 115 CIC §10540 ................................................................................................................. 116 CIC § 10127.10 ........................................................................................................... 116 CIC § 10127.12 ........................................................................................................... 116 CIC § 10127.13 ........................................................................................................... 117 Surrender Charge Waivers .............................................................................................. 117 Nursing Home ............................................................................................................. 118 Terminal Illness .......................................................................................................... 118 Unemployment ............................................................................................................ 118 Disability ..................................................................................................................... 118 Death ........................................................................................................................... 118 Charges and Fees ........................................................................................................ 118 Required Notice and Printing Requirements .............................................................. 118 Withdrawal Privilege Options..................................................................................... 119 Market Value Adjustment ............................................................................................... 119 Policy Administration Charges and Fees ........................................................................ 120 Life Insurance and Annuity Contract Riders .................................................................. 120 Long-Term Care Benefits Rider ..................................................................................... 120 Terms of Riders........................................................................................................... 120 Difference between Crisis Waivers & Long-Term Care Riders ................................. 120 Skilled Nursing Facility Rider .................................................................................... 121 11
Hospice Rider.............................................................................................................. 121 CIC Penalty Statutes ....................................................................................................... 121 CIC Section 780 .......................................................................................................... 121 CIC Section 781 .......................................................................................................... 122 CIC Section 782 .......................................................................................................... 122 CIC § 786 .................................................................................................................... 122 CIC § 789.3 ................................................................................................................. 123 CIC § 1738.5 ............................................................................................................... 123 CIC § 10509.9 ............................................................................................................. 124 CIC § 10509.916 ......................................................................................................... 124 Chapter 8 Review Questions .......................................................................................... 125 APPENDIX A ............................................................................................................... 127 APPENDIX B ................................................................................................................ 147 CHAPTER REVIEW ANSWERS............................................................................... 149 CONFIDENTIAL FEEDBACK .................................................................................. 151 12
CHAPTER 1
INTRODUCTION
Overview
Many financial professionals think of the annuity as a modern day investment. However,
annuities were in use long before the Internal Revenue Code was enacted. The creation
of annuities was not tax driven; it was driven by our need for security in an uncertain
world. It was, and is, driven by our need for the insurance features that the annuity
contract provides. The principal insurance role of annuities is to indemnify individuals
against the risk of outliving their resources.
In this chapter, we will define the annuity and review the historical uses of the annuity.
In addition, we will examine the role of annuities in the U.S., their sales, who purchases
the annuity and the reasons for the purchase of an annuity. At the end of the chapter, we
will examine the future outlook for annuities.
Learning Objectives
Upon completion of this chapter, you will be able to:





Identify how an annuity is defined;
Demonstrate the mathematical concept of an annuity
Explain how annuities have been used throughout history;
Explain the reasons why people purchase annuities today; and
Understand the outlook for the future of annuities.
Annuity Defined
In general terms, an annuity is a mathematical concept that is quite simple in its most
basic application. Start with a lump sum of money, pay it out in equal installments over a
period of time until the original fund is exhausted, and you have an annuity. Expressed
differently, an annuity is simply a vehicle for liquidating a sum of money.
But of course, in practice, the concept is a lot more complex. An important factor
missing from above is interest. The sum of money that has not yet been paid out is
earning interest, and that interest is also passed on to the income recipient (the
“annuitant”).
13
Anyone can provide an annuity as long as they can calculate the payment based upon
three factors:



A sum of money
Length of payout period, and
An assumed interest rate
However, there is one important element absent from this simple definition of an annuity,
and it is the one distinguishing factor that separates insurance companies from all other
financial institutions. While anyone can set up an annuity and pay income for a stated
period of time, only an insurance company can do so and guarantee income for the life of
the annuitant.
The insurance companies, with their unique experience with mortality tables, are able to
provide an extra factor into the standard annuity calculation, a survivorship factor. The
survivorship factor provides insurers with the means to guarantee annuity payments for
life, regardless of how long that life lasts.
Don’t get confused between an annuity and a life insurance contract. Annuities are not
life insurance contracts. Even though it can be said that an annuity is a mirror image of a
life insurance contract—they look alike but are actually exact opposites. Life insurance
is concerned with how soon one will die; life annuities are concerned with how long one
will live.
But did you know that annuities existed long before the existing of insurance companies.
As you will see, annuities have a long and illustrious history going back thousands of
years. In fact, annuities can actually trace their origins back to Roman times.
History of Annuities
There is some evidence that shows that one of the first life annuity ever purchased (or
invested), would have been around 1700 BCE. According to research by Moshe
Molevsky, he uncovered evidence that a life annuity was purchased by a prince ruling the
region of Sint in the Middle Kingdom (1100-1700 BCE). The annuitant’s name was
Price Hepdefal, but little else is known about the annuity itself, in what units it was paid
for and whether it ended up being a good investment for him.
Around the sixth century BCE, within the Old Testament, 2 Kings 25:30 makes reference
to the (life) annuity that was granted to Jehoiakim, king of Judah, by the king of Babylon
upon on his release from prison. By the second and third centuries CE, life annuities
became quite popular in Rome, where mutual aid societies of the Roman legions granted
them to soldiers who retired from military service at age 46. In addition, it has been
reported that during that time ancient Roman contracts known as annua (or “annual
stipends”) promised an individual a stream of payments for a fixed term, or possibly for
life, in return for an up-front payment. Such contracts were apparently offered by
14
speculators who dealt in marine and other lines of insurance. A Roman, Domitius
Ulpianus, compiled the first recorded life table for the purpose of computing the estate
value of annuities that a decedent might have purchased on the lives of his survivors.
During the 17th century, governments in several nations, including England and Holland,
sold annuities in lieu of government bonds, to pay for massive, on-going battles with
neighboring countries. The governments received capital in return for a promise of
lifetime payouts to the annuitants. The governments would then create a “tontine”,
promising to pay for an extended period of time if citizens would purchase shares today.
The United Kingdom, locked in many wars with France, started one of the first group
annuity contracts called the State of Tontine of 1693. Participants in these early
government annuities would purchase a share of the Tontine for ₤100 from the UK
Government. In return, the owner of the share received an annuity during the lifetime of
their nominated person (often a child). As each nominee died, the annuity for the
remaining proprietors gradually became larger and larger. This growth and division of
wealth would continue until there were no nominees left. Proprietors could assign their
annuities to other parties by deed or will, or they passed on at death to the next of kin.
Annuities in the U.S
In the United States, annuities made their first mark in America during the 18th century.
In 1759, Pennsylvania chartered the Corporation for the Relief of Poor and Distressed
Presbyterian Ministers and Distressed Widows and Children of Ministers. It provided
survivorship annuities for the families of ministers. Ministers would contribute to the
fund, in exchange for lifetime payments. In Philadelphia in 1812, the Pennsylvania
Company for Insurance on Lives and Granting Annuities was founded. It offered life
insurance and annuities to the general public and was the forerunner of modern stock
insurance companies. The Pennsylvania Company for Insurance on Lives and Granting
Annuities was the very first American company to offer annuities to the general public.
Annuities constituted a small share of the U.S. insurance market until the 1930s, when
two developments contributed to their growth. First, concerns about the stability of the
financial system drove investors to products offered by insurance companies, which were
perceived to be stable institutions that could make the payouts that annuities promised.
Flexible payment deferred annuities, which permit investors to save and accumulate
assets as well as draw down principal, grew rapidly in this period. Second, the group
annuity market for corporate pension plans began to develop in the 1930s.
The entire country was experiencing a new emphasis saving for a “rainy day.” The New
Deal Program introduced by President Franklin D. Roosevelt (FDR) unveiled several
programs that encouraged individuals to save for their own retirement. Annuities
benefited from this new-found savings enthusiasm.
By today’s standard, the first modern-day annuities were quite simple. These contracts
guaranteed a return of principal, and offered a fixed rate of return from the insurance
15
company during the accumulation period (Fixed Annuity—see Chapter 3 for a full
discussion of Fixed Annuities). When it was time to withdraw from the annuity, you
could choose a fixed income for life, or payments over a set number of years. There were
few bells and whistles to choose from.
That all changed beginning in 1952, when the first variable annuity was created by the
College Retirement Equities Fund (CREF) to supplement a fixed-dollar annuity in
financing retirement pensions for teachers. Variable annuities credited interest based on
the performance of separate accounts inside the annuity. Variable annuity owners could
choose what type of accounts they wanted to use, and often received modest guarantees
from the issuer, in exchange for greater risks they (the owner) assumed. This type of
annuity was then made available to any individual, when the Variable Life Insurance
Company (VALIC) in 1960, began to market its own nonqualified variable annuity (See
Chapter 4 for a full discussion of Variable Annuities). It was the variable annuity that
boosted the popularity of annuities. Then in 1994, Keyport Life Insurance Company
introduced a new type of a fixed annuity called an index annuity (see Chapter 5 for a full
discussion of Index Annuities). And the rest is history.
U.S. Individual Annuity Sales
According to the Life Insurance Marketing Research Association (LIMRA), for full year
2014, total U.S. Individual Annuity sales were $235.8 billion, a 3 percent increase over
2013. Assets under management in annuities reached a record-high of nearly $2.7 trillion
(see Table 1.1).
Table 1.1
Total U. S. Individual Annuity Sales and Assets, 2000 – 2014 (billions)
Year
Sales
Assets
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
$190.0
187.6
218.3
218.0
221.0
217.0
238.0
257.0
265.0
235.0
222.0
238.0
219.0
230.0
235.8
$1,279
1,237
1,217
1,484
1,633
1,751
1,916
2,028
1,707
2,009
2,035
2,220
2,454
2,589
2,730ͤ
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
16
Annuity Buyers
In a survey conducted by LIMRA, more than three-quarters of recent annuity buyers are
satisfied with their purchase of an annuity. LIMRA published this finding in a summary
of results from a survey of 1,200 consumers age 40 or over who purchased retail deferred
annuities within the past three years. The study was conducted in the third quarter of
2011.
Nearly 9 in 10 buyers of traditional fixed annuities are happy with their purchase, new
research reveals. The survey reveals that 86% of traditional fixed annuity buyers are
satisfied with their deferred annuity purchase. Likewise, most buyers are variable
annuities (75%) and indexed annuities (83%) are also satisfied with the purchases, the
survey reveals.
LIMRA observes that, of those who are satisfied, two-thirds of the VA households (61%
for indexed and half for traditional fixed) own two or more annuities. The study also
discloses that five of six deferred annuity buyers would recommend an annuity to their
friends or family.
Primary Uses of Annuities
The top reason consumers give for buying an annuity is to supplement their Social
Security or pension income. The second most popular reason is to accumulate assets for
retirement; this is especially true for individuals under age 60 (see Table 1.2).
Receiving guaranteed lifetime income is also a concern, especially for buyers aged 60
and older, the survey says. Annuity buyers’ single most important financial objective is to
have enough money to last their and/or their spouse’s lifetime.
Table 1.2
Intended Uses for Annuities
Source LIMRA Study, The “Deferred Annuity Buyer Attitudes and Behaviors” 2012
17
Annuity Outlook
Over the past few years, we saw some companies have slowed down or eliminated new
annuity sales, for various reasons. Many thought these departures would mark the
beginning of the end for the annuity market. Instead, it has created opportunities for
other companies to attract new customers and expand their holdings in one of the safest
investment options available today. We have seen an influx of private equity firms
entering the annuity market, specifically by purchasing interests in fixed-indexed
companies, as well as variable annuity blocks. Additionally, companies are innovating
with new products that are less capital-intensive, which may increase the capacity at
certain companies. The prognosis for 2015 and beyond shows increased investment in
annuities and new players in the marketplace.
18
Chapter 1
Review Questions
1. What is the principal role of annuities?
(
(
(
(
) A. Indemnify individuals against market declines
) B. Indemnify individuals against the risk of dying too soon
) C. Indemnify individuals against the risk of outliving their resources
) D. Indemnify individuals against interest rate risk
2. What is the name of the extra factor that insurance companies can provide with the
means to guarantee annuity payments for life, regardless of how long that life lasts?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Survivorship factor
Gross interest factor
Annuity factor
Morbidity factor
3. In 1952, the first variable annuity was created by:
(
(
(
(
) A. The Romans
) B. College Retirement Equities Fund (CREF)
) C. Presbyterian ministers
) D. Variable Annuity Life Insurance Company (VALIC)
4. In 1960, the first non-qualified annuity was issued by:
(
(
(
(
) A. The Pennsylvania Company for Insurance on Lives and Granting Annuities
) B. The Teachers Insurance Association of America (TIAA)
) C. Variable Life Insurance Company (VALIC)
) D. College Retirement Equities Fund (CREF)
5. According to the Life Insurance Marketing Research Association (LIMRA), what is
the major reason why an individual purchases an annuity?
(
(
(
(
) A. Pay for LTC premiums
) B. Pay for emergencies only
) C. Leave an inheritance
) D. Supplement Social Security or pension income
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CHAPTER 2
CLASSIFICATION OF ANNUITIES
Overview
Annuities can be categorized along many dimensions. In this chapter we will examine
the various ways annuities are classified. It also describes the age-old problems that
annuities attempt to solve and explains how annuities have been used over the years.
Finally, the chapter discusses how important annuities are to our society today.
Learning Objectives
Upon completion of this chapter, you will be able to:





Identify the various classifications of annuity contracts.
Demonstrate an understanding of the differences between a deferred annuity and
an immediate annuity;
Distinguish between an immediate annuity and a deferred income annuity;
Recognize the key elements of a variable annuity and fixed annuity; and
Identify the various payout options of an annuity in the distribution phase
Classification of Annuities
Annuities are flexible in that there are a number of classifications (options) available to
the purchaser (contract holder/owner) that will enable him or her to structure and design
the product to best suit his or her needs. Those options are:




Purchase Option
Date Benefit Payments Begin
Investment Options
Payout Options
Let’s review each of these classifications in greater detail beginning with the purchase
option.
21
Purchase Option
An annuity begins with a sum of money, called principal. Annuity principal is created
(or funded) in one of two ways; immediately with a single premium or over time with a
series of flexible premiums.
Single Premium
A single premium annuity is basically just what the name implies; an annuity that is
funded with a single, lump-sum premium, in which case the principal is created
immediately. Usually, this lump sum is fairly large.
Periodic (Flexible) Payment
But not everyone has a large lump sum with which to purchase an annuity. Annuities can
be funded through a series of periodic premiums that, over time, will amass an amount
large enough to buy a significant annuity benefit. At one time, it was common for
insurers to require that periodic annuity premiums be fixed and level, much like insurance
premiums. Today, it is more common to allow contract owner’s flexibility as to allowing
premiums of any size (within certain minimums and maximums, such as none less than
$25 or more than $1,000,000) and at virtually any frequency.
Date Benefit Payments Begin
The annuity is the only investment vehicle that has two phases based upon when the
income payment begins. The phases are:


Deferred (Accumulation Phase); or
Immediate. (Pay-out/Distribution Phase)
The main difference between deferred and immediate annuities is when annuity payments
begin. Every annuity has a scheduled maturity or annuitization date (usually age 90 or
age 95), which is the point the accumulated annuity funds are converted to the payout
mode and benefit payments to the annuitant are to begin.
According to LIMRA SRI, total sales of deferred annuities in 2014 were $218.0 billion
and immediate (income) annuities totaled $17.8 billion, (which includes $9.7 billion of
immediate annuities, $2.7 billion of deferred income annuities and $5.4 billion of
structured settlements).
22
Table 2.1
Annuity Industry Total U.S. Sales
Deferred vs. Immediate Annuities; 2000 - 2014 ($ billions)
YEAR
DEFERRED
IMMEDIATE
TOTAL
2000
$ 181.1
$ 8.8
$189.9
2001
175.0
10.3
185.3
2002
208.6
11.3
219.9
2003
207.5
8.3
215.8
2004
209.2
11.6
220.8
2005
204.9
11.5
216.4
2006
226.3
12.4
238.7
2007
243.8
13.0
256.8
2008
250.6
14.4
265.0
2009
225.4
13.2
238.6
2010
209.0
13.5
221.3
2011
227.1
13.2
240.3
2012
207.0
12.7
219.7
2013
216.0
14.1
230.1
2014
218.0
17.8
235.8
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Deferred Annuities
Deferred annuities are designed for long-term accumulation and can provide income
payments at some specified future date. A deferred annuity can be funded with either
periodic payments, commonly called flexible premium deferred annuities (FPDAs), or
funded with a single premium, in which case they’re called single premium deferred
annuities, or SPDAs. While a deferred annuity has the potential of providing a
guaranteed lifetime income at some point in the future, the current emphasis in a deferred
annuity is on accumulating funds rather than liquidating funds. An advantage that
deferred annuities have over many other long-term savings vehicles is that there are no
taxes (tax-deferral) paid on the accumulated earnings in an annuity until withdrawals are
made.
23
Immediate Annuities
An immediate annuity is designed primarily to pay income benefit payments one period
after purchase of the annuity. Since most immediate annuities make monthly payments,
an immediate annuity would typically pay its first payment one month (30 days) from the
purchase date. If, however, a client needs an annual income, the first payment will begin
one year from the purchase date. Thus, an immediate annuity has a relatively short
accumulation period. As you might guess immediate annuities can only be purchased
with a single premium payment and are often called single-premium immediate annuities,
or SPIA’s. The SPIA is the simplest individual annuity contract. In return for a single
premium payment, the annuitant receives a guaranteed stream of future payments that
begin immediately. These types of annuities cannot simultaneously accept periodic
funding payments by the owner and pay out income until the annuitant dies (a simple life
annuity), or when both the annuitant and a co-annuitant, such as a spouse, have died (a
joint life survivorship annuity). A simple life annuity is primarily designed to insure
annuitants against outliving their resources; a joint life survivorship annuity addresses
this risk and also provides retirement income for dependents. The average age of a SPIA
buyer is 73.
A once-snubbed annuity product—the immediate income annuity—appears to be gaining
a foothold in the broad annuity marketplace and in the practices of advisors who serve the
boomer and retirement income markets. According to LIMRA SRI, immediate income
annuity sales jumped 17 percent in 2014; totaling $9.7 billion (see Table 2.2).
Table 2.2
Total Sales of Immediate Annuities 2000 – 2014 ($ billions)
YEAR
VARIABLE
FIXED
TOTAL
2000
$ 0.6
$ 8.0
$ 8.6
2001
0.6
9.6
10.2
2002
0.5
10.7
11.2
2003
0.5
4.8
5.3
2004
0.4
6.1
6.5
2005
0.6
6.3
6.9
2006
0.8
6.3
7.1
2007
0.3
6.7
7.0
2008
0.4
8.6
9.0
2009
0.1
7.5
7.6
2010
0.1
7.6
7.7
2011
0.1
8.1
8.1
2012
0.1
7.7
7.7
2013
0.1
8.3
8.4
24
2014
0.1
9.6
9.7
Source: Morningstar Inc. and LIMRA International, March 2015. Not including $5.3 of Structured Settlements.
Deferred Income Annuity
In recent years, a new form of retirement income annuity solution has been gaining
visibility: Deferred Income Annuity (DIA), also known as the longevity annuity.
According to LIMRA, deferred income annuities experienced record growth in 2014,
reaching $2.7 billion. This was 22 percent higher than sales in 2013. Like immediate
annuities, DIA’s suffered from falling interest rates in the fourth quarter. DIA sales were
$680 million in the fourth quarter 2014, 4 percent lower than fourth quarter 2013 results.
A "cousin" to the more familiar immediate annuity discussed above, the goal of the DIA
is similar - to provide income for life - but the payments do not begin until years (or even
decades) after the purchase. As such, these "deferred income annuities" can provide
significantly larger payments when they do begin - e.g., at age 85 - in light of both the
compounded interest and the mortality credits that would accrue over the intervening
time period.
Example: A couple both age 65, purchase a $100,000 DIA contract and stipulate that
payments will not begin until they reach age 85. However, the couple does reach age
85, payments of $2,656.20 will commence and be payable for as long as either
remains alive. Notably, the trade-off here is rather “extreme” – if the couple dies
anytime between now and age 85 (assuming both pass away), the $100,000 is lost.
However, if they merely live half way through age 88, they will have recovered their
entire principal, and from there will continue to receive $31,874.40/year thereafter, a
significant payoff for “just” $100,000 today.
Of course, the payout rates will vary depending on the starting age. If the 65-year-old
couple begins payments at age 75 instead of 85, the monthly payments are only
$934.18/month, instead of $2,656.20. The couple could also purchase a single premium
immediate annuity (SPIA) at age 65 with payments that start immediately, but the
payouts would only be $478.91/month. Thus, in essence, by introducing a 10-year
waiting period, the payments more than double; by waiting 20 years, the payments more
than quintuple! And if the couple starts even earlier, the payments are greater; a longevity
annuity purchased for $100,000 at age 55 with payments that don’t begin until age 85
receive a whopping $4,054.10/month ($48,649.20/year!) if at least one of them remains
alive to receive the payments! Alternatively, the couple could include a return-ofpremium death benefit (to the extent the original $100,000 is not recovered in annuity
payments, it is paid out at the second death to the beneficiary), which would drop the
payments to a still-significant $3,690.30/month. (Quotes are from Cannex, as of
7/8/2014)
In essence, the concept of the DIA is to truly hedge against longevity; while the couple
may receive limited payments if they don’t survive, the payments are very significant
25
relative to the starting principal if they do live long enough; in fact, the payments can be
so “leveraged” against mortality that the couple doesn’t actually need to set aside very
much in their 50s and 60s to fully “hedge” against living beyond age 85 (which also
makes it easier to invest for retirement when the time horizon is known and fixed to just
cover between now and age 85!).
In theory, a longevity annuity could be purchased with after-tax dollars (a non-qualified
annuity), or within a retirement account. After all, the reality is that for many people, the
bulk of their retirement savings is currently held within retirement accounts, and if there’s
a goal to use a longevity annuity to hedge against long life, those are the dollars to use!
Unfortunately, though, there’s a major problem with holding a longevity annuity inside of
a retirement account: how do you have a contract that doesn’t begin payments until age
85 held within an account that has required minimum distributions (RMDs) beginning at
age 70 ½!
We’ll that was settled when the IRS issued final regulations (T.D. 9673) that now permits
participants of IRAs and 401(a) qualified retirement plans, 403(b) plans and eligible
governmental 457 plans to purchase a “Qualified Longevity Annuity Contracts
(QLACs),” using a certain amount of their account balance, without having these
amounts count for calculating required minimum distributions (RMDs).
Investment Options
An annuity can be classified by two types of investment options. They are:


Fixed and
Variable
Fixed Annuity
A fixed annuity is an insurance contract in which the insurance company guarantees both
the earnings and principal (See Chapter 3 for a full discussion of fixed annuities).
Variable Annuity
A variable annuity, on the other hand, is an insurance contract where the contract holder
decides how to invest the money invested in sub-accounts (essentially mutual funds)
offered within the annuity. The value of the sub-accounts depends on the performance of
the funds chosen. The most popular type of annuity sold is the variable annuity (see
Chapter 4 for a full discussion of Variable Annuities).
26
Sales of Annuities
Table 2.3 illustrates the total U.S. Sales of Annuities between Variable Annuities and
Fixed Annuities. As you can see for the full year 2014, VA total sales fell 4 percent in
2014, totaling $140.1 billion. This represents the lowest annual VA sales since 2009. On
the other side, Fixed Annuity (FA) sales were $95.7 billion in 2014, improving 13
percent compared with 2013.
Table 2.3
Annuity Industry Total U.S. Sales
Variable vs. Fixed 2000 - 2014 ($ billions)
Year
Variable
Fixed
Total
2000
$ 137.3
$ 52.7
$190.0
2001
113.3
74.3
187.6
2002
115.0
103.3
218.3
2003
126.4
84.1
215.8
2004
133.0
88.0
221.0
2005
137.0
80.0
217.0
2006
160.0
78.0
238.0
2007
184.0
73.0
257.0
2008
156.0
109.0
265.0
2009
128.0
111.0
239.0
2010
140.0
82.0
222.0
2011
158.0
80.0
238.0
2012
147.0
72.0
219.0
2013
145.0
85.0
230.0
2014
140.1
95.7
235.8
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Payout Options
Another way to classify an annuity is the payout option chosen. Once an annuity matures
and its accumulated fund is converted to an income stream, a payout schedule is
established (see Table 2.4). There are a number of annuity payout options available:

Straight (Single) Life Income Option. A straight life income option (often called a
life annuity or single life annuity) pays the annuitant a guaranteed income for his
or her lifetime. This is the purest form of life annuitization. The straight life
27





income option pays out a higher amount of income than any other life with period
certain or a joint and survivor option, but they might not be higher than other
options (such as cash refund, installment refund, or pure period certain). At the
annuitant death, no further payments are made to anyone. If the annuitant dies
before the annuity fund (i.e., the principal) is depleted, the balance, in effect, is
“forfeited” to the insurer. It is used to provide payments to other annuitants who
live beyond the point where the income they receive equals their annuity
principal.
Cash Refund Option. A cash refund option provides a guaranteed income to the
annuitant for life and if the annuitant dies before the annuity fund (i.e., the
principal) is depleted, a lump-sum cash payment of the remainder is made to the
annuitant’s beneficiary. Thus, the beneficiary receives an amount equal to the
beginning annuity fund less the amount of income already paid to the deceased
annuitant.
Installment Refund Option. Like the cash refund, the installment refund option
guarantees that the total annuity fund will be paid to the annuitant or to his or her
beneficiary. The difference is that under the installment option, the fund
remaining at the annuitant’s death is paid to the beneficiary in the form of
continued annuity payments, not as a single lump sum.
Life with Period Certain Option. Also known as the life income with term certain
option, this payout approach is designed to pay the annuitant an income for life,
but guarantees a definite minimum period of payments. For an example, if an
individual has a ten-year period certain annuity, and receives monthly payments
for six years before dying, his or her beneficiary will receive the same payments
for four more years. Of course, if the annuitant died after receiving monthly
annuity payments for ten or more years, his or her beneficiary would receive
nothing from the annuity.
Joint and Full Survivor Option. The joint and full survivor option provides for
payment of the annuity to two people. If either person dies, the same income
payments continue to the survivor for life. When the surviving annuitant dies, no
further payments are made to anyone. There are other joint arrangements offered
by many companies:
o Joint and Two-Thirds Survivor. This is the same as the above
arrangement, except that the survivor’s income is reduced to two-thirds of
the original joint income.
o Joint and One-Half Survivor. This is the same as the above arrangement
except that the survivor’s income is reduced to one-half of the original
joint income.
Period Certain. The period certain option is not based on life contingency;
instead it guarantees benefit payments for a certain period of time, such as 5, 10,
15, or 20 years, whether or not the annuitant is living. At the end of the specified
term, payments cease.
Table 2.4 illustrates the comparison of the monthly settlement cash flow options for a
Male and Female age 65 with $100,000 purchase payment and income begins one month
after purchase date (as of February 9, 2015). As you can see the single life income with
28
no payments to beneficiaries pays out the highest amount of income at $550 for a male
and $512 for a female per month. Notice as well, the 5-year period certain payment of
$1,703, a payment of both principal and interest of 20.44%.
Table 2.4
Comparison of Monthly Settlement Options
Cash
Flow
Female
Estimated
Monthly
Income
Cash
Flow
$542
6.50%
$517
6.20%
Single life w/10 years certain
$526
6.31%
$506
6.07%
Single life w/20 years certain
$482
5.78%
$469
5.63%
Single Life w/Installment (Cash) Refund
$492
5.90%
$472
Income Payment Options
Single life
beneficiaries
income
no
payments
Male
Estimated
Monthly
Income
to
5.66%
Income Payment Options
Estimated Monthly
Income
Cash Flow
Joint Life 100% Survivor (no payments to
beneficiaries)
$441
5.29%
Joint Life 100% Survivor (10 year certain)
$439
5.27%
5-Year Period Certain
$1,703
20.44%
10-Year Period Certain
$910
10.92%
Source: http://www.immediateannuities.com/; Date 3-22-2015. Cash flow –monthly income times twelve divided by
the deposit amount. Cash flow percentage is significantly higher than the internal rate credited to the premium.
Contract options dramatically change the pay-out on an IA, as shown by the projected monthly payout on a $100,000
annuity purchased by a hypothetical 65-y.o. M/F.
29
Chapter 2
Review Questions
1. What is the most popular type of annuity sold?
(
(
(
(
2.
)
)
)
)
A.
B.
C.
D.
Fixed Annuity
Deferred Annuity
Immediate Annuity
Variable Annuity
Which of the following types of annuities is basically a single premium deferred
annuity with an income annuity component?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Fixed Annuity
Deferred Annuity
Immediate Annuity
Deferred Income Annuity
3. What is the average age of a SPIA buyer?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
55
73
60
63
4. Which type of annuity will begin to make annuity payments one month after
the purchase payment?
(
(
(
(
) A. Index Annuity
) B. Period Certain Annuity
) C. Single Premium Immediate Annuity
) D. Deferred Income Annuity
5. Which annuity payout option is the purest form of life annuitization?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Straight (single) life income
Joint and survivor
Life with 10 years certain
Life with 20 years certain
30
CHAPTER 3
FIXED ANNUITIES
Overview
Fixed annuities place the investment risk on the insurer. One of the major features of a
“fixed” annuity is safety of principal and also safety in that the rate of return is certain.
Over the past several years, we have seen the sales of fixed annuities decline drastically
due to the overall low interest rate in the financial markets. However, as interest rates
begin to tick up, we certainly are seeing an insurgence of interest in fixed annuities with
both deferred and income payout annuities.
In this chapter, we will examine the basic advantages and disadvantages of fixed
annuities, the sales of fixed annuities as well as the various types of fixed annuities. We
will also examine how fixed annuities are credited with interest payments.
Learning Objectives
Upon completion of this chapter, you will be able to:






Identify the advantages and disadvantages of fixed annuities;
Identify the various expenses of a fixed annuity;
Explain the various types of fixed annuities;
Explain the various interest crediting methods of fixed annuities;
Demonstrate differences between portfolio rate and new money rate; and
Demonstrate the payout options of a fixed annuity.
Advantages of Fixed Annuities
One of the major features of a “fixed” annuity is safety. Safety of principal and also
safety in that the rate of return is certain. The fixed aspect of the annuity also offers
safety in that the annuity holder does not take on responsibility for making any decisions
about where or in what amount the funds in his or her annuity should be invested. This is
in contrast to a variable annuity in which the annuity holder does take on this type of
responsibility.
31
Premiums made to a fixed annuity are invested in the insurance companies’ general
account. The company then invests the premiums it receives in a manner that will allow
it to credit the rates it has stated it will pay. The interest rate chosen by the insurance
company during the first year is meant to be competitive with rates currently offered on
other financial vehicles.
Disadvantages of Fixed Annuities
Like everything else in life, even though fixed annuities offer several advantages, they
also have their disadvantages. Probably the most significant disadvantage is that by
locking in the fixed annuity’s fixed rate of interest, the policyholder might lose out on
any potentially greater gains that could be realized if the same funds were invested in the
stock market.
A second potential disadvantage of the fixed annuity involves the fact that the benefit
payout amount will be a fixed amount. While this fixed payout amount will be viewed
by some annuity holders as a decided advantage, others will realize that, over time, the
fixed benefit amount will lose ground against inflation with the potential reduction of
spending power over time. For example, at an inflation rate of 3 percent per year, the real
value of annuity payouts in the first year of an annuity liquidation period is more than
twice that of the name nominal payout 24 years later. At an inflation rate of 4 percent,
the purchasing power of the fixed monthly payment would be halved in only 18 years.
Fixed Annuity Fees and Expenses
Fixed annuity fees and expenses generally cover the insurance company's administrative
expenses, the cost of offering the annuitization guarantee and profits to the insurance
company and sales agent.
Contract Charge
The rate quoted is the rate paid. Some fixed annuities may assess an annual contract fee,
typically around $30 to $40.
Interest Spread
Just like other investments fixed annuities have fees and expenses. Most fees and
expenses of a fixed annuity are factored into the stated annual percentage rate (APR) the
investor is quoted, this is known as the interest spread.
Surrender Charges
Most fixed annuity contracts impose a contract surrender charge on partial and full
surrenders from the contract for a period of time after the annuity is purchased. This
32
surrender charge is intended to discourage annuity holders from surrendering the contract
and to allow the insurance company to recover its costs if the contract does not remain in
force over a specific period of time.
Fixed Annuity Sales
According to LIMRA SRI, total U.S Fixed Annuity sales increased 13 percent in 2014,
totaling $95.7 billion (see Table 3.1).
Table 3.1
Fixed Annuity Sales and Assets, 2000 - 2014 ($ billions)
YEAR
TOTAL SALES
NET ASSETS
2000
$ 52.7
$ 322
2001
74.3
351
2002
103.3
421
2003
84.1
490
2004
86.7
497
2005
77.0
520
2006
74.0
519
2007
66.6
511
2008
106.7
556
2009
104.3
620
2010
82.0
659
2011
81.0
675
2012
72.0
692
2013
85.0
715
2014
95.7
745ͤ
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Types of Fixed Annuities
The basic types of deferred fixed annuities can be broken down into the following
categories. They are:

Book value deferred annuity products earn a fixed rate for a guaranteed period.
The surrender value is based on the annuity’s purchase value plus a credited
33


interest, net of any charges. Book value products are the predominant fixed
annuity type sold in banks.
Market value adjusted annuities are similar to book value deferred annuities but
the surrender value is subject to a market value adjustment based on interest rate
changes.
Index annuities guarantee that a certain rate of interest will be credited to
premiums paid but also provide additional credited amount based on the
performance of a specified market index (such as the S&P 500®).
Types of immediate (fixed income) annuities:


Structured settlement annuities are used to provide ongoing payments to an
injured party in a lawsuit.
Single premium immediate annuities (SPIA’s) are usually purchased with a lump
sum and payments begin immediately (usually within 30 days) or within one year
after the annuity is purchased.
As reported by LIMRA SRI, total sales of fixed annuities in 2014 increased by 14 percent
to total $95.7 billion, as compared to $84.4 billion in 2013. Market value-adjusted
products increased 15 percent in 2014, totaling $8.6 billion in sales as compared to $7.5
billion in 2013. In addition, indexed annuities grew by 23 percent, totaling $48.2 billion,
compared to $39.3 billion in 2013. However, book value annuities decreased 3 percent,
from $21.8 billion in 2013 to $21.1 billion in 2014.
Table 3.2
Fixed Annuity Industry Estimates (billions)
TYPE
YTD SALES
2014
YTD Sales
2013
Pct. Chg.
2014/2013
Fixed-rate deferred
Book value
Market value adjusted
Indexed
Fixed deferred
Deferred income
Fixed immediate
Structured settlements
$29.7
21.1
8.6
48.2
77.9
2.7
9.7
5.8
$29.3
21.8
7.5
39.3
68.6
2.2
8.3
5.3
1%
-3%
15%
23%
14%
22%
17%
3%
Total Fixed
$95.7
$84.4
13%
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Crediting Rates of Interest
As discussed earlier, typically a fixed annuity contract will offer two interest rates: a
guaranteed rate and a current rate. The guaranteed rate is the minimum rate that will be
credited to funds in the annuity contract regardless of how low the current rate sinks or
34
how poorly the issuing insurance company fares with its investment returns. A typical
guaranteed interest rate is between 1.5% and 3%.
Non-forfeiture Interest Rate
In 2003, the National Association of Insurance Commissioners (NAIC) adopted a new
annuity Standard Non-forfeiture Law (SNFL) that ties the minimum interest rate that
must be paid by fixed annuities to current yields. Prior to this, the state-mandated
minimum interest rate was 3% in most states. During times of extremely low interest
rates, this made profitably crediting an interest rate above 3% difficult and sometimes
impossible. As a result, many companies had no choice but to pull specific products or
interest rate guarantee periods from the market.
With the new law, the rate floats between 1% and 3%. The standard does not become
effective until adopted by individual states, but almost all states now have enacted one of
two types of relief—either in the form of a 1.5% minimum guaranteed interest rate, or a
rate that moves with prevailing interest rates.
Current Rate of Interest
The current interest rate (excess rate) varies with the insurance company’s returns on its
investment program. Some annuity contracts revise the current rate on a monthly basis;
others change the current interest rate only one time each year. The overall current
interest rate credit to a fixed annuity is normally 1 percent to 3 percent higher than bank
CDs and money markets.
Once the interest rate on an annuity contract has been set, there remains at least one other
item to understand regarding the method in which the interest will be credited to the
funds placed in the annuity. This item is the method of interest rate crediting that the
insurance company will apply to the specific annuity contract. Generally, there are two
methods of crediting interest:

Portfolio (average) rate method, and

New money rate method.
Portfolio Rate
The portfolio (average) rate method credits policyholders with a composite of interest
that reflects the company’s earnings on its entire portfolio of investments during the year
in question. During periods of rising interest rates, the interest credited to the “new”
contribution received during the year will be heavily influenced by the interest earned on
investments attributable to “old” contributions those received and invested 5, 10, 15 or
more years earlier. The interest credited will therefore be stabilized.
35
To illustrate this method under both a rising and declining interest trend (see Illustration
3.3). Under the steadily increasing trend, the contribution made in year 1 earns 3.0%, all
funds in the account (new or old) in year 2 earn 4.0%, and all funds in the account during
year 3 earn 5.0%.
Illustration 3.3
Illustrative Comparison of Increasing and Decreasing Portfolio Rates
Increasing Rates
Year
One
Two
Three
Year 1
3%
Year 2
4%
4%
Year 3
5%
5%
5%
Decreasing Rates
One
Two
Three
5%
4%
4%
3%
3%
3%
New Money Rate
Under the new money rate (sometime referred to as the “banding approach”, or
investment year method of crediting interest), the contributions made by all contract
holders in any given period are banded together and credited with a rate of interest
consistent with the actual yield that such funds obtained during the period. Thus, even
though a company’s average return on all money may be only 5% in a given period, the
contributions made by all participants during the current period may be credited with the
5.0% if the company was able to make new investments that, on average, returned in
excess 5.0% interest. Moreover, the interest rate credited on those contributions should
continue to earn 5.0% until the monies are reinvested. After reinvestment, the interest on
these contributions will change and the rate credited to contributions banded in the
following period could be higher or lower.
Under a trend of increasing interest, and assuming monies are reinvested every year, an
investment in year 1 earns 5.0% (the new money rate for that year) and then earns 5.25%
in the second year and 5.50% in the third year (see Illustration 3.4). An investment in
year 2 earns 6.0% (the new money rate for that year) and then earns 6.00% in the second
year and 6.25% in the third year. Finally, an investment in year 3 earns 7.0%.
36
Illustration 3.4
Illustrative Comparison of Increasing and Decreasing Portfolio Rates
Increasing Rates
Year
One
Two
Three
Year 1
5.00%
Year 2
5.25%
6.00%
Year 3
5.50%
6.25%
7.00%
Decreasing Rates
One
Two
Three
5.00%
4.50%
4.00%
4.50%
4.00%
3.00%
Note: The higher rates were used for the new money rate illustration. That is because the
portfolio rate includes the return on investments made in earlier years at lower rates.
The illustrations points out three things. First and most important, it is deceptive to
compare the current interest rate between two companies using different approaches.
Second, the new money rate method is advantageous to the participant when interest rates
are increasing. Third, in a declining interest rate period, the portfolio method has merit.
Another consideration in analyzing the products of tax-deferred annuity companies that
use the new money approach is how funds are treated when a participant makes a partial
withdrawal of funds. There are three approaches that are used: LIFO, FIFO and HIFO.
“Last-In, First Out” (LIFO) means that the sum withdrawn will be taken from the most
recent contribution band. “First In, First Out” (FIFO) means that the sum withdrawn will
be taken from the earliest contribution band. “Highest In, First Out” (HIFO) means that
the sum withdrawn will be taken from the band that is being credited with the highest
interest rate.
Keep in mind that, although interest rates are very important, they are but one of several
items to be considered when selecting a fixed annuity.
Calculating the Rate
Whether the portfolio rate or the new money rate method is used, there are several
approaches used to arrive at the actual numerical rate to be credited. A common approach
is to credit a rate (or rates, in the case of the new money rate method) that reflects the
company’s earnings on its entire portfolio of investments during the year in question.
Another approach would be to use an expected rate of return on the accumulations.
37
Interest Rate Trends
In valuing the rate of interest credited (rate of return) on their investments, a number of
insurance companies have moved from the calendar year to a quarterly approach. Some
have even adopted techniques for valuing the return on a daily basis. The objective of
such a move is twofold:


The insurance company can move quickly if it believes the spread between the
rate of return actually being earned on its investment and the rate credited to the
contract is moving in a direction disadvantageous to its best interests, and
Competitive position in the marketplace can be maintained, especially when
interest rates increase sharply.
Interest Rate Projections
Most companies’ sales literature will show projections for the guaranteed interest rate,
however, these types of data provide little, if any, information to help select an annuity.
Since projected values are hypothetical, their use as an instrument of prediction is
significantly flawed. Only when a company has established a trend of consistently high
historical current interest rates do projections of future accumulations become significant.
Bonus Annuities
Some insurance companies declare a “bonus” rate of interest that will be paid on top of a
current or “base” rate offered on an annuity contract. This bonus is designed to attract
new business to the insurance company. The bonus amount offered by many insurance
companies can range from one percent to five percent of the original single premium
payment. For example, if an applicant purchases an annuity with a single premium of
$100,000, and the extra credit sign-up bonus is 5 percent, the account value will be
$105,000. Some insurers may credit the bonus with the initial premium payment and or
may credit the premium payments made within the first year of the annuity contract.
Under some annuity contracts, the insurer will take back all bonus payments made to the
annuity holder within the prior year or some other specified date, if the annuity holder
makes a withdrawal, if a death benefit is paid to the annuity holder’s beneficiaries upon
the annuitant’s death, or in other circumstances.
Though this feature is attractive, there might be some hidden costs. Some companies
charge extra fees and/or extend surrender periods. Some contracts may impose higher
mortality and expense (M&E) charges, while others may impose a separate fee
specifically to pay for the bonus feature. As the advisor, it is your responsibility to
understand these costs and fully disclose to the purchaser of an annuity.
38
Two-Tiered Annuities
A two-tiered annuity is basically a dual-fund, dual-interest rate contract. The two funds
are the accumulation account and the surrender value. There is a permanent increasing
surrender charge.
The interest rate offered is a relatively high interest rate, but only if the owner holds the
contract for a certain number of years and then must annuitize the contract. If the annuity
is surrendered at any point prior to the contract period, the interest credited to the contract
is recalculated from the contract’s inception using a lower tier of interest rates.
The higher tier of rates is designed to reward annuitization and to make the product more
attractive than competing annuities, the lower tier of rates generally makes the contract
very unattractive compared to other alternatives. And the interest penalty applies under
some contracts even if the annuity is surrendered due to the death of the owner. This type
of fixed annuity contract has come under scrutiny by state insurance departments in how
they are marketed and sold especially to seniors.
Fixed Annuitization: Calculating Fixed Annuity Payments
Another aspect of the fixed annuity that is “fixed” is the amount of the benefit that will be
paid out when the contract is annuitized. Fixed annuity payments are determined by
insurance company annuity tables that give the first payment value per $1,000, which
depends on:




The age of the annuitant,
The sex of the annuitant,
The payout options chosen, and
Deductions for expenses.
Thus, if an annuitant has $100,000 in his/her account, and the value is $5 per $1,000, then
the first payment will be $500. For a fixed annuity, this will be the value of all
subsequent payments. This would be true whether the insurance company’s investment
returns are better or worse.
39
Chapter 3
Review Questions
1. In a fixed annuity, who assumes the investment risk?
(
(
(
(
) A. Owner
) B. Annuitant
) C. Insurance company
) D. Beneficiary
2. Which of the following is an advantage of investing in a fixed annuity?
(
(
(
(
) A. Safety of principal
) B. Protection against inflation
) C. Returns tied to the stock market
) D. Invest in sub-accounts
3. What type of fixed annuity’s account value is subject to a market value adjustment
based on interest rate changes?
(
(
(
(
) A. Bonus Annuity
) B. Two-tiered Annuity
) C. Index Annuity
) D. Market Value Adjusted Annuity
4. Which type of interest rate crediting method reflects the company’s earnings on its
entire portfolio during the year of crediting?
(
(
(
(
) A. Old Money Rate
) B. Portfolio Rate
) C. New Money Rate
) D. Current Money Rate
5. Which method is used when taking a withdrawal from an annuity from funds recently
contributed?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
HILO
LIFO
HIFO
FIFO
40
CHAPTER 4
VARIABLE ANNUITIES
Overview
Variable annuities (VA’s) are commonly called "mutual funds with an insurance
wrapper". In an all-in-one package sold by an insurance company, a variable annuity
combines the characteristics of a fixed annuity with the benefits of owning mutual funds.
They are one class of annuity products, designed to reduce the risk of inflationary erosion
of real benefit payments.
The VA is one of the most rapidly growing insurance products of the last two decades.
They offer the opportunity to link payouts to the returns on an underlying asset portfolio.
But they also have the potential for the contract holder of the annuity to lose principal due
to market corrections.
In this chapter, we will define a variable annuity, review the history of the VA market,
and discuss the VA features and benefits. It will also review the various VA investment
options, the VA guaranteed minimum death benefits (GMDBs) and the enhanced
GMDBs, as well as the guaranteed living benefit (GLB) riders. At the end of the chapter,
we will examine VA annuitization, as well as VA regulation and, discuss the future
outlook for VA’s.
Learning Objectives
Upon completion of this chapter, you will be able to:







Define a variable annuity and explain the history of the VA;
Determine the various features and benefits of the VA;
Identify the various investment options in a VA;
Identify the fees and expenses within a VA;
Differentiate between the various enhanced guaranteed minimum death benefits
and riders;
Differentiate between the various guaranteed living benefit riders; and
Explain the regulation of the VA.
41
VA Defined
A variable annuity (VA) is a long-term tax-deferred contract between an investor
(contract owner/holder) and an insurance company, under which the insurer agrees to
make periodic payments, either immediately or at some time in the future. A VA is
structured to have both an investment component and an insurance element. A VA offers
a range of investment options, known as sub-accounts (discussed below). Opposite a
fixed annuity, it is the investor (contract owner/holder) who assumes all of the investment
risk.
The VA Market
Variable annuities were introduced in the United States by the Teachers Insurance and
Annuities Association-College Retirement Equities Fund (TIAA-CREF) in 1952. The
first variable annuities were qualified annuities that were used to fund pension
arrangements.
VA’s grew slowly during the next three decades—in part because of the need to obtain
regulatory approval for these products from many state insurance departments. Because
variable annuities are usually backed by assets, such as corporate stocks, that do not
guarantee a fixed minimal payout, the reserves that back these policies are maintained in
separate accounts from the other policy reserves of the life insurance companies. Other
than TIAA-CREF no other insurance company had issued a variable annuity policy as of
1960, primarily because state laws prohibited insurers from supplying a new class of
products backed by common stock assets that were segregated from the insurer’s other
assets. In addition, the 1959 Supreme Court ruling that the VA fell under joint
jurisdiction of the Securities and Exchange Commission (SEC) and the state level
insurance regulations department made it even more difficult to develop a VA.
However, all that changed when financial planner John D. Marsh conceived a variable
annuity that would be available to the general public. Mr. Marsh began his quest in 1955
when he and a group of associates established the Variable Annuity Life Insurance
Company (VALIC). However, it wasn’t until May 13, 1960, that the first commercial
variable annuity prospectus became available in the United States, and, with it, the first
insurance company separate account. And the rest is history.
The slow growth experienced in the 1950’s and 1960’s had been reversed. VA’s have
now become one of the most popular investment products offered by insurers. The
attractions of tax-deferred growth, guarantees and a broad range of investment choices
made VA’s one of the fastest growing products in the insurance industry.
U.S. VA gross sales had been increasing steadily from 2001 to 2007. By 2005, VA gross
sales had rebounded virtually to 2000 levels (a historic high). In 2007, U.S. VA gross
sales totaled $182.2 billion, again the highest in history.
42
Then in 2008, the financial market crisis led to a downturn in VA sales. Total gross VA
sales in 2008 were $154.8 billion, representing a 15 percent decrease in sales from 2007.
VA sales also showed a further decline in 2009, with sales of $125.0 billion, representing
a 19 percent decrease from 2008 sales.
Beginning in 2010 thru 2011, we saw the economy recover and demand for VA products
with guaranteed living benefit riders surged. VA gross sales increased 13 percent in 2011
to $159.3 billion from 2010 sales of $140.5 billion. Total VA assets at the end of 2011
were $1.6 trillion.
However, since 2012, we have seen a trend that VA sales are no longer tracking with the
equities market. Despite extraordinary growth in the equities market we have seen three
years of negative growth in VA sales, from $159. 3 billion in 2010 to $140.1 billion in
2014 (see Table 4.1).
Table 4.1
U. S. Sales of Variable Annuities and Net Assets 2000 - 2014 ($ billions)
YEAR
TOTAL SALES
ASSETS
2000
$ 137.3
$ 956
2001
113.3
888
2002
115.0
796
2003
126.4
999
2004
129.7
1,136
2005
133.1
1,231
2006
157.3
1,397
2007
182.2
1,517
2008
154.8
1,151
2009
125.0
1,389
2010
140.5
1,561
2011
159.3
1,593
2012
147.4
1,762
2013
145.4
2,008
2014
140.1
2,130
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Total VA sales in 2014, were down 4 percent to $140.1 billion from $145.4 billion in
2013.
43
VA Product Features
Just as there are characteristics of the fixed annuity that are consistent from product to
product, as discussed in Chapter 3, so too there are certain features shared by all variable
annuities. Let’s begin our discussion with some of the basic features of the variable
annuity and then, we will review the optional protection benefits (riders) that are used to
design the new versions of the VA product.
Separate Accounts
The variable annuity is characterized by a separate account (also known as sub-accounts)
that holds all of the variable account options. The separate account receives its name
because it is not part of the general account assets of the insurance company. Instead
they are investment fund options or sub-account that make-up the variable annuity.
Actually, the separate account is maintained solely for the purpose of making investments
for the contract owner. This transfers the risk from the insurer to the contract owner.
The separate accounts are not insured (guaranteed) by the insurance company, except in
the event of the owner or annuitant’s death. Account values will fluctuate, depending
specifically on the performance of the underlying investment of the separate account. All
profits and losses, minus fees, are passed along to the contract owner. In the event the
insurance company becomes insolvent, separate accounts are not attachable by the
insurer’s creditors and are normally distributed immediately to the contract owners. A
wide variety of funds are available to the contract owner in the separate account.
Investment Options
As mentioned above, in a variable annuity, investment choices are offered through subaccounts, which invest in a selection of funds, similar to mutual funds that are sold to the
public. The value of the funds will fluctuate over time, and the variable annuity’s return
is based on the investment performance of these funds. Variable annuities have, on
average, 49 sub-accounts.
A variable annuity contract will generally permit the contract owner to choose from a
range of funds (asset classes) with different investment objectives and strategies. The
basic asset classes include:






Money market fund
Equity
Fixed accounts
Balanced
Bonds
Alternative Investments
44
Premiums allocated to the guaranteed (fixed) account option are guaranteed against
investment risk and are credited with a guaranteed fixed rate of interest. However,
insurance companies may calculate the fixed rate payable differently (based on either the
portfolio rate or new money rate as discussed in Chapter 3).
Under some variable annuity contracts, the various sub-accounts are managed by the
insurance company (single management), while others are often managed by different
investment advisors (multi-managers), who may or may not be affiliated with the
insurance company. In fact, a number of well-known mutual fund companies offer funds
that serve as investment options for variable annuities.
Recently, a growing number of insurers have added a number of new sub-accounts that
will use alternative investments and dynamic asset allocation strategies to the investment
options available to VA investors. Since 2012, insurers added 102 VA sub-accounts that
use alternative strategies which include: currencies, long-short, market neutral and
precious metals, according to Morningstar Inc. That’s up from 63 new additions in 2011.
In fact, in a recent survey by one of the leading VA insurers, they reported that more than
nine out of 10 advisers expect to increase their use of alternative asset classes over the
next year. Among those advisors who anticipate an increase, more than half said they
would increase their use of alternatives by 15 percent or more in the next 12 months.
Nearly a third will boost their use of alternatives by 20 percent or more. Of the small
percentage of advisors who have not used alternative assets classes to date, more than 90
percent say they are now considering using them.
The major goal of using these types of alternative sub-accounts: real estate holdings,
hedge funds, commodities and the like, in the pursuit of diversification is to allow
investors to have tactical management strategies without suffering the tax consequences
of frequent trading. It would allow small investors to have access to alternatives that
otherwise would be available only to more affluent investors. And most importantly will
provide the tax efficiency (tax-deferral).
Accumulation Units
Once invested into the sub-account, the amount invested is then converted into
accumulation units. The use of accumulation units is simply an accounting measure to
determine a contract owner’s interest in the separate account during the accumulation
period of a deferred annuity.
Not all purchase payments (gross payments) made by a contract owner goes toward the
purchase of accumulation units. Before units can be purchased, the various charges and
fees (discussed later in this chapter) are deducted. The money to buy accumulation units
is then the net purchase payment.
The number of units, which the net payment will buy, depends upon the value of an
accumulation unit at that time. This value is determined periodically, usually daily. At
45
the risk of oversimplification, the value of one accumulation unit is reached by dividing
the value of the separate account by the number of accumulation units outstanding.
As the contract owner continues to buy accumulation units, these are added to those
already purchased. The dollar value of all the units owned by the contract owner equal
the number of units the contract owner owns times the value one accumulation unit.
The following example illustrates how this works out in practice:



Initial Value of Accumulation Unit on 01/01
Monthly Premium Payment
Initial Number of Units Purchased
= $5
= $100
= 20
Subsequent
Accumulation
Unit
Values
Number of
Units Purchased
01/01
$5.00
20.00
02/01
5.05
19.80
03/01
4.87
20.53
04/01
4.94
20.24
05/01
4.99
20.04
06/01
5.12
19.53
At the end of the six-month period, the annuity holder would have a total of 120.14
accumulation units. As stated above, the value of these units will continue to fluctuate
according to the unit’s market value. With each premium payment, the annuity owner
adds to the total accumulation units. The accumulation unit price will probably continue
to fluctuate. When the annuity matures, the annuity owner will have been credited with a
specified number of accumulation units.
The only exception to this process/equation is the money market account whose net asset
value is maintained on a constant dollar basis, where one dollar buys one unit. The
money market account credits a stated interest rate that changes as the underlying assets
of the money market changes.
VA Charges and Fees
The charges and fees levied under variable annuity contracts, while somewhat similar to
those charged by fixed annuity contracts, are subject to a greater degree of regulation due
to the fact that variable annuities are considered to be securities. (Remember: charges and
fees must be disclosed in the annuity’s prospectus). With a variable annuity, the fees are
calculated on either an annual basis and/or an asset basis.
46


Annual fees are fixed expenses that are deducted from the contract and average
about $35 to $50 a year. (Many contracts waive the annual fee at certain account
values, for example $50,000.)
Asset-based fees are percentages of the total value of the annuity, deducted on a
regular basis, usually daily, monthly, or annually. All owners of the same
contract pay the same percentage of their assets in these fees, but different dollar
amounts.
Mortality and Expense (M&E) Charge
The asset-based mortality and expense risk fee, also called the M&E charge, on all
variable annuity contracts pays for three things:



The guaranteed death benefit,
The option of a lifetime of income,
The assurance of fixed insurance costs including the M&E fee itself, which are
guaranteed (frozen) for the life of the contract.
In most cases, the fee is subtracted proportionately from each of the variable portfolios
that funds are invested in. According to Morningstar data, the average annual mortality
and expense charge was 1.27% in 2014.
Management (Fund Expense) Fees
The asset-based management fees (fund expenses) that are paid to the sub-account
manager for managing sub-account assets are debited from the annuity unit value and are
reflected in the investment return. These fees are described in the prospectus, and are
sometimes broken down into an investment advisory fee and an operating expense fee.
They’re often aggregated under the management fees (fund expenses) heading.
Because of the large amounts of assets under management, insurance and investment
companies are able to offer economies of scale, or competitive fee schedules, to their
customers. While operating fees vary amongst contracts, they can vary quite
dramatically, based primarily on the way the portfolio invests. For example, fees on index
portfolios tend to be significantly lower than the norm because the management costs are
lower. On the other hand, fees on foreign equity portfolios or those requiring extensive
research and management tend to be higher. These fee structures tend to be fairly
consistent from contract to contract. They’re also comparable to, but generally lower
than, the management fees you pay as part of a mutual fund investment. Remember to
compare apples to apples: in this case, similar equities to equities sub-accounts and
similar bonds to bonds sub-accounts.
47
Contract (Account) Maintenance Fees
A yearly contract (account) maintenance fee is commonly assessed to cover the
administrative expenses associated with the variable annuity contract. This charge
(usually a flat dollar amount), which covers the cost of issuing the contract and providing
administrative services, is usually applied at each contract anniversary date and upon a
surrender of the contract. The annual flat dollar fee ranges from $25 to $50 dollars.
Most insurers waive this fee if the contract value is greater than a certain amount (usually
$50,000 to $100,000) depending upon the contract.
The average Administrative and Distribution Fee in 2014, as calculated by Morningstar,
remained at 0.28%.
Summary of Above Fees
Based on its averages for Mortality and Expense Risk Charge, Administrative Fees,
Annual Records Maintenance Fees and Total Fund Expense Averages, Morningstar
calculated the Total Weighted Average Expenses for the year of 2014 was 2.51%.
According to Morningstar, the average annual expense ratio for publicly available equity
mutual funds was 1.25%, while the typical bond fund charges 1%. The comparable
figures show for underlying funds in variable annuities was 0.96%—0.29% lower. These
figures show that the lower expense ratio of underlying funds in some VA’s may actually
offset part of the additional insurance charges and suggest that, on average, the actual
cost differential of the two products is about 1.19% (see Table 4.2).
Table 4.2
Mutual Funds vs. VA Expense Comparison 2014
Mutual Funds
Fund Expense
M&E
Administrative charges
Distribution
Total
Difference
Variable Annuities
1.25%
0.96%
1.27%
0.19%
0.09%
2.51%
1.25%
1.26%
Source: Morningstar and LIMRA International June 2014.
Why are the average expense ratios for publicly available mutual funds higher than those
of underlying funds in variable annuity sub-accounts? The difference may be attributable
to several factors, but a primary reason is the additional handling and administrative
expenses incurred by mutual funds that are sold to the public. These mutual funds have
thousands of individual shareholders, and each shareholder has an investment account
that must be administered by the fund or another service provider. In the case of variable
annuities, however, most of these functions are handled by the insurance company and
are reflected in the insurance and administrative charges. The insurance company is, in
effect, one “account holder” of the underlying mutual fund.
48
The potential for variable annuity underlying fund expense ratios to be lower than
publicly available mutual funds is an important factor to keep in mind when considering
whether to invest in a variable annuity. By choosing carefully and comparing the costs of
the investment funds in a variable annuity to those of publicly available mutual funds, the
additional cost of the variable annuity may be partially offset by the cost savings offered
by the annuity sub-accounts. The point to remember is this—although there will be
charges for the valuable insurance features of a variable annuity, depending on the
product selected and the underlying investment options offered, the total cost differential
between the variable annuity and publicly available mutual funds may be less than one
might think.
Surrender Fees
Variable annuity contracts also have a charge, or surrender fee, when an owner
withdraws part or all of their annuity contract value during the early years of the contract.
These surrender fees are usually calculated as a percentage of the amount of the
withdrawal and generally decline each year until the fee disappears, typically seven years
after the purchase. With some contracts, the surrender fee period begins with the
purchase of the contract. With others, a new surrender fee period begins with each new
purchase payment.
Surrender fees serve several purposes. First, they make people think of their long-term
retirement account. The fee also benefits the insurance company issuing the contract,
since the charge can help to offset any losses it may incur in the liquidating holdings or
changing investment strategy to pay out the cash. In addition, since the company has
significant up-front costs in issuing the contract and is expecting to receive asset-based
fees or interest margins over a period of years, the surrender fees cover this loss of
income that results when the annuity is surrendered.
Remember, many annuities let the owner withdraw a certain percentage, generally up to
10%, from either the premiums paid into the contract, while other contracts may allow
the withdrawal from the total net surrender value of the annuity, without. As you can
imagine, the amount available to be withdrawn can be significantly different depending
on which contract is purchased.
VA Sales Charges
A number of insurers offer their VA contracts with various charge structures to meet
different investor needs. The following are the most common:

A-share: VA’s have up-front sales charges instead of surrender charges. Sales
charges are calculated as a percentage of each premium payment. A-share VA’s
offer breakpoint pricing, which means up-front sales charges decrease depending
on the cumulative amount of purchase payments that have been made. In
addition, assets that a contract owner has in other products in the company’s
49






product line may be recognized in the cumulative payment amount used to
determine the breakpoint pricing. A-share contracts often have lower ongoing
M&E annual fees than annuities with surrender charges.
B-share: Most VA contracts are B-share products. They are offered with no
initial sales charge, but cancellation of the contract during the early years may
trigger a surrender charge. These charges typically range from 5-7% of the
premium in the first policy year, and subsequently decline to zero.
C-share: No surrender charge variable annuities, offer full liquidity to clients at
any time, without any up front or surrender charges (although tax penalties may
apply to withdrawals prior to age 59½). There are ongoing M&E and
administrative fees, however, which may be higher.
Class I (No Load): No front load or contingent deferred sales charge and M&E
less than 1%.
L-share: Have no up-front sales charges. They typically have relatively short
surrender charge periods, such as three or four years, but may have higher
ongoing M&E and administrative charges.
O-share: Front load spread out over x years and contingent deferred sales charge,
both determined by a breakpoint-based reducing schedule.
X-share: X-Share variable annuity contracts credit an additional amount to the
contract value, which is calculated as a percentage of purchase payments added to
the contract at or subsequent to contract issue. This category does not include
contracts that credit additional amounts to the contract value after a designated
period, sometimes referred to as “persistency bonuses.” There are ongoing M&E
and administrative fees, which tend to be higher than B-Share contracts.
According to Morningstar Inc., B-shares were the most popular type of surrender charge
based on VA Share Class Distribution (Non-Group New Sales) for year-end 2014.
Surrender charges underscore the long-term nature of the annuity product. As long as
contract owners remain committed to accumulating money for retirement through their
variable annuity, they generally will not incur these charges. A number of insurers have
begun to offer other types of charge structures to meet different investor needs.
Premium Tax
A few states impose premium taxes on variable annuity purchases. These taxes range
from 0.50% - 5.0% depending on the state of residence but in most cases do not exceed
5% (see Table 4.3).
50
Table 4.3
States Charging a Premium Tax on Annuities
State
California
Maine
Nevada
South
Dakota
Virgin
Islands
West
Virginia
Wyoming
Qualified
Funds
Taxed Upfront
Qualified
Funds
Taxed @
Annuitization
2.35%
2.00%
3.50%
NQ-Funds
Taxed Upfront
NQ-Funds
Taxed @
Annuitization
0.50%
1.25%
5.00%
1.00%
5.00%
1.00%
1.00%
Investment Features
A variable annuity offers a wide range of investment options for the contract holder
(owner) to invest their premiums in various sub-accounts. To assist the contract holder in
their investment strategies the VA contract also offers various investment features such as
dollar cost averaging, fund transfers, asset allocation strategies and automatic portfolio
(asset) rebalancing.
Dollar Cost Averaging
Dollar cost averaging may reduce an individual’s concern about making an investment at
the “wrong” time. Investors sometimes delay the purchase of a security whose price has
been rising rapidly because they feel that it may be due for a correction. Meanwhile the
price continues to rise and they lose the good investment opportunity. They may also
delay the purchase of a security whose price has been falling because they fear it may be
in a long-term downward trend.
Dollar cost averaging alleviates this problem. With dollar cost averaging, an individual
invests the same flat dollar amount in the same securities at regular intervals over a
period of time, regardless of whether the price of the securities is rising or falling.

If the price of the security rises, the investor cannot purchase as many units of that
security for the same flat dollar amount. However, the value of the investment as
a whole will have risen. And if the price of the security later falls, the fewer units
purchased at the higher price will not drag down the total return on the investment
as much as if a large lump sum had been invested at the higher price.
51

If the price falls, the value of the investment also falls, but the investor is able to
purchase more units of those securities. If the price of the units later rises, the
larger number of units purchased at the lower price will more quickly offset the
loss in value caused by the earlier decline.
Dollar cost averaging does not offer a guarantee of gain or a guarantee against loss, but
over time it helps to average out the highs and lows in the security’s price. This frees the
investor from the anxiety of trying to predict the long-and short-term price swings that, in
many cases, can fool even the most experienced investor.
With all that said, there are several financial experts who argue that DCA does not work.
In an article in the October 2006, “Journal of Financial Planning”, John G. Greenhut,
Ph.D., writes that:
“…the behavior of stock volatility, which has given rise through illustrations to the
widespread belief that dollar-cost averaging, allows more shares to be bought over
time than would occur through a lump-sum investment. We have exposed that
illustration as a mathematical illusion, based on arithmetic changes in a denominator
leading to disproportionate changes in the fraction.”
Enhanced Dollar Cost Averaging
Enhanced dollar-cost-averaging (EDCA) follows the traditional DCA very closely but
allows for a slight change. The EDCA strategy invests a fixed additional amount after a
down month, and reduces the investment by a fixed amount after an up month. Note:
Due to the current interest rate environment a number of insurers have decided to
discontinue the EDCA in their VA contracts.
Fund Transfers
A variable annuity will allow the annuity contract holder to transfer funds from one subaccount to another (subject to some restrictions) tax-free. This flexibility to reposition
investments under the umbrella of the variable annuity offers the annuity holder the
opportunity to change his or her investment focus. It also allows an annuity holder to
change the level of risk that he/she is willing to accept. However, most contracts do have
some limitations on transfers. They are:



May limit the frequency of transfers by stipulating that they must be separated by
a certain interval, such as seven or thirty days.
There may be a minimum dollar amount or percentage of sub-account value that
is being transferred, and a minimum dollar amount or percentage of value that
must remain in the sub-account.
Some contracts limit the number of transfers that may be made each year. Some
contracts have no limits, but reserve the company’s right to charge a fee.
52

Because fixed account guarantees are supported by investments that may have to
be liquidated at a loss to accommodate a transfer, limits on the timing and amount
of transfers from the fixed account are common.
Asset Allocation
Asset allocation involves the use of a number of different investment options, each of
which plays a role in meeting the contract holder’s overall financial goals. It also
involves adjusting the percentage of assets devoted to each investment option to increase
the chances that the contract holder’s goals will continue to be met as circumstances
change.
The essence of asset allocation is to establish a mix of investments to match a contract
holder’s financial objectives and risk profile, and to change that mix as expectations
change in regard to the returns available in each class of investments. Some contracts
offer asset allocation services which will move the owner’s money according to a
professional asset manager’s assessment of the outlook for stocks, bonds, interest rates,
and so on. Under some other contracts, this is established by allowing the money
manager to make the appropriate transfers in the owner’s sub-accounts. Other contracts
offer an asset allocation sub-account in which the money manager changes the mix of
various investments on an on-going basis in an attempt to achieve the next favorable
return.
Asset Rebalancing
Asset rebalancing is a technique used by many portfolio managers to reduce risk and
improve a portfolio’s overall return. It involves making security trades at certain intervals
in order to bring the asset mix back into line with the allocations originally determined
for the portfolio. In effect, the portions of the portfolio that have performed the best are
reduced so that additional assets can be purchased for the portions of the portfolio that
have performed the worst.
There are no guarantees, of course, that automatic asset rebalancing will improve a
contract holder’s return, nor does automatic asset allocation provide any assurances
against the chance that the value of the securities underlying the investment option may
fall.
Guaranteed Minimum Death Benefit
A common feature of variable annuities is the death benefit. The contractual payout of
the death benefit varies by contract. The death benefit is generally payable as a lump sum
payment or as an annuity payment. Variable annuity contracts have traditionally offered a
guaranteed minimum death benefit (GMDB) during the accumulation phase that is
generally equal to the greater of:
53


The contract value or
Premium payments less prior withdrawals.
The GMDB gives the contract owners the confidence to invest in the stock market, which
is important in order to keep pace with inflation, since we know that their family will be
protected against financial loss in the event of an untimely death.
Enhanced GMDB Features
Over the past ten years, many insurers have offered enhanced GMDB riders. Some type
of enhanced death benefit is now available with most variable annuity contracts. There
are four types of enhanced GMDB riders. They are:




Initial Purchase Payment with Interest or Rising Floor (Roll-up)
Contract Anniversary (Market Anniversary Value) or Ratchet
Reset Option
Enhanced Earnings Benefit
These different types of enhanced GMDBs are riders to the contract and will have
additional associated charges. The charges could be applied to the contract value or
benefit base. Generally, these optional death benefit riders can only be elected at issue if
the owner(s)/annuitant(s) are within the age specifications as set forth in the contract rider
and prospectus and are irrevocable once elected.
Let’s review each of these enhanced guaranteed minimum death benefits in greater detail.
Initial Purchase Payment with Interest or Rising Floor
Some insurers offer rising floor or rollup GMDBs that is equal to the greater of:


The standard GMDB, or
The purchase payments accumulated at a specified annual rate (5% - 7%) up
to a specified age and adjusted for any withdrawals.
Note: By stepping up the increasing GMDB to the Account Value may start over a new
surrender charge period.
Example: Mr. Jones purchased a $100,000 variable annuity with a surrender charge
of 5 years. Over the years Mr. Jones owned the contract, his account value jumped
around from $150,000 to $250,000. At the end of the five years, Mr. Jones’ surrender
charges had expired and the value of his account was $200,000. At that time, Mr.
Jones locks in his step-up death benefit to the account value of $200,000. In
exchange, the insurer restarts another 5-year surrender charge penalty schedule.
54
Of course, these types of increasing death benefits do not last forever. Most contracts
call for the suspension of the increasing death benefit at ages from age 75 to age 85,
depending on the contract.
In some cases, a ratchet and a rising floor may be available within the same contract.
Some contracts offer a choice of a ratchet or a rising floor.
Contract Anniversary, Or “Ratchet”
Some insurance companies offer ratchet GMDBs that are equal to the greater of:



The contract value
Premium payments less prior withdrawals
The contract value on a specified prior date
This is essentially a discrete look-back option—the death benefit equals to the larger of
the amount invested or the ratcheted account value. More precisely, the death benefit
guarantee only moves up at the beginning of every ratchet period. The specified date
could be a prior contract anniversary date such as the contract anniversary date at the end
of every seven-year period, every anniversary date or even more often. A ratchet GMDB
locks in the contract’s gains on each of the specified prior dates.
Reset Option
Here, the GMDB can be adjusted (moved up or down) at the beginning of every reset
period. The frequency of the resetting interval ranges from once a year to once every five
years.
Enhanced Earnings Benefits
Some insurers offer enhanced earnings benefits (EEB), which provide a separate death
benefit that can be used, for example, to pay the taxes on any gains in the contract. With
this feature, beneficiaries will receive not only the death benefit amount, but also an
additional amount, which is usually equal to a percentage of earnings.
Guaranteed Living Benefit (GLB) Riders
The introduction of “guaranteed living benefit” riders (GLBs) back in the late 1990s
conceptually filled a void in the investment spectrum that had been identified by
academic research decades earlier. Beginning in the 1960’s economists puzzled over
why retirees, the most risk-averse segment of the population, have historically eschewed
converting their defined benefit pension and 401(k) plan savings into guaranteed lifetime
annuity payments in favor of far riskier self-directed investment choices.
55
However, with the arrival of GLB riders attached to VA contracts, they now offered
retirees (and those approaching retirement) a guaranteed lifetime income solution with
the potential to let them have their figurative cake and eat it too. At the heart of these
GLB riders is the concept of “deferred annuitization,” a financial engineering innovation
that allows VA contract owners (holders) to invest in an underlying portfolio of risky
assets for capital appreciation while retaining the right to receive a guaranteed lifetime
income stream, from the benefit base, if the investments and/or the overall markets
perform poorly and are exhausted through systematic withdrawals (assuming rider terms
and conditions are met). Conversely, if the underlying investments perform well, the
contract holders retain complete control over the asset (contract value) during their
lifetimes and, upon death, the named beneficiaries receive the remaining assets.
It is important to remember that a VA’s guaranteed living benefit withdrawal benefit is
calculated using a separate metric known as the “benefit base,” which is distinct from its
contract value. A VA’s benefit base will typically grow at a fixed rate known as a “rollup rate” during the accumulation phase unless strong performance propels the contract
value above the benefit base on a specified date. In that scenario, the benefit base will
reset higher to the contract value. Today, many VA’s have a rollup that range from 4
percent to 6.5 percent, based on the annuitant age. A VA’s benefit base typically will not
decline regardless of what happens to the contract value, which is how the market
protection feature works. Thus, once a benefit base is reset higher, those gains a locked
in. This is what’s known as a “high-water mark” provisions.
Types of GLB Riders
GLB riders attached to a VA can be offered as one of the following:




Guaranteed Minimum Income Benefits (GMIB),
Guaranteed Minimum Accumulation Benefits (GMAB),
Guaranteed Minimum Withdrawal Benefits (GMWB), and
Guaranteed Minimum Withdrawal Benefit for Lifetime (GMWBL).
Guaranteed Minimum Income Benefit (GMIB)
The GMIB was the first living benefit rider that hit the market back in 1996. What it’s
designed to do is guarantee the client (contract holder/annuitant) a future income stream.
The VA-GMIB has two values: a Contract Value and an Income Benefit Base. The
GMIB payment will be based on the Income Benefit Base and the annuitization factor.
GMIB Features and Benefits
One of the important features of the VA—GMIB rider is how the income credit
accumulates. With the GMIB rider, the income credit accumulation can continue
whether or not the client (annuity holder/owner) makes a withdrawal. This is different
56
than most GMWBs/GMWBLs contracts, where the credit accumulation stops once you
commence withdrawals (discussed below).
For Example: If the accumulation rate of the GMIB is 5%, then you can take any
amount up to 5%. Whatever you don’t take out continues to accumulate in the
Income Benefit.
Credit accumulation ends when the age limit (usually age 85/91) is reached or when
annuitization occurs.
Another important feature of the GMIB is annuitization. When your client purchases a
GMIB rider, their future annuity rates are stated in the prospectus. These rates are
generally lower than the life annuity rates in the open market. It does this via its income
base or bases. Today, GMIBs may have both a roll-up base, which increases annually
from 4-5 percent depending on the insurance company, and a second income base that
steps up to the account (contract) value, typically annually.
GMIBs also have a waiting period in which the benefit cannot be exercised. This period
ranges from five to ten years depending on the insurance company and benefit.
Something to keep in mind is that some insurance companies will require your client to
restart the waiting period if you lock in a new value for the step-up base.
GMIBs are available at contract issue, provided the oldest annuitant is not over the age
specified in the rider and the prospectus at issue (usually, ages 70 or 78). GMIBs are
irrevocable, optional living benefits that provide a safety net for retirement assets in the
form of a guaranteed minimum income stream—no matter how the underlying annuity
investments performs as long as no withdrawals are taken.
To receive the income benefits from the rider the client must annuitize the contract under
the terms of the contract. Note: The guaranteed payout rates with the GMIB are based on
conservative actuarial factors and are currently less favorable than the current payout
rates used to convert contract values to annuitization income. In other words, there is a
“haircut” on the GMIB annuity actuarial factors.
GMIB Caveats
The following are some of the caveats of the GMIB rider:





A set waiting period (usually 7-10 years)
Maximum age required for annuitization age 80 - 91.
May require Asset Allocation /Immunization strategies
To benefit greatly the difference between the guaranteed amount and the actual
account value must be substantial
Must annuitize the contract with the insurer
57
GMIB Client Suitability
The following would be individuals who the guaranteed minimum income benefit rider
may be suitable:



Client looking for a lifetime income stream and wants to maximize security above
all other considerations.
Individual plans to annuitize their contract.
Owner/annuitant cannot be over a specified age set forth in the contract.
Guaranteed Minimum Account Balance (GMAB)
The GMAB rider offers a guarantee of principal while remaining invested in the market
after a specific waiting period usually five to ten years. Be aware that there may be
conditions and restrictions on this benefit. Most variable annuities using the GMAB come
with prepackaged asset allocation models into which you place the premiums invested in
the contract by the contract holder. Today, many insurers now offer access to a wider
range of investment options so that your client can design a strategy specific to their
needs and timelines. Some contracts now offer target maturity date funds in their
portfolios, making the job that much easier.
What’s important with this feature is that the benefit base is a walk away amount. Your
client does not need to annuitize the contract.
GMAB Example
A client invests $100,000 in a variable annuity with a GMAB feature. After 10 years the
contract holder has taken no withdrawals and the market value has dropped to ½ of its
original value, or $50,000. With the GMAB rider, the account is returned back to the
benefit base of $100,000, the original principal, and because no withdrawals were taken
during the 10-year period the contract holder could then surrender the contract and
receive $100,000.
GMAB Caveats
The following are some of the caveats of the GMAB rider:



Some GMAB contracts mandate that all assets be allocated in specified
investment options (asset allocation models) to access the benefits.
Some contracts allow the insurer to change the client’s allocation at their
discretion and the client has no control over the investment choices.
At the end of the waiting period, the benefit may be exercised, expired, or
renewed, depending on terms of the contract.
58


If the benefit is not exercised or renewed, the guaranteed amount will be subject
to market risk and may lose value.
If benefit is renewed it will start a new waiting period.
GMAB Client Suitability
The following would be individuals who the guaranteed minimum accumulation benefit
rider may be suitable:



Clients who are seeking protection against unpredictable markets.
Clients who have a number of years before they will need the money, and
Clients who are not seeking a death benefit or looking to convert their contract to
income (annuitize).
Guaranteed Minimum Withdrawal Benefit (GMWB)
The GMWB rider was the second type of GLB, it evolved in 2002 in response to some of
the limitations posed by the GMIB, especially during bull markets. The idea behind the
GMWB is to allow the contract holder to withdraw a maximum percentage of their total
investment each year for a set number of years, regardless of market performance, until
recovery of 100% of the investment. The insurer can be defined as a rider that guarantees
a fixed percentage–generally 5% (some contracts may be higher) of the annuity
premiums can be withdrawn annually for a specified period of time until the entire
amount of paid premiums have been withdrawn, regardless of market performance and
without annuitizing the annuity.
GMWB Example
A client invested $100,000 into a variable annuity with a GMWB with a 5% systematic
withdrawal; the contract holder could withdraw $5,000 per year for 20 years regardless of
market performance. If the contract holder’s account value went to zero before the 20
years were up, the contract holder would continue to receive the $5,000 for the remainder
of the 20-year benefit period. You calculate the benefit period by taking the benefit base
and dividing it by the percentage of the dollar-for-dollar withdrawal. Here in our
example, a 5% dollar-for-dollar withdrawal would give the client a benefit period of 20
years.
GMWB Caveats
The following are some of the caveats of the GMWB rider:

Owner/annuitant cannot be over a specified age (usually age 70 or 75) as set forth
in the contract rider.
59




Generally, with the GMWB there are no lifetime income guarantees (no longevity
insurance). However, as we will discuss later, there are some new contracts that
have come to market that have lifetime guarantees known as GMWBL.
Withdrawals lower the benefit base on a dollar for dollar basis up to a certain
level (usually 5-7%). Any excess amount withdrawn will be treated on a pro-rata
basis which will decrease greatly the benefit base (also there may be additional
surrender charges).
Any withdrawals from the GMWB are taxed under the LIFO method—last in–
first out method—resulting in all interest/earnings must come out of the contract
first and will be taxable.
If used for a 72(t) Series of Substantial Equal Periodic Payments (SOSEPP) or
held in a qualified plan and/or IRA and required minimum distributions (RMDs)
are needed, the amount that may be distributed may be greater than the
withdrawal amount allowed in the contract and this may disrupt the rider
guarantees.
Example: If a client, who is in their 80s and is required to take an RMD of
6% and only is allowed a systematic withdrawal of 5% from the contract, then
there will be a problem. Note: Some contracts have become “RMD friendly”
and they will allow the distribution to be greater than the contract withdrawal
in order to meet these requirements without any charges.
Some people believe you can take the withdrawals for a period of time and
then annuitize based on their premium. That is not the case. You can annuitize
the feature, but it is based on the income base, not the premium. If the income
base is exhausted, there is no annuitization benefit.
GMWB Client Suitability
Best suited for clients who are looking for current income and would like to remain
invested in the market - clients who prefer a “safety net” (portfolio insurance) if the
market goes down.
Guaranteed Minimum Withdrawal Benefit for Lifetime
As discussed above, the earlier GMWB riders covered only a certain term, usually 17-20
years. GWMBs did not provide longevity insurance. All that changed in 2004, with the
Guaranteed Minimum Withdrawal Benefit for Lifetime (GMWBL).
The GMWBL rider attached to variable annuities provides two market values that will
fluctuate similar to a mutual fund (similar to GMIB discussed above): The Contract
Value and the Income Benefit Base. The Income Benefit Base’s value does not fluctuate
with market conditions, but it is used to calculate the income payments. When you first
purchase a GMWBL rider, both the Contract Value and the Income Benefit Base are the
same, i.e. your initial premium. Even if the contract value goes down to zero in adverse
60
markets, annual payments continue for life of the contract, based on the Income Benefit
Base.
GMWBL Features and Benefits
There are several important features and benefits of GMWBL rider. They are:




Guaranteed pay: Most contracts pay, for life, 5% of the Income Benefit Base
each year. Some contracts may pay higher. For example, if your client purchases
a VA with the GMWBL rider with $100,000 at age 65, he/she is guaranteed to
receive at least $5,000 each year for the rest of his or her life (longevity
insurance), regardless of how his or her investments perform (portfolio
insurance).
Step-Up Reset: If the portfolio does well and the contract value exceeds the
Income Benefit Base, then the Income Benefit Base is reset higher, equal to the
contract value. Most contracts allow for an annual reset. Many insurers put a
time limit on step-up resets, such as 30 years from the initial contract date, or until
age 80 or 85.
Income Credit: If your client buys a VA- with the GMWBL rider prior to needing
income, then an income credit may be added to the Income Benefit Base annually,
usually 5%. A higher Income Benefit Base pays a higher guaranteed income
when it starts. For example, the insurer might agree to pay 5.0% at age 55. But if
you wait until age 70 to begin taking income, the insurer might increase to 6.0%.
At age 80, it could be 7%. If there is a step-up reset that increases the Income
Benefit Base by more than the income credit amount in that year, then no income
credit is added. There is usually a time or an age limit on income credit.
Other Benefits: The same benefits that are available for a regular variable annuity
also apply to a VA—GMWBL; such as death benefits, principal protection, and
conversion to a life annuity. Keep in mind that these benefits, or riders, differ
from contract to contract, and usually come with additional costs.
Jim Otar, in his book: “Unveiling The Retirement Myth: An Advanced Retirement
Planning based on Market History,” writes about the VA—GMWBL “as one of the most
versatile income classes in an advisors toolbox. They convert longevity and market risks
into inflation risk. They go a long way in minimizing the “fear” for the retiree.”
Note: The annuity starting date on most annuity contracts is age 95. Most insurance
companies will force the individual to annuitize the contract at that point in time. Some
contracts may pay out the larger of: the annuitization factor or the withdrawal benefit
amount.
GMWBL Client Suitability
For Example: Rebecca is 65 years old and a recent widow. She has $700,000 to last her
for the rest of her life. She wants an equity-based investment that will guarantee her a
minimum of $35,000 a year starting immediately with a chance for that income to
61
increase (but not decrease) should the stock market move up. Rebecca also wants to
know that:




Her stream of income will last for her entire lifetime, even if she should live to
well over age 100;
If she dies prematurely, any remaining account value will be paid out to
beneficiaries;
She won’t have to annuitize;
She has the option to withdraw against the account balance at any time.
For Rebecca’s $700,000 investment, a VA with the GMWBL rider may be suitable.
Treatment of Withdrawals from GLB Riders
Let’s review the two different treatments of withdrawals and how they affect the income
base of the guaranteed living benefit chosen.
Dollar-for-Dollar
The first and simplest is a dollar-for-dollar withdrawal, in which the base is simply
reduced by the same amount as the withdrawal.
Example: With a dollar-for-dollar withdrawal an account value of $100,000 and
an income base of $200,000, a withdrawal of $10,000 from the account value will
lower the income base to $190,000 ($200,000 - $10,000).
Pro-Rata
The second type of withdrawal, pro-rata, is a little more difficult to calculate. The
income is reduced on a proportionate basis in relation to the current account value when
the withdrawal is taken.
Example: Using the same scenario as above, with a $100,000 account value and
a $200,000 benefit base, this time when we withdraw the $10,000 we have to look
to the current account value to calculate the reduction in the benefit base. The
$10,000 represents 10 percent of the account value, or $10,000 divided by
$100,000. We then reduce the income base a proportionate amount of the 10
percent, or $20,000. This is simply 10 percent of the $200,000 income base. We
end up with an income base of $180,000.
62
Variable Annuitization: Calculating Variable Annuity Income
Payouts
Annuitization is one of the least utilized and often misunderstood options of a variable
annuity contract. The annuity contract holder may elect to allocate all or part of the value
of the contract to either the fixed account and/or the separate account.
Allocations to the fixed account will provide annuity payments on a fixed basis; amounts
allocated to the separate account will provide annuity payments on a variable basis
reflecting the investment performance of the underlying sub-account.
To understand why and how the income payout amount will vary under the variable
payout option, it is necessary to understand the two important concepts:
 “Annuity units” and
 “Assumed interest rate” (AIR)
Annuity Units
An annuity unit is a unit of measure used to determine the value of each income payment
made under the variable annuity option. How the value of one unit is calculated is a
fairly complex process involving certain assumptions about investment returns. It is
probably sufficient to understand that the amount of each month’s variable annuity
income payout is equal to the number of annuity units owned by the contract holder in
each investment account multiplied by the value of one annuity unit for that investment
account.
Example: Let’s assume that on January 1, the date the annuitant retires, he or she has
collected a total of 10,000 accumulation units. Assume further that at that time the
10,000 units have a market value of $50,000.
Using the above process, the insurance company then converts the annuitant’s 10,000
accumulation units to 100 annuity units.
On the first payment, each annuity unit is worth $10. If the annuitant chooses the fixed
payment option, the $1,000 monthly payment, as listed in the example below as of
January 1, would remain constant for the balance of the payout period.
Assume that the annuitant chooses a variable payout; in that case, a six-month projection
of monthly payments would be as follows:
63
Date
Annuity
Unit Value
Monthly Payment
to Annuitant
01/01
$10.00
$1,000
02/01
10.17
1,017
03/01
9.73
973
04/01
9.89
989
05/01
10.11
1,011
06/01
10.57
1,057
The major benefit of using the variable accounts during the annuitization phase of a
variable annuity is that it gives the annuity contract holder the opportunity for his/her
income payment amounts to increase sufficiently so that they may keep up with inflation.
However, as shown above there is the risk that the income payment may also decrease.
To accommodate those clients who are concerned with that risk, many insurers allow the
annuity contract holder to place a portion of the accumulation value in the guaranteed
general account and thus receive a fixed income payment (fixed annuitization) and place
the remainder of the accumulation value into a separate investment account (variable
annuitization) and receive a variable benefit amount from these funds.
Assumed Interest Rate (AIR)
The selection of the assumed interest rate (AIR) is unique to a variable annuity and
requires a high degree of knowledge about the subject. The AIR is the most significant
component in the conversion factor for a variable annuity. A poor decision could result
in receiving less than the maximum possible benefit. All variable annuities require an
AIR as the basis for the initial and subsequent payments.
Also, the AIR will have a significant impact on the initial payment level and on the
pattern of subsequent payments. Many contracts allow the annuity contract holder to
select the interest rate to be assumed (AIR) in calculating the initial payment level. Other
companies only offer one AIR. A higher AIR produces a larger initial payment than a
lower AIR.
Since the AIR is an assumption and not a guarantee, subsequent payments will vary
according to the relationship between actual investment performance and the selected
AIR. If actual investment returns are exactly to the AIR, then the payment amount will
not change. If actual investment returns are greater than the AIR, then the payment
amount will increase. If investment returns are less than the AIR, payments will
decrease.
64
A higher AIR means not only that the initial payment level will be higher, but also that
subsequent payments will increase more slowly or decline more quickly than payments
determined with a lower AIR. If the annuity contract holder lived long enough and had
two annuities alike except for the AIR, the payments based upon two different AIRs
would eventually cross, and the payments based upon the higher AIR would thereafter
always be less than those based upon the lower AIR.
Typically, the payment patterns of a high AIR and a low AIR will cross after eight or
nine years of payments; however, the total payments received will not be equal until after
about 14 or 15 years of payments. In other words, an annuity contract holder who lives
less than 15 years would receive more annuity benefits under a higher AIR than under a
lower AIR; conversely, an annuity contract holder who lives more than 15 years would
receive more annuity benefits under a lower AIR than under a higher AIR. Favorable
investment performance will result in an increase under all AIRs.
Here is an example of the impact of the AIR on payment levels: Monthly payments
under alternative AIRs based on a 6 percent actual investment return and a $10k annuity
purchase at age 65 would mean $100 at year five. On a basis of 3 percent actual
investment return at age 65 would be $91 at year five. The monthly payment for a 9
percent actual investment return at age 65 would increase to $108 at year five.
VA Regulation under the Federal Securities Laws
Besides being governed by the state regulatory framework, variable annuities as
securities are regulated under federal securities laws. The primary federal securities that
regulate variable annuities and the separate accounts through which they are issued are:



Securities Act of 1933 (1933Act),
Securities Act of 1934 (1934 Act), and
Investment Company Act of 1940.
The Securities Exchange Commission (SEC) administers these acts.
Securities Act of 1933
The Securities Act of 1933 sets out three very important rules:

Registration of Contracts. Because variable annuities are securities, they must be
registered with the SEC under the 1933 Act before they can be offered to the
public (with two exceptions noted below). The SEC staff reviews and comments
on registration statements, which usually must be amended in response to staff
comments before they will be declared effective. (The SEC does not, however,
approve or disapprove of any securities, including variable annuities and does not
pass on the accuracy or adequacy of any prospectus.) A “post effective”
amendment updating the variable annuities registration statement generally must
65


be filed at least annually. The first registration exception is for annuity contracts
that are issued in connection with certain qualified plans such as 401(k) plans.
The second exception is for “privately offered” annuities, which are contracts
that, among other things, are not offered to the general public. Even with these
exceptions, however, issuers and others involved in marketing non-registered
variable annuities, remain subject to the anti-fraud provisions of the 1933 Act.
Prospectus Delivery. When someone purchases a registered non-qualified
variable annuity he or she receives a prospectus. These prospectuses are updated
regularly. Separate prospectuses describe underlying investment options—the
funds to which the annuity holder may allocate his or her investments. This can
result in the annuity holder receiving numerous prospectuses. However, the SEC
recently adopted a rule permitting fund “profiles” which are shorter, user friendly
summary prospectuses, to be given to the prospective purchaser. The SEC also
permits limited use of variable annuity profiles.
Disclosure of Fees and Expenses. Variable annuity prospectuses contain fee
tables that list the amounts of each contract and underlying fund charges. These
amounts are expressed in dollar amounts or percentages of the contract value or
fund assets so purchasers will know what they will pay if they buy the contract.
In addition, variable annuity prospectuses contain numerical examples showing in
dollar amounts per $1,000, what the annuity holder would pay for the contract and
each portfolio of the fund over 1-, 3-, 5-, and 10-year periods.
o For example, the ABC VA prospectus could have a tabular example
showing total expenses on a $1,000 investment in the contract allocated to
the stock fund to be $78, $106, $126, and $208, for the 1-, 3-, 5-, and 10
year periods, respectively, following the purchase. These examples
assume a 5% return and that the contract is surrendered at the end of the
relevant period.
Additional examples are required that assume that the investor does not surrender
the contract. This format shows the effect of any surrender charge.
Securities Act of 1934
The 1934 Act generally requires variable annuities to be distributed through registered
broker-dealer firms and their registered representatives. Broker-dealers and their
representatives are subject to extensive operational and financial rules that cover
minimum net capital requirements, reporting, record keeping, supervision, advertising,
and sales activities.
In addition to the broker-dealer regulatory framework established by the 1934 Act,
registered broker-dealer firms that sell variable annuities also must be members of the
NASD. The NASD is a self-regulatory organization overseen by the SEC. It has an
extensive body of rules with which broker-dealers must comply. For example,
examinations are required; fingerprints must be provided; and numerous supervisory,
suitability, advertising, record keeping, and reporting rules apply.
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Note: As of July 2007, the NASD, with the consolidation of the member regulation,
enforcement and arbitration functions of the New York Stock Exchange, will now be
called the Financial Industry Regulatory Authority (FINRA).
A 1934 Act rule requires broker-dealers to send confirmation statements to annuity
holders after each purchase and sales transaction made involving a variable annuity
contract. In addition, insurance companies send annuity holders periodic account
statements showing a beginning balance, transactions during the period, and an ending
balance so that the annuity holder will have a record of all activity in his or her contract.
Investment Company Act of 1940
The 1940 Act imposes an extensive federal regulatory structure on investment
companies, including separate accounts and underlying funds. Note: Some separate
accounts and funds however, such as those used in connection with tax-qualified
retirement plans, are not subject to the 1940 Act. For example, the Act governs how
variable annuities and shares of underlying funds are issued and redeemed. There are
also corporate governance requirements and prohibitions against self-dealing.
Each separate account regulated under the 1940 Act must file a report on its operations
annually with the SEC. In addition, an annual and semi-annual report containing
information about the underlying mutual funds that serve as investment options for the
variable annuities must be sent to annuity holders. In some cases, these reports also
contain information on the variable annuities themselves.
The SEC inspects variable annuity separate account operations regularly. The SEC also
inspects various locations, such as broker-dealer offices, from which variable annuities
are sold. Recommendations are made and any deficiencies are noted. If the situation is
serious enough, it is referred to the SEC’s enforcement division.
Regulation of Fees and Charges
Currently, the SEC does not regulate individual variable annuity fees and charges.
However, the 1940 Act makes it unlawful for any registered separate account funding
variable annuity contracts, or for the sponsoring insurance company, to sell any such
contract unless the fees and charges deducted under the contract are, in aggregate,
reasonable in relation to the services rendered, the expenses expected to be incurred, and
the risks assumed by the insurance company. The insurer must represent in the annuity
contract’s registration statement that the fees and charges are reasonable.
Outlook for Variable Annuities
67
The fact that several major insurers exited from the annuity business should tell us all we
need to know about the health and viability of the industry heading into 2015. If only it
were that simple, since the industry, like the product itself, is a bit more complicated.
The industry has dealt with several issues in recent years: hedging issues, suitability, 77
million baby boomers going into retirement, the living benefit “arms race” and also, let’s
not forget the worst global financial crisis in the history of the world.
In fact, the insurance industry’s exposure to variable annuities that are in the money,
where the account value is smaller than the guaranteed living benefit base, continues to
shrink. In 2011, life insurers had $721.3 billion in assets under management tied to VA’s
with these features, while benefit bases were worth $823.4 billion. That leaves the
industry under water on these benefits by $102.1 billion, according to Morningstar.
During the crisis in 2008, insurers were underwater on these benefits by $253.7 billion.
In 2006, the halcyon days prior to the downturn and the living benefits arms race, carriers
were only underwater by $3 million.
As the markets return to normalcy, the appetite for variable annuities is poised for a
comeback, which will perhaps outshine the growth of the past decade. The reason for
this optimistic outlook is that many investors continue to face volatile financial markets,
dwindling pensions and a money-strapped Social Security system that may be incapable
of providing the income they need for a secure and, very likely, extended retirement.
Given the various challenges in retirement funding within today’s risk-averse investment
climate, the VA, coupled with an appropriately diversified portfolio, can serve as an
important retirement-income solution.
In the end, VA providers with the best risk management capabilities should emerge from
the current crisis in a stronger position with solid products that continue to play a critical
role in meeting retirement needs. There are compelling reasons to believe that a surge in
demand is just over the horizon. And insurers who persist in refining their products and
hedging programs should be in the best position to exploit it.
Ultimately, investors (especially baby boomers) will continue to seek ways to allocate a
portion of their portfolio to the kind of guaranteed, lifelong income their parents enjoyed
via their company pensions. As these investors intensify the search for defined benefitlike retirement alternatives, VA’s may increasingly be seen as a vehicle of choice, given
their role in portfolio diversification and providing a potential source of stable income.
In addition, with the increasing income tax rates and the new IRC Section 1411
(Medicare Surtax) of 3.8% many investors will be seeking the basic benefits of plain tax
deferral. We have seen a number of insurers that have come to market with specific VA
products to meet this demand.
LIMRA estimates that VA sales should grow to $162 billion by 2018.
68
Chapter 4
Review Questions
1. In a variable annuity who assumes all of the risk in the sub-accounts?
(
(
(
(
) A. Contract holder (owner)
) B. Insurance Company
) C. Investment Company
) D. Management Company
2. Mortality and Expense (M&E) charges in a variable annuity pays for all of the
following fees and charges EXCEPT:
(
(
(
(
) A. Guaranteed death benefit
) B. Investment Management fees
) C. The option of a lifetime of income
) D. The assurance of fixed insurance costs
3. What is the measure used in a variable annuity to determine the contract owner’s
interest in the separate account during the accumulation phase?
(
(
(
(
) A. Annuity unit
) B. Assumed interest rate
) C. Net asset value
) D. Accumulation unit
4. Which of the following provides a separate death benefit that can be used to pay taxes
on gains in the contract?
(
(
(
(
) A. GMAB
) B. GWSIP
) C. Enhanced Earnings Benefit
) D. GMIB
5. Which of the following is the most significant component in the conversion factor for
a variable annuity?
(
(
(
(
) A. Net asset value
) B. Accumulation unit
) C. Annuity unit value
) D. Assumed interest rate
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70
CHAPTER 5
INDEX ANNUITIES
Overview
The IA is designed for safety of principal with returns linked to upside market
performance. Since their inception back in 1994, there have been numerous articles
written about the positives as well as the negatives of Index Annuities (IA’s). But one
thing is certain, sales of IA’s has vastly increased every year since 1996.
In this chapter, we will define an Index Annuity (IA), review the IA market and history,
the various terms and provisions specific to an IA, and the regulatory issues of IA’s.
Learning Objectives
Upon completion of this chapter, you will be able to:






How to define an Index Annuity;
Determine a consumer profile that would be suitable for an Index Annuity;
Demonstrate an understand the various moving parts of the Index Annuity;
Identify the various interest linked interest crediting methods;
Understand the various IA Waivers and Riders; and
Recognize the role of state insurance departments in the regulation of IA’s.
Index Annuity Defined
Fundamentally, an Index Annuity (IA) is a type of fixed annuity whose ultimate rate of
return is a function of the appreciation in an external market index, with a guaranteed
minimum return. As such, IA’s provide their owners with the potential for larger interest
credits—based on growth in the equities market—than what might be paid on traditional
fixed-rate annuities, while avoiding the downside risk that accompanies the direct
investing in equities. The external market index used in IA’s is almost always the
Standard & Poor’s 500 Composite Stock Price Index (i.e., S&P 500), although one of
several other recognized market indices might also be used.
The fundamental concept that underlies all IA’s is a fairly simple one; interest credits are
tied to an external market index. However, as will be seen later, achieving a full
understanding of IA product design is not a simple task, due partly to the proliferation of
71
product designs and interest-crediting structures that currently exist in the marketplace.
Although introduced in the U.S. market more than a decade ago, IA product design is still
evolving. New products, containing one or more new features or offering variations on
one or more “old” features, are introduced into the marketplace on a relatively frequent
basis. Furthermore, a number of contract features affect the financial performance of
IA’s, not just the change in the external market index.
The major features, or components, of IA product design are described later in this
chapter. However, it is important to note here that for many contract features the insurer
has a variety of options from which to choose in designing an IA product. As a result, the
current IA marketplace contains hundreds of variations in IA product design. Many
insurers have multiple IA products, each one designed to address a differing set of
customer needs and objectives.
Index Annuity Market
The origin of IA’s in the U.S. is generally traced back to 1995 when Keyport Life
Insurance Company began selling its “Key Index” product that year. The first IA was
purchased February 15, 1995 by a 60 year old from Massachusetts. Over the next five
years the original $21,000 premium placed in a Keyport Key Index annuity grew to
$51,779. The IA era had begun. These products have garnered a lot of excitement in the
annuity marketplace and, simultaneously, have achieved record industry sales in a
relatively short period of time. However, IA’s, as well as certain sales and marketing
practices, are also currently the subject of controversy and criticism.
In 1997, IA sales were $3 billion, a mere blip on the annuities marketplace. Fast forward
17 years and IA’s racked up $48.2 billion in sales by the end of 2014, and comprise 50
percent of all fixed annuity sales, according to data compiled by Advantage Compendium
(see Table 5.1).
Profile of an IA Buyer
Who would be a typical IA buyer? IA’s are designed for people that are averse to risk.
The type of person whom, if given a choice between an investment that has an equal
chance of doubling in a year or losing 20% of its value versus an investment that will
make 6%, will always choose the low risk/low return alternative. Certificate of deposit
and traditional fixed annuity buyers fit this profile. IA’s can be used to overcome this
aversion to risk by providing the potential for higher returns than traditional savings
vehicles without market risk to principal.
It is important to remember that an IA should never be used in comparison with a VA or
any other type of equity investment.
Next, let’s review some of the various terms and provisions of an IA.
72
Table 5.1
Sales Index Annuities 2000 – 2014 ($ billions)
Year
Total
IA Assets
Total
IA Sales
Sales as a % of
Total FA Sales
2000
$19
$5.5
10%
2001
25
$6.8
9
2002
35
$11.8
11
2003
47
$11.3
14
2004
71
$21.1
24
2005
93
$26.8
35
2006
103
$25.1
34
2007
125
$25.0
38
2008
138
$26.7
25
2009
157
$29.5
28
2010
185
$32.4
43
2011
205
$32.2
44
2012
225
$33.9
47
2013
257
$39.3
51
2014
$365
$48.2
50
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
IA Basic Terms and Provisions
If there is one major complaint about IA’s, it is that there are too many moving parts,
terms and provisions, to understand. For an example, in 2013 there were 51 insurance
companies offering index annuities with over 27 variations according to Advantage
Compendium. Let’s now review some of the basic terms and provisions that are part of
an index annuity.
Tied Index
Each and every IA contract ties the actual interest-crediting rate, in excess of the
guaranteed rate, to an external market index. Different IA products may use varying
indices. Some IA’s allow the contract owner to allocate individual portions of the
premium between two or more indices and may also permit a portion of the premium to
be allocated to a fixed interest rate option within the IA contract. In these instances
73
owners are usually allowed to change their allocations annually on policy anniversary
dates.
The majority of IA products are based on the S&P 500 Composite Stock Price Index (or
simply, S&P 500). In theory, however, any market index that tracks the performance of a
specific collection of securities, a segment of a securities market, or the entire market
could be used. While many, if not most, IA contracts specify a single index, some IA
products permit purchasers to choose one or more indices from a group of prescribed
indices. This latter category of IA’s frequently permits the contract holder to change
from one external index to another at one or more times during the term of the contract.
In addition to the S&P 500, other market indices used by some IA’s include the DJIA, the
Barclay Indexes, Nasdaq 100, Mid-Cap 400, Russell 2000, some contracts allow an
interest rate benchmark strategy tied to the 3-Month London Inter-Bank Offered Rate
(LIBOR), and a number of contracts also allow a fixed interest rate strategy. Of course,
different indices pose varying levels of risk to the IA purchaser. To illustrate, an interestcrediting rate tied to the S&P 500, on average, would be expected to vary from one
period to the next to a lesser extent than in interest-crediting rate tied to the Nasdaq 100.
Market indices other than the S&P 500 are currently offered by approximately one-fourth
of the IA carriers. At present time, however, approximately 95 percent of sales are for
S&P 500 indexed products, with very little money flowing into any of the other indices.
Index (Term) Period
The index (term) period of an index annuity is defined as the length of time that index
interest credits are linked to the particular index used in the contract. The “initial” index
period must be listed on the contract data page. Index periods vary from contract to
contract, and can be as short as one year and as long as twelve years. Using a shorter
index period limits the percentage of index growth that the client can receive as an index
interest credit when compared with the percentage of longer index periods.
Participation Rate
The indexed-link interest rate credited to an IA’s accumulation value invariably is lower
than the full gain in the tied index over the duration of the interest-crediting period. This
is usually accomplished in one or more of the following ways:
 By applying a “participation rate” to the total index gain
 By deducting a state percentage, or “yield or spread,” from the otherwise
calculated interest-crediting rate; and/or
 By placing a ceiling or cap on the interest-crediting rate.
An IA’s participation rate is multiplied by the gain in the tied index in determining the
index-linked interest that will be credited to the IA’s accumulation value. Participation
rates can be anywhere from 45% to 100%. Some variations in this and other IA contracts
74
incorporate two participation rates, with a higher rate applied to the initial index gain and
a somewhat lower rate applied to any additional gains.
Participation rates cannot be compared among products without also considering the
indexing crediting method used (discussed below). To add to some of the confusion, a
contract with a 100% participation rate does not necessarily produce a greater index
benefit than a contract with an 85% participation rate. Some contracts that may offer a
100% participation rate may have a cap or a spread.
Spreads or Margins
The spread or margin, also referred to as an administrative fee, is another way of
determining the interest rate for the year or for the index period. Instead of multiplying
by a participation rate, some index annuities simply deduct a spread or margin from the
growth of the index as measured by the particular indexing method chosen by the issuing
company.
Example: If the calculated change in the index is 7.75%, the contract might
specify that 2.25% will be subtracted from the rate to determine the interest
credited. In this example, the rate would be 5.50% (7.75% - 2.25% = 5.50%). In
this example the insurer subtracts the percentage only if the change in the index
produces a positive interest rate.
Note: Spreads and margins can be issued in the contract as either guaranteed or nonguaranteed.
Some index annuities may use a hybrid approach with the use of a participation rate and
also deduct a spread or margin. Typically, these methods have higher participation rates
and then utilize the spread or margin as the main working calculation element. Why
would a company choose both of these methods? There are two main reasons:


First, it allows the insurance company to express a very high participation rate
compared with designs in which do not add a spread or margin. At first glance,
the higher participation rate can attract interest in the product and produce a
marketing advantage.
The second reason has to do with pricing. When the company is able to
incorporate two different interest rate determiners into its pricing, it has more
flexibility in dealing with market changes that occur during the index period.
Caution: Some index annuities allow the insurance company to change participation
rates, cap rates, or spread/asset/margin fees either annually or at the start of the next
contract term. If an insurer subsequently lowers the participation rate or cap rate or
increases the spread/asset/margin fee, this could adversely affect the return on the
contract. As the insurance producer/financial advisor, you must read your contracts
carefully to see if it allows the insurer to change these features.
75
Cap Rate
Many IA’s specify an interest rate cap, or ceiling rate, that establishes an upper limit on
the amount of index-linked interest that will be credited to the accumulation value. The
cap may be expressed as a monthly limit (e.g., 1.5%), an annual limit (e.g., 5%) or as a
ceiling on the total amount of index-linked interest credited over the entire contract term
(e.g., 30%). A review of the www.indexannuity.org website shows a large number of
annual interest rate caps between 2.5% to as high as 5%, inclusive. Some insurers show a
monthly cap of 1.20% to as high as 2.35% and quarterly caps between 1.1% and 2.3% (as
of 1/05/2015).
When permitted by state law, insurers typically reserve the right, by contract, to change
the size (up or down) of their participation rats, yield spreads and interest rate caps,
subject to some guaranteed amount (a minimum or “floor” for participation rates and
interest rate caps, and a maximum in the case of yield spreads). Such changes (in
percentages) usually can be made only once a year on the contract’s anniversary date and
remain in effect for the entirety of the next policy year. Since they may be subject to
change by the insurer, participation rates, yield spreads and interest rate caps frequently
are referred to as moving parts. It should be noted that, when more than one of these
features is included in a specific IA contract, only one of the provisions is subject to
change and the other provisions are fixed throughout the duration of the contract.
Example: If the issuing insurer reserves the right to change the participations
rate, any yield spread and/or interest rate cap included in the IA will be
guaranteed for the life of the contract.
These contract provisions, used individual or in tandem with each other, play a
significant role in determining the ultimate amount of index-linked interest that will be
credited under a specific interest-crediting structure. As we will discuss shortly, the three
approaches affect the financial performance of the IA’s in slightly different ways.
However, they all serve a common purpose and, to that extent, the three separate types of
“moving parts” are somewhat interchangeable with each other.
It is important to remember, that interest rate caps are applied after the interest
calculation is made and the participation rate applied or the spread or margin is deducted.
The cap is the last element applied before the index interest rate for the year or the index
period is determined.
Example: Let us assume that a particular index annuity has a 75 percent
participation rate and a 3 percent annual cap. Assuming that for a given year (or
for the entire index period) the indexing method produces an index growth of 5.5
percent, the 75 percent participation rate will result in a net of 4.125 percent (75 x
5.50). However, with the cap of 3 percent, the client receives an index interest rate
of only 3 percent.
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In the first half of 2014, more insurers have introduced un-capped crediting strategies that
utilize volatility-controlled indices to manage the risk
No-Loss Provision
The no-loss provision in an IA, means that once a premium payment has been made or
interest has been credited to the account, the account value will never decrease below that
amount. This provides safety against the volatility of the index (S&P 500).
Guaranteed Minimum Account Value
In order for the IA to be classified as a fixed annuity it must comply with the Guaranteed
Minimum Account Value (GMAV) rules specified in the Standard Non-Forfeiture Law
for Individual Annuities. Pertaining to fixed annuities, Section 4 states that they:
“provide for a guaranteed minimum account value at all times no less than 90
percent of the single premium amount compounded by interest of no less than 3
percent per year.”
For a declared fixed rate annuity the insurance companies base their GMAVs on 100
percent of the single premium amount compounded at 3 percent per year. This means that
after the first policy year, the declared fixed rate annuity buyer will never receive an
annual statement where the GMAV is less than the single premium amount, unless a
withdrawal has been made.
However, with an index annuity its value at any point in time is the greater of a
guaranteed floor value or an accumulation value less a surrender charge. Under the new
non-forfeiture regulation, the guaranteed floor is 87.5 percent of premium compounded at
a value based on the 5-year treasury yield (no less than 1 percent, usually no greater than
3 percent). So then, it is possible to see a guaranteed minimum account value of less than
the single premium amount on the policy statement. This is not necessarily a bad thing.
However, it is different from what is customary with most fixed rate annuities. That fact
may cause a concern for your client who is looking to purchase an equity index annuity
and will need to be explained.
Liquidity
Generally a 10% withdrawal is allowed annually without surrender penalty and some FIA
contracts offer more standard withdrawal provisions. (Some contracts allow 15%
annually.) Reminder: Most articles analyzing appropriate withdrawal rates for retirees
range in the 4-6% range annually, depending upon various methods of thought. This
being said, a 10% withdrawal privilege should not be an issue for most retirees and
individuals.
Nearly all IA’s provide a full surrender value upon death of the owner or annuitant. Many
IA issuers offer full surrender for nursing home stays, extended hospital visits and
77
terminal illness. Several carriers offer full surrender for unemployment if under 65 years
of age. IA opponents commonly cite surrender fees in some older IA products that were
marketed that were as long as 15 -20 years and fees as high as 20% in the earlier years of
surrender, as an issue.
But, proponents of IA’s claim that, if you review the various free withdrawal privileges
and based on the appropriate range of annual withdrawals, most individuals who
purchase an IA will not encounter a penalty except through their choice. Second,
surrender fees are required by state insurance regulators in order for policies to be
qualified for sale. The existence of surrender fees helps an insurer recapture up-font costs
on products that were designed to be held for several years, and protects persisting
policies from the imposition of extra costs by those who choose to surrender early. Third,
the idea that securities do not have penalties is not only flawed but simply not accurate.
Even if the actual mutual fund one is holding does not assess surrender charges, it is
subject to annual management fees and market risk. Furthermore, they claim, IA’s
provide a guaranteed minimum return along with principal preservation which mutual
funds and other similar investments do not provide.
Fees and Expenses
Unlike mutual funds, an IA does not deduct sales charges, management fees or 12b-1
marketing fees. Instead, the insurance company uses a small amount from the underlying
portfolio which lowers participation rates in the market index to cover administrative
costs and commissions to agents. Because the IA provides policy crediting rate formulae
and periodic annuity owner reports net of any fees and management expenses, it does not
separately disclose them.
Surrender Charges
All IA’s charge a penalty if the policy is surrendered, cashed-in, prior to the end of the
surrender period. Depending on the policy purchased, surrender periods vary in length
from one to eighteen years, and penalties can be as high as 25 percent of the initial
premium (although very high penalties are usually offset by a “premium bonus”.) Keep
in mind; it is usually because of the high up-front bonuses that result in the very high
surrender charge schedules.
A typical surrender charge is expressed either as a percentage of the accumulated value of
the IA or as a percentage of the original premium. Although IA principal is protected
from market risk, most index annuities would return less than the original premium if
surrendered too early. Surrender penalties do not usually apply if the policy is paid out, if
the policy is annuitized, or due to death of the owner (all deferred annuities issued after
January 18, 1985 must pay out upon the death of the owner).
A number of IA contracts do not state a specific surrender charge, but instead base the net
surrender value on the minimum guaranteed value. Although this calculation may not be
called a surrender charge, it has the same effect.
78
Example: If the minimum guaranteed surrender value is based on 3 percent
interest compounded on 90 percent of the premium, then the cash received upon
surrender would be 90% during the first contract year, 92.7 percent during the
second, 95.5 percent during the third and 98.3 percent during the fourth year.
This is really a de facto declining penalty of 10%, 7.3%, 4.5% and 1.7% for the
first four years of the IA contract.
Interest Calculation
The way an insurance company calculates interest (compounding or simple) earned
during the term of the index annuity can make a big difference in the amount credited to
the annuity. Some index annuities pay simple interest during the term of the annuity.
Because there is no compounding of interest, the return credited will be lower. While the
annuity may earn less from simple interest, it may have other features more beneficial to
the client, such as a higher participation rate.
Exclusion of Dividends
Depending on the index used, stock dividends may or may not be included in the index’s
value. For example, the S&P 500® is a price index and only considers the prices of
stocks. It does not recognize any dividends paid on those stocks. Since the annuity is not
being credited dividends, it will not earn as much as if invested directly in the market.
Index-Linked Interest Crediting Methods
One of the most important features in determining the actual interest received on an IA
contract is the crediting method used to measure the amount of change in the underlying
index. The three most common methods are:



Annual Reset (Ratcheting) Method
High Water Mark Method
Point-to-Point Method
In addition, several variations exist within these three common methods creating several
dozen different approaches to measuring index gains. While the following discussion is
extensive, it is not intended to be an exhaustive treatment of all methods for measuring
index gains as many of these methods account for only a very small percentage of totalindustry wide IA sales.
Let’s discuss each of these in greater detail beginning with the Annual Reset.
Annual Reset (Ratchet) Method
The annual reset, aka the ratcheting method, the interest is determined by comparing the
index value at the end of the contract year with the index value at the beginning of the
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contact year. Interest is added each year for the term of the contract. In years where
gains in the tied index are negative, a “0” is recorded. Consequently, while there can be
“flat” years—with no index gains—under annual reset IA’s, it is impossible to have a
“down” year. Accumulation values will either grow or remain steady from one year to
the next, regardless of the amount of volatility in the underlying market index.
Positive gains are divided by the index value at the beginning of the year to determine a
percentage amount. Depending on the specific IA contract, this percentage may be
reduced by a participation rate less than 100 percent, a yield spread and/or a cap in
determining the index-linked interest-crediting rate. The index-linked rate multiplied by
the beginning-of-year accumulation value generates the dollar amount of index-linked
interest for the year. Once interest is credited to the accumulation value, it is locked-in
and the accumulation value will never decrease from that level regardless of the future
performance of the tied index.
The annual crediting of interest and the corresponding protection against market declines
in future years is a primary reason underlying the popularity of annual reset (ratcheting)
IA’s. Once locked-in, index-linked interest gains can never be lost due to a subsequent
downturn in the tied index. A related advantage is that the annual locked-in interest
credits provide the purchaser with periodic “progress reports” of the IA’s financial
performance. The accumulation value at any point in time can serve as a partial predictor
of what the total financial gain might be at the end of the contract term.
Let’s review an example: Let’s assume that an individual purchased an Annual Reset IA
with a four-year surrender period. Further assume that the tied market index declines
from a beginning value of 1000 to 800 at the end of the first contract year. In this case, no
interest is credited to the accumulation value in the first year. However, the index value
at the beginning of the second year is reset at 800 and any growth in the index during the
second year will be measured from this lower amount. If the tied index increases again to
1000 at the end of the second year, the index gain is 25 percent for this year. Let’s now
assume that this exact pattern is repeated in years three and four. Under this scenario,
zero gain will be recorded in the third year since the index declined in value from 1000 to
800. And, another 25 percent gain will be recorded in the fourth year since the
beginning-of-year index value was reset to 800, and the index value at the end of the
fourth year is assumed to have reached 1000 again. In summary, the index gains for this
four-year Annual Reset IA are:




Year 1 = 0%
Year 2 = 25%
Year 3 = 0%
Year 4 = 25%
Assuming a $1,000 initial premium, a participation rate of 0.60 and annual compounding
of interest, the accumulation value at the end of the four-years is $1,322.50.62. In
contrast, if this IA were either a Point-to-Point or High Water Mark product, there would
be no index-linked interest credits since:
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

There was no gain in the index between the beginning and ending dates of the
term, and
The index value never exceeded the index value at the date of purchase.
Next, let’s review the first successful index interest crediting method—High-Water Mark.
High-Water Mark Method
The High-Water Mark method calculates the interest crediting method is recorded at
various points in time during the term of the contract. Typically, the annual anniversary
is used as the reference points. Interest is added at the end of the contract period and is
based on the difference between the highest index value and the beginning index value.
Both approaches incorporate a multi-year index term. However, IA’s using a High Water
mark approach generally credit index-linked interest each time a new index “high” is
reached. The High Water Mark method is also sometimes referred to as the “no regret”
or “term-high” design. It is also known as the “look-back” method since, at the end of the
index term, the insurer and the purchaser look back over the entire term to identify the
peak value of the index.
The advantage of the high-water mark method is that a customer may receive a higher
amount of interest than other methods if the index reaches a high point towards the
beginning or middle of the contract, then falls at the end of the contract term. However,
the disadvantages are that this method sometimes comes with a cap and a lower
participation rate than other methods. In addition, some contracts state that if the
annuitant surrenders the contract before the end of the term, then the interest is forfeited.
Point-to-Point Method
The final method, Point-to-Point, measures the change in the tied market index between
two discrete points in time, such as the beginning and the ending dates of the contract
term, usually greater than one year or two years. Similar to the high-water mark method
discussed above. The beginning point is usually the purchase date of the IA contract and
the ending point is typically the end of the multi-year index term. If there is a decrease in
the market index between the beginning and end points, the change is recorded as zero.
Point-to-point is the simplest approach to measuring index gain over the life of the
contract and, possibly, also the easiest for insurance producers and financial advisors to
explain to prospective IA purchasers. Under this design no index-linked interest is
credited prior to the end of the index term. Unlike what typically occurs with traditional
fixed-rate annuities and many other types of interest-bearing products, interest is not
calculated and credited annually (or more frequently) under a Pont-to-Point IA product.
This approach is sometimes referred to as the European method since recognizing the
index gain only at the end of the index term is characteristic of options trading that occurs
in many European equities markets. European options can be exercised (or recognized”)
only on their expiration date and not at any earlier time. This is in direct contrast to the
typical American stock option where the option can be exercised at any time up to, and
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including, the expiration date. For obvious reasons, the Point-to-Point is also known as
the “term –end point,” “end of term,” “term point-to-point,” or “long-term point-to-point”
design.
The first step in determining the amount of index-linked interest to be credited to the IA’s
accumulation value is to subtract the beginning index value from the endpoint value. If
the result is negative (i.e., the market index declined in value from the beginning to the
end of the index term), it is recorded as zero and the IA’s accumulation value is credited
with the minimum guaranteed return.
Positive index gains are divided by the beginning index value to arrive at a percentage
gain. The percentage gain is then multiplied by a participation rate. The product of these
two numbers is then multiplied by the amount of money invested in the contract (i.e.,
premiums plus any bonuses) and then added to this principal amount to arrive at the
contract’s accumulation value. At the end of the index term, the contract owner is
entitled to the larger of the accumulation value and the guaranteed minimum value.
A potential, yet significant, drawback to purchasers of IA’s incorporating the traditional
Point-to-Point structure results from the fact that the index-linked interest-credit depends
on a single index value—the value at the end of the index term. All other index values
throughout the term of the contract are completely irrelevant under this design (other than
the beginning index value, of course). This situation may not be troublesome to IA
purchasers so long as the index trend is generally upward throughout the contract term or
the index value, while experiencing several “ups” and “downs,” is significantly higher at
the end of the contract term than at the beginning. However, a pattern of equity returns
that leads to generally higher index values over time, followed by a sudden and
significant decline in the external index in the last few days, weeks or months just prior to
the end of the index term may lead to significant disappointment on the part of contract
owners in the financial performance of their EIA.
To address this concern, most EIA’s using the Point-to-Point method incorporate an
averaging process into the design of the interest-crediting mechanism. Commonly
referred to as the Asian-end, or average-end, design, this interest crediting method
calculates the ending index value as the average of a series of index values—typically
daily, weekly or monthly values occurring during the last year of the index term. To
illustrate, the ending index value might be defined as the average of the index values on
the last business day of each month for the 12 months prior to the end of the term.
Alternatively, the ending index value might be computed as the average of the index
values over the last few days, few weeks, or the last three months in the last year of the
index term. Of course, other averaging possibilities exist. The index gain is computed as
the difference between the “average” ending index value and the index value at the time
the IA was issued. Clearly, the Asian-end variation is designed to mitigate the negative
effects on the contract’s financial performance that otherwise would result from a
significant decline or a series of declines in the tied index during the last few days, weeks
or months of the index term. One might expect that an EIA purchaser who is risk averse
would prefer an Asian-end averaging method or even an entirely different structure, e.g.,
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Annual Reset, to the traditional Point-to-Point method for crediting index-linked interest.
The Point-to-Point design (with or without averaging) may be preferred, however, since it
is “less costly” to the insurer due to lower option prices and, as a result, typically
provides for greater index participation in comparison with Annual Reset methods.
In addition to the traditional and Asian-end designs, a third Point-to-Point (i.e., term-end
point) approach to measuring gain in the external index is the Term Yield Spread
indexing method. This type of structure:




Computes the total index gain for the entire term;
Converts the total gain into an annualized compounded rate of return;
Subtracts a yield spread from the annual rate of return; and then
Recalculates the total index gain for the entire term by compounding the “net”
annualized rate.
To illustrate, assume that the tied external index increased from a beginning index value
of 1000 to an index value of 1800 at the end of a six-year term. This 80 percent total gain
is equal to an annualized compounded rate of return of 10.3 percent (rounded to the
nearest tenth of one percent). Assuming an annual yield spread of 1.8 percent, the net
annualized rate equals 8.5 percent. The total index gain credited to the policy’s
accumulation value is equal to 8.5 percent compounded over six years, or 63.1 percent
(rounded).
Under Point-to-Point designs, significant increases in index values during the early or
middle years of the contract term will not automatically result in large index-linked
interest credits. At the point where it really matters, when index gains are measured and
index-linked interest is credited to the IA’s accumulation value, many or all of these early
gains could vanish prior to the end of the index term. Consequently, purchasers of Pointto-Point IA’s are unable to measure or otherwise ascertain the periodic growth in their
accumulation values. This can be a significant drawback since the typical Point-to-Point
IA has an index term of five, seven, 10 years or longer. The absence of periodic indexlinked interest credits increases the uncertainty as to the values—both current and
future—that should be placed on this asset as part of an overall financial plan. This can
pose serious planning issues if the IA comprises a significant portion of the individual’s
total financial portfolio.
Another potentially significant disadvantage of the Point-to-Point approach concerns the
period—frequently the entire index term—during which surrender charges are imposed.
Since any index-linked interest earnings under the Point-to-Point method are credited to
the contract’s accumulation value only at the end of the index term, the purchaser is
generally not entitled to any index-linked interest credits whatsoever if the IA is cashedin prior to the end of the surrender-charge period. Most likely, in this instance, the
contract owner will be entitled to a return of premiums paid plus any guaranteed interest
less the surrender penalties, subject to the guaranteed minimum value “floor.” It is
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possible that surrender charges will exceed any guaranteed interest credits, thereby
creating a financial loss to the IA purchaser.
Interest Crediting Method Comparison
The three index annuity crediting methods discussed above seem similar, however, the
index-linked interest that is paid on an annuity will heavily depend on which method is
used for the particular policy. Therefore, it is important that investors weigh the pros and
cons of each method and choose the one best suited to current market trends.
Table 5.2 shows the various tradeoffs to get features a client may want in an IA. This
means that the IA he/she may choose may also have some features they don’t want.
Table 5.2
Advantages and Disadvantages of Different Indexing Methods
Interest Crediting
Method
Annual Reset
High-Water Mark
Point-to-Point
Advantages
Disadvantages
Since the interest earned is "locked
in" annually and the index value is
"reset" at the end of each year, future
decreases in the index will not affect
the interest you have already earned.
Therefore, your annuity using the
annual reset method may credit more
interest than annuities using other
methods when the index fluctuates
up and down often during the term.
This design is more likely than
others to give you access to indexlinked interest before the term ends.
Since interest is calculated using the
highest value of the index on a
contract anniversary during the term,
this design may credit higher interest
than some other designs if the index
reaches a high point early or in the
middle of the term, then drops off at
the end of the term.
The IA’s participation rate may
change each year and generally
will be lower than that of other
indexing methods. Also, an
annual reset design may use a
cap or averaging to limit the total
amount of interest that can be
earned each year by the contract.
Since interest cannot be calculated
before the end of the term, use of this
design may permit a higher
participation rate than annuities
using other designs.
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Interest is not credited until the
end of the term. In some IA’s, if
the contract is surrendered before
the end of the term, the contract
may not get index-linked interest
for that term. In other IA’s, the
contract may receive indexlinked interest, based on the
highest anniversary value to date
and the IA’s vesting schedule.
Also, contracts with this design
may have a lower participation
rate than IA’s using other
designs or may use a cap to limit
the total amount of interest the
contract may earn.
Since interest is not credited until
the end of the term, typically six
or seven years, you may not be
able to get the index-linked
interest until the end of the term.
Averaging
An IA may use an average of an index’s value rather than the actual value of the index on
a specified date (as discussed with the three various interest crediting methods above).
The index average may be taken at the beginning, the end or throughout the entire term of
the contract.
Today, the majority of IA contracts sold today are structured with annual reset designs
(discussed below) that average index values to determine the index movement.
Averaging at the beginning of a term protects the client from buying their annuity at a
high point, which would reduce the amount of interest earned. Averaging at the end of
the term protects against severe declines in the index and losing index-linked interest as a
result. On the other hand, averaging may reduce the amount of indexed-linked interest
earned when the index rises either near the start or at the end of the term.
It is important that you and your client understand that a 100% index participation rate,
when applied to a contract using averaging, will never credit precisely the same return
reported for that index in the financial section of the newspaper. Occasionally it may be
higher, but usually it will be lower.
Other Interest Crediting Methods
The annual reset method and the point to point method discussed above represent the
bulk of the IA sales. Most of the IA’s sold use some degree of averaging, a significant
number of IA’s apply ceilings or caps on maximum interest credited, and whether a
participation or yield spread is used often depends on the marketing climate. Design
structures are often combined. Several annual reset structures use averaging of index
values, have a cap, and either use a participation rate or a yield spread. There are several
other crediting methods used.
Multiple (Blended) Indices
The multiple indices method, as it name implies adds up returns from different indices
and applies a participation rate to the overall index gain or loss. The IA performance
over multiple years uses a percentage of the gains or losses of the different indices.
Note: This is not a rainbow method (described below) because the allocation of the
indices is fixed and does not change based on index performance.
Monthly Cap (Monthly Point-to-Point)
The monthly cap calculates gains losses of the index on a monthly basis, adds up the
monthly figures, and the final number is the interest credited for the period; the period’s
interest can never be less than zero. The maximum monthly gain recognized is subject to
a cap., but monthly losses are not subject to a cap. This method is also called monthly
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point-to-point, the difference between this method and an annual point-to-point is that the
values are not locked each month.
Assuming a 2% cap, a “best case” scenario would be where the index increases 2% each
month for 12 months, producing a 24% interest for the year. On the flip side, a “worst
case” scenario would be if the index were to increase, say, 35% over eleven months, but
then decline 25% in the twelfth month. The maximum possible gain for the eleven
months would be 22% (2 x 11), which would be offset by the 25% decline in the 12th
month resulting in zero gain, even though the index would have increased by 14% for the
year.
Binary, Non-Negative (Trigger) Annual Reset
This design method will pay a stated interest rate if the index does not go down. The
insurer will declare that the “trigger” rate for the coming year is 5. If the index does not
end lower a year from now the trigger method will credit 5% interest. Whether the index
goes up 1% or 90% the trigger method will credit 5%. Even if the index ends up exactly
where it started, posting neither gain nor loss for the previous twelve months, the trigger
method will credit 5%.
Bond-Linked Interest with Base
Don’t get confused, although there are a few IA’s offering a bond index, or a bond index
in addition to equity choices, that is not what we are describing. This crediting method
links interest crediting to U.S. Treasury Notes. If the T-note rate is higher at contract
anniversary, the IA renewal rate is credited with a like increase. If the T-note rate is
lower in subsequent years, the IA rate goes down the same amount, but the IA rate can
never be less than the initial rate.
Hurdle
With this method, the IA is credited with the gain above the floor (the hurdle), but
nothing below. For example, say the current participation rate is 50% above a floor of
5%. If the index increased 10% next year the IA would credit 2.5% (10% - 5% = 5% x
50%). But, if the index increased 45% the IA would credit 20% (45% - 5% = 40% x
50%).
Annual Fixed Rate with Equity Component
There a couple of IA’s that credit a fixed rate to a portion of the premium with the
remainder participates in the index. A yield spread or asset fee is then deducted from the
total. Net gains are credited as interest and net losses are treated as zero interest earned.
Another method, known as the balanced allocation method, uses a fixed rate component
(the range of rates depends on the interest rate environment) and also a term end point
part that participates in positive index movements over a four, five or six year period.
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The higher the fixed interest rate selected, the lower the participation rate applied to the
index. At the end of the period, gains from the fixed rate and index-linked components
are combined and credited. An annualized asset fee (yield spread) may be deducted from
the combined return.
The “equity kicker” or “balanced” structure might look at a six year time period and offer
a couple of options. For example, one option may be to allocate 50% into a fixed account
paying, let’s say 3% and the remaining 50% would provide a 100% participation rate on
any gains in the index from start to end of the six year period. Another option might
allocate 20% into a fixed account paying 3% and the remaining 80% would provide a
100% participation rate on any gains in the index from start to end of the six year period;
however, a 2% yield spread would be deducted from the combined annualized gain
before net interest was credited.
Example: Let’s suppose that the index has increased from 100 to 150 (50%) in
six years, and that the 4% fixed rate gain, compounded over six years is 26.5%.
What is the return under these two balanced method options?
Since the yield spread was not deducted from the 50/50 allocation the total gain
remains 38.3% for the six year period and that translates into an annualized return
of 5.5%, while the 80/20 allocation produced a total gain of 29.7% (after
application of the yield spread) for an annualized return of 4.4%.
In this example the better choice would have been putting half of the premium
into the fixed rate. When would the 80/20 allocation have won? If the index had
gone up more than 87% the total net yield, even after the 2% yield spread, would
have been higher than the yield on the 80/20 allocation.
Rainbow Method
The latest trend in the IA market is a new type of crediting method, commonly referred to
as a “rainbow method”. It is an option basket whose best-performing indices are
weighted more heavily than those that perform less well. It is always a “look back”
because the money is allocated based on the rankings of the performance after the period
is over. Not all allocation methods are rainbows. Theoretically, the rainbow method can
be used on any of the methods we have discussed. However, it is used mainly with the
monthly averaging and annual point-to-point strategies. Note: A couple of insurers IA
products credit interest based on the blended performance of multiple indices, but the
specific index allocation is fixed at the beginning of each year so they are not rainbow
methods.
Here’s how it works: The IA contract offers a choice of 2 or more indices on a single
crediting method during a term. This is different from traditional IA products which
typically offer only one index per crediting method during the term. (Note: In the
rainbow products, the contract currently credits their interest in anywhere from 1-3
years.)
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The so-called rainbow products now on the market tend to credit interest by using one of
the following two approaches.

In the first approach, the contract applies a stated percentage weighting to each
index; these percentages stay the same over the stated term of the crediting
method. Potential indexed gains will be credited based on those weightings at the
end of the crediting period, in view of each index’s performance.
Example: An insurer offers indices A, B, and C on a monthly averaging
crediting method in an index annuity with a 3-year period. Index A will
receive a weighting of 40% over the 3-year period; Index B will receive a
weighting of 35%; and Index C will receive a weighting of 25%. The
carrier then deducts a spread from any potential indexed gains at the end
of the term, and then applies the remainder to policy’s account value.

The second approach, after the end of the crediting period, the insurer does a
look-back on the performance of the indices. Then, it ranks the best performing
indices for that term. From that ranking, the carrier applies a stated percentage per
index, and then credits any potential index interest accordingly. (These
calculations can vary; some will use participation rates, while others may use caps
or spreads.)
Example: An insurer offers indices A, B, and C on an annual point-topoint crediting method on an index annuity with a 1-year term. The best
performing index over the one-year period gets 75% weighting in the
crediting calculation; the next-best performing index gets 25% weighting;
and the least-best performing index gets zero credit. The carrier then
applies a participation rate to any potential indexed gains to determine the
amount to credit to the policy.
Many agents are drawn to the appeal of a “we’ll give you the best performing index”
approach. Besides the S& P 500, the Nasdaq and the Dow Jones, many carriers allow a
number of international indices such as, The DJ Euro Stoxx 50, the FTSE 100, Heng
Seng and the Nikkei 225. Most recently one insurer has added a commodity index using
the S&P GSCI Index from Standard & Poor’s, New York.
Naysayers who have argued about lack of diversification in the IA product line may now
have difficulty finding an argument not to recommend these fixed products.
Index Annuity Waivers and Riders
Index annuity contracts offer a number of waivers and riders for policy owners to enjoy
and use at their discretion. Before we discuss the various waivers and riders, let’s
differentiate between a waiver and a rider.
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A waiver allows the policy owner to withdraw funds from the IA without incurring a
surrender charge. There are no additional charges for a waiver. On the other hand, a
rider is an extra feature that can be added to an IA and there are additional costs.
Types of Riders
Most IA contracts offer the following riders:



Death Benefit Rider: Most IA’s may provide a rider that acts like a life insurance
benefit. (Note: Annuity death benefits to heirs have a different tax status than life
insurance benefits which pass to beneficiaries’ tax free.) If the policy owner dies
before he/she collects the full value of the annuity, the rider pays to their heirs the
amount invested plus interest or the market value of the funds minus whatever the
policy owner has collected in payouts.
Long-Term Care Rider: A Long-Term Care rider provides long term care
insurance in addition to a steady stream of income. The 2006 Pension Protection
act now allows for withdrawals from an annuity or life insurance policy with a
long term care rider to be tax free to the individual for qualified long term care
expenses (discussed further in Chapter 5). Note: This only applies to nonqualified
contracts.
Guaranteed Lifetime Withdrawal Benefit Riders (GLWB): GLWBs have grown in
prominence, but they have also become more complex. More than 40 companies
now offer the GLWB rider with their IA’s. According to LIMRA, a GLWB was
available on 87 percent of IA’s sold in 2014 and 72 percent of policyholders
purchased this rider. It is important to remember every GLWB is different. Some
offer rollups with simple interest, when most pay compound interest on their
rollups (and no, double-digit simple interest is not always greater than single-digit
compound interest). Some GLWB riders do not have an explicit cost where
others charge as much as 0.95 percent annually. Some have a charge that is
calculated on the benefit base value of the GLWB, where a few have charges that
are calculated on the lower account value of the contract (remember, charges
based on the benefit base always cost more because the Benefit Base is always
higher). Some have bonuses on the benefit base value, where most do not. Some
have greater withdrawal percentages than others. A few IA contracts provided
inflation adjusted withdrawals (or withdrawals that will increase by a stated
percentage each year).
IA’s with Bonuses
For IA’s, the most common type of bonuses are:


Income account bonuses; or
Premium bonuses
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Income account bonuses are added to the amount from which future guaranteed lifetime
withdrawals will be made. These bonuses were less frequently offered in 2013 than in
prior years. Premium bonuses (usually a percentage of the initial purchase amount) are
added to the annuity’s accumulation (cash) value. Along with the GMWB rider,
premium bonuses have become a main feature used to promote IA’s. Some companies
offered these bonuses with a vesting schedule, entitling owners to an increasing
percentage of the bonus over time. Fixed rate annuities sometimes offer premium
bonuses as well. But interest rate bonuses are more frequent. These bonuses make the
initial credited rate more attractive. In 2014, they were most often offered on contracts
with credited rates that can change annually during the surrender charge period.
Two other bonus types were less frequently offered in 2014. They were:


Persistency bonuses reward owners for keeping their annuity for a specified
period.
Annuitization bonuses reward owners who convert their deferred annuity contract
into an income annuity.
But remember the saying, “there is no free lunch.” Typically when an insurance
company offers bonuses, the surrender charges in the annuity are greater and for a longer
period of time. Your job, as the financial professional, is to understand those charges, as
well as to disclose and explain them to your clients prior to them purchasing a fixed index
annuity.
Regulation of IA’s
As was discussed earlier, over the years, IA’s have been subjected to increasing
regulatory scrutiny. Back in August, 2005, the then National Association of Security
Dealers (NASD), now known as the Financial Industry Regulatory Authority (FINRA)
issued Notice to Members 05-50, which detailed the responsibility of member firms for
supervising sales of unregistered index annuities, in which the Notice referred to as
Equity Index Annuities (EIA’s). The Notice began with a section titled “Investor
Protection Issues Presented By Equity-Indexed Annuities”, and noted, in the opening
sentence, the following, “EIA’s are complex investments”. After detailing some of the
complexities of these products, the Notice declared that, “NASD is concerned about the
manner in which associates [persons or individuals engaged in the sales of securities,
including “Registered Representatives”, in NASD member firms] are marketing and
selling unregistered EIA’s, and the absence of adequate supervision of these sales
practices”. In other words, the NASD was sufficiently concerned that registered
representatives of NASD member firms, over which it had regulatory authority, might
have been marketing these unregistered products (over which it did not have authority) in
ways that “could confuse or mislead investors”. “Moreover”, it continued, “because of
the products complexity, some associated persons might have difficulty understanding all
the features of the product and determining the extent to which those features meet the
need of the customer”.
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In Section 3 of the Notice entitled “Supervision under Rule 3030 and Rule 3040, the
Notice outlined the supervisory methods that it deemed necessary for NASD member
firms to implement with regard to equity index annuities. It began by acknowledging that
many B-Ds treat the sale of unregistered EIA’s as “outside business activities”, beyond
the reach of their supervision. It declared that:
“A broker-dealer runs certain risks in applying Rule 3030 to the sale of an
unregistered EIA on the assumption that the product is not a security. As a result,
if a particular EIA did not qualify for the exemption, a firm might incorrectly treat
the EIA transaction as an outside business activity under Rule 3030 rather than a
private securities transaction under Rule 3040 and thereby fail to supervise sales
of the product as required by NASD rules”.
This was the justification used by the NASD in 05-50 to why B-Ds should require their
registered representatives to submit all index annuity business through them.
However, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,
with the work of Iowa Senator Harkin, changed all that and removed the uncertainty of
IA’s by preserving them as fixed insurance products and not as a security. In order to
meet this requirement under the Act, the IA must satisfy the standard non-forfeiture laws
and be issued by an insurer that is either from a state that has adopted the NAIC Annuity
Suitability rules or the company itself has implemented practices contained in the annuity
suitability rules.
FINRA Investor Alerts
FINRA has put out an Investor Alert Title: Equity Index Annuities—A Complex Choice.
You can view the alert at:
http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndInsurance/p0
10614
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Chapter 5
Review Questions
1. In what year was the “Key Index” Annuity sold?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
1974
1995
2001
1984
2. What is the term for the index-link interest rate credited to an IA’s accumulation
value?
(
(
(
(
) A. Participation Rate
) B. Spread
) C. Cap Rate
) D. Margin
3. The spread or margin is also referred to as:
(
(
(
(
) A. Participation Rate
) B. Cap Rate
) C. Administrative Fee
) D. Index Period
4. What is the interest crediting method that compares two discrete points in time,
such as the beginning and ending dates of the IA contract term?
(
(
(
(
) A. Annual reset (Ratchet)
) B. High water
) C. Point-to-point
) D. Interest averaging
5. What is the interest-crediting method in an IA contract that is also known as the lookback period?
(
(
(
(
) A. Point-to-point method
) B. Annual reset method
) C. Ratchet method
) D. High water mark method
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CHAPTER 6
ANNUITY CONTRACT STRUCTURE
Overview
There is more to the sales process than just having a purchaser sign an application to buy
an annuity. Deciding whom to name as the owner, annuitant, and beneficiary of an
annuity is commonly referred to as “structuring the contract.” The problem with
improper structuring is that it may cause unwanted tax bills and cause the improper
distribution of the annuity proceeds. It is important to remember to always structure an
annuity in a way that results in the least amount of negative tax and penalties upon payout
of the death benefit.
In this chapter we will examine how to properly structure an annuity contract. It will also
review the various parties to the annuity contract: The contract owner, the Annuitant, and
the Beneficiary.
Learning Objectives
Upon completion of this chapter, you will be able to:





Identify the importance of proper annuity contract structure;
Distinguish between an Owner-driven vs. Annuitant-driven contract;
Recognize the importance of simple vs. complex contract structure;
Identify the various parties to the annuity contract; and
Apply the roles and rights to each of the parities to the annuity contract.
Background
As the insurance professional (agent), it is your responsibility to help your client
understand the different types of annuity contracts (full disclosure) and how to properly
structure the contract to meet the needs and financial goals of the client.
The most critical point for agents to remember about annuity contracts is that they are
ALL DIFFERENT! There are some tax laws and IRS regulations that apply equally to
all annuity contracts, but annuities differ from company to company because they may
have different contract provisions.
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If a contract is improperly structured the result may cause unwanted income, gift and
possibly estate tax consequences to the purchaser and his or her beneficiaries. To avoid
these consequences, it is vital the insurance professional (agent) know the annuity
contracts they are selling.
Structuring the Contract
When structuring an annuity contract it is probably best to keep it simple by naming the
same individual as both owner and annuitant. If that individual dies, any remaining
annuity value is paid to the beneficiary. This simple structure generally assures that the
benefits of the contract flow to the parties that the purchaser intended.
However, there may be times when a contract must have a more complex structure. Such
a situation may call for the annuitant to be someone other than the owner of the annuity.
In such cases, you must take care to ensure that various contingencies do not have
unintended consequences.
Example: Let’s say that Bill is the owner of a deferred annuity that is still in the
accumulation (deferral) phase. His wife Paula is the annuitant, and their son Dan
is the beneficiary. If Paula dies while Bill is still alive, would Bill want the value
of the annuity to be paid immediately to Dan or kept under Bill’s control?
You must know the answer to that question in order to structure the contract properly.
You must understand the variations in the annuity contract language.
Annuity Contract Forms
Annuities can be divided into two contract forms. They are:


Owner-Driven (OD) contracts; and
Annuitant-Driven (AD) contracts.
By “driven” we mean that certain actions occur upon death that are beyond the control of
the named parties to the contract, unless proper structuring is done regarding who owns,
who is an annuitant, and who is a beneficiary to the contract. These structuring issues
must be understood and addressed before investing in an annuity. The first thing that the
insurance producer/financial advisor must understand is the type of annuity contract
being used to make the investment and then proceed cautiously from there. Is it an OD
or an AD?
Note: Annuity contracts must display on Page 1 of the prospectus whether the contract is
an owner-driven or an annuitant-driven contract.
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Let’s examine in greater detail the differences between Owner-Driven vs. AnnuitantDriven annuity contracts.
Owner-Driven
Owner-driven (OD) contracts pay a death benefit upon the death of the contract owner
(who may not be the primary annuitant). This would likely lead a person to conclude that
any given deferred annuity contract is either one or the other. That would make sense, but
it’s not the case.
If the annuitant in an owner-driven contract dies, the owner can become the annuitant and
enjoy the income. Alternatively, the owner can name a new annuitant and the contract
continues unchanged.
Annuitant-Driven Contract
With an Annuitant-Driven contract, the owners can usually be changed. It is contract
specific as to whether an annuitant can be changed once the contract is issued. Also, the
contract will pay out upon the death of either owners or annuitants. In an AD contract, if
the annuitant dies, there must be a distribution immediately to the beneficiary, and the
contract will cease to exist. For this reason, most insurance producers/financial advisors
should keep annuity structures as simple and clean as possible, which, in most cases,
means avoiding joint owners and annuitants. In the case of spouses, naming anyone other
than the surviving spouse as primary beneficiary should be avoided, or if done, a lot of
caution should be used.
Next, let’s review the parties to the contract.
Parties to the Annuity Contract
An annuity is a contract between an annuity owner and an insurance company. However,
while most other types of contracts involve only two parties, an annuity contract involves
more because the contract rights and benefits are measured by the life of a third party
who is called the annuitant. In many cases the owner and the annuitant are the same
person. In addition, because disbursement of annuity values can occur after the death of
the contract owner or annuitant, another party is usually named in the contract, a
beneficiary. Let’s discuss the rights and benefits of each of the parties, beginning with
the owner.
The Owner
The contract owner, also known as the contract holder, is the individual who purchases
the annuity. As the owner of the contract, the individual is given certain rights.
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Rights of the Owner
The annuity contract gives the owner of the contract certain key rights. While the
annuitant is living, the contract owner generally has the power to do the following:








Name the annuitant.
State and change the annuity starting date.
Choose (and change, prior to the annuity starting date) the payout option.
Name and change the beneficiary.
Request and receive the proceeds of a partial or full surrender.
Initiate and change the status of a systematic withdrawal.
Assign or otherwise transfer ownership of the contract to other parties.
Amend the contract with the issuing company’s consent.
Changing the Annuitant
Note that “change the annuitant” was not included in our general list of rights. Some
annuity contracts specifically give the owner the right to change the annuitant and some
do not. If the owner of the contract is a not a natural person, a change of annuitant is
treated as the death of an owner for income tax purposes, which means that certain
distributions are required to be made from the contract. Therefore, even if the contract
specifically allows the owner to change the annuitant, care should be taken in naming the
annuitant when the owner is a non-natural person in order to avoid the possibility that
unfavorable tax consequences may be incurred if a change of annuitant is later desired.
Duration of Ownership
As noted earlier, when we introduced the general list of owner’s rights with the clause
“while the annuitant is living,” under some annuities, the owner’s rights in the contract
cease to exist when the annuitant dies. One of two things can happen; either the value of
the annuity is paid to the beneficiary or the beneficiary becomes the new owner.
This is fine where the owner and the annuitant are the same person. But care must be
taken in those situations where the owner and the annuitant are different parties.
Under some contracts, the owner’s rights do not automatically cease when the annuitant
dies. If the owner is not the annuitant and the annuitant dies first, some contracts provide
that the owner automatically becomes the annuitant. Other contracts provide for a period
of time in which the owner can name a new annuitant, after which, if a new annuitant is
not named, the owner becomes the new annuitant. Still other contracts provide for a
contingent owner to assume ownership of the contract in the event the original owner dies
before the annuitant.
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Purchaser, Others as Owner
In most cases the purchaser of the contract names himself or herself as owner. However,
sometimes the purchaser names another party, such as a trust, as owner. For example,
trust ownership may be used when the purchaser wishes to make a gift to a minor.
Certain forms of trust ownership may shift income and estate taxation of the benefits of
the contract away from the purchaser. However, the purchaser may be liable for gift
taxes on the value of the annuity and/or the premiums paid on it.
In any case, by giving up ownership of the contract, the purchaser also gives up all
contractual rights to control the annuity. A purchaser could name a trust as owner and
still retain control over the trust, but such a trust would not shift income or estate tax
away from the purchaser. Purchasers should consult tax and legal counsel before giving
ownership of an annuity to anyone other than himself or herself.
Taxation of Owner
In general, it is the owner of the annuity who is taxed on any amounts disbursed from the
annuity during the annuitant’s lifetime. This is true even if someone else is receiving
annuity benefit payments: naming another person as annuitant does not shift tax liability
away from the owner. Only a gift or other transfer of ownership can do that. However,
you should note that under some contracts, once the contract is annuitized, the annuitant
automatically would become the owner. This change of owner may have tax
consequences to the old owner.
Remember that, with certain exceptions, if the owner of the annuity is not a natural
person, the annuity does not provide income tax-deferral on accumulations. The major
exceptions to the nonqualified person rule are the following: a trust acting as agent for a
natural person, a qualified plan, or the estate of the deceased owner (IRC § 72(u)).
Death of Owner: Required Distribution
As was discussed above, federal tax law requires that certain distributions be made from
an annuity in the event that any owner of the contract dies. If the owner of the contract is
not a natural person, then the annuitant will be considered the owner and a change of
annuitant is treated the same as the death of an owner for tax purposes.
Required distributions are as follows:


If an owner dies after the annuity starting date, any remaining payments that are
due under the annuity must continue to be made at least as quickly as payments
were being made prior to the death of the owner.
If an owner dies before the annuity starting date, the entire value of the annuity
must either be distributed within five years of the date of such owner’s death, or
the value of the annuity must be annuitized within one year of the date of such
owner’s death.
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Spousal Exception
There is an exception to the rule requiring distributions in the event of an owner’s death.
If, the beneficiary of the annuity is the surviving spouse of the deceased owner, then the
surviving spouse is permitted to become the owner. Distributions will not be required
until the surviving spouse’s subsequent death (IRC § 72(s)(3)).
The Annuitant
Many annuity contracts define the annuitant as the individual who is designated to
receive income benefits, under the contract. However, under some contracts, as well as
in the tax law, the annuitant is the individual whose life is of primary importance in
affecting the timing or amount of the payout under the contract. In other words, the
annuitant’s life is the measuring life in the contract.
A Natural Person
The annuitant must be an individual (or in the case of joint annuitants, two individuals).
If, a trust, a corporation or other non-natural person were the annuitant, there would be
no natural life by which to measure the benefits of the contract.
Role of the Annuitant
The role of the annuitant as the measuring life under an annuity contract is similar to the
role of the insured under a life insurance policy. Just as it is the insured’s age in which
determines the premium rates for a life insurance policy, it is the annuitant’s age in which
determines the benefits payable under an annuity contract. And just as it is the insured’s
death in which triggers the payment of benefits under a life insurance policy, it is the
attainment of a given age on the part of the annuitant that triggers the annuity starting
date under an annuity. And just as the insured is usually also the owner of a life
insurance policy, the annuitant is usually also the owner of an annuity, though there are
exceptions, as we have discussed previously.
Naming Joint Annuitants/Co-Annuitants
Some contracts allow the owner to name joint or co-annuitants. However, having joint
annuitants to a deferred annuity may unnecessarily increase the risk that unwanted
changes would be made to the contract prior to the annuity starting date. This is because
the risk of death for either two people is higher than the risk of death for one person.
Under some contracts, the value of the annuity would be paid immediately to the
beneficiary. Under others, the owner could change the annuitant designation. But if the
owner is not an individual, this change would be treated the same for tax purposes as a
death of an owner, triggering required distribution from the contract.
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The increased risk of naming joint annuitants may be unnecessary because even if only
one annuitant is named under a deferred annuity contract, a joint-and-survivor income
option can be chosen at the annuity starting date. If a guaranteed lifetime income stream
over the lives of two individuals is desired, this objective can be achieved without
naming joint annuitants during the accumulation (deferral) period.
Taxation of Annuitant
As mentioned earlier, it is generally the owner rather than the annuitant who is taxed on
annuity payments. If the owner and the annuitant are the same person, of course, it is the
owner/annuitant who is taxed.
As a reminder, some annuity contracts provide that the annuitant will become the owner
of the contract after the annuity starting date. In that case, the annuitant, as owner, would
become liable for the tax on the income-taxable portion of those payments earned after
the annuity starting date. Earnings before annuity starting date should be taxed to old
owner on the annuity starting date or as distributions are made after the annuity starting
date.
Death of Annuitant
The death of the annuitant can cause some major changes to the contract or in some cases
even the cessation of the contract, because the annuitant is the measuring life under the
contract. We’ve already discussed above the possible effects of the annuitant’s death
prior to the annuity starting date. Under an annuitant-driven contract, when the annuitant
dies, the guaranteed death benefit is paid and the contract ceases.
Under an owner-driven contract, the annuity remains in force if the annuitant dies. The
owner must name a new annuitant, or the contract may specify that the owner also
becomes the annuitant. If there is a contingent annuitant, then the contingent annuitant
becomes the annuitant; the owner typically may not name a new contingent annuitant.
However, if it is a contingent annuitant who dies, not the primary annuitant, the owner
may simply name a new contingent annuitant.
If the annuitant dies after the annuity starting date, the income option under which
annuity payments are being made controls what happens next. Under a “life only”
income option, payments cease. Under a “period certain” or “refund” payment option,
the balance of any remaining guaranteed payments will be made to the beneficiary.
Under a joint and survivor payment option, payments will continue to the surviving
annuitant for the remainder of his or her life.
99
The Beneficiary
The beneficiary is the person designated under the contract to receive any payments that
may be due upon the death of the owner (owner driven contracts) or annuitant (annuitant
driven contracts).
Death Benefit
The death benefit payable to the beneficiary of a deferred annuity prior to the annuity
starting date is usually equal to the greater of either:


The total premium paid for the annuity to date, minus any withdrawals, or
The current accumulated value of the annuity fund.
For variable annuities, this protects the beneficiary in case of declines in the financial
markets. Under some variable annuities, item 2 above may be increased by crediting
interest at the guaranteed rate rising interest and/or step-up).
Generally, no surrender charges or market value adjustments are applied in determining
the amount of a deferred annuity’s death benefit.
Today, most variable annuities offer “stepped-up” death benefit features or “resets” under
which gains achieved in the separate account investment options may be preserved for
the purpose of calculating the death benefit even if the accumulated value later drops.
The stepped-up death benefit is generally calculated with reference to the highest
accumulated value recorded at certain intervals—for example, every third or every fifth
policy anniversary. The stepped-up death benefit may also include any premiums paid
(minus any withdrawals taken) since that time.
Whose Death Triggers the Death Benefit
A similarity between a life insurance contract and an annuity contract is that death is the
event in which triggers the payment of benefits to the beneficiary. However, with a life
insurance contract, the benefit is paid at the death of the insured. With an annuity, the
payment of the death benefit is triggered upon the death of the owner (owner-driven
contracts) and may also be triggered by the death of the annuitant (annuitant-driven
contracts), depending on how the pertinent provisions in the contract are worded. If the
owner and the annuitant are the same person, this potential complexity does not come
into play.
Remember that, regardless of the type of contract, the value of the contract must be
distributed or annuitized if an owner dies. This forced distribution is not the same as a
guaranteed death benefit.
100
Changing the Beneficiary
Most annuities reserve the contract owner’s right to change the beneficiary at any time
during the annuitant’s life. However, some contracts, give the owner the option of
naming a permanent, or irrevocable, beneficiary. If an irrevocable beneficiary is named,
the beneficiary designation can later be changed only with the beneficiary’s consent.
Designated Beneficiary
The term “designated beneficiary” is defined in Section 72(s)(4) to mean “any
individual designated a beneficiary by the holder of the contract.”
Spouse or Children as Beneficiaries
In most cases, the beneficiary is the owner’s spouse so that the spousal exception to the
required distribution rules can be used to continue the contract in the event of the owner’s
death. Sometimes it is appropriate for the owner to name his or her child or children as
beneficiaries. If a beneficiary is a minor child, the owner should have a will and name a
guardian to receive the benefits on the child‘s behalf. Otherwise, the child’s lack of legal
competence will likely cause the insurer to delay paying the benefits until the court
names a guardian.
Non-Natural Person as Beneficiary
In some cases, it may be appropriate to name a trust or estate beneficiary under an
annuity—a beneficiary need not be a natural person. If the proceeds are paid to a nonnatural person as a required distribution upon the owner’s death prior to the annuity
starting date, proceeds must be distributed within five years—the annuitization option
will not be available, since the beneficiary is not a natural person.
Multiple Beneficiaries
An annuity contract can have more than one beneficiary. Most annuities provide that if
more than one beneficiary is named, equal shares will be paid out to each named
beneficiary unless a specific percentage is mandated.
Taxation of Beneficiary
With an annuity-driven contract, upon the annuitant’s death, the beneficiary becomes
liable for income tax on any gain paid out of the contract, if owner and annuitant is the
same person. If, owner is still alive, amounts earned before annuitant’s death are taxable
to owner.
Also, in some cases, the beneficiary may become liable for the 10% penalty tax on
premature distributions. This is because of the way the definition of the “premature
101
distributions” is written in the tax law for annuities purchased on a nonqualified basis.
For annuities purchased on a nonqualified basis:


The definition of a premature distribution is written with reference to the
taxpayer’s age. Upon the death of the annuitant, to the extent the beneficiary
becomes the taxpayer rather than the owner, the beneficiary’s age must be used
to determine whether a penalty is due.
In addition, the distribution-at-death exception to the definition of “premature
distribution” refers to the death of the contract owner or to the annuitant only if
the owner is not a natural person. If the owner and annuitant are different
persons and the owner is a natural person, the distribution-at-death exception
does not apply at the death of the annuitant.
Therefore, if an annuity is purchased on a nonqualified basis and the owner of the annuity
is a natural person and is not the annuitant; the annuitant’s beneficiary will be liable for
the 10% penalty tax if he or she receives taxable death proceeds from the annuity when
he or she is under age 59½.
The situation is not as unlikely as it may sound. Most annuities are purchased on a
nonqualified basis, and if the husband of a married couple is the purchaser, he is likely to
name himself owner. However, it is also common for a married couple to assume that the
husband will die before the wife, since men have a shorter average life expectancy than
women, so the owner may name his spouse as annuitant. And since it is assumed that the
husband will have already died by the time the wife dies, the couple’s child or children
may be named beneficiary.
However, as we have already discussed, depending on the provisions in the contract, if
the wife dies first, the husband’s ownership rights may cease and the value of the annuity
may be paid to the children. The surviving husband-owner will have to pay income tax
on any gain existing in the contract at the time of the wife’s death. If the husband is
under age 59½, they’ll be liable for the 10% penalty tax as well as regular income tax on
any future income paid out of the contract.
Better results can be obtained by having either the husband or wife as both owner and
annuitant, and naming the other spouse beneficiary. Then regardless of who dies first,
the spousal exception is available to continue the contract without income tax
consequences. The children can be named as contingent beneficiaries in the event of a
common disaster involving both the husband and wife.
Death of Beneficiary
The death of the beneficiary does not affect the contract itself. If death of the beneficiary
occurs prior to the death of the owner or annuitant, the owner could name a new
beneficiary or if one was named in the contract, the contingent beneficiary, would
become the primary beneficiary. However, if the beneficiary dies before the owner or
102
annuitant and a new beneficiary is not named, benefits may end up being paid to the
owner’s or annuitant’s estate.
Maximum Ages for Benefits to Begin
Every deferred annuity contract specifies a maturity date or annuity date, which is the
date on which annuitized payments are scheduled to begin. A contract's maturity date
usually is the later of 10 contract years or the contract anniversary that falls in the year
the annuitant reaches age 85. (In some contracts, the maturity age is 100.) Most insurers
allow a contract owner/annuitant to continue the deferral period for some time past the
maturity date or annuitize the contract before the maturity date.
Typically, an annuity contract provides the insurer the right to require proof that the
annuitant is living on the date of any annuity payment.
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Chapter 6
Review Questions
1. Deciding whom to name as the owner, annuitant and the beneficiary of an annuity
contract is commonly called what?
(
(
(
(
) A. Taxation structure
) B. Contract structure
) C. Annuitization structure
) D. Annuity classification
2. What is the most critical point for an agent to remember about annuity contracts?
(
(
(
(
) A. They are impossible to understand
) B. They are all easy to understand
) C. They are all different
) D. They are all created equal
3. When structuring an annuity contract it is probably best to:
(
(
(
(
) A. Keep it simple
) B. Keep it complex
) C. Name the trust as the annuitant
) D. Name the estate as beneficiary
4. Under an annuitant-driven (AD) contract the death benefit would be paid at whose
death?
(
(
(
(
) A. Death of the owner only
) B. Death of the beneficiary only
) C. Death of either the annuitant and/or owner
) D. Death of the contingent beneficiary only
5. In general, who is taxed on any amounts disbursed from the annuity contract during
the annuitant’s lifetime?
(
(
(
(
) A. Contract owner
) B. Annuitant
) C. Beneficiary
) D. Contingent annuitant
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CHAPTER 7
SUITABILITY OF ANNUITIES
Overview
Suitability should be a concept that is familiar to all of us. Whether it is a routine
purchase or a life decision, we are always assessing our choices based upon what best
suits our needs. The topic is no different in the world of insurance. When we carefully
align a client’s needs and objectives with a life insurance or annuity product, we can
conclude that the sale is “suitable”.
However, like any industry there will always be a few bad apples that try to take
advantage of a situation and put their own interests first. Regretfully, because of these
few rogue salespersons, the state of California (as well as many other state insurance
regulators) and federal regulators have been forced to mandate new reporting, disclosure
and suitability requirements on all insurance producers/agents selling annuity products,
especially when selling annuity products to seniors (age 65 and older).
In this Chapter, we will examine the licensing requirement for life agents only and then
review the California Annuity Suitability requirements as set forth in Assembly Bill 689,
Chapter 295, an Act to add Article 9 (commencing with CIC § 10509.910) to Chapter 5
of Part 2 of Division 2 of the California Insurance Code, relating to annuity transactions.
Learning Objectives
Upon completion of this chapter, you will be able to:




Identify the license and training requirements for a Life-Only agent;
Apply the California Suitability of Annuity laws;
Distinguish between the 13 points to determine the suitability of an annuity
recommendation; and
Identify the role of the Wall Street Reform and Consumer Protection Act of 2010
as it pertains to the suitability of annuity sales.
Licensing and Training Requirements
A California Life-Only license entitles licensee’s to transact insurance coverage,
including benefits of endowment and annuities, benefits in the event of death or
dismemberment by accident and benefits for disability income.
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CIC 1749.8
Before a Life-Only agent can sell annuities in California, he or she must meet special
training requirements of CIC § 1749.8 of the California Insurance Code.


Pursuant to Subdivision (a), every life agent who sells annuities shall
satisfactorily complete eight (8) hours of training prior to soliciting individual
consumers in order to sell annuities.
Pursuant to Subdivision (b), every life agent who sells annuities shall
satisfactorily complete four (4) hours of training prior to each license renewal.
For resident licensees, this requirement shall count toward the licensee’s
continuing education requirement, but may still result in completing more than the
minimum number of continuing education hours set forth in this section.
The training required by CIC Section 1749.8 shall be approved by the commissioner and
shall consist of topics related to annuities, and California law, regulations, and
requirements related to annuities, prohibited sales practices, the recognition of indicators
that a prospective insured may lack the short-term memory or judgment to knowingly
purchase an insurance product, and fraudulent and unfair trade practices. Subject matter
determined by the commissioner to be primarily intended to promote the sale or
marketing of annuities shall not qualify for credit towards the training requirement. Any
course or seminar that is disapproved under the provisions of this section shall be
presumed invalid for credit towards the training requirement of this section unless it is
approved in writing by the commissioner.
Note: Combo plans combine an annuity product and a rider that may provide benefits for
long term care, life insurance, or both. California allows Life-Only agents to sell combo
type plans without the A&H license.
California Suitability Law
On September 20, 2011, Governor Gerry Brown signed into law Assembly Bill (AB) 689
(Chapter 295, Statutes of 2011), an act to add Article 9 (commencing with Section
10509.910) to Chapter 5 of Part 2 of Division 2 of the Insurance Code, relating to annuity
transaction. This act became effective January 2, 2012.
CIC § 10509.910
Under CIC § 10509.910, the purpose of this article is to require insurers to establish a
system to supervise recommendations and to set forth standards and procedures for
recommendations to consumers that result in transactions involving annuity products, so
that the insurance needs and financial objectives of consumers at the time of the
transaction are appropriately addressed.
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CIC § 10509.911
Under CIC § 10509.910, this article shall apply to any recommendation to purchase,
exchange, or replace an annuity made to a consumer that results in the purchase,
exchange, or replacement that was recommended.
Nothing in this act shall be interpreted to preclude, preempt, or otherwise interfere with
the application of any other laws of this state that may apply in any matter involving the
sale of an annuity that is subject to this article.
CIC § 10509.912
Under CIC § 10509.912, unless otherwise specifically included, this article shall not
apply to transactions involving any of the following:


Direct response solicitations where there is no recommendation based on
information collected from the consumer pursuant to this article.
Contracts used to fund any of the following:
o An employee pension or welfare benefit plan that is covered by the federal
Employee Retirement and Income Security Act (ERISA) (29 U.S.C. Sec.
1001 et seq.).
o A plan described by Section 401(a), 401(k), 403(b), 408(k), or 408(p) of
the Internal Revenue Code (IRC), as amended, if established or
maintained by an employer.
o APPROVES government or church plan defined in Section 414 of the
IRC, a government or church welfare benefit plan, or a deferred
compensation plan of a state or local government or tax-exempt
organization under Section 457 of the IRC.
o A nonqualified deferred compensation arrangement established or
maintained by an employer or plan sponsor.
o Settlements of or assumptions of liabilities associated with personal injury
litigation or any dispute or claim resolution process.
o Formal prepaid funeral contracts.
CIC § 10509.914
Under CIC § 10509.914(a) when recommending to a consumer the purchase of an
annuity or the exchange of an annuity that results in another insurance transaction or
series of insurance transactions, the insurance producer, or an insurer if no producer is
involved, shall have reasonable grounds for believing that the recommendation is
suitable for the consumer on the basis of the facts disclosed by the consumer as to his or
her investments and other insurance products and as to his or her financial situation and
needs, including the consumer’s suitability information, and that there is a reasonable
basis to believe all of the following:

The consumer has been reasonably informed of various features of the annuity,
such as the potential surrender period and surrender charge, potential tax penalty
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if the consumer sells, exchanges, surrenders, or annuitizes the annuity, mortality
and expense fees, investment advisory fees, potential charges for and features of
riders, limitations on interest returns, insurance and investment components, and
market risk.
The consumer would receive a tangible net benefit from the transaction.
The particular annuity as a whole, the underlying sub-accounts to which funds are
allocated at the time of purchase or exchange of the annuity, and riders and
similar product enhancements, if any, are suitable, and in the case of an exchange
or replacement, the transaction as a whole is suitable, for the particular consumer
based on his or her suitability information.
In the case of an exchange or replacement of an annuity, the exchange or
replacement is suitable, including taking into consideration all of the following:
o Whether the consumer will incur a surrender charge, be subject to the
commencement of a new surrender period, lose existing benefits, such as
death, living, or other contractual benefits, or be subject to increased fees,
investment advisory fees, or charges for riders and similar product
enhancements.
o Whether the consumer would benefit from product enhancements and
improvements.
o Whether the consumer has had another annuity exchange or replacement
and, in particular, an exchange or replacement within the preceding 60
months.
Prior to the execution of a purchase, exchange, or replacement of an annuity resulting
from a recommendation, an insurance producer, or an insurer where no producer is
involved, shall make reasonable efforts to obtain the consumer’s suitability information.
Except as permitted below, an insurer shall not issue an annuity recommended to a
consumer unless there is a reasonable basis to believe the annuity is suitable based on the
consumer’s suitability information (discussed below). The preceding sentence and
subdivision notwithstanding, neither a producer nor an insurer shall in any event
recommend to a person 65 years of age or older the sale of an annuity to replace an
existing annuity that requires the insured to pay a surrender charge for the annuity that is
being replaced, where purchase of the annuity does not confer a substantial financial
benefit over the life of the policy to the consumer, so that a reasonable person would
believe the purchase is unnecessary.
CIC § 10509.914(i)
Under CIC § 10509.914(i), “Suitability information” means information that is
reasonably appropriate to determine the suitability of a recommendation, including all of
the following (13 points):


Age.
Annual income.
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


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Financial situation and needs, including the financial resources used for the
funding of the annuity.
Financial experience.
Financial objectives.
Intended use of the annuity.
Financial time horizon.
Existing assets, including investment and life insurance holdings.
Liquidity needs.
Liquid net worth.
Risk tolerance.
Tax status.
Whether or not the consumer has a reverse mortgage.
CIC § 10509.914(e)
Under CIC § 10509.914(e), an insurance producer or, where no insurance producer is
involved, the responsible insurer representative, shall at the time of sale do all of the
following:



Make a record of any annuity recommendation. (These types of notes should be
entered into the client’s file or database and be accessible for reference or review
by the State).
Obtain a customer signed statement documenting a customer's refusal to provide
suitability information, if any. (This can be as simple as a handwritten sheet of
paper, signed by the client stating that the client refuses to provide requested
information. To limit suitability exposure this letter should disclose to the client
that failure to provide the required information may limit the protections offered
under the law. Check with your compliance department before making or using
any such form.)
Obtain a customer signed statement acknowledging that an annuity transaction is
not recommended if a customer decides to enter into an annuity transaction that is
not based on the insurance producer's or insurer's recommendation.
An insurance producer may be absolved of the suitability requirements if the following is
met:


The client refuses to give the agent the required information, the client provides
false or incomplete information, or
The client chooses to purchase annuities against the recommendation of the agent.
CIC § 10509.914(f)(D)(E)
Under CIC § 10509.914(f)(D)(E), it is the responsibility of the insurer to establish a
supervision system to meet suitability compliance requirements including, but not limited
to, all of the following:
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

Review procedures to ensure that a recommendation is suitable before a
recommendation is made.
Maintain procedures to identify unsuitable recommendations including, but not
limited to,
o Consumer suitability information,
o Customer surveys and interviews,
o Confirmation letters and,
o Internal monitoring procedures.
Nothing stated above prevents an insurer from complying with this section by applying
procedures after issuance or delivery of the annuity.
CIC § 10509.916
Under CIC 10509.916, it is the insurer who will be responsible for compliance. If a
violation occurs, either because of the action or inaction of the insurer or its insurance
producer, the commissioner may, in addition to any other available penalties, remedies,
or administrative actions, order any or all of the following:



For the insurer to take reasonably appropriate corrective action for any consumer
harmed by the insurers, or by its insurance producers’ under this section.
A managing general agent or an insurance producer to take reasonably
appropriate corrective action for any consumer harmed by the insurance
producer’s violation of this article.
Penalties and sanctions pursuant to CIC § 10509.9. For purposes of CIC §
10509.9, this article shall be deemed to be part of Article 8 (commencing with
Section 10509), and the commissioner may in a single enforcement action seek
penalties for a first and a second or subsequent violation.
o Nothing in this article shall affect any obligation of an insurer for acts of
its agents, or any consumer remedy or cause of action that is otherwise
provided for.
CIC § 10509.917
Under CIC § 10509.917, an insurer and insurance producer shall maintain or be able to
make available to the commissioner records of the information collected from the
consumer and other information used in making the recommendations that were the basis
for insurance transactions for five (5) years after the insurance transaction is completed
by the insurer. An insurer is permitted, but shall not be required, to maintain
documentation on behalf of an insurance producer.
The following records required to be maintained by this section may be maintained in
paper, photographic, micro-process, magnetic, mechanical, or electronic media, or by any
process that accurately reproduces the actual document.
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CIC § 10509.918
Under CIC § 10509.918, the commissioner shall adopt reasonable rules and regulations,
and amendments and additions thereto. The commissioner may adopt regulations not
inconsistent with this article pursuant to Section 989J of the federal Dodd-Frank Wall
Street Reform and Consumer Protection Act (Public Law 111-203).
The Wall Street Reform and Consumer Protection Act of 2010
Under Section 989J of the Wall Street Reform and Consumer Protection Act of 2010
(also known as the Harkin Amendment), it called for all states to adopt and enforce the
NAIC 2010 Suitability in Annuities Transaction Model Regulation (Model Act 275). In
addition, the Federal Insurance Office (FIO), which was created by the Act, also calls on
the states to adopt the NAIC Model Act 275. The annuity suitability recommendation
appears in the “marketplace oversight” section. It runs only 650 words, but annuity
professionals will be perusing those words very carefully. The report states:
“The suitability of an annuity purchase should not be dependent upon the state in
which the consumer resides,”
Reading between the lines, the underlying message is that this is no time for footdragging. All states need to adopt and implement the NAIC suitability model ASAP. If
all states aren’t on board fairly soon, the feds might step in. According to the 71-page
report:
“Given the importance of national suitability standards for consumers
considering or purchasing annuities, states should adopt the Model Suitability
Regulation. In the event that national uniformity is not achieved in the near term,
federal action may become necessary.”
The last statement – that “federal action may be necessary” – will no doubt stir up a
certain amount of industry murmuring. That is because, according to various published
reports, many states have already adopted one version or another of the annuity suitability
model developed by NAIC. “So why even bring this up?” some professionals will ask.
Apparently, this has to do with the lack of uniformity among those regulations. As was
discussed above, the NAIC has adopted three versions of its suitability model over the
years. The 2003 version applies to sales involving senior buyers. The 2006 version
updates the model to apply to consumers of all ages. And the 2010 model substantially
strengthens the standards (by clarifying insurer compliance and producer education
requirements, for example).
To bolster its case, the FIO researchers point out that the Dodd-Frank Act has two sets of
provisions that incorporate this suitability model.

One set of provisions essentially involves voluntary adoption. Here, the act
provides “incentives” for state regulators to enact national suitability standards.
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
These include grants for which states can apply to support efforts “to enhance the
protection of seniors from misleading and fraudulent sales of financial products,”
the researchers say. The catch is, in order to obtain the grants, the states must
meet certain requirements, including a requirement to “adopt suitability standards
that meet or exceed” those in the model regulation. They could choose not to
adopt the standards, but then they won’t qualify for the grants.
The second set of provisions moves closer to being an indirect requirement. Here,
Dodd-Frank includes a direction to the Securities and Exchange Commission that
involves both the suitability model and regulation of indexed annuities. This is
the so-called Harkin Amendment, and it exempts indexed annuities from
securities regulation. To get the exemption, an indexed annuity must meet certain
standards. One of the standards is that the annuity must be issued in a state that
has adopted the suitability model or be issued by an insurer whose nationwide
practices meet or exceed the suitability model standards.
Currently, only thirty-five states have adopted the 2010 version.
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Chapter 7
Review Questions
1. Pursuant to CIC § 1749.8(b), every life agent who sells annuities shall satisfactorily
complete how many hours of annuity training prior to each license renewal?
(
(
(
(
) A. 2 hours
) B. 3 hours
) C. 4 hours
) D. 8 hours
2. Which of the following CIC Sections is known as the California Suitability of
Annuity laws?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
CIC § 759.1
CIC § 10509.910
CIC § 10127.13
CIC § 786
3. Under the California Suitability law, it requires "suitability information" that consists
of at least how many points?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Four
Seven
Twelve
Thirteen
4. Under CIC § 10509.917, an insurer and insurance producer shall maintain or be able
to make available to the commissioner records of the information collected from the
consumer that were the basis for insurance transactions for how many years after the
insurance transaction is completed?
(
(
(
(
) A. 2 years
) B. 3 years
) C. 5 years
) D. 7 years
5. Section 989J of the Wall Street Reform and Consumer Protection Act of 2010 is also
known as the:
(
(
(
(
) A. Reid Amendment
) B. McConnell Amendment
) C. Dodd-Frank Amendment
) D. Harkin Amendment
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CHAPTER 8
CIC CONTRACT PROVISIONS, RIDERS AND PENALTIES
Overview
As was discussed in Chapter 6, an annuity is a complex product, so it is important that
the California insurance producer (agent) understand the various contract provisions and
riders as well as to realize the penalties that may be levied if the insurance producer
(agent) does not follow the rules under the California Insurance Code.
In this chapter, we will examine several annuity contract provisions, policy riders and
penalties under the California Insurance Code (CIC).
Learning Objectives
Upon completion of this chapter, you will be able to:
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Determine who can enter into a contract in California;
Identify the free look provision under CIC § 10127.10
Recognize the various types of surrender and withdrawal penalties;
Identify the various life insurance and annuity contract LTC riders; and
Apply the various penalties under the CIC.
CIC Contract Provisions
There is no specific California law governing the maximum issue ages for annuities, and
most insurers will issue an annuity contract up to age 85 or even older. However, under
CIC § 10112, and the California Probate Code, a minor does not have the right to enter
into a contract for life, disability insurance, or an annuity contract.
Younger buyers, age 18 and under, may even possess all legal rights associated with
owning contracts as long as they have the written consent of a parent or guardian. In
California, a person younger than 18 years of age is a minor.
The California Uniform Transfer to Minors Act (UTMA) allows minors to own
investments and other types of property. In a California UTMA, a donor appoints a
custodian and irrevocably gifts money to a trust. The property then legally belongs to the
minor but is controlled by the custodian until the minor reaches the age specified in the
trust. In California, this age is 18 and may be extended to a maximum age of 25
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(California Probate Code, Section 3920.5). Agents should check with the insurer if using
annuities when minors are involved.
CIC §10540
Under CIC § 10540, incorporated life insurers issuing life insurance policies on the
reserve basis may collect premiums in advance. They may also accept money for the
payment of future premiums related to any policies issued by it. Insurers may not accept
the following:


Money in any amount that exceeds the sum of future unpaid premiums on any
policy, or
A sum of 10 such future unpaid annual premiums on a policy if the sum is less
than the sum of future unpaid premiums for the policy.
This does not limit the right of insurers to accept funds under an agreement that provides
for accumulation of funds for the purpose of purchasing annuities at some future date.
CIC § 10127.10
Under CIC § 10127.10, senior citizens (persons 60 years and older) who purchase
annuities must now be given the right to cancel them within 30 days. This law applies to
all contracts sold and delivered after 1/1/04. Return of the policy during the cancellation
period has the effect of voiding the policy from the beginning and placing the parties in
the same position as if no policy had been issued. That means that all premiums and
policy fees shall be refunded by the insurer. If the insurer or entity issuing the policy or
certificate fails to refund all of the premiums paid, in a timely manner, then the applicant
shall receive interest on the paid premium at the legal rate of interest.
If a variable annuity is involved, the owner is entitled to a full refund of his/her account
value. And, during the 30-day free look cancellation period the premium must only be
invested in fixed-income investments.
CIC § 10127.12
Most annuity contracts impose a surrender charge against a partial or full surrender from
the contract for a period of years after the annuity is purchased. This charge, usually
referred to as a “surrender charge” or a “deferred sales charge,” is intended to make it
less attractive for annuity owners to move funds in and out of the annuity and to allow the
insurance company to recover its costs if the contract does not remain in force over the
long run.
The surrender charge is usually applicable to surrenders made from the annuity for a
certain number of years. Although this period varies from one annuity to another, it often
runs anywhere from 5-8 years (see Table 8.1 )
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Table 8.1
Surrender Charge Table
Contract Year
Surrender Charge
1
8%
2
3
4
5
6
7
8
7%
6%
5%
4%
3%
2%
1%
Thus, any surrender made in the fifth contract year under this schedule will incur a
surrender charge under the contract of 4%. After the contract has been in force for 8
years, no surrender charge will apply.
Under CIC §Section 10127.12, a senior citizen (persons age 60 and older) who owns an
individual life insurance policy or an individual annuity contract (issued after January 1,
1995), the insurer is now required when providing annual statements to also provide the
current accumulation value (CAV) and the current cash surrender value (CSV).
CIC § 10127.13
Under CIC § 10127.13, a senior citizen (persons age 60 and older) who purchases either
an individual life insurance policy or an annuity contracts that contains a surrender
charge period, the insurer is now required to disclose the surrender period and all
associated penalties in 12-point bold print and in the following manner:

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On the cover sheet of the policy, or
Disclose the location of the surrender information in bold 12-point print on the
cover page of the policy, or
Printed on a sticker affixed to the cover page or to the policy jacket.
Surrender Charge Waivers
Many annuity contracts provide for a waiver of the contract’s surrender charges in the
event that the annuitant is hospitalized or confined to a nursing home, has a terminal
illness, becomes unemployed for a specified period of time, or suffers a disability that
lasts for a certain period of time.
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Nursing Home
A number of insurers include this special feature to provide additional liquidity without
surrender charges. Their annuity contracts offer a waiver of the contract’s surrender
charges or withdrawal penalties in the event that the annuitant is either hospitalized or
confined to a nursing home for a certain period of time, such as 30 days or longer. This
provision allows the owner of the contract to remove funds from the annuity contract that
might be needed to meet the expenses or lost income associated with the long-term
hospitalization or confinement.
Terminal Illness
The same can hold true if a policyholder becomes terminally ill (generally a condition
that results in death within six months to a year) thus allowing access to money when it
may be needed most.
Unemployment
While not as common as medical waivers, some annuities provide for surrender charge
relief if an annuitant becomes unemployed for a specified amount of time and due to a
specified number of causes and/or reasons.
Disability
This type of waiver eliminates the withdrawal and/or surrender fees should the annuitant
suffer a disability that lasts a specified period of time such as 30 days and/or qualifies as
disabled under a specific set of conditions.
Death
This surrender charge waiver is found in almost every annuity contract.
Charges and Fees
When one of the above crises occurs triggering a waiver, there is no extra charge for such
crisis waivers because they are built into the contract when purchased. Variable annuity
contracts may offer crisis waivers for an additional expense.
Required Notice and Printing Requirements
When there are penalties associated with surrendering an annuity contract, the
notification requirement can be met by a notice in 12-point bold print on the cover page
making the mandated disclosures, or by indicating the location of this information in the
policy.
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Withdrawal Privilege Options
Annuities are designed to be long-term investments, however, to compete with other
investments, insurers needed to provide some liquidity during the term of annuity.
Insurers usually allow policyholders to withdraw a portion of the annuity's value free of
surrender charges. The amount available differs by contract, but there are usually three
types of “Free” withdrawals:
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
Withdrawals of interest earnings; or
Withdrawals equal to a percentage of premium deposited; or
Withdrawals equal to a percentage of the annuity's value
The penalty-free amount is typically accessible each year. If a larger amount is
withdrawn, it may be subject to withdrawal (surrender) charges. Clients may lose any
interest above the minimum guaranteed rate on the amount withdrawn.
Most annuity contracts allow the contract owner (holder) to withdraw or make a partial
surrender of an amount equal to 10% of the accumulation value each contract year
without the contract surrender charges being applied.
Whatever the specifics of the free withdrawal provisions, it does not release the contract
owner (holder) from the income tax consequences, including the 10% penalty for
premature distribution (prior to age 59 ½) tax.
Market Value Adjustment
Some annuity contracts have a market value adjustment (MVA) feature. If interest rates
are different when the annuity is surrendered than when it was purchased, a market value
adjustment may make the cash surrender value higher or lower. Since the contract owner
and the insurance company share this risk, an annuity with an MVA feature may credit a
higher rate than an annuity without that feature. The MVA can be positive or negative.


If interest rates have fallen, the MVA will be positive. It will offset at least a
portion of any applicable surrender charges, and perhaps even add to the annuity's
surrender value.
On the other hand, if interest rates have risen, the MVA will be negative and will
be added to any applicable surrender charges, further decreasing the surrender
value.
Some MVA products on the market today do not guarantee principal or minimum
interest. With these contracts, the market value adjustment can be negative enough to
cause a loss of principal.
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Policy Administration Charges and Fees
Companies may charge a flat annual fee (usually $30 -$50) to cover costs such as
statement fees, administrative, ownership and beneficiary changes. The fees and charges
in fixed annuities are generally lower than those charged in variable annuities. Insurance
companies may also adjust the current interest to be credited downward enough to allow
for a portion of the interest to be retained by them to offset administrative expenses.
Life Insurance and Annuity Contract Riders
Most insurance policies and/or annuity contracts may provide a rider that acts like a life
insurance benefit. (Note: Annuity death benefits to heirs have a different tax status than
life insurance benefits which pass to beneficiaries’ tax free.) If the policy owner dies
before he/she collects the full value of the annuity, the rider pays to their heirs the amount
invested plus interest or the market value of the funds minus whatever the policy owner
has collected in payouts.
Long-Term Care Benefits Rider
A Long-Term Care rider provides long term care insurance in addition to a steady stream
of income. The 2006 Pension Protection Act now allows for withdrawals from an
annuity or life insurance policy with a long term care rider to be tax free to the individual
for qualified long term care expenses.
Note: This only applies to nonqualified contracts.
Terms of Riders
Riders are designed to provide added benefits without reducing monthly annuity
payments. A long-term care rider will provide coverage if an accident or unplanned
illness occurs. Cost can be a drawback as with any added policy benefits. Most longterm care riders require that the annuity be held for a certain term, such as 5-10 years.
Difference between Crisis Waivers & Long-Term Care Riders
A crisis waiver (also known as hardship clauses and medical waivers) is documentation
attached to an existing policy. A waiver is an intentional and voluntary surrender of some
known right, which generally may either result from an express agreement or can be
inferred from circumstances that will allow funds to be paid to the annuitant or policy
owner. Situations that would allow payment of funds include:


Admission to a nursing home for a specified minimum time period (often six
months),
A terminal illness,
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Unemployment, and
Disability.
A long-term care rider is generally used to extend coverage for some specific reason.
Riders are the documents used to shape the standardized policy to fit individual needs. At
least one form must be added to the insuring agreement and the terms and conditions in
order to structure a complete contract. In this case, the addition is the long-term care
coverage.
Skilled Nursing Facility Rider
A Skilled Nursing Facility Rider is a rider that adds skilled nursing facility benefits to the
contract or policy. Skilled nursing care is daily nursing and rehabilitative care that is
performed only by, or under the supervision of, skilled medical professionals or technical
personnel. This care is available 24/7 and involves a medical treatment plan. Skilled
nursing care is based on a physician’s plan of care and performed directly by or under the
supervision of a registered nurse. This type of care is provided when a patient’s
condition is stable and acute medical care is not needed, but the patient does need a high
level of nursing care. Care may be required for a short period or for an extended period
of time depending on the time frame until the patient can make a transition to a lower
level of care. Skilled nursing facilities are licensed by the state and it can be paid for by
Medicare and private insurance.
California Health and Safety Code (Sec. 1250) defines a Skilled Nursing Facility as a
health facility that provides skilled nursing care and supportive care to patients whose
primary need is for availability of skilled nursing care on an extended basis.
Hospice Rider
This type of policy rider would offer services for patients with a terminal illness and it
includes counseling for the patient and the family. Hospice care can be offered in a
hospice setting, a nursing facility or in the patient’s home whereby nurses and social
workers can visit the patient on a regular basis. The purpose of care is to keep the patient
comfortable and to enable the patient to die with dignity.
CIC Penalty Statutes
Below are the statutes stated in SB 618 and the penalty statute from AB 689 (Chapter
295, Statutes of 2011) Insurance: annuity transactions, Section 10509.914 of the
California Insurance Code, which took effect on January 1, 2012. For a complete
analysis of CIC Penalties see Appendix B.
CIC Section 780
Under CIC Section 780, insurers and agents must not misrepresent the following:
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
Terms of a policy issued (or soon to be issued) by the insurer,
Benefits agreed to in the policy,
Future dividends payable under the policy.
CIC Section 781
Under CIC Section 781, insurers and agents must not make statements that are known, or
should have been known, to be a misrepresentation of the following:


Any misrepresentation to persuade a policyholder to lapse, forfeit or surrender his
or her insurance.
Any representation or comparison of insurers or policies to an insured which is
misleading, for the purpose of inducing or tending to induce him to lapse, forfeit,
change or surrender his insurance, whether on a temporary or permanent plan.
CIC Section 782
Under CIC Section 782, any person who violates the provisions of Section 780 or 781
will be punished as follows:


By a fine not exceeding $25,000, or
In a case in which the loss of the victim exceeds $10,000, by a fine not exceeding
three times the amount of the loss suffered by the victim, by imprisonment in a
county jail for a period not to exceed one year, or by both a fine and
imprisonment.
Victim restitution (as ordered by CIC § 1202.04 of the Penal Code) is required to be
satisfied before any fine imposed by this section is collected.
CIC § 786
Under CIC § 786, all disability insurance and life insurance policies and certificates
offered for sale to individuals age 65 or older in California shall provide an examination
period of 30 days after the receipt of the policy or certificate for purposes of review of the
contract, at which time the applicant may return the contract. The return shall void the
policy or certificate from the beginning, and the parties shall be in the same position as if
no contract had been issued. All premiums paid and any policy or membership fee shall
be fully refunded to the applicant by the insurer or entity in a timely manner.
For the purposes of this section a timely manner shall be no later than 30 days after the
insurer or entity issuing the policy or certificate receives the returned policy or certificate.
If the insurer or entity issuing the policy or certificate fails to refund all of the premiums
paid, in a timely manner, then the applicant shall receive interest on the paid premium at
the legal rate of interest on judgments as provided in Section 685.010 of the Code of
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Civil Procedure. The interest shall be paid from the date the insurer or entity received the
returned policy or certificate.
Each policy or certificate shall have a notice prominently printed in no less than 10-point
uppercase type, on the cover page of the policy or certificate and the outline of coverage,
stating that the applicant has the right to return the policy or certificate within 30 days
after its receipt via regular mail, and to have the full premium refunded.
In the event of any conflict between this Section and Section 10127.10 with respect to life
insurance, the provisions of Section 10127.10 shall prevail.
CIC § 789.3
Under CIC § 789.3, people engaged in transactions of insurance, other than the insurer,
who violate the rules regarding sales practices for an insurance producer are liable for the
following administrative penalties:


Not less than $1,000 for the first violation
Not less than $5,000 and no more than $50,000 for each subsequent violation.
Insurers who violate the articles relating to sales practices are liable for an administrative
penalty of:


$10,000 for the first violation.
Insurers who violate this article with a frequency as to indicate a general business
practice or commits a knowing violation of this article, is liable for an
administrative penalty of no less than $30,000 and no more than$300,000 for each
violation.
The commissioner may require rescission of any contract found to have been marketed,
offered, or issued in violation of Insurance Code articles pertaining to good sales
practices.
CIC § 1738.5
Under CIC § 1738.5, a proceeding that involves allegations of misconduct committed
against a person age 65 or over is to be held within 90 days after receipt by the
department of the notice of defense, unless the department or the administrative law
judge grants a continuance of the hearing. Under certain circumstances, a continuance of
the hearing may be granted.
123
CIC § 10509.9
Under CIC § 10509.9, anyone, other than an insurer, who violates the provisions of
Chapter 4 Article 8 of the California Insurance Code (requirements for replacement of
life insurance and annuity policies), is liable for the following administrative penalties of:


Not less than one thousand dollars ($1,000) for the first violation.
Not less than five thousand dollars ($5,000) and no more than fifty thousand
dollars ($50,000) for a second or subsequent violation.
Insurers who violate the provisions are liable for an administrative penalty of:



Ten thousand dollars ($10,000) for the first violation.
Insurers violating the provisions with a pattern resembling a general business
practice are liable for an administrative penalty of no less than thirty thousand
dollars ($30,000) and no more than three hundred thousand dollars ($300,000) for
each violation.
After a hearing, the commissioner may suspend or revoke the license of any
person or entity that violates this article.
CIC § 10509.916
Under CIC § 10509.916: an insurer is responsible for compliance with this article. If a
violation occurs, either because of the action or inaction of the insurer or its insurance
producer, the commissioner may, in addition to any other available penalties, remedies,
or administrative actions, order any or all of the following:


An insurer to take reasonably appropriate corrective action for any consumer
harmed by the insurers, or by its insurance producer's, violation of this article.
A managing general agent or an insurance producer to take reasonably
appropriate corrective action for any consumer harmed by the insurance
producer's violation of this article
124
Chapter 8
Review Questions
1. Under CIC § 10127.10, senior citizens (persons 60 years and older) who purchase
annuities must now be given the right to cancel an annuity contract within how many
days?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
7 days
14 days
21 days
30 days
2. Most annuity contracts allow the contract owner (holder) to withdraw or make a
partial surrender of an amount equal to what percent of the accumulation value each
contract year without the contract surrender charges being applied?
(
(
(
(
)
)
)
)
A. 5 percent
B. 10 percent
C. 15 percent
D. 20 percent
3. Under CIC 782, persons found guilty of persuading a policyholder to lapse, forfeit
or surrender his or her insurance policy can be punished by which of the following?
(
(
(
(
) A. Up to three years in jail
) B. A fine up to $25,000
) C. Suspension of license for 3 years
) D. Loss of license
4. Victim restitution is required to be satisfied ______ any fine is collected.
(
(
(
(
) A. At the same time
) B. After
) C. Before
) D. None of the above
5. Under CIC 1738.5, a proceeding that involves allegations of misconduct committed
against a person age 65 or over is to be held within ______ days after receipt by the
department of the notice of defense, unless the department or the administrative law
judge grants a continuance of the hearing.
(
(
(
(
)
)
)
)
A.
B.
C.
D.
30
21
60
90
125
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126
APPENDIX A
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 1: A typical structure: husband is the owner/annuitant, wife the
beneficiary. Use this structure when the owner wants the spouse to receive the
proceeds if he or she dies. A child or children could be named the contingent
beneficiary to receive the proceeds in case both parents died simultaneously. If
the owner wants children to receive the proceeds at his or her death, the children
should be named as primary beneficiary, but the right of spousal continuation will
be lost.
Owner Annuitant Beneficiary 1st Death
H
H
W
H
Contract
Disposition
Wife can:
1) Take lump
sum,
2) Defer
distribution for
up to 5 years,
3) Annuitize
within one
year.
Federal
Federal Federal
Income Tax Estate Tax Gift Tax
None
Contract
If contract
Value
continued,
taxes remain included in
H's estate.
deferred.
(Included in
gross
If contract is
not continued, estate, not
income taxed taxable
estate.
to W as
This
received.
(Taxed as qualifies for
OR
the marital
ordinary
deduction).
income).
4) Continue
contract
Special
becoming
marital
owner &
deduction
annuitant.
rules apply
Name a new
if wife was
beneficiary.
not a U.S.
Citizen.
Annuitant-Driven: In this arrangement, the death benefit is triggered at the death of the
husband who is both the owner and annuitant.
127
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 2: This arrangement allows the surviving spouse to become owner
following annuity owner’s death.
Owner Annuitant
H
W
Contract
Beneficiary 1st Death Disposition
Survivor can:
Survivor of
H
1) Take lump
H and W
sum,
2) Defer
distribution
for up to 5
years,
3) Annuitize
within 1 year
Federal
Income
Tax
If contract
continued,
taxes
remain
deferred.
Federal
Federal
Estate Tax Gift Tax
None
Value of
contract is
included in
husband’s
gross
estate, but
If contract qualifies for
marital
is not
continued, deduction,
assuming
income
taxed to spouse is a
OR
Wife as U.S. citizen.
4) Continue received.
.
(Taxed as
contract.
(The survivor ordinary
income).
becomes
Owner and
Annuitant).
(If the
beneficiary
continues the
contract, a
new
beneficiary
would have
to be
named.)
Annuitant-Driven: Again, in this arrangement, the death benefit is triggered at the
death of the husband who is the owner while the wife is the annuitant and the beneficiary.
128
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 3: Joint-ownership annuity. Naming the surviving owner as
beneficiary allows the surviving spouse to become owner following the death of
either spouse. If someone other than the surviving joint owner is named as
beneficiary, then the spousal election to continue the contract will be lost,
regardless of the fact that the spouses are joint owners.
These are examples of the way in which an annuity contract should be set up if
you want your surviving spouse to become the owner at your death.
Owner Annuitant Beneficiary 1st Death
H and
H
SJO
H or W
W
Contract
Federal
Disposition
Income Tax
If contract is
SJO can:
1) Take lump not continued,
then deferred
sum,
income is
2) Defer
taxed to
distribution for
beneficiary
up to 5 years,
3) Annuitize (i.e., the SJO)
within one year as received.
(Taxed as
ordinary
OR
income).
4) Continue
contract. (SJO
becomes Owner
and Annuitant).
(If the
beneficiary
continues the
contract, a new
beneficiary
would have to
be named).
Federal
Federal
Estate Tax
Gift Tax
One half of
None
contract value
included in estate
of first to die.
(Included in
gross estate, not
taxable estate.
This qualifies for
the marital
deduction).
Assuming Wife is
a U.S. Citizen.
Note: This
provision is
contractual and
not a federal
income tax
requirement.
Annuitant-Driven: In this arrangement, the death benefit will be triggered at the death
of either the Husband or Wife. When naming both spouses as joint owners and joint
beneficiary. At either, the husbands’ or the wife’s death, the surviving owner can
continue the contract.
129
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 4: The trust is assumed to be a revocable trust with husband as grantor.
Contract
Owner Annuitant Beneficiary 1st Death Disposition
Wife can:
T
H
W
H
Federal
Federal Estate Federal
Income Tax
Tax
Gift Tax
If contract Contract Value None
included in
continued,
1) Take lump taxes remain Husband’s
gross estate,
deferred.
sum,
but qualifies for
If not, income the marital
2) Defer
deduction,
distribution for taxed as
assuming
ordinary
up to 5 years,
spouse is a
income to
U.S. citizen.
Wife as
3) Annuitize
received.
within one
.
year.
OR
4) Continue
contract
becoming
owner &
annuitant.
Name a new
beneficiary.
Note: This
provision is
contractual
and not a
federal income
tax
requirement.
Annuitant-Driven: In this arrangement, the husband is the grantor of the revocable trust
and is also named as the annuitant. At the husband’s death, the beneficiary who is the
surviving spouse will have the right to continue the contract.
130
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 5: When the beneficiary dies, rather than the owner/annuitant, the
contract is not affected. The ownership remains unchanged. No death benefit is
paid.
Owner Annuitant
H
H
Federal
Contract
Income
Tax
Beneficiary 1st Death Disposition
Contract
W
W
remains intact;
new
None
beneficiary
should be
named.
Federal
Estate
Tax
Federal
Gift Tax
None
None
Owner-Driven and/or Annuitant-Driven
Example 6: The following arrangement is NOT recommended. Since the
husband was both the owner and beneficiary of the contract, a better arrangement
would have been for the husband to have named his wife as contingent
beneficiary. For example: Husband if living, otherwise wife. Then if the husband
died, the assets would not be moved into the estate, and the wife would be able to
continue the contract. In order to continue the contract, the beneficiary must be
the deceased owner’s spouse.
Owner Annuitant
H
W
Beneficiary
1st Death
H
H
Contract
Disposition
H's estate
can:
1)Take lump
sum OR
2) Defer
distribution for
up to 5 years.
Federal
Income
Tax
Federal
Estate
Tax
Deferred Contract
value
income
taxed to included in
H's estate H's estate.
as
received.
(Taxed as
ordinary
income).
Federal
Gift Tax
None
Annuitant-Driven: In this arrangement, the husband is both the owner and the
beneficiary. At his death, the assets of the annuity would not be transferred directly
to the surviving spouse, but to the deceased’s estate. The surviving spouse would
lose the benefit of spousal continuation.
131
II. WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 7: The following arrangement is NOT recommended. The Beneficiary
is someone other than the husband or wife; it could be their child or children
(Party X). In order to continue the contract, the beneficiary must be the deceased
owner’s spouse. With this structure, the beneficiary receives the proceeds if
either the owner or the annuitant dies.
st
Owner Annuitant
H
W
Beneficiary
1
Death
Party X
W
Contract
Disposition
Federal
Federal
Income Tax Estate
Tax
Deferred
Beneficiary
income
can:
taxed as
1) Take lump
ordinary in
sum,
year of
2) Defer
distribution for wife’s death.
If H is
up to 5 years
under 59½,
OR
he may
3) Annuitize
within one year. have to pay
the 10%
penalty tax
Note: This
provision is on any gain
which
contractual and
not a federal existed until
spouse’s
income tax
death*
requirement.
None
Federal
Gift Tax
Upon
wife’s
death,
husband
potentially
made a
taxable gift
to
beneficiary
of the full
contract
value on
date of
death.
Beneficiary
is taxed on
all future
income and
if under
59½, is
liable for
10% penalty
on such
amounts.
Annuitant-Driven: * Some tax authorities hold that, in this case the beneficiary rather
than the owner is liable for all income taxes on the proceeds.
132
II. WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 8: In this situation, the annuitant is someone other than the husband or
wife. To qualify for the spousal election, the beneficiary must be the deceased
owner’s spouse. In this case, if the annuitant dies, the owner is not deceased, so
the spousal election is not available.
Owner
H
Annuitant
X
Beneficiary
W
1st
Death
X
Federal
Income
Federal
Tax
Estate Tax
None. Not
Deferred
included in
income
annuitant’s
taxed as
estate.
ordinary
income to
2) Defer
Assumes that
wife as
distribution for
annuitant is
up to 5 years, received.
U.S. Citizen.
If wife is
3) Annuitize
under 59½,
within one
she may
year.
have to pay
the 10%
penalty tax.
Contract
Disposition
W can:
1) Take lump
sum,
Husband is
not taxed
on income
due to the
fact that
this is a
transfer to
his spouse
(see IRC §
1041).
Annuitant-Driven
133
Federal Gift
Tax
Amount to a
gift from
Husband to
wife.
Assuming
Wife is a
U.S. Citizen,
it qualifies
for the
marital
deduction.
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 9: This is the same structure as that of Situation No. 2 earlier. If the
wife-annuitant dies, the husband does not qualify to continue the contract as the
spouse of the deceased owner. However, if this was an owner-driven contract and
the wife-annuitant died, the contract would continue. The husband could either
become the annuitant or name a new annuitant.
Contract
Federal
Federal
Owner Annuitant Beneficiary 1st Death Disposition Income Tax Estate Tax
None
Deferred
Husband can:
H
W
H/W
W
income
1) Take lump
taxed as
sum,
ordinary
2) Defer
distribution for income to
up to 5 years Husband as
received.
OR
3) Annuitize
within one year If Husband
Note: This is under age
provision is 59½, he may
contractual and have to pay
the 10%
not a federal
penalty tax
income tax
as well.
requirement.
Federal
Gift
Tax
None
Annuitant-Driven: In this arrangement, at the wife’s death, who is also the annuitant, the death benefit would be forced to be taken
by the contract provisions. Spousal election would be lost because of the death of the annuitant.
Contract
Federal
Federal
Owner Annuitant Beneficiary 1st Death Disposition Income Tax Estate Tax
None
None
Wife may elect
to
continue
the
H
W
H/W
H
contract.
Federal
Gift
Tax
None
See case No. 2
Note: This
provision is
contractual and
not a federal
income tax
requirement.
Annuitant-Driven: In this arrangement, which is similar to arrangement 2, at the death
of the husband who is also the owner, the wife may elect to continue the contract.
134
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 10: In this situation, if the wife dies, the husband may not continue the
contract. The contingent beneficiary will receive the proceeds of the contract.
However, if the husband dies, spousal election to continue the contract is possible,
since the wife would be the deceased owner’s spouse and primary beneficiary.
Note: Provisions of the contract not a requirement of IRC § 72(a) when Wife
dies. First reason, Husband is owner and he has not died. IRC § 72(s) requires
distribution only upon owner’s death.
1st
Owner Annuitant Beneficiary Death
H
W
W
W
Contingent
Beneficiary
X
Contract
Federal
Federal
Disposition
Income Tax Estate Tax
Deferred
X can:
None
1) Take lump sum, income taxed
as ordinary
2) Defer distribution income to
for up to 5 years. husband in
year of wife’s
death. If
OR
husband is
3) Annuitize within under age
59½ he may
one year for a
period no longer have to pay
than the contingent 10% penalty
tax on any
beneficiary’s life
gain, which
expectancy.
existed until
spouse's
Note: This
death.
provision is
contractual and not
a federal income Beneficiary is
tax requirement. taxed on all
future income
and if under
59½, is liable
for 10%
penalty on
such
amounts.
Federal
Gift Tax
Upon wife’s
death,
husband
potentially
made a
taxable gift
to
contingent
beneficiary
of the full
contract
value on
date of
death.
Contingent
beneficiary
may be
entitled to
IRC § 691(c)
deduction.
Annuitant-Driven: In this arrangement, the annuitant and the beneficiary is the wife.
At her death, the proceeds of the contract would be paid to the contingent beneficiary,
who is not the husband. The husband, who is the owner, would not be able to continue
the contract. The contract must be paid out under the contract provisions.
135
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 11: This is an example of an owner-driven contract. If the Annuitant
dies, there is no distribution and the contract continues. If owner dies, there is a
distribution and spousal election is not available.
Federal
Federal Federal
Contract
Income
Estate
Gift
Owner Annuitant Beneficiary 1st Death Disposition
Tax
Tax
Tax
Contract
None
None
None
H
W
X
W
continues;
Child
husband/owner
may become
the annuitant
or, depending
on the contract,
may name
another
annuitant.
Deferred Value of None
Child can:
H
W
X
H
income contract is
Child
1) Take lump taxed as included in
ordinary husband’s
sum,
income to
gross
child as
2) Defer
estate.
distribution for received.
up to 5 years
Child may
be entitled
OR
to IRC §
3) Annuitize
691(c)
within one
deduction
year.
Owner-Driven: In the first arrangement, at the death of the wife who is the annuitant
would not force the distribution of the contract. The owner, who is the husband can name
a new annuitant and continue the contract. However, in the second arrangement, upon
the death of the husband, who is the owner, a death benefit distribution would be paid to
the beneficiary, the child. Under contract provisions the policy cannot continue for the
surviving spouse who is the annuitant and not the beneficiary.
136
III.
ANNUITIES INVOLVING TRUSTS
Example 12: In these cases, the trust is a grantor trust, with the husband the
grantor. At the owner’s death, the trust receives the proceeds and manages or
distributes the proceeds according to the trust agreement. Note: Again 72 (s) does
not require distribution in this situation. Assume trust becomes owner upon
Wife’s death. IRC § 72 (e)(4)(c) should apply & Federal income tax treatment
would be the same as Example 10.
Contract
Federal
Federal
Federal
Owner Annuitant Beneficiary 1st Death Disposition
Income Tax
Estate Tax Gift Tax
Deferred
Contract value None
1) Take lump
H
W
T
H
income taxed included in H’s
sum,
as ordinary
estate.
or
income to trust
2) Defer
distribution for as received.
up to 5 years.
At Husband’s
death, trust
ceased to be a
grantor trust
and becomes
an irrevocable
trust.
Not in W's
None
Deferred
1) Take lump
H
W
T
W
estate.
income taxed
sum,
to H in year of
2) Defer
distribution for W’s death or
over
up to 5 years
annuitization
OR
3) Annuitize period. If under
within one year. 59½, may be
subject to 10%
penalty.
Note: This
(Taxed as
provision is
ordinary
contractual and
income).
not a federal
income tax
requirement.
Annuitant-Driven
137
III. ANNUITIES INVOLVING TRUSTS
Example 13: Assume the trust is a grantor trust, with the husband the grantor.
The same trust is both the owner and beneficiary. This structure may be useful to
clients who have been advised to handle the ownership of assets including their
annuities, by means of a trust. Note: Need to be careful here, in Grantor trust
situations, insurer needs to know who grantor is because the grantor is the owner
of annuity for tax purposes and their death will trigger IRC 72 (s) not annuitant’s
if a different person.
Owner Annuitant Beneficiary 1st Death
T
H
T
H
Contract
Disposition
Trust can:
Federal
Federal
Federal
Income Tax
Estate Tax Gift Tax
None
Because
Deferred
income taxed husband is the
grantor of
1) Take lump sum as ordinary
income to trust, the value
may be
OR
trust as
included in
received.
Husband’s
2) Defer
estate.
distribution for up A 10% penalty
to 5 years.
would apply if
the grantor of Not all grantor
trusts require
trust were
inclusion in
someone
other than the gross estate of
grantor.
husband.
IRC§ 691
may be
available
Annuitant-Driven: Note: In this example Husband is the owner for tax purposes, not
the trust because the grantor Trust is treated as the owner of the assets held by the trust
for tax purposes.
138
III. ANNUITIES INVOLVING TRUSTS
Example 14: In this case, the owner and beneficiary are NOT the same trust.
Both trusts are grantor trusts.
Owner Annuitant
T
H
Federal
Contract
Income
Federal Federal
Beneficiary 1st Death Disposition
Tax
Estate Tax Gift Tax
Deferred If husband May apply
Trust can:
T
H
on funding
is the
income
1) Take lump
taxed as grantor of if grantor
sum
trust is
ordinary the owner
OR
income to trust, then irrevocable
2) Defer
value of
distribution for trust as
the
up to 5 years. received.
contract
3) Annuitize
within one If contract is may be
continued, included in
year.
income Husband’s
4) If
estate.
taxes
beneficiary
remain
trust is a
grantor trust deferred.
where the
IRC § 691
wife is the
(c)
grantor, then
the wife may deduction
may be
continue the
available.
contract.
Annuitant-Driven
139
III. ANNUITIES INVOLVING TRUSTS
Example 15: In this case, the trust is a grantor trust. If the wife dies, the child
will receive the proceeds of the contract.
Federal Federal
Federal
Estate
Gift
Owner Annuitant Beneficiary 1st Death
Income Tax
Tax
Tax
None. Not None
Deferred
T
W
X
W
income taxed in wife’s
Child
estate.
as ordinary
1) Take lump
income to
sum
child, in the
OR
year of the
2) Defer
distribution for wife’s death or
over
up to 5 years.
annuitization
3) Take
period.
distributions over
his or her life
If child is
expectancy.
under age 59
½, he or she
may be
subject to
10% penalty
tax.
Contract
Disposition
Child can:
Annuitant-Driven
Example 16: This structure can be used when a client wants an irrevocable
Charitable Remainder Trust (CRT) to own the contract and receive the proceeds.
The income beneficiary of the trust should be the annuitant. At the death of the
annuitant, the proceeds will be paid to the CRT and then be distributed to the
charity according to the trust document.
1st
Death
Owner Annuitant Beneficiary
X
T
Annuitant
T
Recipient
of income
from CRT
Contract
Disposition
CRT can:
Federal
Income Tax
CRT is taxexempt.
1) Take lump
Income is
sum
taxable at
OR
distribution
2) Defer
under CRT
distribution for up tax rules.
to 5 years.
Annuitant-Driven
140
Federal
Estate Federal
Tax
Gift Tax
None
None
IV.
GIFT OF AN ANNUITY CONTRACT
Example 17: These are the tax implications when the owner makes a gift of the
annuity contract. The example is the common structure where husband is both
owner and annuitant, with the wife the beneficiary.
Owner
H
Annuitant
H
Beneficiary
X
Contract
Disposition
Gift to W
W
W
H
Gift to H
H
H
W
W
W
H
Federal
Income
Federal
Federal
Tax
Estate Tax
Gift Tax
None. There
None
Qualifies for the
is no income
unlimited marital
tax due on
deduction
gifts to a
assuming
spouse.
donee/spouse is
a U.S. citizen.
IRC § 1041
Same as
above
None
Same as above.
Gift to
Owner/donor
someone other taxed on gain
than spouse. at time of gift
(cash
surrendervalue basis).
May be
subject to
penalty tax if
under age
59½.
None
Donor has made
a gift equal to the
cash surrender
value of annuity.
Donee’s basis is
equal to the cash
surrender value
of the annuity at
the time of the
gift.
Gift to
someone other
than spouse
None
Same as above
Same as
above
Owner –Driven or Annuitant-Driven
141
V. ANNUITIES WHERE PARTIES ARE NEITHER
SPOUSES NOR TRUSTS
Example 18: The two parties, “X” and “Y,” are not meant to be gender-specific.
They could be either male or female, but they are not husband and wife.
.
Owner Annuitant
X
X
X
X
Contract
Beneficiary 1st Death Disposition
1) Take lump
Y
X
sum,
2) defer
distribution for
up to 5 years,
or
3) annuitize
within one
year.
Y
Y
Contract
remains
intact, but a
new
beneficiary
should be
named.
Annuitant-Driven
142
Federal
Income
Federal Federal
Tax
Estate Tax Gift Tax
None
Deferred Contract
value
income
taxed to Y included in
X’s estate.
as
received.
(Taxed as
ordinary
income).
May be
entitled to
IRC 691(c)
deduction.
None
None
None
V.
ANNUITIES WHERE PARTIES ARE NEITHER
SPOUSES NOR TRUSTS
Example 19: Two parties, “X” and “Y,” are not meant to be gender-specific.
They could be either male or female, but they are not husband and wife.
Owner Annuitant Beneficiary 1st Death
X
Y
X
X
X
Y
X
Y
Contract
Disposition
Federal
Income Tax
Federal Federal
Estate Gift Tax
Tax
X’s estate can:
Deferred
Contract
None
1) Take lump sum, income taxed
value
OR
as ordinary included in
2) Defer
income to X’s X’s gross
distribution for up
estate as
estate.
to 5 years.
received.
IRC 691(c)
deduction
may be
available.
None.
Deferred
Value of
income is
contract is
taxed as
1) Take lump sum
not
ordinary
2) Defer
distribution for up income to X included in
“Y’s”
as received.
to 5 years,
estate.
OR
3) Annuitize within If X is under
59½, he or
one year.
she may have
Contract not IRC § to pay 10%
penalty tax.
72 (s) driven
requirements.
X can:
Annuitant-Driven
143
None
VI.
JOINT OWNERS AND/OR JOINT ANNUITANTS
Example 20: In this case, husband and wife are joint annuitants. Caution: Some
annuitant-driven contracts pay the enhanced death benefit only at the second
annuitant’s death. In this example, when the husband dies, who is also the owner,
IRS rules force a distribution to the beneficiary. It may mean no enhanced death
benefit is paid. Once again the importance of knowing your contracts!
Contract
Federal
Joint
1st Death
Disposition
Income Tax
Owner Annuitants Beneficiary
Deferred
Child can:
H
H/W
X
income
Husband dies,
Child
or Husband and 1) Take lump sum, taxed as
ordinary
Wife die
income to
simultaneously.
OR
child as
2) Defer distribution received.
for up to 5 years
IRC 691(c)
3) Annuitize within deduction
may be
one year.
available.
H
H/W
X
Child
W
Contract continues;
husband is still the
owner and
annuitant because
contract pays out
death benefit only
upon death of 2nd
joint annuitant.
Owner has not died
so IRC § 72(s) is
not implicated in
this situation.
Owner-Driven or Annuitant-Driven
144
None
Federal Federal
Estate
Gift
Tax
Tax
Contract None
value
included in
husband’s
gross
estate.
None.
None
VI. JOINT OWNERS AND/OR JOINT ANNUITANTS
Example 21: In this case, husband and wife are both joint owners and joint
annuitants. If either dies, the beneficiary will receive the entire value of the
contract, but will be taxed on just half of the earnings because only ½ of the
contract is distributed by contract terms.
Joint
Joint
Owners Annuitants Beneficiary
H and W H and W
X
Child
1st
Death
Either
H or W
dies
Contract
Disposition
Child can:
1) Take lump
sum,
OR
2) Defer
distribution for
up to 5 years
3) Annuitize
within one
year.
H and W
H and W
X
Child
H and W
Die
simultaneously
Child can:
Same as
above
Federal
Federal
Federal
Income Tax Estate Tax Gift Tax
Decedents Assuming Survivor’s
surviving share is a
deferred
income taxed spouse is a taxable gift.
U.S.
as ordinary
income to Citizen 1/2
of the
child as
contract
received.
value is
IRC 691(c)
deduction included in
decedent’s
may be
gross
available.
estate.
Survivor’s
deferred
income taxed
as ordinary
income to
him or her in
year of death.
Joint owners’
respective
shares of
income
correspond to
their
respective
shares of
premium
payments.
Deferred
Deceased
None
income taxed spouses’
as ordinary shares of
income to
value of
child as
contract
received
are
IRC 691(c) included in
deduction
each of
may be
their
available.
estates.
Owner-Driven or Annuitant-Driven
145
VI. JOINT OWNERS AND/OR JOINT ANNUITANTS
Example 22: Wife and child are joint annuitants when owner/beneficiary
husband dies. This arrangement is not recommended.
Joint
Owner Annuitants
H
Wife and
Child
Beneficiary
H
1st
Death
H dies
Contract
Disposition
Contract
Husband’s estate
Deferred
value
can:
income taxed
as ordinary included in
1) Take lump sum, income to husband’s
gross
husband’s
estate.
OR
estate as
received.
2) Defer distribution
for up to 5 years.
May be
available
IRC 691(c)
deduction.
Owner-Driven or Annuitant-Driven
146
Federal
Federal Federal
Income Tax Estate Tax Gift Tax
None
APPENDIX B
CIC Penalties
California Insurance
Code
Section 782
Establishes penalties for
violation of section 780
and section 781
Section 786 Provides for
an examination period
of 30 days after the
receipt of the policy or
certificate for purposes
of review of the contract
Section 789.3
Administrative
penalties; amounts;
rescission of contracts
Section 1668.1 Acts that
constitute cause to
suspend or revoke any
permanent license
issued pursuant to this
chapter
Section 1738.5 A
proceeding held
pursuant to section
1668, 1668.5, 1738, 1739,
or 12921.8
Violation
Section 780 - Prohibited
Misrepresentation
Section 781 - Twisting
Penalty
Punishable by fine not to exceed
$25,000, or if victim loss exceeds
$10,000, the fine not to exceed 3
times the loss suffered by the
victim, by imprisonment not to
exceed 1 year or by both a fine
and imprisonment
Restitution to victim pursuant to
Section 1202.4 of the Penal Code
shall be satisfied before any fine
imposed by this section is
collected
No violations or penalties cited in this section
Section 789.3:
(a) and (b) by broker,
agent, or other person
engaged in the
transactions of insurance
other than an insurer (d)
and (e) by insurer.
789.3(a) minimum $1,000
for the first violation
789.3(b) minimum $5,000
and no more than $50,000
each subsequent violation
789.3(c) Commissioner may
suspend or revoke license
789.3(d) $10,000 for the first
violation
789.3(e) minimum $30,000
and no more than $300,000
each violation thereafter
789.3(f) Commissioner may
require rescission of contract
No violations or penalties cited in this section
No violations or penalties cited in this section
147
Section 10509.9
Administrative
penalties:
Section 10509.916
Insurer
responsibilities
Section 10509.9:
(a) and (b) by any agent
or other person or entity
engaged in the business
of insurance other than an
insurer (c) and (d) by
insurer (e) by person or
entity after a hearing
10509.9 (a) $1,000 for the
first violation
10509.9 (b) minimum
$5,000 and no more than
$50,000 each subsequent
violation
10509.9 (c) $10,000 for the
first violation
10509.9 (d) minimum
$30,000 and no more than
$300,000 each violation
thereafter
10509.9 (e) the
Commissioner may suspend
or revoke the license
Violations and penalties to be determined
148
CHAPTER REVIEW
ANSWERS
Chapter 1
Chapter 2
Chapter 3
Chapter 4
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
C
A
B
C
D
D
D
B
C
A
C
A
D
B
B
A
B
D
C
D
Chapter 5
Chapter 6
Chapter 7
Chapter 8
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
B
A
C
C
D
B
C
A
C
A
149
C
B
D
C
D
D
B
B
C
D
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150
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How Fixed, Variable, and Index Annuity
Contract Provisions Affect Consumers
(2015 Edition)
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