SUITABILITY IN ANNUITY
TRANSACTIONS
(2014 EDITION)
Researched and Written by:
Edward J. Barrett
CFP, ChFC, CLU, CEBS, RPA, CRPS, CRPC
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2
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.
Broker Educational Sales & Training Inc.
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For more information visit our website at: www.bestonlinecourses.com or call us at 800-3455669.
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TABLE OF CONTENTS
About The Author .......................................................................................................... 3
CHAPTER 1 ANNUITY BASICS................................................................................ 11
Overview ........................................................................................................................... 11
Annuity Defined................................................................................................................ 11
History of Annuities .......................................................................................................... 12
Annuities in the United States........................................................................................... 12
Annuity Sales ................................................................................................................ 13
Annuity Buyers ............................................................................................................. 14
Primary Uses of Annuities ................................................................................................ 15
Classification of Annuities................................................................................................ 15
Purchase Option ................................................................................................................ 16
Single Premium ............................................................................................................. 16
Periodic (Flexible) Premium Payments ........................................................................ 16
Date Income Payments Begin ........................................................................................... 16
Deferred Annuities ........................................................................................................ 17
Immediate Annuities ..................................................................................................... 18
Investment Options ........................................................................................................... 19
Income Payout Options ..................................................................................................... 20
Straight (Single) Life Income Option ........................................................................... 20
Cash Refund .................................................................................................................. 20
Installment Refund Option ............................................................................................ 20
Life with Period Certain Option ................................................................................... 20
Joint and Full Survivor Option ..................................................................................... 21
Period Certain ............................................................................................................... 21
Review Questions ............................................................................................................. 23
CHAPTER 2 FIXED ANNUITIES ............................................................................... 25
Overview ........................................................................................................................... 25
Fixed Annuity Sales .......................................................................................................... 25
Types of Fixed Annuities .................................................................................................. 26
Crediting Rates of Interest ................................................................................................ 27
Non-forfeiture Interest Rate .......................................................................................... 27
Current Rate of Interest ................................................................................................. 27
Portfolio Rate ................................................................................................................ 29
New Money Rate .......................................................................................................... 30
Calculating the Rate ...................................................................................................... 31
Trends ........................................................................................................................... 32
Interest Rate Projections ............................................................................................... 32
Bonus Annuities ............................................................................................................ 32
Two-Tiered Annuities ................................................................................................... 33
Fixed Annuity Fees and Expenses .................................................................................... 33
Disadvantages of Fixed Annuities .................................................................................... 33
Fixed Annuitization: Calculating Fixed Annuity Payments ............................................ 34
Review Questions ............................................................................................................. 35
5
CHAPTER 3 VARIABLE ANNUITIES ...................................................................... 37
Overview ........................................................................................................................... 37
VA Defined ....................................................................................................................... 37
The VA Market ................................................................................................................. 37
VA Product Features ......................................................................................................... 39
Separate Accounts ......................................................................................................... 39
Investment Options ....................................................................................................... 39
Accumulation Units ...................................................................................................... 40
VA Charges and Fees........................................................................................................ 41
Mortality and Expense (M&E) Charge ......................................................................... 42
Management (Fund Expense) Fees ............................................................................... 42
Contract (Account) Maintenance Fees.......................................................................... 43
Summary of Above Fees ............................................................................................... 43
Surrender Fees .............................................................................................................. 44
VA Sales Charges ......................................................................................................... 44
Premium Tax ..................................................................................................................... 46
Investment Features .......................................................................................................... 46
Dollar Cost Averaging .................................................................................................. 46
Fund Transfers .............................................................................................................. 47
Asset Allocation ............................................................................................................ 48
Asset Rebalancing ......................................................................................................... 48
Guaranteed Minimum Death Benefit ................................................................................ 48
Enhanced Death Benefits .............................................................................................. 49
Contract Anniversary, Or “Ratchet” ............................................................................. 49
Initial Purchase Payment with Interest or Rising Floor ................................................ 49
Enhanced Earnings Benefits ......................................................................................... 50
Guaranteed Living Benefit (GLB) Riders......................................................................... 50
Guaranteed Minimum Income Benefit (GMIB) ............................................................... 51
GMIB Features and Benefits ........................................................................................ 51
GMIB Caveats .............................................................................................................. 52
GMIB Client Suitability................................................................................................ 52
GMIB Costs .................................................................................................................. 52
Guaranteed Minimum Account Balance (GMAB) ........................................................... 53
GMAB Example ........................................................................................................... 53
GMAB Caveats ............................................................................................................. 53
GMAB Client Suitability .............................................................................................. 53
GMAB Costs................................................................................................................. 54
Guaranteed Minimum Withdrawal Benefit (GMWB) ...................................................... 54
GMWB Example .......................................................................................................... 54
GMWB Caveats ............................................................................................................ 54
GMWB Client Suitability ............................................................................................. 55
GMWB Costs ................................................................................................................ 55
Guaranteed Minimum Withdrawal Benefit for Lifetime .................................................. 55
GMWBL Features and Benefits.................................................................................... 56
GMWBL Client Suitability ........................................................................................... 56
6
GMWBL Costs ............................................................................................................. 57
Treatment of Withdrawals ................................................................................................ 57
Recent Innovations and Trends of GLBs .......................................................................... 58
Outlook for Variable Annuities ........................................................................................ 58
Variable Annuitization: Calculating Variable Annuity Income Payouts ......................... 59
Annuity Units ................................................................................................................ 60
Assumed Interest Rate (AIR) ........................................................................................ 61
Review Questions ............................................................................................................. 63
CHAPTER 4 INDEX ANNUITIES ............................................................................... 65
Overview ........................................................................................................................... 65
IA Defined ........................................................................................................................ 65
IA Market .......................................................................................................................... 65
Profile of an IA Buyer....................................................................................................... 67
IA Basic Terms and Provisions......................................................................................... 67
Index Period .................................................................................................................. 67
Participation Rate .......................................................................................................... 67
Cap Rate ........................................................................................................................ 68
Spreads or Margins ....................................................................................................... 68
No-Loss Provision ........................................................................................................ 69
Guaranteed Minimum Account Value .......................................................................... 69
Liquidity ........................................................................................................................ 70
Fees and Expenses ........................................................................................................ 70
Surrender Charges ......................................................................................................... 71
Interest Calculation ....................................................................................................... 71
Exclusion of Dividends ................................................................................................. 71
Crediting Interest .............................................................................................................. 72
Interest Crediting Methods ............................................................................................... 72
Point-to-Point ................................................................................................................ 73
High Water Mark (Term High Point) ........................................................................... 74
Annual Reset (Ratchet) ................................................................................................. 75
Index Averaging................................................................................................................ 76
Other Interest Crediting Methods ..................................................................................... 76
Multiple (Blended) Indices ........................................................................................... 76
Monthly Cap (Monthly Point-to-Point) ........................................................................ 76
Binary, Non-Negative (Trigger) Annual Reset ............................................................. 77
Bond-Linked Interest with Base ................................................................................... 77
Hurdle ........................................................................................................................... 77
Annual Fixed Rate with Equity Component ................................................................. 77
Rainbow ........................................................................................................................ 78
IA Waivers and Riders ...................................................................................................... 79
Types of Waivers .......................................................................................................... 80
Types of Riders ............................................................................................................. 80
IAs with Bonuses .............................................................................................................. 81
Regulation of IAs .............................................................................................................. 81
Review Questions ............................................................................................................. 83
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CHAPTER 5 ANNUITY TAX LAWS .......................................................................... 85
Overview ....................................................................................................................... 85
Annuity Defined for Tax Purposes? ................................................................................. 85
Premiums .......................................................................................................................... 85
IRC § 72: Tax-Deferral .................................................................................................... 86
IRC § 72(a) ................................................................................................................... 86
IRC § 72(b): Exclusion Ratio Rule .............................................................................. 86
IRC § 72(c)(4): Annuity Starting Date ........................................................................ 87
IRC § 72(e): Lifetime Distributions ............................................................................. 88
IRC § 72(e)(4)(A): Loans and Assignments ................................................................ 88
IRC § 72(e)(4)(c): Gift of the Annuity Contract .......................................................... 89
IRC § 72(e)(5)(E) Gain in the Contract ....................................................................... 89
IRC §72(e)(11)(A)(ii) Aggregation Rules ................................................................... 89
IRC § 72(t)(1): Additional 10% Penalty Tax on Early Distribution............................ 90
IRC § 72(q)(1): Premature Distribution 10% Penalty Tax .......................................... 91
IRC § 72(s): Death Distribution Rules at Death of the Holder .................................... 92
IRC § 72(u): Non-Natural Person Rule ....................................................................... 94
IRC § 72(u)(4): Defines an Immediate Annuity .......................................................... 95
IRC Section 165: Claiming a Loss................................................................................... 95
IRC Section 7702B(e)(1) .................................................................................................. 96
IRC § 1035: Tax-Free Exchanges .................................................................................... 97
IRC § 1035 Requirements ............................................................................................. 97
Partial IRC § 1035 Exchanges ...................................................................................... 98
Revenue Ruling 2003-76 .............................................................................................. 99
IRS Revenue Procedure 2008-24 ................................................................................ 100
PLR 201330016 Inherited Annuity 1035 Exchange ................................................... 100
The New IRC Section 1035(a)(4) ............................................................................... 102
Partial Annuitization of NQ Annuity Contracts.............................................................. 102
IRC § 2039: Estate Tax Inclusion .................................................................................. 102
IRC § 691(c) Income in Respect of a Decedent (IRD) ................................................... 103
Calculating the IRD Deduction:.................................................................................. 104
Disclaimers With Regards to Tax and Legal Issues ....................................................... 104
Review Questions ........................................................................................................... 106
CHAPTER 6 PARTIES TO THE CONTRACT ....................................................... 107
Overview ......................................................................................................................... 107
The Owner ...................................................................................................................... 107
Rights of the Owner .................................................................................................... 107
Changing the Annuitant .............................................................................................. 107
Duration of Ownership ............................................................................................... 108
Purchaser, Others as Owner ........................................................................................ 108
Taxation of Owner ...................................................................................................... 108
Death of Owner: Required Distribution ..................................................................... 109
Spousal Exception ....................................................................................................... 109
The Annuitant ................................................................................................................. 109
A Natural Person ......................................................................................................... 109
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Role of the Annuitant .................................................................................................. 110
Naming Joint Annuitants/Co-Annuitants.................................................................... 110
Taxation of Annuitant ................................................................................................. 110
Death of Annuitant ...................................................................................................... 110
The Beneficiary ............................................................................................................... 111
Death Benefit .............................................................................................................. 111
Whose Death Triggers the Death Benefit ................................................................... 112
Changing the Beneficiary ........................................................................................... 112
Designated Beneficiary ............................................................................................... 112
Spouse or Children as Beneficiaries ........................................................................... 112
Non-Natural Person as Beneficiary ............................................................................ 112
Multiple Beneficiaries................................................................................................. 113
Taxation of Beneficiary .............................................................................................. 113
Death of Beneficiary ................................................................................................... 114
Insurance Company ........................................................................................................ 114
Collecting and Investing the Premium ........................................................................ 114
Paying the Guaranteed Death Benefit ......................................................................... 114
Paying the Guaranteed Income Option ....................................................................... 115
Review Questions ........................................................................................................... 116
CHAPTER 7 CONTRACT STRUCTURE .............................................................. 117
Overview ......................................................................................................................... 117
Types of Contracts .......................................................................................................... 117
Remedies for Improper Structure.................................................................................... 122
Review Questions ........................................................................................................... 125
CHAPTER 8 SUITABILITY OF ANNUITIES.......................................................... 127
Overview ......................................................................................................................... 127
NAIC Suitability Model.................................................................................................. 127
Senior Protection in Annuity Transactions Model Regulation ................................... 127
2010 NAIC Suitability in Annuity Transactions Model Regulation .............................. 128
Determining Suitability ............................................................................................... 129
Systems of Supervision and Training ......................................................................... 130
FINRA Compliance .................................................................................................... 131
VA Regulation under the Federal Securities Laws ......................................................... 132
Securities Act of 1933 ................................................................................................. 132
Securities Act of 1934 ................................................................................................. 133
Investment Company Act of 1940 .............................................................................. 133
Regulation of Fees and Charges ................................................................................. 134
FINRA Regulation of VA ............................................................................................... 134
FINRA Rule 2821 ....................................................................................................... 134
FINRA Rule 2330 ....................................................................................................... 137
FINRA Rule 2111 ....................................................................................................... 137
FINRA Rule 2090: Know Your Customer ................................................................. 138
SEC Approves Consolidated FINRA Rules ............................................................... 138
Effective Date ............................................................................................................. 138
Benefits of Maintaining Suitability Standards ................................................................ 138
Avoid Market Conduct Trouble .................................................................................. 139
9
Increased Client Satisfaction....................................................................................... 139
A WIN-WIN-WIN Solution ....................................................................................... 139
Review Questions ........................................................................................................... 140
CHAPTER 9 ANNUITIES INSIDE QUALIFIED RETIREMENT PLANS ........... 141
Overview ......................................................................................................................... 141
Background ..................................................................................................................... 141
Congressional Mandate ............................................................................................... 141
Annuities in an IRA ........................................................................................................ 142
Advantages of Annuities inside a Qualified Retirement Plan ........................................ 143
RMD Rule Requirements on Variable Annuity Contracts ............................................. 144
Actuarial Present Value Defined ................................................................................ 145
RMD Calculation under the New Rules ..................................................................... 145
Safe Harbor Rules ....................................................................................................... 145
Example: Calculating RMD Under New Rules ......................................................... 146
New Proposed Treasury Regulation – Longevity Contracts........................................... 147
Review Questions ........................................................................................................... 148
CHAPTER 10 UNFAIR MARKETING PRACTICES............................................ 149
Overview ......................................................................................................................... 149
Misrepresentation ............................................................................................................ 149
Fraud ............................................................................................................................... 149
Altering Applications ...................................................................................................... 149
Premium Theft ................................................................................................................ 150
False or Misleading Advertising ..................................................................................... 150
Defamation ...................................................................................................................... 150
Boycott, Coercion, Intimidation ..................................................................................... 151
Twisting .......................................................................................................................... 151
Churning ......................................................................................................................... 151
Discrimination................................................................................................................. 151
Rebating .......................................................................................................................... 151
Use of Senior Specific Certifications and Designations ................................................. 152
Annuity Disclosure Model Regulation ........................................................................... 153
Fixed and Index Annuities .......................................................................................... 153
Variable Annuities ...................................................................................................... 154
Recordkeeping ............................................................................................................ 154
Review Questions ........................................................................................................... 155
Chapter Review Answers......................................................................................... 157
Confidential Feedback .............................................................................................. 159
10
CHAPTER 1
ANNUITY BASICS
Overview
Did you know that annuities have been in use for more than 2,000 years and date back to
the Roman Empire? Today, the appeal of the annuities is broad. Some annuities are
extremely safe and conservative; others range from moderate-risk to quite risky, offering
the potential of higher returns.
In this chapter, we will review how an annuity is defined, the history of the annuity, and
discuss the outlook for annuities sold in America. We will also review the various
classifications of the annuity, the purchase options, the date annuity benefit payments
begin, the investment options, and the various payout options.
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”).
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
11
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.
History of Annuities
As mentioned above, annuities can actually trace their origins back to Roman times.
Back then, dealers sold contracts called annua, or “annual stipends”—yearly payouts for
life. Roman citizens would make a one-time payment to the annua, in exchange for
lifetime payments made once a year. Annuity comes from the Latin word annuus,
meaning yearly.
During the 17th century, annuities were used as fundraising vehicles. In Europe,
governments were constantly looking for revenue to pay for massive, on-going battles
with neighboring countries. 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 United States
Annuities made their first mark in America during the 18th century. In 1759, a company
in Pennsylvania was formed to benefit Presbyterian ministers and their families.
Ministers would contribute to the fund, in exchange for lifetime payments. It wasn’t until
1912 that Americans could buy annuities outside of a group. 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.
12
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
company during the accumulation period (Fixed Annuity). 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. What was always
proved to be attractive about annuities was their tax-deferred status because they were
issued by insurance companies.
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. 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. And the rest is history.
Annuity Sales
Total annuity sales reached $61.9 billion during the fourth quarter of 2013 resulting in an
increase of 17 percent — the largest quarterly percentage increase in 11 years, according
to LIMRA’s Secure Retirement Institute (SRI). For the entire year 2013, total annuity
sales increased 5 percent to $230.1 billion (see Table 1.1 on the following page).
13
Table 1.1
Total U. S. Individual Annuity Sales and Assets
2000 – 2013 ($ billions)
YEAR
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
SALES
$190.0
187.6
218.3
215.8
217.6
212.6
232.9
255.0
265.0
238.6
210.0
240.3
219.7
230.1
ASSETS
$1,278.5
1,236.8
1,216.6
1,483.9
1,634.2
1,721.3
1,893.7
1,996.2
1,682.8
1,973.7
2,035.2
2,444.1
2,765.4
N/A
Source: Morningstar Inc. and LIMRA International, Windsor, Conn (Estimate from a survey of 60 insurers
that account for 95 percent of Total U.S. annuity sales, February, 2014).
Annuity Buyers
In another 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 a
retail deferred annuity 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.
14
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).
Table 1.2
Intended Uses for Annuities
Source LIMRA Study, the “Deferred Annuity Buyer Attitudes and Behaviors” 2012
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.
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. They are:




Purchase options
Date income payments begin
Investment options
Income payout options
Let’s discuss each of these classifications in greater detail
15
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) Premium Payments
But not everyone has a large lump sum with which to purchase an annuity. Annuities can
be funded through a series of periodic (flexible) premiums payments 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 $2,000,000) and at virtually any frequency.
Date Income 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 annuities in 2013 were $230.1 billion (see Table
2.1). Deferred annuities totaled $216 billion and immediate annuities totaled $14.1
billion, (which includes $5.8 billion of structured settlements).
16
Table 1.3
Annuity Industry Total Sales
Deferred vs. Immediate Annuities
2000-2013 ($ 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
Source: Morningstar Inc. and LIMRA SRI, February, 2014.
Includes Structured Settlements reporting sales of $5.8 billion
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.
17
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 SPIAs. These types of annuities cannot simultaneously accept periodic
funding payments by the owner and pay out income to the annuitant. The average age of
a SPIA buyer is 73.
A once-snubbed annuity product—the 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, SPIA sales were up 30 percent in the fourth quarter of 2013 to
reach a record $2.6 billion. SPIA sales totaled $8.3 billion for 2013, which is 8 percent
higher than in 2012 and another record (see Table 1.4).
Table 1.4
Total Sales of Immediate Annuities
2000-2013 ($ 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
8.0
8.1
2012
0.1
7.6
7.7
2013
0.1
8.3
8.4
Source: Morningstar Inc. and LIMRA International, February. 2014. Not including Structured Settlements
18
Investment Options
An annuity can be classified by two types of investment options. They are:


Fixed Annuity (FA)
Variable Annuity (VA)
The most popular type of annuity sold is the variable annuity (VA). VA sales increased 4
percent in the fourth quarter of 2013 reaching $36.3 billion. Total VA sales fell 1 percent
in 2013 from the prior year and were $145.3 billion (see Table 1.5).
Total fixed annuity sales improved 46 percent in the fourth quarter over the prior year to
reach $25.6 billion — a level they have not reached since the second quarter of 2009.
Total fixed annuity sales rose 17 percent in 2013; totaling $84.8 billion (see Table 1.5).
Table 1.5
Annuity Industry Total Sales
Variable vs. Fixed 2000 – 2013 ($ billions)
YEAR
VARIABLE
FIXED
TOTAL
SALES
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
129.7
86.7
217.6
2005
133.1
77.0
212.6
2006
157.3
74.0
235.6
2007
182.2
66.8
255.0
2008
155.6
106.7
264.1
2009
128.0
110.6
238.6
2010
140.5
81.9
222.4
2011
159.3
80.5
238.4
2012
147.4
72.3
219.7
2013
145.3
84.8
230.1
Source: Morningstar Inc. and LIMRA International, February, 2014
19
Income 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 1.6). There are a number of annuity payout options available:






Straight life income,
Cash refund,
Installment refund,
Life with period certain,
Joint and survivor, and
Period certain.
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 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
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
20
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:


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.
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 1.6
Comparison of Monthly Settlement Options
Income Payment Options
Single life income no payments to
beneficiaries
Single life w/10 years certain
Single life w/20 years certain
Single Life w/Installment Refund
Male
Estimated
Monthly
Income
$567
$545
$487
$515
21
Cash
Flow
Female
Estimated
Monthly
Income
Cash
Flow
6.80%
6.54%
5.84%
6.18%
$517
$505
$460
$483
6.20%
6.06%
5.52%
5.80%
Income Payment Options
Estimated Monthly
Income
Cash Flow
$473
$470
5.68%
5.64%
$1,691
$907
20.29%
10.88%
Joint Life 100% Survivor (no
payments to beneficiaries)
Joint Life 100% Survivor (10 year
certain)
5-Year Period Certain
10-Year Period Certain
*Assumptions: Male age 65; Female age 65; Annuitize $100,000.
Source: www.immediateannuities.com 1/31/2014.
22
Chapter 1
Review Questions
1. Annuity comes from the Latin word “annuus” which means:
(
(
(
(
) A. Yearly
) B. Stipend
) C. Payment
) D. Guaranteed
2. 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
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. Deferred annuity
) B. Period certain annuity
) C. Immediate annuity
) D. Temporary annuity
5. According to LIMRA, what is the major reason a consumer purchases an annuity?
(
(
(
(
) A. Pay for LTC premiums
) B. Pay for emergencies only
) C. Leave an inheritance
) D. Supplement Social Security or pension income
23
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24
CHAPTER 2
FIXED ANNUITIES
Overview
Fixed annuities place the investment risk on the insurer. 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.
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.
Fixed Annuity Sales
According to LIMRA and IRI/Beacon Research, 2013 fourth quarter total fixed annuity
sales increased 45 percent over the prior year to reach $25.6 billion — a level they have
not reached since the second quarter of 2009. Total fixed annuity sales rose 17 percent in
2013, totaling $84.8 billion (see Table 2.1).
Table 2.1
Fixed Annuity Sales and Net Assets
2000-2013 ($ billions)
YEAR
TOTAL SALES
NET ASSETS
2000
$ 52.7
$ 322.0
2001
74.3
351.0
2002
103.3
421.0
2003
84.1
490.0
2004
86.7
510.0
2005
77.0
534.0
2006
74.0
537.0
2007
66.6
511.0
25
2008
106.7
556.0
2009
104.3
620.0
2010
81.9
659.0
2011
81.0
685.5
2012
72.0
545.0
2013
84.8
N/A
Source: Morningstar Inc. and LIMRA International February 2014
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
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®).
Income Payout Annuities guarantee life of the annuitant (or joint annuitant)
either immediately or deferred.
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 (SPIAs) 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 International, traditional book value and market value adjusted
(MVA) annuity sales were hit hard by the decline in interest rate spreads in 2011 and
2012. However, during the fourth quarter of 2013, book value sales increased 46 percent
to $6.6 billion from $4.5 billion during the same period in 2012. Full year 2013 book
value sales were $22.4 billion (see Table 2.2). Market value-adjusted products more than
doubled during the fourth quarter to $1.9 billion from $1.0 billion in 2012.
26
In addition to the substantial growth experienced by fixed-rate deferred annuities,
indexed annuities grew by 40 percent in the fourth quarter of 2013.
Table 2.2
Fixed Annuity Sales 2013 ($ billions)
TYPE
Fixed-rate deferred
Book value
Market value adjusted
Indexed
Fixed deferred
Deferred income
Fixed immediate
Structured settlements
Total
SALES
$29.3
22.4
6.9
39.3
68.6
2.2
8.3
5.8
84.8
Source: U.S. Individual Annuities Survey, February 2014, LIMRA Windsor, CT
Crediting Rates of Interest
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 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
27
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.
As mentioned earlier, today’s low credited interest rates in fixed annuities has caused a
major decline in sales. Rates for 2012 however, are even lower than a year ago.
According to the Fisher Index (see Table 2.3 below and on the following page), the Index
tracks average fixed annuity rates over one-year periods and “CD” type of annuities.
For Example: As of February 7, 2012, the average first year fixed rate for a fixed
annuity on the high norm was 2.84% and the low norm was 0.89%. That’s for
nearly 590 products issued by almost 75 carriers.
But a similar pattern holds for five-year CD rates and treasury bonds, with interest rates
in both products lower than a year ago. So fixed annuity rates are tracking with trends in
the overall environment.
As of March 8, 2013, fixed annuity rates continued to remain below 3 percent. The
highest-paying five-year fixed annuity was crediting 1.60 percent at the beginning of
March 2013, according to the Fisher Annuity Index.
Table 2.3
Interest Rate Trends on Fixed Annuities
1st Year Interest Rate Trends On Traditional Fixed Annuities
Report
Date:
# of
Companies
# Of
Annuities
Lowest
Rate
Normal Annuity Range
Low
Average
High
Norm
Rate
Norm
Highest
Rate
Std.
Deviation
04/08/2013
70
543
0.50%
0.76%
2.53%
4.30%
12.20%
2.08%
04/01/2013
71
550
0.50%
0.77%
2.53%
4.29%
12.20%
2.08%
03/11/2013
72
543
0.50%
0.77%
2.55%
4.33%
12.20%
2.09%
10/08/2012
74
564
0.50%
0.79%
2.52%
4.24%
12.20%
2.09%
04/09/2012
74
574
1.00%
0.95%
2.87%
4.79%
12.20%
2.15%
28
Average Rates for “CD” Type or Multi-Year Guarantee (MYG) Annuities
Note: Averages and number of annuities count each band/tier as a separate
annuity for this summary.
Years
1
2
3
4
5
6
7
8
9
10
# of
Companies
# of
Annuities
0
2
15
8
49
17
36
14
15
22
0
3
26
16
105
47
94
34
29
42
04/08/13
1.13%
1.46%
1.52%
1.65%
1.60%
1.78%
2.06%
2.27%
2.18%
04/01/13
1.13%
1.46%
1.52%
1.63%
1.60%
1.76%
2.08%
2.29%
2.20%
03/11/13
1.13%
1.46%
1.52%
1.63%
1.60%
1.75%
2.06%
2.28%
2.19%
10/08/12
1.10%
1.13%
1.49%
1.39%
1.62%
1.54%
1.72%
1.99%
2.15%
2.09%
04/09/12
1.10%
1.08%
1.61%
1.55%
1.75%
1.85%
1.98%
2.30%
2.46%
2.49%
Source: Fisher Annuity Index, 13140 Coit Rd #102 Dallas, Texas 75240
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, and
New Money Rate.
Portfolio Rate
The portfolio (average) rate credits policyholders with a composite of interest that
reflects the company’s earnings on its entire portfolio of investments during the year of
crediting. 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.
To illustrate this method under both a rising and declining interest trend, see Illustration
2.4. 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%.
29
Illustration 2.4
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
Year
One
Two
Three
Year 1
5%
Year 2
4%
4%
Year 3
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 2.5 on the following page).
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%.
30
Illustration 2.5
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
Year
One
Two
Three
Year 1
5.00%
Year 2
4.50%
4.00%
Year 3
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.
31
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 insurance producer, it is your
responsibility to understand these costs and fully disclose to the purchaser of an annuity.
32
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 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. This may be called the Mortality and Expense (M&E) charge.
A fixed annuity does not have separate account management (as a variable annuity).
Instead, they are claims on the general fund of the insurance company. As such, they
don’t have “expense ratios.” But they do have other expenses such as: Contract Charge:
The rate quoted is the rate paid. Some fixed annuities may assess an annual contract fee,
typically around $30 to $50.


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 Charge: 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 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.
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
33
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, if we have annual inflation of 4 percent, the
purchasing power of the fixed monthly payment would be halved in 18 years.
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.
34
Chapter 2
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 account’s 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 of the following methods is used when taking an annuity withdrawal from
funds recently contributed?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
HILO
LIFO
HIFO
FIFO
35
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36
CHAPTER 3
VARIABLE ANNUITIES
Overview
Variable annuities have become part of the retirement and investment plans of many
Americans. In this chapter we will define a variable annuity—what they are, the market,
their features and benefits, as well as the various charges and fees. At the end of the
chapter we will review the future trend of VAs and their regulation.
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 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
As previously discussed in Chapter 1, the first variable annuity in the U.S. was created
back in 1952 for teachers who participated in the College Retirement Equities Fund
(CREF) of the Teachers Insurance and Annuity Association (TIAA).
Soon after CREF established its variable annuity, 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.
For most of this decade, VAs have been 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 VAs 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.
37
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 and 2011, we saw the economy recover and demand for guaranteed
income 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 $1.5 trillion.
In 2013, Variable annuity sales had positive growth during the fourth quarter, up 4
percent to $36.3 billion. Despite extraordinary 32 percent growth in the equities market in
2013, VA sales were down 1 percent at year-end compared with 2012 and totaled $145.3
billion. However, the growth in the equity markets enabled VA assets to hit a record $2
trillion at the end of 2013. Table 3.1 illustrates the trends in VA gross sales and assets
over time from 2000 through 2013.
Table 3.1
U. S. Sales of Variable Annuities and Net Assets
2000-2013 ($ billions)
YEAR
TOTAL SALES
ASSETS
2000
$ 137.3
$ 956.5
2001
113.3
885.8
2002
115.0
795.6
2003
126.4
999.3
2004
129.7
1,124.0
2005
133.1
1,187.3
2006
157.3
1,356.7
2007
182.2
1,485.2
2008
154.8
1,126.8
2009
125.0
1,353.7
2010
140.5
1,505.0
2011
159.3
1,502.3
2012
147.4
1,659.5
2013
145.3
2,000.0
Source: Morningstar Inc. and LIMRA International February 2014
38
VA Product Features
Just as there are characteristics of the fixed annuity that are consistent from product to
product, as discussed in Chapter 2, 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 variable 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
Premiums allocated to the guaranteed (fixed) account option are guaranteed against
investment risk and are credited with a guaranteed fixed rate of interest. However,
39
insurance companies may calculate the fixed rate payable differently (based on either the
portfolio rate or new money rate as discussed in Chapter 2).
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. In 2011, 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 2010. Those
numbers don’t include commodities which have been included in several VAs in 2012.
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
40
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
41
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.


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 2013 Morningstar data, the average annual
mortality and expense charge was 1.27% in 2012.
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.
42
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 2012, as calculated by Morningstar,
remained at 0.29%.
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 2012 was 2.51%.
According to Morningstar, the average annual expense ratio for publicly available equity
mutual funds was 1.32%, while the typical bond fund charges 1%. The comparable
figures show for underlying funds in variable annuities was 0.96%—0.36% lower. These
figures show that the lower expense ratio of underlying funds in some VAs 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 3.2).
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.
Table 3.2
Mutual Funds vs. VA Expense Comparison 2012
Fund Expense
M&E
Administrative charges
Distribution
Total
Difference
Mutual Funds
1.32%
1.32%
Variable Annuities
0.96%
1.27%
0.19%
0.09%
2.51%
1.19%
Source: Morningstar and LIMRA International 2013; Insured Retirement Institute (IRI) 2012 Fact Book
43
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 – VAs have up-front sales charges instead of surrender charges. Sales
charges are calculated as a percentage of each premium payment. A-share VAs
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
44




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 - or 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.
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.
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 2012 (see
Table 3.3). 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.
Table 3.3
VA Share Class Distribution
Non-Group New Sales Data 2012
A-Share
B-Share
C-Share
L-Share
X-Share
Multi-share
No Load
3.2%
52.8%
3.2%
25.8%
6.7%
7.4%
0.9%
Source: Morningstar and Annuity Intelligence Metrics, Advanced Sales &
Marketing Corp, 4th Quarter 2012; LIMRA March 2013
45
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 3.4).
Table 3.4
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 what had been a good opportunity to buy. Or they
may 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.
46
 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.
 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, and that frees
the investor from the anxiety of trying to predict the long-and short-term price swings
that can fool even the most experienced investor in many cases.
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.”
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.
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.
47
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:


The contract value or
Premium payments less prior withdrawals.
48
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 Death Benefits
Over the past ten years, many insurers have offered enhanced death benefit riders. Some
type of enhanced death benefit is now available with most variable annuity contracts.
There are three types of enhanced death benefit riders. They are:



Contract Anniversary (Market Anniversary Value) or Ratchet
Initial Purchase Payment with Interest or Rising Floor (Roll-up)
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.
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
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.
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 death benefit, or
The purchase payments accumulated at a specified annual rate (5% - 7%) up
to a specified age and adjusted for any withdrawals.
In some cases, a combination contract anniversary value and a rising floor may be
available within the same contract: By stepping up the increasing Death Benefit to the
Account Value may start over a new surrender charge period.
49
For 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.
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.
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
Since their inception in 1996, guaranteed living benefit (GLB) riders have become
increasingly common in sales of VA contracts. In 2012, about 87% of all variable
annuity contracts sold came with a GLB rider, according to Morningstar.
GLB riders attached to a variable annuity 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).
According to LIMRA, VA GLB Tracking Survey (November 2013), in the 3rd quarter of
2013, the rate of election for GLBs was 81% down from 90% in the 4th quarter 2012. In
the 3rd Quarter of 2013, GLB riders were elected in contracts representing 65% of total
VA sales ($19.0 billion out of $26.7 billion). VA assets with GLB riders increased to
$650 billion from $530 billion at the end of the 4th quarter of 2011.
The GMIB and GMAB election rates in 3rd Quarter 2013 continue to decrease, whereas
GMWBL election rates increased seven percentage points, when compared with the 3rd
Quarter of 2012. The GMWBL is the most elected GLB rider (66%), and the GMIB is
second at 12% (see Table 3.5).
50
Table 3.5
GLB Election Rates (When any GLB available)
66%
12%
2%
1%
GMWBL GMIB GMAB GMWB
Source: LIMRA Retirement Research, March 2013.
Note: Hybrid election rate less than ½ of 1%.
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
than most GMWB’s/GMWBL’s 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.
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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
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.
GMIB Costs
According to the Insured Retirement Institute (IRI), the cost of the GMIB rider to a
variable annuity typically ranges from 20% – 1.45% basis points annually.
52
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.
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
53

Clients who are not seeking a death benefit or looking to convert their contract to
income (annuitize).
GMAB Costs
According to the Insured Retirement Institute (IRI), the cost of the GMAB rider typically
ranges from .25 – 1.25 basis points annually, often depending on the extent of asset
allocation required.
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.
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).
54


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.
For example, if the 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.
GMWB Costs
According to the Insured Retirement Institute (IRI), the cost of the GMWB rider typically
ranges from .25 – 75 basis points annually, often depending on the extent of asset
allocation required.
Guaranteed Minimum Withdrawal Benefit for Lifetime
As discussed above, the earlier GMWB riders covered only a certain term, usually 17-20
years. GWMB’s 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
55
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
56
minimum of $35,000 a year starting immediately with a chance for that income to
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.
GMWBL Costs
The benefit of the GMWBL rider does not come free. Most insurance companies
calculate these costs as a percentage of the Income Benefit Base. Some base it on the
market value. Over the long-term, the portfolio value always declines more than the
Income Benefit Base. As a result, the rider costs that are based on the portfolio value
cost about 30% or 35% less than those based on the Income Benefit Base in the long run.
According to the Insured Retirement Institute (IRI), the cost of the GMWBL rider
typically ranges from .25 – 2.50 basis points annually.
Treatment of Withdrawals
Let’s review the two different treatments of withdrawals and how they affect the income
base of the guaranteed living benefit chosen. The first and simplest is a dollar-for-dollar
withdrawal, in which the base is simply reduced by the same amount as the withdrawal.
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. Let’s look at these examples:


Dollar-for-Dollar Withdrawal. 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 Withdrawal. Pro-rata works differently. 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.
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Recent Innovations and Trends of GLBs
Companies in the industry responded to the recent market conditions in several ways.
Some companies pulled back dramatically: dropping riders, removing some of the
richest features. A few insurers got out of the business completely (Sun Life, John
Hancock). Others instituted large fee increases for their products. Over the last several
months, we have seen many new product releases that generally involve product derisking.





Significant fee increases (it is now not uncommon to see fee levels on riders of
100 bps or more)
Removing or scaling back costly GMWBL features, of the roll-up benefit
Modifying other features, such as increasing the minimum age for the 5 percent
lifetime withdrawals from age 60 to age 65
Adding or enhancing asset allocation restrictions (although mandatory asset
allocation was not uncommon prior to the economic downturn, it is now much
more prevalent—also, lower limits on the maximum percentage of equities have
been implemented)
Not allowing allocations to overly volatile funds, or funds that did not track well
to select hedging indices, if the underlying VA contract has the guarantee.
On the other hand, a number of insurers have developed a new-generation of re-designed
variable annuities. Some insurers have developed their variable annuities with a simple
fee structure, while another has incorporated market gains into their “benefit base” based
upon a floating rate. The rate will be set annually at one percentage point above the 10year Treasury, ranging from 4% to 8%, according to the insurer’s marketing material.
Despite these changes, the GLB rider features still are fairly rich and continue to present
exposure to equity market risk (although the higher fees have helped mitigate this
somewhat).
In almost all cases, prices for these product features have been set based on the new
paradigm, instituting an assessment of market conditions in the current environment.
Outlook for Variable Annuities
The fact that two 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 2012. If only it
were that simple, since the industry, like the product itself, is a bit more complicated.
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 are issues the industry has dealt with in recent years; issues that seem
to be coming to a head as the New Year begins. In fact, during the first quarter of 2012,
companies filed 59 annuity product changes with the SEC, which is moderate compared
58
to the 130 filing that were posted in the fourth quarter of 2011. With these filing the
popular theme in the VA product development has been to de-risk mostly by using
investment models that minimize volatility risk to the insurer or by reducing income and
withdrawal benefit features—which are sensitive to low interest rates.
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
variable annuities 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, variable annuities 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, variable annuities may increasingly be seen as a vehicle of
choice, given their role in portfolio diversification and providing a potential source of
stable income.
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.
59
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.
For 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:
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
60
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.
61
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.
62
Chapter 3
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 pay 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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CHAPTER 4
INDEX ANNUITIES
Overview
Since 1994, there have been numerous articles written about the positives as well as the
negatives of Index Annuities (IAs). And of course, the issue of whether the IA is a
security and who should regulate them, had drawn a lot of attention to the industry and to
the producers who sell IAs. The Securities Exchange Commission (SEC) proposed
Section 151 A, which tried to reclassify IAs as investments and to take over regulatory
control. However, with the passage of the Dodd-Frank Wall Street Reform Act,
Democratic Senator Tom Harkin, who is from Iowa, the home of several major IA
insurers, he slipped an amendment in the bill that affirmed that IAs are not investments
and will continue to be regulated by the states.
This chapter 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 IAs.
IA Defined
An Index Annuity (IA) is an annuity that earns interest that is linked to a stock or other
equity index. One of the most commonly used indices is the Standard & Poor's 500
Composite Stock Price Index (the S&P 500). IAs offer consumers what could be
described as the best of both worlds: a market-driven investment with potentially
attractive returns, plus a guaranteed minimum return. In short: You get less upside but
much less downside. Because of these features, many people invest in this type of
investment for their retirement planning.
IA Market
IAs began to be marketed in the U.S. back in 1994. Back then some insurance and
marketing companies (most notably Keyport Life Insurance Company) began to explore
the concept of IAs. The theory behind this concept was similar to how insurance
companies were able to link renewal rates to an interest index; the question was whether
or not something similar could be done with respect to an equity index.
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.
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According to Advantage Compendium, from 1997 to 2007, IAs were one of the hottest
insurance products being marketed in the U.S. Between 2003 and 2004 alone, sales
doubled, going from $14 billion to nearly $22 billion, respectively. However, in 2006 IA
sales took a hit dropping by 7.05 percent to $25 billion from $27.3 billion in 2005, and
remained flat in 2007. Sales were nearly $25 billion in 2007.
Then in 2008 the Securities Exchange Commission (SEC) cracked down on the abusive
sales practices used to promote the product to seniors. An inquiry at a national senior’s
summit revealed that IAs were among the securities involved in senior investment fraud.
The SEC worked on a new rule (Rule 151A) that would consider IAs as securities, and
therefore would have protections afforded by securities law. Many commentators called
the end of sales of IAs. But, IA assets and sales continued to grow and by the close of
2009, over $200 billion of IAs had been purchased.
In 2012, IA sales reached a record high of $33.9 billion—a 5.28 percent increase
compared to sales of $32.2 billion in 2011. The market share for IAs reached 47% of
Fixed Annuity total sales in 2012, compared to 44% in 2011.
Fourth quarter 2013 indexed annuity sales reached $11.9 billion — an increase of $1.9
billion from the prior quarter. Total index annuity sales increased 16 percent in 2013 to
reach $39.3 billion; market share was 46 percent (see Table 4.1).
Table 4.1
Sales Index Annuities 2000 - 2013 ($ billions)
Year
Total
IA Assets
Total
IA Sales
Sales as a % of
Total FA Sales
2000
$19.0
$ 5.5
10%
2001
25.0
6.8
9
2002
35.0
11.8
11
2003
47.0
11.3
14
2004
71.0
21.1
24
2005
93.0
26.8
35
2006
103.0
25.1
34
2007
125.0
25.0
38
2008
138.0
26.7
25
2009
157.2
29.5
28
2010
185.0
32.4
43
2011
205.0
32.2
44
66
2012
255.7
$33.9
47
2013
N/A
39.3
46
Source: LIMRA International; Beacon Research, Evanston, Ill. February 2014;
Insured Retirement Institute (IRI) 2013 Fact Book
Profile of an IA Buyer
Who would be a typical IA buyer? Index annuities 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. IAs 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.
Next, let’s review some of the various terms and provisions of an IA.
IA Basic Terms and Provisions
If there is one major complaint about IAs, it is that there are too many moving parts,
terms and provisions, to understand. For an example, in 2012 there were 48 insurance
companies offering IAs with over 27 variations according to Advantage Compendium.
Let’s now review some of the basic terms and provisions that are part of an IA.
Index Period
The index period of an IA 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
Also known as the “Index Rate,” this is the percentage of the increase in the index (for
example, the S&P 500 and or the Dow Jones Index) that will be credited to the account
value. (The amount credited to the account value may be subject to a “Cap Rate” in some
contracts.) The participation rate may be stated as a fixed annual fee or administrative
charge.
Participation rates cannot be compared among IA products without also considering the
indexing method used. To add to some of the confusion, a contract with a 100%
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participation rate does not necessarily produce a greater index benefit than an IA contract
with an 85% participation rate.
If guaranteed for the term, an 85% participation rate, and a 14% cap would become 65%
and 12% respectively. Realize, you have a design similar to a traditional interest based
annuity and a long-term guarantee of these participation and cap rates would create
significant surplus strain.
Cap Rate
The cap rate is the maximum annual account value percentage increase allowed. A cap
can be an annual cap or a limit on an annual index interest rate type of an IA: it is the
maximum for any one year during the index period. The cap can also be a total cap or
limit on how much interest can be credited for the entire index period with a type that
credits one total index interest rate. A common cap rate right now is 3 percent. Over the
past decade the cap rate has been as high as 13 percent. Cap rates can be either
guaranteed or non-guaranteed.
Typically, caps are applied after the interest calculation is made and the participation rate
applied or the spread or margin deducted. The cap is the last element applied before the
index interest rate for the year or the index period is determined.
For Example: Let us assume that a particular IA 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.
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 IA contracts simply deduct a spread or margin from the growth
of the index as measured by the particular indexing method chosen by the issuing
company. Note: Spreads and margins can be issued in the contract as either guaranteed or
non-guaranteed.
For 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.
Some IA contracts 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
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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 IA contracts 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, you must read your contracts carefully to see if it allows the insurer
to change these features.
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 IA contracts 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 nonforfeiture 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 IA and will need to be
explained.
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Liquidity
Generally a 10% withdrawal is allowed annually without surrender penalty and some IA
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 IAs 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
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 IAs 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, IAs 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.
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Surrender Charges
All IAs 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.
Surrender penalties do not usually apply if the policy is paid out due to death of the
owner (and all deferred annuities issued after January 18, 1985 must pay out upon the
death of the owner) or if the policy is annuitized. A typical surrender charge is expressed
either as a percentage of the accumulated value of the annuity or as a percentage of the
original premium. Note: Although IA principal is protected from market risk, most
index annuities would return less than the original premium if surrendered too early.
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.
For Example: If the minimum guaranteed surrender value is based on 3 per cent interest
compounded on 90 per cent of the premium, then the cash received upon surrender would
be 90% during the first contract year, 92.7 per cent during the second, 95.5 per cent
during the third and 98.3 per cent 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 IA can make a big difference in the amount credited to the annuity.
Some IA contracts 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.
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Crediting Interest
In a fixed rate annuity, as was discussed in Chapter 2, when the investor (contract
owner/holder) pays the premium to the insurance company, the insurance company
invests this money, earns a return, and after subtracting their costs, pays the fixed annuity
purchaser a stated interest rate.
The difference between the fixed rate annuity and the IA is that the return earned above
the minimum guarantee is used to buy an index-link tied to the performance of an
external index. This index-link permits the IA investor to share in the potential increase
in the index during the period without losing interest already credited if the index
declines.
Receiving excess interest earned on an external index gives the IA investor the potential
for more interest if the index increases in value. If the index goes the opposite way, goes
down instead of up, the IA investor earns no index-linked interest for the period, but the
IA investor does not lose what they already have earned.
Interest Crediting Methods
It’s important to remember, that IAs typically have no stated interest rate at the time of
issue. As we discussed above, the actual interest rate received by the IA investor is
determined according to the indexing method used in administering the particular IA
contract. The problem is that a contract’s crediting method—the formula that determines
how much the IA investor earns—can change each year at the whim of the issuer.
With over 42 different crediting methods currently available in more than 95 IA products,
an understanding of how crediting methods work is integral to your recommendation
ability. The interest credit strategy selected for an IA determines several factors, the
participation rate, the cap and the interest spread. The differences are what set IAs apart
from each other as we will discuss later.
Looking back over the past several years, only one completely new IA interest crediting
method structure has been created, and that is called the rainbow method. All other
crediting methods, including the balanced allocation method, (earlier called the equity
kicker) method, hurdle, and low water mark designs, had their beginnings based on one
of the three basic indexed-linked crediting methods used back in 1990’s.
The three most common interest crediting methods are:



Point-to-Point,
High Water Mark,
Annual Reset.
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Let’s discuss each of these in greater detail. We will begin with the term point-to-point,
also known as term end point.
Point-to-Point
Point-to-Point compares the change in the index at two discrete points in time, such as
the beginning and the ending dates of the contract term, usually greater than a year or
two. With a term you get the higher of the minimum guarantee or the index linked
interest. That is how a term end point participation rate crediting method works.
Possibly the most basic type of index method is the Long Term Point-to-Point method.
As the name implies, there are only two days in this index calculation method, the
starting point and the ending point.
For Example: Your client decides to buy an IA with an index-linked interest based
on the performance of an index (currently 100) and the insurance company says that
at the end of nine years they will credit the greater of the minimum guarantee or 100
percent of any index-linked interest earned calculated by dividing the ending index
value (assume 170) by the beginning index value. The client earned a total of 70
percent interest for nine years. That number would then be multiplied by the
participation rate to determine the index gain for that period.
The advantage is that the contract may be combined with other features, such as higher
cap and participation rates, that may credit more interest to the IA contract.
The disadvantage is that the contract relies on a single point in time to calculate interest.
Therefore, even if the index that the contract is linked to is going up throughout the term
of the contract, if it declines dramatically on the last day of the term, then part or all of
the earlier gain can be lost. However, some IA contracts using the equity kicker design
(Balanced Allocation Method) did allow the IA purchaser to lock in the realized gain
prior to the term end point.
Note: A typical point-to-point IA only credits interest realized from index movements at
the end of the term. Interest is not calculated and credited annually. Therefore, if the IA
purchaser surrendered the IA contract prior to the end of the term they would not usually
receive any interest based on positive index movements.
Unfortunately, the index has generally been weak since term end point products were
introduced, which is why the market share of term point to point products has declined,
from representing a third of sales in 1996 to a couple percent in more recent years. It is
rare to find a pure, stand-alone term end point product.
Today, there are a number of IA products that combine a point-to-point with a fixed
account (e.g.: the Balanced Allocation Method). A few of the products use the summed
index movement of several indices and use this composite to compute index gain or loss.
When using this multiple blended index method, you add up the returns from different
73
indices and apply a participation rate to the overall index gain or loss. The index annuity
performance over multiple years uses a percentage of the gains and losses of the different
indices.
For Example: A strategy might blend the following crediting interest rate for the
term based on 35% of the S&P 500 gain or loss over, say five years, 35% of the Dow
Jones Index, 10% of the Nasdaq 100, and 20% of the 10 Year US Treasury. We will
also assume that the respective gains or losses for the term were 60%, 50%, 45%, and
20%. Note: The allocation of the indices is fixed and does not change based on
index performance.
If the gain participation rate was 100 percent the index annuity would be credited 49.5%
index-linked interest. At the end of the term a new participation rate is determined for
the next term (see Table 4.2).
This method may also allow for at least some participation if the blended movement was
negative. Let’s say that the blended index movement was a loss of 25%. A preset
participation rate of 5%, 10%, or more would be applied. At a 10% participation rate the
policy would credit 2.5% index-linked interest even though the actual index performance
was negative.
Table 4.2
Blended Interest Rate Calculated
Index
Gain/Loss
S&P 500
DJIA
Nasdaq 100
10 Year US Treasury
Blended Index
Movement
Credited
Rate
35%
35%
20%
10%
60%
50%
45%
20%
Index-linked
Interest
21.0%
17.5%
9.0%
2.0%
49.5%
Next, let’s review the first successful index interest crediting method—High Water Mark.
High Water Mark (Term High Point)
The high water mark method, also known as the look back method, looks at the index
value at various points during the contract, and will credit interest based on either the end
of the period value or the highest previous annual un-averaged anniversary value.
For Example: The index starting value is 100, and reaches a value of 160 at the
end of the contract year during the period, and ended the period at 150. A term
high point method would use the 160 value-the highest contract anniversary point
reached during the period, as the end point and the gross index gain would be
60% (160 – 100/100). The company would then apply the participation rate.
74
The advantage is that it may credit the contract with more interest than other indexing
methods and protect against declines in the index.
The disadvantage is that because interest is not credited until the end of the term, the
contract may not receive any index-link gain if the contract is surrendered early. It can
also be combined with other features, such as lower cap rates and participation rates that
will limit the amount of interest credited to the contract.
Due to the fact that this method is very expensive for the insurance company, this
crediting method has not been used since 2004.
Next, we will review the most popular index-linked interest crediting method to an IA
used today—the Annual Reset Method.
Annual Reset (Ratchet)
The annual reset method, also known as the annual ratchet method, credits interest at
the end of each contract year. This method begins the calculation of the next period’s
index movement using the closing value of the previous period. It compares the index
from the beginning to the end of each year. Any declines are ignored.
The advantage is that since the interest earned is “locked in” and the index value is
“reset” at the end of each year, future decreases in the index will not affect the interest
already earned. Therefore, the IA contract using the annual reset method may credit
more interest than IAs using other methods when the index fluctuates up and down often
during the term. This design is more likely than others to give access to index-linked
interest before the term ends.
The disadvantage is that the IAs 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 credited to the IA each year.
Note: Annual Point-to-Point designs of greater than one year generally have an annual
reset of the starting point feature. Gains are registered below the initial starting point,
which can be about half of the total possible gains. Also, all annual gains are added or
combined together for a term total, as opposed to Long Term Point-to-Point, Average
End, or High Water Anniversary Mark, Look Back designs, where only one point is
derived from the index formula, and then a number and an effective annual yield are
calculated.
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Index Averaging
The majority of IA contracts sold today are structured with annual reset designs that
average index values to determine the index movement. The index averaging may occur
at the beginning, the end, or throughout the entire term of the annuity.
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 understands 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 IAs sold use some degree of averaging, a significant
number of IAs 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
point-to-point, the difference between this method and an annual point-to-point is that the
values are not locked each month.
76
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 IAs 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 IAs 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.
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
77
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.
For 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
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.
For 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.)
For Example: An insurer offers indices A, B, and C on an annual point-to-point
crediting method on an IA contract with a 1-year term. The best performing index
over the one-year period gets 75% weighting in the crediting calculation; the nextbest 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 insurance producers/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.
IA 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 Waivers
Most IAs provide the following waivers to their contracts. They are:



Death Benefit Waiver: When the policy owner dies, the beneficiary receives the
payment or payout from the annuity
Nursing Home Waiver: Annuity holders will not be charged a surrender fee when
the client enters a nursing home. Most contracts allow for this rider to be exercised
after the first year and the policyholder’s Doctor must verify. paperwork
Terminal Illness Waiver: If the policy owner becomes terminally ill, the policy will
allow him or her to surrender the policy early without a surrender charge.
Types of Riders
Most IA contracts offer the following riders:
 Death Benefit Rider: Most IAs 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. 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 20
companies now offer the GLWB rider with their IAs. According to LIMRA, a
GLWB was available on 87 percent of IAs sold in 2012 and 67 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).
80
IAs with Bonuses
For IAs, the most common types of bonuses are:


Income account bonuses; or
Premium bonuses
Income account bonuses are added to the amount from which future guaranteed lifetime
withdrawals will be made. These bonuses were less frequently offered in 2012 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 GLWB rider, premium
bonuses were the main feature used to promote indexed annuities in 2009 and 2010.
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 2011, 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 2012. 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.
A number of IA products will give the annuity owner a “bonus” for buying the index
annuity. A sampling of the current marketplace shows that one company has a 10% first
year bonus, which would mean that if a client put $100,000 into the annuity, the account
balance would be $110,000 to start off with. Another has a 1% bonus each year for the
first 12 years (based on the first year’s premium), which would mean in the $100,000
example that the annuity company contributes into the IA $1,000 a year for the client no
matter what is happening with the measuring index.
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. As the insurance producer/agent, it is your responsibility to understand
those charges, as well as to disclose and explain them to your clients prior to them
purchasing an IA.
Regulation of IAs
As was discussed earlier, over the years, IAs 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
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supervising sales of unregistered IAs, in which the Notice referred to as Equity Index
Annuities (EIAs). The Notice began with a section titled “Investor Protection Issues
Presented By Equity-Indexed Annuities”, and noted, in the opening sentence, the
following, “EIAs are complex investments”. After detailing some of the complexities of
these products, the Notice declared that, “NASD is concerned about the manner in which
associate [persons [individuals engaged in the sales of securities, including “Registered
Representatives”, in NASD member firms] are marketing and selling unregistered EIAs,
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.”
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 BDs treat the sale of unregistered EIAs as “outside business activities”, beyond the
reach of their supervision. It declared that
“A broker-dealer (BD) 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 BD’s should require their
registered representatives to submit all IA business through them.
Then in 2006, the SEC adopted Rule 151, a “safe harbor” under the Securities Act which
clarifies when certain annuity contracts are exempted securities under Section 3(a)(8).
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
IAs 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 (see Chapter 8).
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Chapter 4
Review Questions
1. In what year were Index Annuities (IA) first marketed in the U.S?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
1974
1994
2001
1984
2. What is the term used in an IA which is the percentage of the increase in
the index that will be credited to the account value?
(
(
(
(
) A. Participation rate
) B. Spread
) C. Cap rate
) D. Margin
3. What is the term used in an IA that defines the maximum annual account
value percentage increase allowed in an index annuity?
(
(
(
(
) A. Participation rate
) B. Spread
) C. Cap rate
) D. Margin
4. What is the interest crediting method that compares two 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. In an IA contract, what is the interest crediting method also known as the look back
method?
(
(
(
(
) A. Point-to-point method
) B. Annual reset method
) C. Ratchet method
) D. High water mark method
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CHAPTER 5
ANNUITY TAX LAWS
Overview
Federal tax law has traditionally encouraged the use of annuities by affording them
favorable tax treatment, including deferral of any income from the accumulation phase to
the distribution (payout) phase.
Over the past fifteen or twenty years, however, there has been a dramatic change in the
traditional picture. With the advent of the variable annuity, policyholders came to enjoy
the same broad array of investment choices as mutual fund investors. This made the
annuity very attractive to anyone who wanted these types of investments but did not want
to pay tax currently on the interest, dividends and capital gains that they generate. Thus
annuities became popular as a tax-favored investment and were marketed and sold to
investors who had little or no interest in ever using them for retirement income.
However, as annuity sales skyrocketed, Congress realized that the tax benefits intended to
encourage retirement savings were also threatening to create a new tax-sheltered
investment industry. Beginning with the Tax Equity and Fiscal Responsibility Act of
1982 (“TEFRA”) and continuing in a series of laws throughout the 1980’s, Congress has
narrowed the favorable tax treatment of annuities to re-emphasize its original purpose of
encouraging retirement savings (one obvious example: the 10% “penalty” tax on income
withdrawn before age 59½). Keeping this theme in mind is useful as you attempt to
understand the technical and seemingly disjointed special rules of annuity taxation
discussed in this chapter.
Annuity Defined for Tax Purposes?
In general terms, an annuity contract is an insurance policy that promises the periodic
payment of a sum of money for a term of years (a term certain annuity), for the life of an
individual or the joint lives of several individuals (a life annuity), or both. How an
annuity is viewed, however, depends upon the context in which it is considered. For
instance, annuities have been described differently for federal securities law, banking,
law, and tax law purposes. However, for federal tax purposes, we will focus on IRC § 72,
which is the principal Code provisions governing the taxation of annuity contracts.
Premiums
Premiums paid into an annuity for federal tax purposes can be classified as either
qualified or nonqualified. A qualified annuity is purchased as part of, or in conjunction
85
with, an employer provided retirement plan or an individual retirement arrangement (such
as an Individual Retirement Annuity or a Simplified Employee Pension Plan). If certain
requirements are satisfied, contributions made to qualified annuities may be wholly or
partially deductible from the taxable income of the individual or employer making
contributions. Premiums (contributions) to a qualified plan are limited by IRS code (see
Chapter 9 for a discussion of Annuities inside Qualified Plans and IRAs).
A nonqualified annuity is not part of an employer provided retirement program and may
be purchased by any individual or entity. Contributions to nonqualified annuities are
made with after-tax dollars and are not deductible from gross income for income tax
purposes. Premium contributions to a non-qualified annuity are only limited by the
insurance company.
IRC § 72: Tax-Deferral
Dividends, interest, and capital gains credited to an annuity are not taxed until they are
withdrawn. This is true as long as the annuity meets certain requirements of IRC § 72
and the owner of the annuity is a natural person. In other words, earnings are taxdeferred and reinvested to help accumulate assets for retirement. Because of this feature,
money may be transferred from one investment option to another inside a variable
annuity without incurring a tax liability. This is not true for taxable investments, where
moving funds from one investment vehicle to another, such as from one portfolio of a
mutual fund to another portfolio of that fund will be treated as a sale and any gains will
be taxed.
IRC § 72(a)
IRC § 72(a) provides that gross income includes any amount received as an annuity.
IRC § 72(b): Exclusion Ratio Rule
Annuities have historically been purchased to provide a stream of income over a period
of years. Annuitization allows the owner of the contract to receive income over his or her
life expectancy. In order to determine how the payments will be taxed, an exclusion
ratio (which may be expressed as a fraction or as a percentage) must be established. This
exclusion ratio is applied to each annuity payment to find the portion of the payment that
is excludable from gross income for the year received. [IRC § 72(b)(1).]
For annuities with a starting date after December 31, 1986, the exclusion ratio applies to
payments received until the payment in which the investment in the contract is fully
recovered. In that payment, the amount excludable is limited to the balance of the unrecovered investment. Payments received thereafter are fully includable in income [IRC
§ 72(b)(2)]. For annuity starting dates before January 1, 1987, the exclusion ratio applies
to all payments received throughout the entire payment period, even if the annuitant has
received his or her investment. For those contracts, it would be possible for a long-lived
86
annuitant to receive tax-free amounts, which in the aggregate exceed his or her
investment in the contract.


Fixed Annuity Exclusion Ratio: With a fixed annuity, the exclusion ratio is
established by (1) dividing the premiums paid for the contract (investment in the
contract IRC § 72(c)) by the expected return, as determined by IRS tables IRC §
72(c)(3), and (2) multiplying the payment by such ratio.
For Example: Assuming that the investment in the contract is $12,650
and expected return is $16,000, the exclusion ratio is $12,650/$16,000, or
79.1%. If the monthly payment is $100, the portion to be excluded from
gross income is $79.10 (79.1% of $100), and the balance of the payment is
included in the gross income. If 12 such monthly payments are received
during the taxable year, the total amount to be excluded for the year is
$949.20 (12 x $79.10), and the amount to be included is $250.80 ($1,200 $949.20).
Variable Annuity Exclusion Ratio: With a variable annuity, since the expected
return cannot be predicted, the exclusion ratio is computed by dividing the
premiums paid for the contract by the number of years payments are expected to
be made. If payments are to be made for a fixed number of years without regard
to life expectancy, the divisor is the fixed number of years. If, payments are to be
made for a single life, the divisor is the appropriate life expectancy multiple
(Treas. Reg. § 1.72-2(b)(3)) whichever is applicable (depending on when the
investment in the contract was made) of the IRS Tables.
For Example: Assume that Mr. Jones, a 65-year-old male elects a life
annuity and his investment in the contract was $100,000. Assume further
that he has elected to receive annual variable annuity payments and the
payment for the first year is $8,000 (since payments are variable, they will
vary each year thereafter). Applicable IRS Tables indicate that such a
person is expected to live 21 years. One hundred thousand dollars divided
by 21 is $4,762, which is the portion of each annuity payment that is
excluded from tax. During the first year, $4,762 of the $8,000 will be
excluded from income and $3,228 will be included. The $4,762 is
excluded each year until the total investment in the contract has been
received. Note: Once the total investment in the contract has been
received any remaining payments will be 100% taxable.
IRC § 72(c)(4): Annuity Starting Date
The exclusion ratio for taxing annuity payments under a particular contract is determined
as of the annuity starting date. This is the “first day of the first period for which an
amount is received as an annuity. For example, suppose that a person purchases an
immediate annuity on August 1st providing monthly payments beginning September 1st
87
(the first payment is for the one-month period beginning August 1st). Hence, the annuity
starting date is 8/1.
IRC § 72(e): Lifetime Distributions
Partial surrenders and withdrawals (distributions not part of a series of payments under an
annuity payout option) are considered “amounts not received as an annuity” [IRC §
72(e)]. The taxation on such distributions depends on when the contract was issued.
If the deferred annuity was issued before August 14, 1982, it gets “FIFO” tax treatment—
first in, first out—and the withdrawals are not taxable until the contract holder has
withdrawn the entire investment in the contract. If the contract was issued after August
13, 1982, it gets “LIFO” tax treatment—last in, first out—and all distributions are taxed
as ordinary income to the extent that there is still undistributed gain.
Two clarifications:


A deferred annuity issued before August 14, 1982 gets “FIFO” treatment only
with respect to distributions allocable to contributions made before that date.
A pre-August 14, 1982 contract that was exchanged under IRC § 1035 for another
annuity issued after August 14, 1982 will generally be grandfathered and only
“FIFO” taxation of withdrawals
Let’s review an example of a withdrawal from an annuity contract after August 13, 1982:
Bob, who is age 50 and in a 35% federal income tax bracket, purchases a variable
annuity contract. The initial deposit is $100,000, all allocated to a growth fund
sub-account. Three years later the contract has an accumulated value of $114,000
and a surrender value of $108,000. Bob withdraws $10,000 as a down payment
for a vacation home. Since the cash value ($114,000) exceeds the investment
($100,000) by $14,000, the entire $10,000 is taxed as ordinary income, costing
Bob $3,500 of tax ($10,000 x 35%).
Note: All income from an annuity contract is ordinary income and none capital gain, even
if the increase in the annuity’s value is entirely due to capital gains in the underlying
investment sub-account. Also the policy’s surrender charge of $6,000 is disregarded for
purposes of determining the amount that is taxable on a partial withdrawal.
IRC § 72(e)(4)(A): Loans and Assignments
Most nonqualified annuity contracts do not offer the option of taking a loan against the
annuity values. This is probably due largely to the fact that any amount received as a
loan under a contract entered into after August 13, 1982 is taxable to the extent that the
cash value of the contract immediately before the loan exceeds the investment in the
contract.
88
IRC § 72(e)(4)(c): Gift of the Annuity Contract
If the contract owner (the “Donor”) makes a gift of an annuity contract issued after April
22, 1987 under which the cash surrender value is greater than his or her investment in the
contract, then the Donor must include the difference as ordinary income in the year of the
gift. This rule does not apply if the transfer is made between spouses or former spouses
as part of a divorce settlement. Gift taxes may also apply.
Any amount that a donor includes in income under this rule (basis adjustment) is added to
the “investment in the contract” for purposes of figuring the income tax consequences of
future distributions.
If the cash surrender value of an annuity contract issued prior to April 23, 1987 at the
time of the gift, exceeds the donor’s cost basis, and the donee subsequently surrenders the
contract, the donor must report as taxable income the “gain” existing at the time of the
gift. In other words, the donor is taxed on the difference between the premiums he or she
paid and the cash surrender value of the contract at the time of the gift. The balance of
the gain, if any, is taxed to the donee.
IRC § 72(e)(5)(E) Gain in the Contract
Generally, an annuity contract provides that if the annuitant dies before the annuity
starting date (annuitization), the beneficiary will be paid as a death benefit the amount of
premium paid or the accumulation value of the contract. The gain, if any, is taxable as
ordinary income. The death benefit under an annuity contract does not qualify for tax
exemption under IRC § 101(a) as life insurance proceeds payable by reason of insured’s
death. Gain is measured by subtracting:
1. Total gross premiums from
2. The death benefit plus aggregate dividends and any other amounts that have been
received under the contract, which was excluded from gross income.
IRC §72(e)(11)(A)(ii) Aggregation Rules
All contracts issued by the same company to the same policyholder during any calendar
year will be treated as one contract for purposes of computing taxable distributions.
For Example: Client A purchases five non-qualified deferred annuity policies in
2011 from ABC Life Insurance Company. For planning purposes, the client
names a different beneficiary on each policy, thinking (wrongly) that this will
avoid the aggregation rule. To make things simple, let’s assume the investment in
each is $50,000. Further, let’s assume that two years later each policy has grown
in value to be worth $60,000. Sometime after, Client A requests a distribution of
$40,000 from one of the contracts purchased two years prior. The investment (tax
cost basis) in each is $50,000, interest earnings in each policy at the time of
withdrawal is $10,000, for a total gain of $50,000 in the five policies. Because
89
the five polices are owned by the same owner and were purchased within the
same calendar year from the same company, the values are aggregated to
determine the amount of gain considered distributed when a withdrawal is
requested. Since the withdrawal of $40,000 is less than the total gain in the five
policies, the entire withdrawal is considered taxable. While the full amount was
removed from a single contract, under the aggregation rules, the gain is
determined on a global (aggregated) basis. Individual policy basis and gain
tracking is effectively ignored.
Exceptions to the Aggregation Rules:




Annuitized contracts
Immediate annuities
Distributions required on death of owner
Contracts issued prior to 10/21/88
Note: If a pre-10/21/88 contract is subsequently exchanged or transferred, the new
contract becomes subject to aggregation.
IRC § 72(t)(1): Additional 10% Penalty Tax on Early Distribution
IRC § 72(t)(1) imposes an additional tax on premature distributions from “qualified”
annuity contracts (e.g., an IRC § 403(b) annuity contract or an IRC § 408 individual
retirement annuity) that is similar to the penalty tax imposed by § 72(q). IRC §
72(t)(2)(A)(iv) also provides that the additional tax does not apply to a series of
substantially equal periodic payments and IRC § 72(t)(4) sets forth a recapture rule
similar to the rule of 72(q)(3).
IRS Notice 89-25 provides guidance regarding the imposition of the additional tax on
distributions from qualified employee plans, § 403(b) annuity contracts, and individual
retirement annuities (IRAs). Notice 89-25 sets forth three methods for determining
whether payments to individuals from their IRAs or from their qualified retirement plans
constitute a series of substantially equal periodic payments for purposes of IRC §
72(t)(2)(A)(iv). The three methods are:

The Required Minimum Distribution Method: Under the required minimum
distribution method, the annual payment for each year is determined by dividing
the account balance for that year by the number from the chosen life expectancy
table for that year. With this method, the account balance, the number from the
chosen life expectancy table (see Rev. Rul. 2002-62 § 2.02(a) (life expectancy
tables)) and the resulting annual payments are re-determined for each year. If this
method is chosen, no modification in the series of substantially equal periodic
payments will be deemed to occur, even if the amount of payments changes from
year to year, provided there is not a change to another method of determining the
payments.
90


The Fixed Amortization Method. Under the fixed amortization method, the annual
payment for each year is determined by amortizing in level amounts the account
balance over a specified number of years determined by using the chosen life
expectancy table and the chosen interest rate (see Rev. Rul. 2002-62 § 2.02(a)
interest rates). With this method, the account balance, the number from the
chosen life expectancy table and the resulting annual payment are determined
once for the first distribution year and the annual payment is the same amount
each succeeding year.
The Fixed Annuitization Method. Under the fixed annuitization method, the
annual payment for each year is determined by dividing the account balance by an
annuity factor that is the present value of an annuity of $1 per year beginning at
the taxpayer’s age and continuing for the life of the taxpayer (or joint lives of the
taxpayer and beneficiary). The annuity factor is derived using the mortality table
in Appendix B to Rev. Rul. 2002-62 and using the chosen interest rate. With this
method, the account balance, the annuity factor, the chosen interest rate and the
resulting annual payment are determined once for the first distribution year and
the annual payment is the same in each succeeding year.
Prior to 2002, Notice 89-25 provided that the additional IRC § 72(t)(1) tax would be
imposed if (i) at any time before attaining age 59½ a taxpayer changed the distribution
method to a method that does not qualify for the exception, or (ii) the taxpayer changed
the distribution method within the five years after the receipt of the first payment. Rev.
Rul. 2002-62 modified notice 89-25 by providing two exceptions to this rule.


First, an individual is not subject to the IRC § 72(t)(1) additional tax if (i) the
payments are not substantially equal because the assets in the IRA (or individuals
account plan) are exhausted, and (ii) the individual followed one of the prescribed
methods of determining whether payments are substantially equal periodic
payments.
Second, an individual who begins receiving distributions in a year using either the
fixed amortization or fixed annuitization method may switch to the minimum
distribution method for the year of the switch, and all subsequent years, and the
change will not be treated as a modification within the meaning of IRC § 72(t)(4).
Any subsequent change, however, will be a modification for purposes within the
meaning of IRC 72 § (t)(4).
IRC § 72(q)(1): Premature Distribution 10% Penalty Tax
IRC § 72(q)(1) imposes a penalty tax on certain premature or early distributions under a
nonqualified annuity contract equal to 10 percent of the amount that is includible in gross
income. The penalty tax is imposed on premature distributions received prior to the
taxpayer’s attaining age 59½ from nonqualified annuity contracts issued after January 18,
1985. The penalty does not apply to any part of a distribution that is tax free, such as
amounts that represent a return of principal (cost basis) or that were rolled over to another
retirement plan. The penalty tax will not be imposed, however, if the distribution
91
satisfies one of the exceptions set forth in IRC § 72(q)(2). IRC § 72(q)(2)(D) provides
that a distribution will not be subject to the penalty tax if it is “part of a series of
substantially equal periodic payments (SOSEPP) made at least annually for the life (or
life expectancy) or the joint lives (or joint life expectancies) of such taxpayer and his
designated beneficiary.” If the payments are subsequently modified, IRC § 72(q)(3)
generally requires a taxpayer to take into account the penalty tax, plus interest, that would
have been imposed if IRC § 72(q)(2)(D) had not applied to the prior distribution.
The penalty tax will also not apply to the following distributions from a nonqualified
annuity contract:




From a deferred annuity contract to the extent allocable to investment in the
contract before August 14, 1982,
From a deferred annuity contract under a qualified personal injury settlement,
From a deferred annuity contract purchased by an employer upon termination
of a qualified employee plan or qualified employee annuity plan and held by
the employer until the employee separates from service, or
From an immediate annuity contract (a single premium contract providing
substantially equal annuity payments that start within one year from the date
of purchase and are paid at least annually).
The IRS and Treasury believe that, when the provisions of IRC § 72 are intended to
address different concerns with respect to the treatment of qualified and nonqualified
annuities, it is appropriate to apply those provisions in a different manner. However, if
the provisions of IRC § 72 are designed to achieve the same purpose whether or not the
annuity is qualified or non-qualified, it is appropriate to apply that provision in the same
manner to both qualified and non-qualified annuities.
IRC § 72(s): Death Distribution Rules at Death of the Holder
Section 72(s)(1), which was added to the Internal Revenue Code effective for contracts
issued after January 18, 1985, states that a contract will not be treated as an annuity
contract under IRC § 72 and subtitle A purposes (meaning it would not be eligible for tax
deferral) unless it provides the following:


If, “any holder of such contract” dies on or after the annuity starting date and
before the entire interest in the contract has been distributed, the remaining
portion must be distributed at least as rapidly as under the method of distributions
being used as of the date of the holder’s death; and
If, “any holder of such contract” dies before the annuity starting date, the entire
interest must be distributed within five years after the death of the holder.
Note: It is especially important to note that IRC § 72(s) focuses on “the holder.” The
“holder” has been interpreted to mean the owner of the contract. As you will see in our
later discussion, in many cases, the owner will also be the “annuitant” under the contract.
This can lead to some tricky planning and technical issues.
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To reiterate, if the holder dies before annuitization has begun, the general rule is that the
contract proceeds must be distributed within five years of the holder’s death. This rule is
to prevent deferral of income on the gains in an annuity contract by passing ownership
from person to another person without taxation occurring. However, there are exceptions
to this rule, under IRC § 72(s)(2) and (3), which provides two important exceptions:
The first exception, under IRC § 72(s)(2), states that if:



Any portion of the holder’s interest is payable to or for the benefit of a
“designated beneficiary,”
That portion will be distributed over the life of such designated beneficiary (or
over a period not extending beyond the life expectancy of such beneficiary);
Distributions of that portion begin no later than one year after the holder’s death,
then, for purposes of the one-year rule under IRC § 72(s)(1), that portion will be
treated as fully distributed on the day the distributions begin.
In other words, the death distribution rules will be satisfied by a payout over the life or
life expectancy of the designated beneficiary as long as the payout begins within one year
of the holder’s death.
The second exception, under IRC § 72(s)(3), states that:
“If, the designated beneficiary is the holder’s surviving spouse, then IRC §
72(s)(1) is to be applied by treating the spouse, as the holder of the contract.”
In other words, since the spouse, as holder, would be alive, there would be no required
distribution as a result of the original holder’s death.
As noted, the required distribution rules apply when the holder dies. If the holder of the
contract is not an individual, IRC § 72(s)(6)(A) provides that the primary annuitant is to
be treated as the holder of the contract, meaning the death of the annuitant will trigger
the required distribution rules. The term “primary annuitant” is defined in IRC § 72
(s)(6)(B) as “the individual, the events in the life of whom are of primary importance in
affecting the timing or amount of the payout under the contract.”
IRC § 72(s)(7) states that when the holder is not an individual, and thus the death benefit
of the primary annuitant would trigger the required distribution rules, any change in the
primary annuitant is treated as the death of the holder.
Finally, there are certain annuity contracts that are not subject to the required distribution
rules of IRC § 72(s). Specifically, IRC § 72(s)(5) makes IRC § 72(s) inapplicable to the
following:
 Annuity contracts provided under qualified plans covered by IRC § 401(a) or
qualified annuity plans covered by IRC § 403(a),
 Annuity contracts described in IRC § 403(b),
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 Annuity contracts that are individual retirement annuities or provided under
individual retirement accounts or annuities, or
 Annuity contracts that are qualified funding assets.
Note: Annuity contracts provided under qualified plans, such as 401(a), 403(b)
IRAs, etc. are subject to the required distribution rules of IRC 401(a)(9)(6)
rather than IRC § 72(s).
IRC § 72(u): Non-Natural Person Rule
Prior to 1986, the interest earned inside the annuity was tax deferred no matter who or
what entity owned the annuity. However in 1986, Congress passed The Tax Reform Act
of 1986, to prevent corporations and other “non-natural persons’ from taking advantage
of the tax deferral of an annuity.
If an annuity contract is owned by a “non-natural person” (an entity),” i.e., a corporation,
and contributions are made to that contract after February 28, 1986 the earnings on those
contributions are not eligible for tax-deferral in most cases. Thus, such an entity is taxed
each year on the change in the net surrender value of the contract, issued after February
28, 1986, minus premiums paid during the year. Congress enacted this requirement (IRC
§ 72(u)) to ensure that the tax deferral granted by annuities is used primarily as a vehicle
for individuals’ retirement savings.
However, under IRC § 72(u)(3), there are some types of annuities to which this rule,
which is often referred to as the “non-natural person rule” does not apply. These include
any annuity contract that is:





Acquired by a person’s estate at the persons’ death;
Held under a qualified retirement plan, a Tax Sheltered Annuity (TSA), or an
Individual Retirement Arrangement (IRA);
Purchased by an employer upon the termination of a qualified retirement plan or
TSA program and held by the employer until all amounts under the contract are
distributed to the employee for whom the contract was purchased or to his or her
beneficiary;
An immediate annuity (an annuity which is purchased with a single premium and
begins payments within a year); and
A qualified funding asset (an annuity contract issued by a licensed insurance
company which is purchased to fund a payment for damages resulting from
personal physical injury or sickness).
Under IRC § 72(u)(1), an annuity contract held by a trust or other entity as agent for a
natural person is considered held by a natural person. In Private Letter Rule (PLR)
9204014 and 9204010, a trust that owned an annuity contract which was to be distributed,
prior to its annuity date, to the trust’s beneficiary, a natural person, was considered to
hold the annuity contract holding “as an agent” not clearly required for a natural person
(see PLRs 199933033 (May 25,1999) & 199905015 (Nov. 5, 1998)). Further, a bank
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holding an annuity contract used to fund a pre-need funeral arrangement as trustee was
considered to hold an annuity contract as an agent for a natural person, where the trust
constituted a grantor trust (PLR 9120024).
IRC § 72(u)(4): Defines an Immediate Annuity
Internal Revenue Code Section 72(u)(4) defines an immediate annuity as an annuity
purchased with a single premium or annuity consideration, with an annuity starting date
no later than one year from the date of purchase and providing for a series of substantially
equal periodic payments to be made no less than once a year during the annuity period.
IRC Section 165: Claiming a Loss
A loss deduction can be claimed only if the loss is incurred in connection with the
taxpayer’s trade or business or in a transaction entered into for profit [IRC §165].
Generally, the purchase of a personal annuity contract is considered a transaction entered
into for profit. Consequently, if a taxpayer sustains a loss upon surrender of a refund
annuity contract, he/she may claim a deduction for the loss regardless of whether he/she
purchased the contract in connection with his/her trade or business or as a personal
investment. The big question is: How does the taxpayer take the deduction and what is
the amount of the deduction?
For Example: Sara invested $100,000 in a variable annuity a few years back. The
value of the annuity is now $80,000. Sara is told that if she cashes out the annuity,
she'll have to pay a surrender charge of $5,000, leaving her with a total of
$75,000. Given all of this, Sara decides to pull the plug, and the annuity company
sends her a check for $75,000. Sara lost $25,000 in real dollars -- and that's the
amount she can deduct on her tax return.
Remember that a deductible loss is realized only if the annuity is completely cashed out
or otherwise surrendered. Note: If you conduct a 1035 exchange, any gain or loss on the
prior annuity will simply be transferred into the new annuity, and there’ll be neither
income nor deductions to report on the exchange.
There is one silver lining to Sara’s misfortune: She won't have to pay a penalty tax of
10% on any of the $75,000 distributed to her when she cashed out the annuity, even if
she's not yet age 59½. The penalty applies only to gains on income when an annuity is
cashed out. Since Sara actually lost money from her initial investment, she's spared the
tax hit.
You might think that Sara’s $25,000 is a capital loss, to be reported on Schedule D with
other investment losses, but that's not quite the case. The IRS has clearly ruled that losses
like these are ordinary losses, not investment losses. And it gets even trickier when you
look at where on the tax return to report the loss.
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Some say (more conservative approach) that the loss should be treated as a miscellaneous
itemized deduction that is not subject to the 2% floor on miscellaneous itemized
deductions. Others, say it is a miscellaneous itemized deduction subject to the 2% floor.
So if you have high AGI -- let's assume that Sara's is $150,000, with no other
miscellaneous itemized deductions – the actual deduction will be limited to less than the
loss. In this case, Sara's 2% works out to $3,000. Subtracting that from the $25,000 she
lost in the annuity, she can only deduct $22,000.
It can get worse: Large miscellaneous itemized deductions can wreak havoc with the
alternative minimum tax (AMT). So claiming the loss as a miscellaneous itemized
deduction is a tough route no matter what. (And if you don't itemize deductions, you'll be
subject to the 2% hit and the standard deduction.)
A more aggressive approach is the recommendation to take the loss using Form 4797,
and then move that Form 4797 number directly to the front of the tax return under "other
gains or losses." This method lets you deduct the full loss without that 2% bite.
Additionally, you'll have no AMT issues, and the loss will help to reduce your AGI,
which might help in many other ways.
Note: In the 2007 edition of IRS Publication 575, page 20 (Pension and Annuity Income),
the IRS says that a loss under a variable annuity is treated as a miscellaneous itemized
deduction subject to the 2% floor.
As the financial advisor, I would highly recommend that you consult your clients’ tax
attorney to let him or her determine how much risk the client is willing to assume when
preparing their tax return. If you'd like to read what little authority there is on this issue,
visit the IRS website and check out Revenue Ruling (Rev. Rul.) 61-201 and 72-193.
IRC Section 7702B(e)(1)
The Pension Protection Act of 2006, signed into law on August 17th, 2006 and effective
2010, allows life insurance and annuity companies to offer long-term care riders on top of
regular policies. It also provides that internal charges against the values in annuities and
permanent life insurance policies used to pay long-term care insurance premiums aren’t
taxed.
Section 844 of the PPA of 2006 was intended to expand accessibility to tax-favored longterm care insurance by providing the ability for life insurance and annuity contracts to
add long-term care insurance riders and use the cash value to cover the cost of long-term
care insurance premiums without incurring taxable distributions, effective after 2009.
The new law broadens the provisions for Code Section 1035 tax-free exchanges to allow
for exchange of life and annuity policies into long-term care insurance contracts
(discussed below).
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IRC § 1035: Tax-Free Exchanges
Tax-free exchanges of annuity contracts play an important role in the annuity business. In
order to appreciate their importance, consider that tax-free exchanges are like refinancing
in the mortgage business. Just as homeowners are often looking for competitive interest
rates, annuity owners are often looking for new product features and competitive returns.
Annuity owners generally can exchange their annuity contract for a new contract, taxfree. There are several reasons why an annuity holder may want to be interested in such
an exchange. They may be:




The solvency of the insurance company that issued the existing contract.
The interest rates currently being offered are higher than current contract.
The new contract may have substantially better features and benefits.
Desire for better guarantees and or investment options.
IRC § 1035 Requirements
However, to assure the tax-free exchange the agent must make sure that the exchange
meets certain IRS requirements. Some of the requirements are:



The insured (or annuitant) on the new contract must be the same as on the old
one.
The owner on the new policy must also be the same as the owner on the old one.
“Basis” (or investment in the contract) is carried over from the old contract to the
new one.
Generally, IRC § 1035 provides that the following exchanges may be made without
current income taxation:





An annuity contract for another annuity contract;
A life insurance policy for an annuity;
An endowment contract for an annuity contract;
A life insurance contract for another life insurance contract;
An endowment contract for an endowment contract, which will begin making
payments no later than payments would have commenced under the old contract.
Note: The Pension Protection Act (PPA) of 2006 expanded the scope of IRC § 1035 to
include tax-free exchanges of qualified long-term care (LTC) contracts. Under Provision
824, it will also cover LTC provided as part of, or a rider to a life or annuity contract.
This will become applicable to exchanges occurring after 12/31/09.
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Partial IRC § 1035 Exchanges
As discussed above, Internal Revenue Code (“IRC”) §1035(a)(3) permits taxpayers to
transfer an annuity contract, life insurance or endowment policy from one insurance
company to another insurance company without recognizing a taxable event. IRC §1035
has always permitted taxpayers to execute tax-free exchanges of entire contracts or
policies; however, the Code and its accompanying regulations had never addressed the
tax treatment of partial IRC § 1035 exchanges. Consequently, insurance and annuity
companies have been processing 1035 exchanges of entire insurance and annuity
contracts for over 17 years but, due to the lack of guidance from the Internal Revenue
Service (“IRS”), they have been reluctant to allow contract owners to enter into an
exchange of anything less than an entire contract.
The first indication that the IRS was considering changing its position regarding partial
IRC § 1035 exchanges came in 1998 when the Tax Court ruled in favor of a taxpayer
who had exchanged a portion of an annuity contract from one company to another
(Conway v. Commissioner, 111 T.C. 350 (1998), acq., 1999-2 C.B. xvi). In Conway, the
petitioner asked the Tax Court to recognize the transfer of a portion of an annuity
contract from one insurance company to another as a tax-free exchange under IRC
§1035(a). The IRS did not challenge the Tax Court’s favorable ruling, but rather issued
an “Action on Decision.” In the “Action on Decision” the IRS indicated that they would
not challenge the facts of the case, however they would continue to challenge similar
transactions by taxpayers who entered into these partial 1035 exchanges for the purpose
of avoiding taxes and penalties under IRC §72.
The IRS’s concern regarding the use of partial 1035 exchanges for the purpose of
avoiding taxes and penalties arises because of potential abuse in the treatment of the cost
basis between the original and the new contract. For example, when a contract owner
enters into a 1035 exchange of an entire contract, the insurance company surrendering the
contract and transferring the cash surrender value is responsible for providing the
receiving company with the cost basis (premiums deposited) and gain (any amount above
the original premium(s)) information on the original contract. The receiving company
relies on the accuracy of that information in order to properly report the taxable portions
of any future distributions on Form 1099R. The transmission of this information is not
difficult when the entire contract is being exchanged. However, when only a portion of a
contract is being exchanged, the question arises as to what is being transferred. Basis or
gain? If the owner were to transfer all the gain to the new contract and leave the entire
cost basis in the original contract, he could take distributions from the original contract
and thus avoid paying any tax on the distributions. The aggregation rule (discussed
above) would not apply. Of course, if the IRS did not allow partial 1035 exchanges, the
contract would distribute gain first, which is taxable at ordinary income rates.
After Conway, the majority of annuity companies still did not permit partial 1035
exchanges, citing the IRS’s warning and its lack of guidance on how to treat the annuity
cost basis. Nonetheless, Conway was seen by some as an opening, after which some
annuity companies did begin to allow contract owners to enter into partial tax-free
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exchanges of their annuity contracts. With no guidance, however, there was very little
consistency within the industry regarding how partial 1035 exchanges were processed. As
a result, some companies allowed contract owners to exchange a portion of their annuity
contract on a LIFO (last in first out) basis, while other companies allowed partial
exchanges on a pro rata basis (the portion exchanged is reduced equally between cost
basis and gain). Inconsistencies in the processing of partial 1035 exchanges were due not
only to the lack of guidance from the IRS but to companies’ systems and technological
constraints.
Revenue Ruling 2003-76
On July 8, 2003, the Department of the Treasury and the IRS issued Revenue Ruling
2003-76. This revenue ruling addressed the issue of partial 1035 exchanges of annuity
contracts and outlined how such transactions would be considered valid tax-free
exchanges. Specifically, the revenue ruling indicated that a taxpayer could transfer a
portion of the cash surrender value within an annuity contract to another annuity contract
at another company without realizing a taxable event on the amount transferred.
Furthermore, the revenue ruling provided guidance with respect to the treatment of cost
basis, stating that the portion of the cash surrender value exchanged should be reduced
ratably between the cost basis and gain of the original contract. This concept is illustrated
below.
CONTRACT A
Contract A’s value before partial 1035 exchange
Cost basis before partial 1035 exchange (50%)
Gain before partial 1035 exchange (50%)
$100,000
50,000
50,000
Partial 1035 exchange amount
$ 60,000
Contract A’s new value after partial 1035 exchange
Cost basis after partial 1035 exchange (50%)
Gain after partial 1035 exchange (50%)
$ 40,000
20,000
20,000
CONTRACT B
Contract B’s value after partial 1035 exchange
Cost basis after partial 1035 exchange (50%)
Gain after partial 1035 exchange (50%)
$ 60,000
30,000
30,000
To supplement the revenue ruling, the Treasury and IRS also issued Notice 2003-51,
which stated that the IRS would consider issuing regulations to deter taxpayers from
entering into partial 1035 exchanges for the purpose of avoiding taxes. For example, the
IRS indicated that it might propose a rule that would require any surrender or distribution
from either the original contract or the newly issued contract that occurs within 24
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months of the partial 1035 exchange to be treated as if the two contracts were one for tax
reporting purposes. In addition, the IRS would likely create “safe harbor” exceptions for
certain withdrawals within the 24-month period, such as withdrawals due to disability or
divorce, or substantially equal periodic payments under IRC 72(q).
In summary, Revenue Ruling 2003-76 and Notice 2003-51 certainly provided the
industry with much needed guidance regarding partial 1035 exchanges. However, more
guidance may still be required, especially if and when regulations are published. For
example, if the 24-month distribution rule is enacted, how will companies track
distributions from contracts held at different companies? Will there be additional tax
reporting requirements? Who will determine if a “safe harbor” exception is met? What
tax reporting requirements will be imposed on companies for “safe harbor” distributions?
Notwithstanding these questions, the issuance of Revenue Ruling 2003-76 and Notice
2003-51 has dramatically changed the way annuity companies can do business. Most
companies will likely be updating their systems and procedures in order to provide partial
1035 exchanges. As in any other business, annuity companies are always looking for
ways to differentiate themselves. For now, those companies that can accommodate
partial 1035 exchanges efficiently and accurately will certainly have a competitive
advantage.
IRS Revenue Procedure 2008-24
The IRS has changed the way it treats annuity withdrawals that follow a partial exchange
of assets from one annuity to another. Under Revenue Procedure 2008-24, the IRS will
reduce the period it considers when deciding whether a taxpayer made a partial exchange
to avoid taxes on withdrawals to 12 months, from 24 months under IRS Revenue
Procedure 2003-51 (discussed above).
In addition to shortening the exchange review period, the IRS also removed the
requirement relating to the taxpayer’s motives for making the partial annuity exchange.
PLR 201330016 Inherited Annuity 1035 Exchange
PLR 201330016 granted the beneficiary of a series of several fixed and variable nonqualified inherited annuities to complete a 1035 exchange of those contracts into a new
variable annuity to gain access to more appealing investment returns. In the IRS'
viewpoint, the beneficiary-as-inheritor had sufficient ownership and control of the
inherited annuity to allow the exchange, and permitted the exchange to occur, as long as
the technical requirements for the 1035 exchange were honored, and the beneficiary
committed to taking post-death distributions from the new annuity at least as rapidly as
were occurring under the old contract.
Historically, annuity companies have not permitted beneficiaries to complete 1035
exchanges of inherited annuities (at least in the case of non-qualified annuities; for
inherited annuities held inside of retirement accounts, post-death transfers were generally
permitted under the existing rules for direct transfers of inherited IRAs). For better or for
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worse, the non-qualified annuity contract that was originally owned was the one the
beneficiary was stuck with, as it wasn't clear how the "owner" of an annuity could
exchange to a new contract when the (original) owner was deceased. This inability to
exchange an annuity contract after the death of the original owner was especially
problematic if the beneficiary ended out tied to an annuity company with a weak or
declining credit rating. More commonly, it was a challenge simply because the
investment choices of the original owner's annuity often didn't align with how the
beneficiary wished to invest, especially in circumstances where the beneficiary inherited
a fixed annuity but wanted to invest in equities for growth (i.e., wished that he/she had
inherited a variable annuity instead).
Yet in passing through the historical legislative guidance from Congress and subsequent
rulings from the IRS on 1035 exchanges, the IRS in PLR 201330016 acknowledged that
in reality, the beneficiary of an inherited annuity does effectively become the new owner,
that the guidance on how to complete a 1035 exchange can be applied accordingly (as
long as the ownership doesn't change, and the funds are transferred directly from the old
company to the new company), and as a result that a 1035 exchange should be
permissible.
The key point of emphasis in the IRS' ruling was simply that the terms of the new
contract must ensure that distributions will continue in compliance with IRC Section
72(s)(1), which stipulates the rules for required minimum distributions over the life
expectancy of the beneficiary (or subject to the 5-year rule) after death of the original
owner. In other words, as long as the 1035 exchange by the beneficiary isn't done in a
manner to circumvent the post-death distribution rules, and is simply a change of contract
and investments with the same (beneficiary) owner maintained, that the exchange of the
inherited annuity is permissible.
Don’t forget to keep in mind that ultimately a private letter ruling applies only to the
individual who applied for the ruling; technically, the IRS is not bound to follow this
ruling, and its prescriptions for postmortem 1035 exchanges of inherited annuities by
beneficiaries are certainly not required to be followed by today's annuity companies.
Nonetheless, there's little reason to expect that the IRS would not continue to follow the
ruling, at least for exchanges that occur within the faith and intent of the rules (a properly
executed 1035 exchange where the new contract continues to make distributions at least
as rapidly as the prior contract). Companies that wish to honor the guidance in the ruling
will likely establish "standard" inherited annuity 1035 exchange forms that conform to
the requirements acknowledged in the PLR (including contractual provisions that annuity
ownership cannot be transferred, that new contributions cannot be made, and that
distributions must occur at least as rapidly as prescribed under IRC Section 72(s) for the
original decedent's annuity contract).
The bottom line, though, is simply this: for beneficiaries of inherited annuities who were
unhappy with the annuity contracts and companies to which they were tied - because it's
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what the decedent owned when he/she passed away - a new world of flexibility looks to
be opening up for those who follow the 1035 exchange guidance.
The New IRC Section 1035(a)(4)
IRC Section 1035, providing for tax-free exchanges of insurance and annuity contracts, is
expanded to allow a life insurance, endowment, or annuity contract to be exchanged for a
qualified long-term care insurance policy (QLCI).
The new IRC Section also allows a qualified long-term care insurance policy to be
exchanged for another long-term care policy. In addition, under the new IRC Sections
1035(b)(2) and (3), an exchange to or from a life insurance or annuity contract that has a
long-term care insurance rider to a policy that does not have such a rider will still be
treated as like-kind property for exchange purposes.
Partial Annuitization of NQ Annuity Contracts
Under H.R. 5297, the Small Business Jobs Act of 2010, signed into law by President
Obama, Section 2113 provides for a partial annuitization provision for nonqualified
contracts. The new provision, which becomes effective January 1, 2011, will allow a
portion of an annuity, endowment or life insurance contract that is not part of a qualified
retirement plan may be annuitized, while the balance is not annuitized, provided that the
annuitization period is for 10 years or more, or is for the lives of one or more individuals.
If any amount is received as an annuity for a period of 10 years or more, or for the lives
of one or more individuals, under any portion of an annuity, endowment or life insurance
contract, then that portion of the contract is treated as a separate contract for income tax
purposes. The investment in the contract is allocated on a pro rata basis between each
portion of the contract from which amounts are received as an annuity and the portion of
the contract from which amounts are not received as an annuity.
This should simplify the process for nonqualified deferred annuity owners to annuitize a
portion of their annuity contract while allowing the remaining amount to grow taxdeferred. Currently, as discussed above, annuity owners can partially annuitize their
contracts through a complex process that involves exchanging their annuity contract for
two and then annuitizing one of the new contracts. The partial annuitization provision
will allow the individual (annuitant) to receive annuity payments from a portion of their
contract in one step.
IRC § 2039: Estate Tax Inclusion
Basically, the value of an annuity contract is included in the deceased contract owner’s
gross estate. [IRC § 2039.] The value of the contract is determined by federal estate tax
valuation rules. When the annuity is owned jointly, the amount included in each owner’s
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estate depends on the marital status of the joint owners. If the joint owners are not
married, or if they are married but the surviving spouse is not a U.S. Citizen, the value is
included in the estate to the extent of the owner’s proportional contribution to the contract
purchase.
However, when an annuity is jointly owned by a married couple, one-half of the
annuity’s value is included in the estate of each spouse. This treatment means that estate
tax treatment for annuities is different from its treatment of life insurance. In a life
insurance policy, it does not matter who paid the premium on a policy. With annuities,
payments define the tax treatment at death.
The value of the contract is defined as accumulated cash value when the death occurs
before payments begin. When death occurs after payments have started, contract value is
defined as the present, or commuted, value of remaining contract payments. This contract
value can also be defined as the single premium amount that could buy the balance of
benefits available in the contract. The insurer that issued the contract supplies this figure.
Note that in terms of estate taxes, it does not matter how the survivor benefits are paid.
They may be paid as a lump sum, as an annuity, in “period certain” installments, or in
fixed amount installments. The present value of the remaining annuity payments is
included in the gross estate, proportionate to the amount purchased with funds of the
decedent.
For tax year 2013, based on the Americans Taxpayers Relief Act of 2012 (ATRA 2010),
signed into law by President Obama, the federal estate tax, gift tax and the generation
skipping transfer will be set at a maximum tax rate of 35% with a $5,250,000 exemption
(indexed with inflation).
IRC § 691(c) Income in Respect of a Decedent (IRD)
The IRD deduction [IRC 691(c)] is one of the oldest provisions in the tax code, dating
back to the early 1940’s. With so many baby boomers inheriting larger retirement plans
(including nonqualified annuities and IRAs) more people are in a position to qualify for
this deduction than ever before. But they may not receive it due to their ignorance of its
existence, which is why it is very important for the advisor to understand IRD and to be
able to help their clients take advantage of this deduction.
Treasury regulations define “income in respect of a decedent” (IRD) as “those amounts to
which a decedent was entitled as gross income but which were not properly includible in
computing his taxable income for the taxable year ending with the date of death or for a
previous taxable year under the method of accounting employed by the decedent” (Treas.
Regs. § 1.691(a)-1(b)). So, with this definition and IRC § 691, we are left to identify and
administer assets that, upon the owner’s death, will produce an immediate ordinary
income tax liability to the recipient of the asset.
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The death benefit of an annuity contract received upon the death of the owner/annuitant is
income in respect of a decedent to the extent that the death benefit amount exceeds the
basis in the annuity contract. The IRD deduction is a way for the beneficiaries to offset
the effect of the double taxation (estate taxation and income taxation) that comes with
inheriting assets such as a nonqualified annuity. Note: The deduction only applies to
federal income and federal estate taxes.
The IRD deduction is much more valuable than most other itemized deductions because
it is not eroded by the 2 percent of adjusted gross income (AGI) limitation nor is it even
subject to the dreaded alternative minimum tax (AMT). By not checking to see if your
clients can qualify for this deduction could end up costing them as much as 60 to 70
percent of the inherited annuity.
Calculating the IRD Deduction:
To calculate the IRD you need to take the following steps:





Step 1. Take the federal estate tax amount from page one of IRS Form 706.
Step 2. Calculate the estate tax again without including any of the IRD items in
the estate (Note: subtract out the cost basis of the annuity).
Step 3. Subtract the estate tax in Step 2 from the estate tax in Step 1. The result
is the total amount of the IRD deduction.
Step 4. Divide the amount from Step 3 by the amount of the Annuity value minus
the cost basis. This will give you the percentage of the deduction the client will
be able to claim.
Step 5. Multiply the amount of the distribution (if any) by the percentage from
Step 4 to get the deduction amount for the year.
Note: There is no place on the IRS forms to guide your clients through the IRD
calculation. Without your guidance your client is more likely to miss this important tax
opportunity. You should educate your clients on what IRD is and encourage them to
speak to their tax accountant and/or attorney to help calculate the deduction.
Disclaimers With Regards to Tax and Legal Issues
The financial advisor/insurance professional should make every effort to assure the client
that they are not giving tax or legal advice. Review disclaimers below:


If a financial advisor/insurance professional offers to sell to a client any life insurance
or annuity product, the life agent shall advise the client or the client’s agent in writing
that the sale or liquidation of this product may have tax consequences.
The financial advisor/insurance professional shall disclose that the client may wish to
consult independent legal counsel for financial advice before buying, selling or
liquidating any assets being solicited or offered for sale.
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
This course is not intended to provide advice with issues surrounding income and
estate taxation of annuities. If expert tax assistance is required, financial
advisor/insurance professional shall advise client to consult with other professionals.
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Chapter 5
Review Questions
1. What is the principal IRS § (section) of the Code governing the tax-deferral of
annuity contracts?
(
(
(
(
) A. IRC § 401(a)
) B. IRC § 408
) C. IRC § 408 A
) D. IRC § 72
2. Which legislation passed by Congress prevented corporations and other “nonnatural persons” from taking advantage of the tax-deferral of an annuity?
(
(
(
(
) A. Employment Retirement Income Security Act of 1974
) B. Tax Reform Act of 1986
) C. Economic Growth Tax Relief Reconciliation Act of 2001
) D. Tax Equity and Fiscal Responsibility Act of 1982
3. Which of the following would not be considered a qualified IRC § 1035 tax-free
Exchanges?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
An annuity to an annuity
Life to life
Annuity to life
Life to an annuity
4. Under IRC Section 72(s)(1), if the owner dies after annuitization, but before the
entire interest in the contract has been distributed, the beneficiary must:
( )
A. Distribute at least as rapidly as under the method of distribution in effect
at time of death.
( ) B. Distribute remaining balance of annuity over five years.
( ) C. Take an immediate distribution of the full value remaining within one
year.
( ) D. Take distribution over his or her life expectancy immediately upon the
death of the owner.
5. Generally, under IRC Section 72(s)(1), if the owner of an annuity contract dies
prior to annuitization of the contract, the entire amount of the contract must be
distributed in how many years?
(
(
(
(
) A. Within seven years
) B. Within one year
) C. Within five years
) D. Immediately
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CHAPTER 6
PARTIES TO THE CONTRACT
Overview
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, which 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 these 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.
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
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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.
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.
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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 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
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.
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.
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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.
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
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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.
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.
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
111
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.
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
112
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 are 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
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
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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
annuitant and a new beneficiary is not named, benefits may end up being paid to the
owner’s or annuitant’s estate.
Insurance Company
The insurance company that issues the annuity contract assumes a number of financial
and fiduciary obligations to the owner, the annuitant, the beneficiary, and to the agent
who sold the contract. Depending on the type of annuity contract, such as Individual
Retirement Annuities (IRAs), Tax-Sheltered Annuities (TSAs), and annuities issued in
connection with qualified retirement plans, those financial and fiduciary obligations will
differ especially from a nonqualified annuity. It is important to be aware of these
differences even though many insurance companies use the same single annuity contract
form for nonqualified as well as qualified retirement plan purposes.
Collecting and Investing the Premium
In its simplest form, it is the insurance company that issues an annuity contract, collects
the premium, and then promises to invest the premiums collected responsibly and then
credit interest to the funds placed in the annuity. How the premium payments are
invested and how much, if any, control the owner retains over the investment decisions
affecting his or her funds varies depending upon which type of annuity is purchased.
Some annuities provide variable annuitization.
Paying the Guaranteed Death Benefit
In addition to investing the owner’s premium payments and crediting funds with interest,
the issuing insurance company of the annuity also promises to pay the guaranteed death
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benefit in the contract, as determined in the provisions of the contract, at the death of the
owner and/or the annuitant prior to annuitization of the contract.
Paying the Guaranteed Income Option
As discussed earlier, an annuity has one basic purpose—to provide a series of payments
over a period of time. It is the responsibility and the financial obligation of the insurance
company who issues the annuity contract to set aside reserves and to invest those reserves
conservatively to meet the future obligations of those guaranteed income payments to its
policyholders. By fulfilling these contractual obligations, the insurance company meets
the objective of the annuity –to avoid the annuity owner from outliving his or her
financial means.
While it may seem at first glance that an annuity contract issued by one company is just
the same as a contract issued by any other company, the truth is that annuity contracts do
differ from one company to the next.
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Chapter 6
Review Questions
1. The parties to a nonqualified annuity contract are:
( )
( )
A. The third party administrator, the annuitant, the owner, and the beneficiary
B. The pension plan trustee, the annuitant, the owner, the insurance company
and the beneficiary
( ) C. The owner, the annuitant, the beneficiary, and the insurance company
( ) D. The owner, the annuitant, the tax partner, the beneficiary and the insurance
company.
2. Generally, all of the following are basic rights of the owner of an annuity contract,
EXCEPT?
(
(
(
(
) A. Name or change the beneficiary
) B. Request a withdrawal
) C. State and change the annuity starting date
) D. Change the annuitant
3. The contract rights and benefits to an annuity are measured on whose life?
(
(
(
(
) A. Beneficiary
) B. Annuitant
) C. Owner
) D. Contingent owner
4. What happens at the death of the annuitant during the accumulation phase in an
annuitant-driven contract?
(
(
(
(
) A. Contract continues with the owner as the annuitant
) B. Contract owner names a new annuitant
) C. Contract ceases to exist and is paid out to the beneficiary
) D. Contract ceases to exist and is paid out to the owner
5. What is the basic purpose of an annuity?
(
(
(
(
) A. Provide a series of payments over a period of time.
) B. Tax-free
) C. Provide a lump-sum payment to lottery winners
) D. Safety
116
CHAPTER 7
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.” As the insurance
producer/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 you 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.
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 producer/agent know the annuity contracts
they are selling. When selling variable annuities all this information must be disclosed in
the prospectus.
Types of Contracts
There are two types of deferred annuity contracts:


Owner driven (OD), or
Annuitant driven (AD).
By “driven” we mean that certain actions occur upon death that are beyond the control of
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. So, to begin, we must first
understand the type of annuity contract being used to make the investment and then
proceed cautiously from there:


Owner Driven (OD): Owners have all legal rights, and can change the designated
annuitant as needed without any negative tax or penalties, as the contract
specifies. OD contracts pay out only upon the death of the owner.
Annuitant Driven (AD): Owners can usually be changed. It is contract specific as
to whether an annuitant can be changed once the contract is issued. Also, the
117
contract will pay out upon the death of either owners or annuitants. [In either form
of contract, changes to beneficiaries (primary or contingent), may always be
made.]
The way an annuity contract is structured is of critical importance due primarily to the
way death benefits are paid out and in AD contracts that is based upon the death of the
owner or annuitant. For this reason, most insurance producers/agents 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.
Before proceeding further we must recall two important tax law rules discussed in
Chapter 5, that directly affect annuity contract structuring surrounding the event of death:


The Death of the Holder Rule [IRC§ 72 (s)] states that upon the death of a holder,
death benefits of the annuity must and will be paid out. The “holder” is
synonymous with the taxpayer/owner in any contract. In the case of a non-natural
trust-owner, the annuitant is considered the owner, but only for death
distributions. The IRS enacted these contract provisions after January 18, 1985 to
prevent generational tax skipping. After April 22, 1987, the provision became
applicable to “any holder.”
The Spousal continuation Rule [IRC 72(s)(3)] states that the deceased owner’s
surviving spouse can become the contract owner. The surviving spouse can then
continue the contract throughout his or her lifetime and is not forced to take a
distribution. However, not all insurance annuity contracts offer the spousal
continuation provision. If anyone else is named as a primary beneficiary along
with the spouse, the option of the surviving spouse becoming the contract owner
is usually lost. In cases where a child and spouse are named as primary
beneficiaries, some companies will allow spousal continuation but only on the
spouse’s remaining portion of the contract. The IRC states only that the
beneficiary be a spouse; however, some contracts specify that the spousal election
letter will only be sent out if the surviving spouse is the “sole” beneficiary, which
is a narrower interpretation of IRC.
However, in the two policy forms we are discussing, a key to death benefit payouts is to
know on whose life the enhanced benefits are actually based. Is it the owner or the
annuitant who triggers the enhancement? In an OD contract, death benefits are based on
the death of the owner (i.e. owner driven). In an AD contract, death benefits are based
upon the death of the annuitant (i.e. annuitant driven). In the case of AD contract forms,
it’s interesting that distributions will occur on the owner’s death as “distributions of
annuity assets” whereas on the death of the annuitant distributions come out in the form
of “death benefits” (enhanced or not). This different “treatment” can bring about adverse
income tax, gift tax, and premature distribution penalties to various named parties to the
annuity contract.
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Another adverse outcome can occur for spouses with an improper designation of
beneficiaries. In the Spousal Continuation Rule there is special flexibility on death
benefits for spouses of owners. This rule gives the surviving spouse of a deceased owner,
the right to continue to build a tax-deferred asset for heirs without being forced to take
any form of distribution; therefore, the surviving spouse is not forced to take any assets
until so desired. This rule is a meaningful exception to the Death of the Holder Rule
noted above. Problems can and do arise when multiple primary beneficiaries are named,
or primary beneficiaries other than a spouse are named. Therefore, such structuring
arrangements require great care and caution.
Why is any of this important? In the typical husband and wife annuity investor scenario,
spouses want to continue the investment until after the second spouse dies in order to
pass remaining assets onto their children. Without correct contract structuring, serious
problems can affect the parties to a contract; however, if the contract is structured
correctly, it’s possible to avoid the following four main pitfalls of poor annuity
structuring, brought about by death, namely:




Untimely income taxation.
Unwanted gift taxes.
The 10% IRS penalty.
The loss of the Spousal Right of Continuation.
Let’s look at the following identical structuring examples under the owner-driven and
annuitant-driven types of contracts to see some of the problems that can and should be
avoided when structuring owner, annuitant or beneficiary designations so that you too
will see the importance of these factors in proper structuring.
Problematic Spousal Structure
Annuitant-Driven (AD) Contract Form
Owner
Wife (AD contract holder)
Annuitant
Husband and Wife
Beneficiary
Husband and Wife
In the example above, when the wife (annuitant) dies first, the husband becomes the sole
beneficiary, but he cannot continue the annuity under the Spousal Continuation Rule
because there will have been no deceased owner spouse – he, the husband/owner has not
died! Since the only owner is the husband, distributions will be forced upon him as the
sole surviving beneficiary upon the death of his wife. There are several potential
problems in the following structure:
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Typical Family Faulty Structure
Owner-Driven (OD) Contract Form
Owner
Husband age 60 & Wife (age 50)
Annuitant
Wife
Beneficiary
Children
Annuitant-Driven (AD) Contract Form
Owner
Husband & Wife
Annuitant
Wife
Beneficiary
Children
Problem One: Under the AD contract in the above example, if the wife dies before her
husband, the kids get the payout. While this may look fine, it’s not. The surviving
husband/owner is subject to having made a lifetime gift to the children. After all, he
“owned” 50% of the annuity. This creates adverse gift-tax consequences in the year he
dies, such as a reduction to the exemption equivalent. If the kids are under age 59 ½, they
will be liable for the 10% penalty tax as well as ordinary income tax on any future
income paid out of the contract because, upon the death of the annuitant, the beneficiary
(children in this example) become the “taxpayer,” not the owner!
Problem Two: In the AD contract, when the annuitant-wife dies, the surviving
owner/spouse is considered to have made a gift to the beneficiaries (the kids in this
example) and income taxes become due. However, gifts between spouses are not subject
to gift or income taxes. In contracts where a non-spousal joint owner dies, the surviving
owner still maintains all “owner rights” over that contract. Under the Death of the Holder
Rule, the owner immediately becomes subject to income taxes on any gain in the
contract. Let’s suppose that we instead had an AD contract in which there were no joint
owners, upon the death of the annuitant/wife (as shown above), there would then be a
10% premature withdrawal penalty on the owner/husband if he were under 59 ½ at the
time of the annuitant wife’s death.
Problem Three: The children, not the surviving spouse, would be in full control of the
assets!
Problem Four: Since a spouse is not made the sole primary beneficiary, the surviving
spouse loses the right of continuation under the Spousal Continuation Rule. In a jointly
owned contract between spouses, you could instead name the beneficiary as “joint
survivor owner” to avoid losing the spousal continuation option.
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Problem Five: Finally, by instead naming the kids as contingent beneficiaries the
remaining assets would also avoid probate.
Obviously, in the following example, it’s not possible to protect against losing spousal
continuation. When advising non-spouse parties, you will want to avoid the three
remaining pitfalls of:



Untimely income taxation,
Unwanted gift taxes, and
The 10% IRS penalty.
This is especially relevant for gay and lesbian couples in states that don’t recognize their
relationships as legal marriages; however, regardless of state law the IRS will not “look
through” IRAs or qualified plans since federal law doesn’t recognize such unions as
marriages.
Non-Spouse Relationship Example
Owner-Driven (OD) Contract Form
Owner
Bob Older and John Younger
Annuitant
Bob
Beneficiary
John
Annuitant-Driven (AD) Contract Form
Owner
Bob and John
Annuitant
Bob
Beneficiary
John
In the example above, a number of problems arise especially under the AD contract.
Again, in the AD contract, if Bob dies first, his death forces a payout of the death benefit
and/or any enhanced death benefits that may have been optionally selected. The death
payout again results in a 10% penalty to the taxpayer beneficiary if he’s under age 59 ½.
Still, we also have not structurally avoided the problems of untimely income taxation or
unwanted gift taxes. In either contract, when Bob dies before John, as joint-owner, Bob
will be considered to have made a taxable gift to John equal to his 50% ownership,
valued on the date of death FMV of the annuities assets. Additionally, in the AD contract,
when Bob (the annuitant) dies, the surviving owner is considered to have made a gift to
the beneficiary (John), and income taxes become due. Again, in contracts where a nonspousal joint owner dies, the surviving owner still maintains all “owner rights” over that
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contract. Under the Death of the Holder Rule (IRC § 72(s)), he immediately becomes
subject to income taxes on any gain in the contract. If John were to die first, the annuities
assets would pass to his estate. His assets would be subject to reduction in value due to
the costs of probate that could have been avoided by simply naming a contingent
beneficiary. Again, the gift tax problem arises out of the faulty structure, which is so
often inherent in having joint-owners, specifically under non-spousal conditions.
Remedies for Improper Structure
Are there remedies to solve an improperly structured annuity contract? Yes, but it is not
an easy road to travel, so to speak. If you come across a client who has an AD or OD
contract with improper structuring, you may want to have the client consider cashing out
of it during a down market when their principal is very close to their policy value so that
there would be minimal, if any, tax consequences (non-IRAs).
Using SEPP (substantially equal periodic payment payout options), under the first of the
three available methods (Annuitization, Amortization, or Minimum Distribution), your
client can effectively stretch out payments thereby lowering any taxes due. Note,
however, that the “Exclusion Ratio,” which provides that a portion of the payout is a
return of principle and is therefore non-taxable, only applies to payments made under one
of these three methods; namely, Annuitization.
Some insurance producer/agents may recommend a 1035 exchange of contracts;
however, a requirement of the Law is that exchanges must be like for like structuring.
Use of the 1035 exchange is generally not advisable, on contracts where there was a stepup-in-basis before 1979 (pre 10/21/1979), but would be acceptable on contracts pre
8/14/1982 since these are grandfathered such that withdrawals from these contracts are
taxed as “return of basis first” and then income-“FIFO.” Bearing in mind these contract
dates, if your client had an AD contract with an undesirable Annuitant designation, then
he/she could 1035 exchange it for an OD contract that has the same Owner & Annuitant
designation, and after contract issue your client would then be able to correct the
structuring of the Annuitant since in an OD contract the Owner can (depending on the
specific Insurance Companies contract) change a “faulty” Annuitant. One can employ
other strategies, but clearly the best course is to structure the contract properly from the
outset!
Always structure an annuity in a way that results in the least amount of negative tax and
penalties upon payout of the death benefit. You’ll also want to have the maximum
amount of flexibility regarding those payouts. There are four payout options upon the
death of the holder/owner (these are not to be confused with contract “Annuitization
Options”), and they are:


Lump sum, within 60 days of death (insurer contract specific).
Five-Year Rule – all money must be out of the contract by the end of the fifth
year (Code 72 Rule).
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

Annuitize over life expectancy, but make the decision within one year (insurer
contract specific). There are several options under this category, such as 10-year
certain, etc.
Spousal continuation of contract over the lifetime of the surviving spouse (IRC §
(s)(3) Rule).
Death benefits or distributions that are paid out upon the death of the taxpayer/owner will
result in an exception to the 10% pre-age 59 ½ IRS penalty; however, that is not the case
upon the death of an “annuitant” as in an AD contract. Assets that appreciate during the
five-year payout are not treated as part of the “death benefit” but are instead treated as
“taxable earnings” in the year earned. They also subject the taxpayer/beneficiary under
59 ½, to the 10% pre-age 59 ½ IRS tax penalty noted earlier.
To achieve the maximum payout flexibility when structuring the annuity, try to preserve
not only the first three of these four payout options but, most importantly, the fourth one;
namely, the spouse’s right of continuation. The best way to accomplish this is to name
one or the other spouse as sole beneficiary. In the case of jointly owned spousal annuity
you should title the beneficiary as “the surviving spousal owner.” If there are children,
they should be named as contingent beneficiaries since by doing so you will at least
preserve the first three payout options for them at the death of the second spouse.
In this next example, if the wife dies first, the husband simply names new beneficiaries,
who are likely to be the kids or grandchildren. This allows him to maintain control over
the asset.
If the husband dies first, the wife gets the asset and can continue the tax deferral, and the
children could ultimately receive an even larger asset because the wife is not “forced” to
take distributions. Under this structure, all of the four pitfalls under an OD or AD
contract are avoided!
Preferred Family Structure Example:
Owner-Driven Contract Form
Owner:
Husband
Annuitant:
Husband
Beneficiary:
Wife
Contingent:
Kids
One problem for some clients is their objection to making one or another spouse the sole
“owner.” It is, however, best to recommend that they do so and to also name the older of
the two spouses as the owner, or in AD contracts, both the owner & annuitant should be
the same, based on the reasonable assumption that the older spouse is likely to die sooner.
Justification for this is found in mortality tables that show that the number of years a
same aged female is likely to live beyond a same aged male is only about two to four
years (ages 50-85), but as the spread in age differences increases the likelihood of the
older spouse dying first is statistically much higher (doubled with a 10 year difference in
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ages where the younger spouse is the female). A practical solution for spousal ownership
objections like this is to simply buy two separate contracts, one on each spouse.
Many designate trusts as beneficiaries or even as contingent beneficiaries of an annuity.
First, there is no need to do this because annuities pass probate free, and second, trusts
don’t allow for any form of spousal continuation or lifetime annuitization because a trust
is considered to be a “non-natural person.” Third, trusts limit payout options to only the
first two options listed above resulting in a 50% reduction in payout flexibility. This
impedes income tax efficiencies on lesser-taxed distributions, which otherwise could be
stretched out. When making a trust the owner it is important to know whether the
insurance company that’s issuing the annuity views the trust as either a “natural” or “nonnatural person” especially in revocable trusts (living trusts) where there are often spouses
involved. If they view the owner/trust as a trust, they will not allow for spousal
continuation; hence, another problem with making a trust the owner of an annuity. There
is no look-through provision on non-qualified annuities (i.e. where the IRS will “look
through” the grantor/trustee designation and recognize the spouse for spousal
continuation rights). The “look-through provision” applies only to IRS-provided rationale
for IRAs/qualified plans when a trust is the beneficiary. You should proceed very
carefully when using a trust as any part of an annuity structure. Insurance
professionals/agents should require and obtain a written letter of instruction from the
client’s attorney on exactly how they want the structuring set up under an annuity
contract.
I hope you can now understand, when structuring an annuity contract it is probably best
to keep it simple.
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Chapter 7
Review Questions
1. Deciding whom to name as the owner, annuitant and the beneficiary of an annuity
contract is commonly called:
(
(
(
(
) 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.
B.
C.
D.
They are too difficult to understand
They are all easy to understand
They are all different
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 contract the death benefit would be paid at whose death?
(
(
(
(
) A. Death of the owner
) B. Death of the beneficiary
) C. Death of annuitant and/or owner
) D. Death of the contingent beneficiary
5. Which of the following is NOT a Substantially Equal Periodic Payment (SEPP)
payout option?
(
(
(
(
) A. Annuitization
) B. Amortization
) C. Minimum Distribution
) D. Lump-sum
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CHAPTER 8
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”. According to LIMRA’s (Life
Insurance Marketing Research) Producer Guide to Market Conduct,
“a suitable life insurance or annuity sales is one that is appropriate for the customer
in light of his or her total financial situation—one that balances adequate coverage
with affordability.”
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, many state insurance regulators and other regulatory bodies, such
as the NAIC, FINRA and the SEC have been forced to mandate new reporting, disclosure
and suitability requirements on all insurance professionals/agents selling annuity
products, especially when selling annuity products to seniors (65 or older).
NAIC Suitability Model
The National Association of Insurance Commissioners (NAIC) has taken specific action
to require that insurance producers/agents and insurers selling annuities to senior citizens,
and to all Americans, for that matter, take affirmative steps to ensure the suitability of the
annuity for the consumer.
Senior Protection in Annuity Transactions Model Regulation
In 2000, the NAIC adopted a white paper calling for the development of suitability
standards for non-registered products similar to those existed for some time under the
Securities and Exchange Commission (SEC) for registered products (discussed below).
The result of the white paper was a working group of the NAIC under the Life Insurance
and Annuities Committee that drafted a model setting suitability standards for all life
insurance and annuity products.
The NAIC Life Insurance and Annuity Committee decided to focus first on the area that
had been identified as subject to the greatest abuse: the inappropriate sales of annuities to
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persons (seniors) age 65 and over. The resulting Senior Protection in Annuity
Transactions Model Regulation (“Suitability Model”) was adopted by the NAIC in
2003. This Model Regulation was another tool that regulators could use to protect
consumers from inappropriate sales practices in addition to the NAIC’s Annuity
Disclosure Model Regulation.
In 2006, still concerned about the abusive and unsuitable sales of both life insurance and
annuity products not just to seniors, the NAIC membership overwhelmingly adopted
revisions to the “Suitability Model” to have its requirements apply to all consumers
regardless of age.
The amended “Suitability Model” imposes certain duties and responsibilities on insurers
and insurance producers regarding the suitability of a sale or exchange of an annuity to a
consumer. Specifically, in recommending to a consumer the purchase of an annuity or
the exchange of an annuity, the insurance producer, or the insurer if no producer is
involved, must have “reasonable grounds” for believing that the recommendation is
suitable for the consumer. This is based on 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. To ascertain the product’s suitability, prior to the execution of a purchase or
exchange of the recommended annuity, the insurance producer, or insurer if no producer
is involved, must make all reasonable efforts to obtain information concerning:




Consumer’s financial status;
Consumer’s tax status;
Consumer’s investment objectives, and
Any other information used or considered to be reasonable in making the
recommendation to the consumer.
However, since fixed annuities are not considered securities, they are regulated only by
state departments of insurance and traditionally were not subject to the same suitability
requirements as variable annuities. In March 2010, the NAIC took action to recommend
model regulations to bring all annuities in line with existing securities regulations
governing variable annuity transactions with the 2010 NAIC Suitability in Annuity
Transactions Model Regulation.
2010 NAIC Suitability in Annuity Transactions Model Regulation
This Model Regulation was adopted to set standards and procedures for suitability
annuity recommendations and to require insurers to establish a system to supervise
recommendations so that the insurance needs and financial objectives of consumers are
appropriately addressed.
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Specifically, this Model Regulation was adopted to:



Establish a regulatory framework that holds insurers responsible for ensuring that
annuity transactions are suitable (based on the criteria in Section 5I, discussed
below), whether or not the insurer contracts with a third party to supervise or
monitor the recommendations made in the marketing and sale of annuities.
Require that producers be trained on the provisions of annuities in general, and
the specific products they are selling.
Where feasible and rational, to make suitability standards consistent with the
suitability standards imposed by the Financial Industry Regulatory Authority
(FINRA).
Determining Suitability
As discussed above, the 2006 version of the NAIC Model Regulation required that, prior
to recommending an annuity, an insurance producer/agent or an insurer must make
reasonable efforts to obtain information about the consumer's financial status, tax status,
and investment objectives, as well as other information that could be used in making a
recommendation to the consumer.
However, the newly revised 2010 Model Regulation, Section 6, imposes a substantially
higher benchmark for determining the "suitability" of all types of annuities, closely
approximating FINRA standards applicable to variable annuity sales.
First, the 2010 Model Regulation requires that the insurance producer/agent have
"reasonable grounds" to believe that the annuity recommendation is suitable for the
consumer. This suitability determination is to be made from "suitability information"
disclosed by the consumer about his investments and other insurance products and his
financial situation and needs. Such "suitability information" consists of 12 different
factors, including the consumer's intended use of the annuity, financial time horizon,
existing assets, liquidity needs, liquid net worth, and risk tolerance.
These 12 suitability factors are clearly more expansive than the few listed in the 2006
version of the Model Regulation. They are:
1. Age;
2. Annual income;
3. Financial situation and needs, including the financial resources used for the
4. funding of the annuity;
5. Financial objectives;
6. Financial experience;
7. Intended use of the annuity;
8. Financial time horizon;
9. Existing assets, including investment and life insurance holdings;
10. Liquidity needs;
11. Liquid net worth;
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12. Risk tolerance; and
13. Tax status.
Note: California added a 13th factor: Whether or not the consumer has a reverse
mortgage.
Second, duties of insurers and of the insurance producer/agent must also have a
"reasonable basis" to believe that the annuity as a whole, its unique features, and the
transaction itself are in the best interests of, and can be understood by, the consumer.
Specifically, Under Section 6A, the insurance producer/agent, or the insurer where 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 is reasonably informed of the annuity's features;
The consumer will benefit from certain features of the annuity, such as taxdeferred growth, annuitization, or a death or living benefit;
The particular transaction, the annuity as a whole, the underlying sub-accounts,
and any riders and similar product enhancements are suitable for the particular
consumer; and
As applicable, the exchange or replacement is suitable, considering surrender
charges, increased fees, benefits from product enhancements and improvements,
and other exchanges or replacements within the preceding 36 months.
Both the 2006 and 2010 versions of the Model Regulation limit the producers'
obligations to the consumer where the consumer refuses to provide complete or
accurate suitability information or enters into an annuity transaction that expressly
is not recommended. Section 6D of the 2010 Model Regulation states that neither
a producer nor an insurer has any obligation to a consumer under the provisions of
this regulation if:
No recommendation is made;
The consumer provided materially inaccurate information which led to an
unsuitable recommendation;
A consumer fails to provide relevant suitability information and the transaction is
not recommended of an insurance producer.
However, an insurer’s issuance of an annuity is to be reasonable under all
circumstances actually known to the insurer, even if the situations listed above
apply.
Systems of Supervision and Training
The 2006 version of the Model Regulation merely required insurers and producers to
maintain written procedures and to conduct periodic reviews of their records in order to
prevent violations. The 2010 Model Regulation Section 6F provides additional guidance
for establishing effective supervisory procedures.
130
Under the newly amended Model Regulation, producers must make a record of any
annuity recommendation and obtain a consumer signed statement if the consumer refuses
to provide the required suitability information or decides to purchase an annuity not
based on a recommendation.
In addition, prior to the issuance of an annuity contract, the insurer (or a third party with
whom the insurer has contracted) must review annuity recommendations to ensure that
there is a reasonable basis to believe the transaction is suitable. This may be
accomplished by a screening system that would identify selected transactions for
additional scrutiny.
The insurer also will be required to maintain reasonable procedures to detect
recommendations that are not suitable, including confirming consumer suitability
information, conducting customer surveys and interviews, sending confirmation letters
and establishing internal monitoring programs.
Finally, the 2010 Model Regulation mandates that insurers train their insurance
producers/agents on the new suitability requirements and on the products themselves.
Section 7A requires the insurance producer to have adequate product training, prior to
soliciting an annuity product. In addition, Section 7B requires a one-time, minimum four
(4) credit hour general annuity training course offered by an insurance-department
approved educational provider and approved by an insurance department in accordance
with applicable insurance education training laws or regulations. For this mandated
course, the provider may not train in sales or marketing techniques or product specific
information.
Section 7B(3) outlines the minimum required topics for this program of instruction,
which can be offered in the classroom or via an insurance department approved self-study
method. If an insurance producer is licensed with a life insurance line of authority prior
to the effective date of the regulation, there is a six month grace period to comply with
the training requirements; insurance producers /agents who obtain the life authority on or
after the effective date of the regulation must complete the training prior to the sale of an
annuity product.
FINRA Compliance
It should be noted that under Section 6H of the Model Regulation's safe harbor provision,
sales of annuities already in compliance with FINRA rules will comply with the new
NAIC suitability regulation as well. Broker-Dealers may subject fixed annuity sales to
FINRA suitability and supervision rules; and sales made in compliance with such rules
would also qualify as complying with the NAIC suitability regulation. However, since,
FINRA does not have authority to enforce its rules on the sale of fixed annuities, brokerdealers supervising fixed annuity sales may be subject to more intensive insurance
examination than for the sale of security insurance products. Representatives of a brokerdealer, who are not required by the broker-dealer to comply with the FINRA
131
requirements on the sale of fixed annuities, will have to comply with the insurance
suitability regulation adopted by the state. In any case, insurers are responsible for any
unsuitable annuity transactions no matter what suitability regulation or rule is applied by
a broker-dealer.
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 (1933 Act),
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
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
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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. For example, the
ABC variable annuity 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.
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.
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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.
FINRA Regulation of VA
The Financial Industry Regulatory Authority (FINRA), previously known as the National
Association of Security Dealers (NASD), is an independent self-regulatory organization
charged with regulating the securities industry, including sellers of variable annuities.
FINRA has issued several investor alerts on the topic of variable annuities and has issued
a number of Rules pertaining to the sale and suitability of variable annuities (discussed
below).
FINRA Rule 2821
Based on the findings of a joint report “Examinations Findings Regarding BrokerDealer Sales of Variable Insurance Products” (Joint Report) which identified “weak
practices” regarding the suitability of variable annuity sales practices for investors and
the lack of adequate disclosure of the risks, fees and tax consequences, FINRA published
Rule 2821.
FINRA Rule 2821 imposed stringent sales practice standards and supervisory
requirements on the sale of variable annuities by its members. The Rule set forth
disclosure and information-gathering responsibilities regarding the sale of deferred
variable annuities, as well as supervisory requirements to increase disclosure and sales
force training.
134
The key requirements of the rule include:

Suitability (Rule 2821(b)): Requires that no recommendation shall be made
unless reasonable efforts have been made to obtain, at a minimum, information
concerning the customer’s:
o
Age,
o
Annual income,
o
Financial situation and needs,
o
Investment experience,
o
Investment objectives,
o
Intended use of the deferred variable annuity,
o
Investment time horizon,
o
Existing investment and life insurance holdings,
o
Liquidity needs,
o
Liquid net worth,
o
Risk tolerance, and
o
Tax status.
Under the new rules, the insurance producer/registered representative would be required
to ascertain the following key pieces of information from the client:



Has the client been informed of the unique features of the variable annuity?
Does the client have a long-term objective?
Are the annuity and its underlying sub-accounts the right match for the particular
client?
Once the suitability requirements are reviewed, the insurance producer/registered
representative would need to sign off on their validity. At the end of the day, the
insurance producer/registered representative should be able to answer yes to the above
checklist of suitability guidelines.
Disclosure: The member firm or its representative would be required to provide the
client with a current prospectus and a separate, brief, “plain English” risk disclosure
document highlighting the main features of the particular variable annuity transaction.
Those features would include:
o
o
o
o
o
o
Liquidity issues, such as potential surrender charges and IRS penalties;
Sales charges;
Fees (including mortality and administrative fees, investment advisory
fees and charges for riders or special features);
Federal tax treatment for variable annuities;
Any applicable state and local government premium taxes, and
Market risk.
The risk disclosure document would be required to inform the client whether a “free
look” period applies to the variable annuity contract, during which the client could
135
terminate the contract without paying any surrender charges and receive a refund of his or
her purchase payments.

Principal Review (Rule 2821 (c)): Requires that a registered principal must
review and sign off on suitability and disclosure requirements, no later than seven
(7) business days following the date when a firm’s office of supervisory
jurisdiction (OSJ) receives a complete an correct application package. The
registered principal will be required to retrace the suitability requirements that the
writing agent addressed, including:
o What is the client’s age and liquidity need?
o Does the amount of money exceed a specific percentage of the client’s net
worth or more than a set dollar amount?
o Does the transaction involve an exchange or replacement?
o Is the purchase of the VA for a tax-qualified retirement account?
If a transaction has an exchange or replacement clause, the registered principal would
need to review and approve a separate exchange or replacement document. Justification
for the FINRA’s new rules, according to the agency, is that the principal review
requirements ultimately give the client the ability to review, complete and execute an
application for a VA in a quick one-step process.

Training (Rule 2821 (e)): Registered firms would be required to develop and
document specific training policies or programs designed to ensure that registered
representatives and registered principals comply with the rule’s requirements and
that they understand the unique features of deferred variable annuities.
The Security Exchange Commission (SEC), after years of review and discussion,
approved Rule 2821 on September 7, 2007 with an effective date of May 5, 2008.
The SEC made several changes to Rule 2821.



The rules application applies to the purchase or exchange (not sale or surrender)
of a deferred variable annuity and the initial sub-account allocations.
The rule does not apply to reallocations of sub-accounts made or to funds paid
after the initial purchase or exchange of a deferred variable annuity. Note: There
are other FINRA rules, however, that are applicable to such transactions. For
instance, FINRA’s general suitability rule (FINRA Rule 2310) continues to apply
to any recommendations to reallocate sub-accounts or to sell a deferred variable
annuity. FINRA Rule 2821 applies to the use of deferred variable annuities to
fund IRAs, but not to deferred variable annuities sold to certain tax-qualified,
employer-sponsored retirement or benefit plans, unless a member firm makes a
recommendation to an individual plan participant, in which case the rule would
apply to that recommendation.
“The new rule applies to sales to all investors and not just to seniors.
136
The SEC published the order approving the new rules in Release Number 34-56375,
which relates to File Number SR-NASD-2004-183.
FINRA Rule 2330
January 2010, FINRA consolidated Rule 2821 on deferred variable annuities into FINRA
Rule 2330. The consolidated rule establishes sales practice standards regarding
recommended purchases and exchanges of deferred variable annuities. All of the rule’s
provisions became applicable as of February 8, 2010. The rule has the following six
main sections:






General considerations, such as the rule’s applicability;
Recommendation requirements, including suitability and disclosure obligations;
Principal review and approval obligations;
Requirements for establishing and maintaining supervisory procedures;
Training obligations; and
Supplementary material that addresses a variety of issues ranging from the
handling of customer funds and checks to information gathering and sharing.
FINRA Rule 2111
As part of the process to develop a new consolidated rulebook (the Consolidated FINRA
Rulebook), Regulatory Notice 09-25, calls for the elimination of FINRA Rule 2310 to be
consolidated with the new FINRA Rule 2111 (“Suitability Rule”). The modified rule
would codify various interpretations regarding the scope of the suitability rule, clarify the
information to be gathered and used as part of a suitability analysis and create a clear
exemption for recommended transactions involving institutional customers, subject to
specified conditions.


Scope of FINRA Rule 2111: FINRA Rule 2111 will explicitly apply suitability
obligations to a recommended transaction or investment strategy involving a
security or securities. In this regard, the Rule would codify longstanding SEC and
FINRA decisions and other interpretations stating that FINRA Rule 2111 covers
both recommended securities and strategies. FINRA also proposes to codify in
one place the discussions of the three main suitability obligations (reasonable
basis, customer specific and quantitative), which are currently located in various
IMs following FINRA Rule 2310.
Information Gathering Regarding the Proposed Suitability Rule: FINRA
Rule 2111 contains a number of minor changes regarding the gathering and use of
information as part of the suitability analysis. For instance, the information that
must be analyzed in determining whether a recommendation is suitable would
include not only information disclosed by the member firm’s or associated
person’s reasonable efforts to obtain it, but also information about the customer
that is “known by the member or associated person.” The Rule also requires
members or associated persons to make reasonable efforts to obtain more
137
information than is explicitly required by FINRA Rule 2310 (age, investment
experience, investment time horizon, liquidity needs and risk tolerance).
FINRA Rule 2090: Know Your Customer
FINRA Rule 2090, will also transfer into the Consolidated FINRA Rulebook a modified
version of NTSE Rule 405(1) requiring firms to use due diligence to know their
customers and eliminate the NYSE version and its related supplementary material and
rule interpretation. The Rule would eliminate paragraphs (2) and (3) of NYSE Rule 405
and their related supplementary materials and rule interpretations as duplicative of NASD
provisions that FINRA has proposed (or will be proposing) to be transferred into the
Consolidated FINRA Rulebook. For instance, NYSE Rule 405(2) (Supervision of
Accounts) is duplicative of NASD Rule 3110 (c )(1)(C )(Customer Account Information)
and 3011 (Anti Money Laundering Compliance Program) and, to a certain extent, the
proposed modified version of NYSE Rule 405(1), discussed below.
FINRA Rule 2090, know-your-customer obligation, captures the main ethical standard of
NYSE Rule 405(1). Firms would be required to use due diligence, in regard to the
opening and maintenance of every account, to know the essential facts concerning every
customer (including the customer’s financial profile and investment objectives or policy).
This information may be used to aid the firm in all aspects of the customer/broker
relationship, including, among other things, determining whether to approve the account,
where to assign the account, whether to extend margin (and the extent thereof) and
whether the customer has the financial ability to pay for transactions. The obligation
arises at the beginning of the customer/broker relationship and does not depend on
whether a recommendation has been made.
SEC Approves Consolidated FINRA Rules
The SEC approved FINRA’s proposal (Regulatory Notice 09-25) to adopt rules
governing know-your-customer (FINRA Rule 2090) and suitability (FINRA Rule 2111)
obligations for the consolidated FINRA rulebook. The new rules are based in part on and
replace provisions in the NASD and NYSE rules and are discussed below.
Effective Date
These rules were scheduled to take effect on October 7, 2011, but were extended to July
9, 2012.
Benefits of Maintaining Suitability Standards
The benefits of maintaining suitability standards are the following:


Avoid market conduct trouble.
Increased customer satisfaction and trust.
138

A Win-Win-Win Solution.
Avoid Market Conduct Trouble
As insurance professionals, when we prepared for our licensing exams, we read
extensively about proper market conduct and the types of sales practices that could put
our licenses in jeopardy. Every state Insurance Department has passed an Unfair Trade
Practices Act that has laid out the types of unfair trade practices that can be costly and
even put our careers in danger.
Increased Client Satisfaction
Paying attention to suitability will not just keep you on the right side of market
compliance regulations it will also improve your business.
Let’s face it, without satisfied clients, insurance professional/agent’s, cannot stay in
business. That’s why it’s so important to take steps to ensure that clients are satisfied
with the products that you present to them and purchase from you. Applying suitability
standards to the recommendations you make will increase client satisfaction because
clients will know you are helping them reach their financial goals and objectives. To
borrow from an advertisement from a popular men and women’s clothing store, “An
educated consumer is the best consumer.”
Remember that a satisfied client becomes a lifetime client and will more than likely
purchase more than one product from you. In addition, fully satisfied clients will feel
more comfortable in giving you referrals of other friends and family, and that will expand
your business even further.
A WIN-WIN-WIN Solution
Everyone wins when insurance and financial services professionals make suitable
recommendations. The insurance companies win, because lapse rates will fall, meaning
that the business you worked so hard to put on the books will stay on the books. Renewal
rates will improve. As an insurance professional/agent you will win because building a
long-term client relationship helps lock out the competition and gives you the inside track
on meeting your clients’ other financial needs as they arise in the future. Most
importantly, the clients win because they end up with products and services they need
and receive full value for what they’ve paid for while meeting their financial goals.
139
Chapter 8
Review Questions
1. New FINRA Rule 2111 is modeled after former NASD Rule:
(
(
(
(
)
)
)
)
A.
B.
C.
D.
2090
2310
2111
2110
2. The original NAIC Senior Protection in Annuity Transaction Model Act set forth
standards and procedures for recommendations to seniors of what age?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
65 and older
55 and older
70 and older
60 and older
3. In the 2010 Suitability in Annuity Transaction Model Regulation, Section 7B,
recommends that insurance producers who sell annuities take a one-time general
annuity training program consisting a minimum of how many hours?
(
(
(
(
) A. 2 hours
) B. 3 hours
) C. 4 hours
) D. 8 hours
4. The Senior model regulation applies to which type of insurance products sold to
seniors (age 65 and older)?
(
(
(
(
) A. Fixed annuities only
) B. Variable annuities only
) C. Both fixed and variable annuities
) D. Variable life insurance and variable annuities only.
5. Which of the following proposed FINRA Rules would use the NASD suitability rule
as the model for a modified suitability rule for the Consolidated FINRA Rulebook and
eliminate NASD Rule 2310?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Rule 2810
Rule 2110
Rule 2090
Rule 2111
140
CHAPTER 9
ANNUITIES INSIDE QUALIFIED RETIREMENT PLANS
Overview
There seems to be continued controversy in the financial world about placing an annuity
inside a qualified retirement plan, especially a deferred variable annuity. Critics charge
that since both annuities and qualified retirement plans offer income tax-deferral, putting
an annuity in a qualified retirement plan is redundant and inappropriate. They also
charge that the annuity is more costly and that additional costs will reduce the overall
performance over the long run. And finally, they contend that government regulations
and ethical guidelines militate against placing an annuity into qualified retirement plans.
This concept has received much negative attention in recent years—ranging from class
action lawsuits, to FINRA arbitrations, to critical press, even to FINRA and SEC
commentary – all questioning the appropriateness of using annuities within qualified
retirement plans.
This chapter will look at some of this negative attention and hopefully will show you that
these unfavorable views concerning annuities (especially variable annuities) in qualified
retirement plans are based on a lack of understanding of the features, benefits and
expenses of the annuity. And, depending on your client’s financial goals and needs, you
will see that an annuity, specifically a variable annuity, may be a superior method for
funding tax-qualified retirement programs.
Background
Fixed and variable annuities have been used extensively as funding vehicles for qualified
retirement programs for many years. This is due to the favorable design of these
products, which provides not only professional investment management of retirement
assets, but also incorporates important insurance protections of assets and a future stream
of guaranteed lifetime income.
According to a new report from Conning Research & Consulting, “The Big Payout:
Growing Individual Retirement Income Opportunities,” reports that at the end of 2011,
individual and group annuities held 46% of all defined contribution plan assets.
Congressional Mandate
The history of variable annuities in qualified retirement plans is strong and clear, with the
basis formed by Congress through statutory provisions (Sections) in the Internal Revenue
Code (“IRC”) of 1986. Let’s review some of those specific provisions:
141





IRC § 401 – Qualified Pensions, Profit Sharing and Stock Bonus Plans. IRC §
401(f) – Annuity Contract shall be treated as Qualified Trust.
IRC § 403(a) – Qualified Annuity Plan.
IRC § 403(b) – Annuity purchased by IRC § 501(c)(3) organization or public
school.
IRC § 408(b) – Individual Retirement Annuity.
IRC § 457 – Plans established for state and local government employees, funded
with annuities.
It seems quite clear from this legislation that annuities have been recognized by the U.S.
Congress to be a legitimate funding vehicle for qualified plans. It should also be noted
Congress provided specifically for annuity investments in tax-qualified plans well before
the Internal Revenue Code of 1954 was enacted, funding these programs with fixed
annuities at the time.
By using variable annuities as the investment within these tax-qualified retirement plans,
regulators at both FINRA and the SEC have recognized that the disclosure with regard to
the variable annuity benefits, risks and costs must be complete, and the investment must
meet the suitability criteria applicable to the customer’s situation (as was discussed in
Chapter 4).
Annuities in an IRA
Individuals may also open a Traditional IRA and or a Roth IRA with an annuity provider
and build an annuity-based plan. With this plan, the IRA stands for Individual
Retirement Annuity (IRC § 408(b)). An individual retirement annuity operates much
like a traditional individual retirement account. The main difference is that an individual
retirement annuity involves purchasing an annuity contract or an endowment contract
from an insurance company. An endowment contract is an annuity that also provides life
insurance protection.
An individual retirement annuity must be issued in the name of the owner. The owner or
the owner’s surviving beneficiaries are the only ones who can receive benefits or
payments from the annuity. The annuity contract must also meet the following
requirements:




The owner’s interest in the annuity contract must be non-forfeitable (i.e., fully
vested).
The contract must provide that the owner cannot transfer any portion of it to any
person other than the issuer (i.e., the insurance company).
The contract must allow for flexible premiums so that if the owner’s
compensation changes, the amount of the payments can also change.
Yearly contributions cannot exceed $5,000 for 2012, or if 50 or older, a total of
$6,000 (includes $1,000 catch-up contribution).
142


Any refunds of premiums can only be used to pay for future premiums or to buy
more benefits before the end of the calendar year after the year the refund is
received.
Distributions from the annuity must begin to be made by April 1 of the year
following the year the owner reaches age 70½ (if not, 50% penalty).
Advantages of Annuities inside a Qualified Retirement Plan
Some of the advantages of owning a variable annuity inside a qualified retirement plan
and/or IRA that may debunk those critics are the following:




Investment Portfolio Choice. Variable annuities typically offer a number of
investment portfolios so that your client can choose those that are best suited to
match their goals and tolerance for risk. Most variable annuities also offer a
guaranteed fixed rate of return, which can be valuable for some plan participants.
(Note: Some of the fixed rate portfolios may be subject to a market value
adjustment). Today, most variable annuities offer guaranteed living benefit riders
to protect the annuity owner from the volatility in the market with “portfolio
insurance”.
Guaranteed Death Benefit. Variable annuities often guarantee the owner that
regardless of what happens to the underlying funds held in his or her annuity,
their beneficiary would receive the greater of the market value of the annuity at
death, or the net value of contributions paid into the annuity. Several annuity
issuers pay a death benefit that automatically adjusts or ratchet upward every few
years (at an additional cost). Other issuers allow a variable annuity owner to
purchase a death benefit that is guaranteed to increase in value each year at a set
rate (at an additional cost). These guaranteed death benefits ensure that the
owner’s beneficiaries will always receive at minimum, proceeds that will exceed
net contributions made by the annuity owner. In fact, FINRA has held that the
death benefit offered by variable annuities may be an appropriate reason for
placing a variable annuity inside a qualified plan.
Guarantees of Income for Life. Annuities provide the guarantee of income
payments for the life of an individual or the joint life of two individuals, no matter
how long the individuals live. With people living longer lives, this annuitization
guarantee of income payments that cannot be outlived is increasingly important as
individual’s fear of running out of money during their lifetimes. With the variable
annuity people are buying “longevity insurance.”
Also, with variable
annuitization it provides an added benefit of basing lifetime payments on a
portfolio of equity investments, which may provide an important hedge against
inflation. In combination with a fixed annuity, a portion of the regular payments
can be a guaranteed fixed dollar amount, with the balance providing the
opportunity for growth through variable payments.
Guaranteed Living Benefits. Guaranteed living benefits, optional riders on a
growing number of variable annuities, create a variety of guarantees for investors
while they are still living, as opposed to a variable annuity standard death benefit,
143



which are really only guarantees for the investor’s beneficiaries. The growth of
living benefits during the bear market years defined their success. Today,
variable annuities with guaranteed living benefits are becoming the norm, rather
than the exception.
Guarantee of Annuity Purchase Rates (Annuitization). Annuity contracts also
provide minimum annuitization payments for any given amount applied through
contractually guaranteed initial annuity purchase rates. These minimum purchase
rates are guaranteed at the time the contract is initiated and continue in force for
the life of the contract, no matter what the changes are in economic conditions,
life expectancies, interest rate climate, etc. At the time of inception, the
individual knows the very minimum rate, which could be paid upon annuitization
at any time in the future, with the opportunity for higher payments based upon
conditions when payments commence. The variable annuity’s annuitization
benefit has been cited by industry regulators as appropriate reason for placing a
variable annuity in a qualified plan.
Expense Guarantee. Most variable annuity contracts guarantee that the
mortality and expense risk charges and administrative fees within the contract will
never be increased for as long as the contract is owned by the individual. It seems
evident that this guaranteed lock on contract expenses is very meaningful over a
30 – 40 year period, which is typical of contract ownership, particularly when one
considers how account and administrative fees have increased over recent years
for other financial service products.
Building/Replacing a Defined Benefit Plan. Over the past few years there has
been numerous reports talking about the changing retirement landscape and how
retirees in the 21st century will need to build their own retirement plans. A new
acronym has been developed: YoYo plans. Which stands for: You’re On Your
Own. Gone are the days when an employee could depend upon their employer
(defined benefit plans) and the government (social security) to retire for the
“golden years.” For many new retirees, the largest retirement plan they may own
may be their 401(k) plan. This defined contribution plan does not guarantee the
income for life that a defined benefit plan would. Then it would seem logical that
the opportunity would present itself for many of these retirees to rollover their
qualified plan (401(k)) into an IRA and inside the IRA purchase an annuity. The
annuity would accomplish all that a defined benefit plan would: Guaranteed
income for life of the annuitant and/or his or her beneficiary.
These important guarantees provide real protection and benefits to the participant-owners
who own an annuity inside a qualified plan and/or IRA. The tax deferral in the annuity is
a matter of law—it is not a benefit provided by the insurance company, and there is no
fee or charge for tax deferral.
RMD Rule Requirements on Variable Annuity Contracts
For RMD calculation purposes the entire interest of an individual’s qualified assets in
their qualified retirement account or certain self-directed qualified annuity is the sum of
144
all their individual assets held within their qualified retirement account or self-directed
qualified annuity as of December 31 of a given year. To determine the RMD for a
qualified retirement account or self-directed qualified annuity for a given year, the total
account value or contract interest for self-directed annuities is then divided by the
owner’s life expectancy using the appropriate IRS tables as provided in the Treasury
Regulations.
The new rules require that the actuarial present value of additional benefits, must be
combined with the actual account value of the contract to determine the “entire interest.”
Previously, if a deferred annuity was held as an asset in a qualified account or as a selfdirected IRA annuity, only the contract value of the annuity was used to determine the
“entire interest” for RMD purposes.
Actuarial Present Value Defined
The actuarial present value (APV) is determined by projecting the actuarial value of the
guaranteed benefit provided under the contract into the future and then estimating its
present value. In determining this value, companies may consider what the benefit will
be worth in the future and how likely it is that the benefit will become payable, taking
into account the likelihood of various occurrences such as death and contract surrender
value. This likely future value is then discounted at a reasonable rate of interest at the
present value.
RMD Calculation under the New Rules
To determine a contract’s value for RMD calculation purposes, the amount derived from
the calculation of the actuarial present value of any guaranteed benefit is added to the
December 31 account value of the previous year. This value is then divided by the
owner’s life expectancy using the appropriate IRS tables. The resulting number is the
RMD for the year.
Safe Harbor Rules
There is a safe harbor under the rules. This safe harbor provision states that an additional
benefit under a deferred annuity contract can be disregarded for purposes of determining
the actuarial present value requirement if it fits at least one of two circumstances:


When the only additional benefit is a death benefit that does not exceed the
premiums paid less the amount of prior withdrawals (Return of Premium GMDB),
or
When withdrawals impact benefits of a pro-rata basis and the actuarial present
value of all “guaranteed benefits” under the contract do not exceed 20% of the
contract value.
145
Example: Calculating RMD Under New Rules
Detailed below is a hypothetical example of how the APV may be determined for a
qualified annuity contract with a guaranteed minimum death benefit (GMDB) and
guaranteed minimum income benefit (GMIB). This example is based on assumptions
that a hypothetical company may deem reasonable. Other annuity issuers may determine
different values based on the assumptions they have selected. Note: Under the Workers
Retirement Employer’s Rescue Act of 2008, RMDs for 2009 are not required.

GMDB Example 1: Assume the Owner (who is also the Annuitant) is 75 years
old with a variable annuity with a pro-rata Maximum Anniversary Value (MAV)
GMDB. On December 31, 2010, the annuity contract value is $500,000 and the
MAV GMDB is $1,000,000.
o Step 1: Using the life expectancy tables prescribed by the IRS, the RMD
factor for a 75-year old is 22.9. To determine the client’s RMD for this
contract prior to determining an actuarial present value calculation for the
GMDB, divide the annuity contract value by the RMD factor: $500,000 /
22.9 = $21,834.
o Step 2: To calculate the actuarial present value of the GMDB, an
insurance company must reflect the net amount at risk (i.e. the difference
between the contract value and GMDB) and the maximum age through
which such a benefit may be paid.
Let’s assume the following: The Company requires annuitization at age
95; the Company assumes the net market performance for this product is
6.5% and a discount rate of 5.0% is appropriate to reflect the time value of
money.
Based on these hypothetical assumptions, an actuarial present value of the
$1,000,000 MAV GMDB would be $65,519.
o Step 3: Next determine whether the actuarial present value of the GMDB
falls within he “safe harbor” prescribed by the rules.
To calculate this value, divide the actuarial present value of the GMDB by
the annuity contract value: $65,519 / $500,000 = 13.1%. Since this value
is less than 20% and the MAV GMDB design is pro-rata, there would be
no impact on the previously RMD of $21,834 (Step 1).
As previously noted, the “safe harbor” does not apply to benefits that are
adjusted on a dollar-for-dollar basis for withdrawals. Based on the
assumptions above, if a 75 year old owner had a dollar-for-dollar MAV
GMDB design, the RMD would be increased as follows: ($500,000 +
146
$65,519) / 22.9 = $24,695. This RMD is 13.1% INCREASE over the
previously calculated RMD of $21,834.

GMDB Example 2: Using the same assumptions described above, suppose the
annuity contract value is $400,000.
o Step 1: Determine the client’s RMD for this contract prior to determining
an actuarial present value calculation for the GMDB by dividing the
annuity contract value by the RMD factor: $400,000 / 22.9 = $17,467
o Step 2: The actuarial present value of the $1,000,000 MAV GMDB is now
$104,317.
o Step 3: Determine whether the actuarial present value of the GMDB falls
within the “safe harbor” set by the new rules.
To make this determination, divide the actuarial present value of the
GMDB by the annuity contract value to get: $104,317 / $400,000 =
26.1%.
Here is the actuarial present value does not fall within the “safe harbor.”
o Step 4: Determine the RMD for this contract by adding the actuarial
present value of the GMDB to the annuity contract value and divide it by
the RMD factor to get the RMD for the year—($4000,000 + $104,317) /
22.9 = $22,023.
As previously outlined in Step 1, under the old rules the RMD for a client
in this scenario would have been: $400,000 / 22.9 = $17,467. This new
RMD is a 26.1% INCREASE over the old RMD.
New Proposed Treasury Regulation – Longevity Contracts
On February 9, 2012, the U.S. Treasury Department proposed new regulations (Treasury
Regulation 26 CFR 115089-11) to allow participants in qualified retirement plans
(401(a), 403(b), 408 and 457 plans) to purchase longevity annuity contracts.
The proposal would allow participants to purchase a fixed annuity contract and be
allowed to defer until age 80 – 85 years old. The purchase would be limited to the lesser
of $100,000 or 25% of plan balance. Husband and wife are allowed separate accounts.
147
Chapter 9
Review Questions
1. An endowment contract is an annuity that provides life insurance protection.
( ) A. True
( ) B. False
2. Which of the following are criticisms of owning a variable annuity inside a qualified
retirement plan?
(
(
(
(
) A. Duplication of tax-deferral
) B. Costly
) C. Ethical guidelines
) D. All of the above
3. Which type of individual retirement arrangement involves the purchase of an annuity
or an endowment contract?
(
(
(
(
) A.
) B.
) C.
) D.
Individual Retirement Annuity
Individual Retirement Account
Tax-sheltered Annuity
Individual Roth Account
4. Which Section of the Internal Revenue Code (IRC) allows public school teachers to invest
in a variable annuity within their qualified retirement plan?
(
(
(
(
) A. IRC Section 401(a)
) B. IRC Section 403(b)
) C. IRC Section 408
) D. IRC Section 408A
5. To determine an annuity contract’s value for RMD calculation purposes, the amount
derived from the calculation of the actuarial present value of any guaranteed benefit is
added to the which of the following?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Account value as of April 15th of the current tax year
Account value as of April 15th of the previous tax year
Account value as of December 31 of the current tax year
Account value as of December 31 of the previous tax year
148
CHAPTER 10
UNFAIR MARKETING PRACTICES
Overview
The Unfair Marketing Practices Act was created by the National Association of Insurance
Commissioners (NAIC) back in the 1940’s and since then has been amended and
expanded. The Act is divided into two parts—Unfair Marketing Practices and Unfair
Claims Practices. In each state, statutes define and prohibit certain marketing practices
and claims practices, which are unfair, unethical, misleading and deceptive. Let’s review
several of these unfair marketing practices beginning with misrepresentation.
Misrepresentation
Misrepresentation is simply a false statement of fact; that is a lie. For many insurance
producers, the biggest market conduct danger they may face is making a
misrepresentation during a sales presentation. Sometimes, it is the result of overenthusiasm of “selling” the benefits of a policy too strongly. It may also be the result of a
willingness to stretch the advantages of a particular product and sidestep the
disadvantages. While on the other hand, providing vague or elusive responses is just as
serious a form of misrepresentation as is deliberately lying about a policy’s features and
benefits or expected performance.
Fraud
If an insurance producer intentionally misrepresents any information in an insurance
transaction, he or she is guilty of fraud. An insurance producer found guilty of fraud may
be subject to fines and/or imprisonment as well as the possible loss of their license to sell
insurance as well as public disgrace.
Altering Applications
Altering applications, for any purpose, is not permitted. It is illegal and insurance
producers must not engage in altering applications.
In the past, applications have been altered for a number of fraudulent reasons, such as to:


Change underwriting information to get a more favorable premium rate, or
Switch the type of coverage applied for, or
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
Add additional zeroes to the amount of coverage applied for.
Premium Theft
Of all the prohibited activities, premium theft ranks among the worst offense an insurance
producer can commit. In addition to the outright theft of the premium money, failure to
turn over a premium on a policy prevents the policy from going into effect. The
consumer believes he or she is insured, but in fact, the application was never submitted to
the insurance company. These situations are quickly discovered if any inquiry is made
by the prospective insured or the insurance company.
Premium theft is rigorously punished by every state Insurance Department.
False or Misleading Advertising
The potential for false (deceptive) advertising or promotion by insurance companies and
or insurance producers alike is significant and the consequences to the consumer can be
grave. Accordingly, all states regulate insurance advertising.
The NAIC has created a model regulation more specifically directed at advertising—the
Rules Governing Advertising of Life Insurance. This model regulation, which so far has
been adopted by more than 31 states, defines advertising and attempts to address those
actions that have caused the most problems in the industry. It also mandates the proper
identification of insurance producers and companies, a system of control over its
advertisement, a description of the type of policy advertised, and the disclosure of graded
or modified benefits over time and so forth.
Recently, several states have passed specific legislation (For example in California, two
bills were passed by the legislators, SB 620 and SB 618) for regulating advertising to
seniors age 65 and older.
Defamation
“Defamation” is any false maliciously critical or derogatory communication written or
oral—that injures another’s reputation, fame or character. Without the element of
communication there can be no defamation. Both insurance producers and insurers can
be defamed. Unethical insurance producers participate in defamation by spreading
rumors or falsehoods about the character of a competing insurance producer or the
financial condition of another insurer.
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Boycott, Coercion, Intimidation
Boycott, coercion and intimidation are unethical trade practices, which attempt to limit
or restrain trade in the sale of insurance. No person or company has the right or the
power to force, coerce or intimidate any person into purchasing insurance from a specific
insurance producer or insurer.
Twisting
“Twisting” is the unethical act of inducing a client to lapse, surrender or terminate an
existing insurance product solely for the purpose of selling another policy with another
insurer without regard to the possible disadvantages to the policy owner. By definition,
twisting involves some kind of misrepresentation by the insurance producer to convince
the policy owner to switch insurers. The key word in the definition of “twisting” is
“inducement”. Twisting is illegal and should not be confused with replacement, which is
legal if done in accordance with specific state laws.
Churning
Related to twisting is “churning”. If an insurance producer induces a prospect/client to
replace a policy with a new policy with the same insurer and if the replacement is not in
the client’s best interest, the insurance producer is guilty of churning. In cases involving
churning, there is no demonstrated benefit to the policy owner with the new policy or
contract. Churning is unethical and illegal.
Discrimination
“Discrimination” is both illegal and unethical in accordance with state and federal laws.
From an insurer’s perspective, it is unlawful to permit discrimination between individuals
of the same class and life expectancy regarding life insurance rates, dividends or other
policy benefits. It is unlawful to discriminate because of age in the issuance of and rates
for automobile insurance. It is unethical and illegal to permit or cause discrimination due
to race, creed, color or national origin regarding the issuance or the rates charged for
insurance.
Rebating
Splitting a commission or paying a client for his or her business is considered "rebating."
Rebating occurs if the buyer of an insurance policy receives any part of the insurance
producer's commission or anything else of significant value as an inducement to purchase
the insurance product being sold by the insurance producer. Rebating is illegal in all but
two states:
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

California (Rules regarding unfair practices are outlined in CA Assembly Bill 689
specific to annuity sales and suitability to seniors, and in CIC 790-790.15 for all
insurance transactions); and
Florida (Rules specific to the allowance of rebating are found in the 2012 Florida
Statues, Title XXXVII, Section 626.572).
However, most insurers forbid their insurance producers to rebate even in jurisdictions
where it is legal. It is acceptable to provide gifts of nominal value (pens, calendars, coffee
mugs, etc.) to prospects and clients when those gifts are given regardless of whether or
not you make a sale. If you provide a nominal gift, you must provide it to everyone you
approach.
Use of Senior Specific Certifications and Designations
The NAIC membership gave its final approval (Fall Meeting-September 2008) on the
Model Regulation on the Use of Senior-Specific Certifications and Professional
Designations in the Sale of Life Insurance and Annuities (Model Regulation 278). The
new model follows the approach for regulating senior-specific designations taken in the
model rule adopted on April 1, 2008 by the North American Securities Administrators
Association (NASDSA).
Both models are designed to stop the use of misleading senior-specific designations by
establishing a standard of whether the use of a particular designation indicates or implies,
in a way that misleads the consumer, that the agent has special certification or training in
advising seniors. Neither model references specific designations; rather, individual
designations will be measured against this standard. The models establish what is
essentially a safe harbor for designations that:


Are not primarily sales/marketing oriented and
Are issued/accredited by the American National Standards Institute, the National
Commission for Certifying Agencies, or an institution of higher education.
The models also expressly prohibit the use of designations that have not been legitimately
earned, that are nonexistent, or that misrepresent a level of expertise of education that
does not exist.
The NAIC Model applies to the sale of insurance-related products. Under Section 5 A(1)
of the Model Act it states:
“It is unfair and deceptive act of practice in the business of insurance for an
insurance producer to use a senior-specific certification or professional designation
that indicates or implies in such a way as to mislead a purchaser or prospective
purchaser that insurance producer has special certification or training in advising or
servicing seniors in connection with the solicitation, sale or purchase of a life
152
insurance or annuity product or in the provision of advice as to the value of or the
advisability of purchasing or selling a life insurance or annuity product, either
directly or indirectly through publications or writings, or by issuing or promulgating
analyses or reports related to a life insurance or annuity product.”
The prohibited use of senior-specific certifications or professional designations includes,
but is not limited to, the following:



Use of a certification or professional designation by an insurance producer who
has not actually earned or is otherwise ineligible to use such certification or
designation;
Use of a nonexistent or self-conferred certification or professional designation;
use of a certification or professional designation that indicates or implies a level
of occupational qualifications obtained through education, training or experience
that the insurance producer using the certification or designation does not have;
and
Use of a certification or professional designation that was obtained from a
certifying or designating organization that:
o Is primarily engaged in the business of instruction in sales or marketing;
o Does not have reasonable standards or procedures for assuring the
competency of its certificants or designees;
o Does not have reasonable standards or procedures for monitoring and
disciplining its certificants or designees for improper or unethical conduct;
or
o Does not have reasonable continuing education requirements for its
certificants or designees in order to maintain the certificate or designation.
Annuity Disclosure Model Regulation
On August 3, 2011, the NAIC Life Insurance and Annuities (A) Committee adopted
revisions to the Annuity Disclosure Model Regulation, Model 245 ("Annuity Disclosure
Model" or "Model"). The revised Annuity Disclosure Model continues to require that
consumers be provided a Buyer's Guide and a disclosure document. The revised Annuity
Disclosure Model applies to fixed, fixed indexed and variable annuities.
Fixed and Index Annuities
The most substantive change to the Annuity Disclosure Model is the addition of the
standards for fixed and fixed indexed annuity illustrations. New Section 6 applies to an
"illustration," which is defined to mean "a personalized presentation or depiction
prepared for and provided to an individual consumer that includes non-guaranteed
elements of an annuity contract over a period of years." In addition to setting forth the
parameters for non-guaranteed and guaranteed elements of illustrated values and the
manner of presentation of such values, the new illustration standards require:
153



A narrative summary (unless the information is provided at the same time in a
disclosure document).
A numeric summary.
If the annuity contains a market value adjustment ("MVA"), a narrative
explanation of the MVA, a demonstration of the MVA under at least one positive
and one negative scenario, and actual MVA floors and ceilings.
New Section 6 includes additional specific requirements for a fixed indexed annuity
illustration. These requirements include illustrating the nonguaranteed values for three
different scenarios:



The last continuous 10 calendar years.
A continuous 10 calendar year period out of the last 20 that would produce the
least index value growth.
A continuous 10 calendar year period out of the last 20 that would produce the
most index value growth.
If any index has not been in existence for at least 10 calendar years, then that index may
not be illustrated.
The Model also was revised to include additional disclosure items for fixed indexed
annuities.
Variable Annuities
Previously, the Annuity Disclosure Model did not apply to the sale of registered variable
annuities. The Model was revised to require the following be delivered in connection
with a sale of a registered variable annuity:


A Buyer's Guide.
After January 1, 2014, a disclosure document, unless prior to such date, the SEC
adopts a summary prospectus rule or FINRA approves for use a simplified
disclosure form applicable to variable annuities.
Variable annuity illustrations, however, are not subject to the revised Annuity Disclosure
Model's new standards for illustrations.
The Annuity Disclosure Model was revised to include a new exception from the Model
for non-registered variable annuities issued exclusively to accredited investors or
qualified purchasers.
Recordkeeping
The Model was revised to include a requirement to maintain or make available to the
insurance regulatory authorities records of the information collected from the consumer
and other information provided in the disclosure statement (including illustrations).
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Chapter 10
Review Questions
1. What year was the Unfair Marketing Practices Act created?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
1940
1955
1960
1980
2. What is the biggest market conduct danger an insurance producer may face during a
sales presentation?
(
(
(
(
) A. Rebating
) B. Fraud
) C. Misrepresentation
) D. False advertising
3. An agent stretches the advantages of a particular product and sidesteps the
disadvantages. He/she has committed the unfair marketing practice known as false
advertising.
( ) A. True
( ) B. False
4. Which of the following statements is TRUE regarding twisting and churning?
( ) A. Twisting and churning are both legal and ethical
( ) B. Twisting and churning are both illegal and unethical
4. Making a false, malicious, critical or derogatory communication that injures another’s
reputation, fame or character is defamation.
( )
( )
A. True
B. False
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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.
A
B
B
C
D
C
A
D
B
B
A
B
D
C
D
B
A
C
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.
D
B
C
A
C
Chapter 9
1.
2.
3.
4.
5.
A
D
A
B
D
C
D
B
C
A
Chapter 10
1.
2.
3.
4.
5.
A
C
B
B
A
157
B
C
A
C
D
B
A
C
C
D
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158
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