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NAIC SUITABILITY IN
ANNUITY
TRANSACTIONS MODEL
REGULATION
4 Hr COURSE
COPYRIGHT © 2011
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Table of Contents
INTRODUCTION .........................................................................................................................1 Brief History of Suitability Issues at the National Level ........................................................................ 1 NAIC White Paper Issued in 2000 ......................................................................................................... 1 Model Regulation Adopted in 2003...................................................................................................... 1 Deceptive Use of Senior Related Designations:.................................................................................... 2 NAIC Revised Model in 2006................................................................................................................. 2 NAIC Adopted Further Revisions March 2010 ...................................................................................... 3 CHAPTER 1 ..................................................................................................................................4 Types of Annuities and Contract Parties.................................................................................................4 Documentation.......................................................................................................................................... 4 Types of Annuities ..................................................................................................................................... 4 Classification of annuities by benefit commencement.............................................................................. 5 Immediate or Deferred.............................................................................................................................. 5 Immediate Annuity ............................................................................................................................... 5 Deferred Annuity .................................................................................................................................. 5 Split Annuity.......................................................................................................................................... 6 Classification of annuities based on premium payment period ................................................................ 6 Single premium annuities .......................................................................................................................... 6 Single premium deferred annuity (SPDA).................................................................................................. 6 Single Premium Immediate Annuity (SPIA)........................................................................................... 6 Periodic Premiums ................................................................................................................................ 6 Flexible Premiums................................................................................................................................. 7 Premium Computation Factors............................................................................................................. 7 Classification of annuities based on policy owner risk .............................................................................. 7 Variable Annuity ................................................................................................................................... 7 Fixed...................................................................................................................................................... 8 Important Characteristics of fixed and variable annuities......................................................................... 8 Important differences between fixed and variable annuities ................................................................... 9 Declared Rate Fixed Annuities .............................................................................................................. 9 Fixed Indexed Annuities........................................................................................................................ 9 Two‐Tiered Annuities............................................................................................................................ 9 Parties to an Annuity Contract ................................................................................................................ 10 The Insurer.......................................................................................................................................... 10 Contract Owner................................................................................................................................... 10 Annuitant ............................................................................................................................................ 11 Beneficiary or Multiple Beneficiaries.................................................................................................. 11 Multiple Titles for One Individual ....................................................................................................... 12 Stranger Originated Annuity Transaction (STAT) ................................................................................ 12 Characteristics of a STAT..................................................................................................................... 12 Regulatory Issues and Concerns with STATs....................................................................................... 13 Insurable Interest................................................................................................................................ 13 Rebating .............................................................................................................................................. 13 Rescission............................................................................................................................................ 13 Annuity Contract Provisions .................................................................................................................... 13 Interest Rate Crediting............................................................................................................................. 13 New Money Rate Interest Crediting Strategy.......................................................................................... 14 Portfolio Based Interest Crediting Strategy ............................................................................................. 14 Initial Interest Rate .................................................................................................................................. 15 Multi year Guaranteed Interest Annuities (MYGIA) ................................................................................ 15 Interest Rates – Guaranteed and Current ............................................................................................... 15 Bonus Annuities .................................................................................................................................. 15 Renewal Interest Rates............................................................................................................................ 16 Minimum Guaranteed rates .................................................................................................................... 16 Issue age guidelines ................................................................................................................................. 17 Annuity Date ....................................................................................................................................... 17 Withdrawal/Surrender Charge Waivers.............................................................................................. 17 Nursing Home Waiver.............................................................................................................................. 17 Terminal Illness Waiver ........................................................................................................................... 18 Unemployment........................................................................................................................................ 18 Death and Disability................................................................................................................................. 18 Withdrawal Privilege ............................................................................................................................... 18 Bail‐Out.................................................................................................................................................... 18 Premium Payments.................................................................................................................................. 19 Single premium Annuity .......................................................................................................................... 19 Periodic or Flexible Premiums ............................................................................................................ 19 Required Premiums vs Optional Premiums ........................................................................................ 19 Surrender Charges and Penalties............................................................................................................. 19 Market Value Adjusted Annuities............................................................................................................ 20 How the MVA Works .......................................................................................................................... 21 How the MVA is Different ................................................................................................................... 21 Risk Factor........................................................................................................................................... 21 Contract Administration Charges and Fees ........................................................................................ 22 Custodial Fees ..................................................................................................................................... 22 Spread /Asset or Margin Fee .............................................................................................................. 22 Loading and Management Fees............................................................................................................... 22 Administrative Fees ............................................................................................................................ 22 Contract Fee........................................................................................................................................ 22 Sub‐Account Fees................................................................................................................................ 23 Other Fees ............................................................................................................................................... 23 Withdrawal Privilege Options.................................................................................................................. 23 Withdrawal Privilege Options Qualified Annuities .................................................................................. 23 Annuitization ........................................................................................................................................... 23 Inflation During Annuitization ................................................................................................................. 24 Annuitization of a Fixed Annuity.............................................................................................................. 24 Annuitization of a Variable Annuity......................................................................................................... 24 Fixed Account...................................................................................................................................... 24 Separate Account..................................................................................................................................... 25 Annuitization Settlement Options ........................................................................................................... 25 Period Certain Only............................................................................................................................. 25 Life Only .............................................................................................................................................. 25 Life and Period Certain........................................................................................................................ 26 Life Only with Guaranteed Minimum Option ..................................................................................... 26 Joint and Survivor ............................................................................................................................... 26 Death benefits ......................................................................................................................................... 26 Tradition Fixed Annuity Death Benefit................................................................................................ 26 Fixed Indexed Annuity Death Benefit ................................................................................................. 27 Variable Annuity Death Benefit .......................................................................................................... 27 Death benefit Settlement Options .......................................................................................................... 27 Lump Sum vs. Extended Payout.......................................................................................................... 28 Death Benefit Settlement of a Qualified Annuity ............................................................................... 28 Principle Guarantee ................................................................................................................................. 28 Safety ....................................................................................................................................................... 28 Loan Provisions ........................................................................................................................................ 29 Additional Contract Provisions Fixed Indexed Annuities ......................................................................... 29 Fixed indexed Annuities........................................................................................................................... 29 Indexed Annuities vs. Traditional Fixed Annuities................................................................................... 30 Terminology............................................................................................................................................. 30 Participation Rate .................................................................................................................................... 30 Participation Rate ............................................................................................................................... 30 Cap rate ................................................................................................................................................... 31 Cap Rate or Cap on Interest Earned.................................................................................................... 31 Floor Rate ................................................................................................................................................ 31 Spread/ Margin/Asset fee........................................................................................................................ 31 Ratchet or Annual Reset .......................................................................................................................... 32 Common indexing strategies ................................................................................................................... 32 Indexing Method................................................................................................................................. 32 Specific Term....................................................................................................................................... 32 Policy Year........................................................................................................................................... 32 Indexing Methods Calculate Percentage Change ............................................................................... 33 Fixed Interest ...................................................................................................................................... 33 Monthly Averaging.............................................................................................................................. 33 Daily Averaging ................................................................................................................................... 33 Point‐to‐Point Indexing....................................................................................................................... 34 Annual Point to Point Indexing ........................................................................................................... 35 Example............................................................................................................................................... 35 Monthly Point to Point Indexing......................................................................................................... 36 Example............................................................................................................................................... 37 Long Term Point to Point Indexing...................................................................................................... 37 High Water Mark Indexing.................................................................................................................. 37 Combination of Indexing Methods .......................................................................................................... 38 Consumer Choice to Allocate/Reallocate Amongst Strategies................................................................ 39 Index Strategy Performance .................................................................................................................... 39 Fluctuation of Cap and Participation Rates ............................................................................................. 39 Insurer Investing to Hedge Indexing Strategies ....................................................................................... 39 Factors Affecting Index Options Prices .................................................................................................... 40 Market Volatility ...................................................................................................................................... 40 Risk Free Rate of Return .......................................................................................................................... 40 Mid ‐ term Withdrawals .......................................................................................................................... 40 Minimum Nonforfeiture Rate Vs. Minimum Annual Credited Rate ........................................................ 41 The Minimum Nonforfeiture Rate ........................................................................................................... 41 The Minimum Annual Credited Rate ....................................................................................................... 41 Historical Perspectives............................................................................................................................. 42 Hypothetical Models................................................................................................................................ 42 Actual Returns ......................................................................................................................................... 42 Renewal Rates ......................................................................................................................................... 42 Common Indexes Used in Fixed Indexed Annuities................................................................................. 42 Standard & Poor’s 500............................................................................................................................. 43 Varying Views...................................................................................................................................... 43 Comparison to the Dow Jones Industrial Average .............................................................................. 43 Available Annuity Riders.......................................................................................................................... 43 Life Insurance Riders................................................................................................................................ 43 Long‐Term Care Riders ............................................................................................................................ 44 Account Balance First LTC Approach................................................................................................... 44 Account Balance Last LTC Approach ................................................................................................... 44 Coinsurance LTC Approach ................................................................................................................. 44 Waiver of Surrender Charge Vs. LTC Rider.......................................................................................... 45 Guaranteed Minimum Withdrawal Benefit Riders ............................................................................. 45 Guaranteed Minimum Withdrawal Benefits in Variable Annuities .................................................... 45 Variations ............................................................................................................................................ 45 Investment Restrictions With GMWB................................................................................................. 46 Guaranteed Minimum Withdrawal Benefit Riders in Fixed Annuities................................................ 46 Guaranteed Minimum Death Benefit Rider............................................................................................. 47 GMDB ‐ Basic Form ............................................................................................................................. 47 GMDB ‐ Enhanced ............................................................................................................................... 48 Chapter 1 ‐ Review Questions.............................................................................................................. 49 CHAPTER 2 ............................................................................................................................... 51 Annuity Taxation and Primary Uses of Annuities.................................................................................. 51 Taxation of Non‐Qualified Annuities ....................................................................................................... 51 When an Annuity is Owned by a Non‐Natural Person............................................................................. 51 Exceptions................................................................................................................................................ 51 Taxation of Withdrawals From Non‐Qualified Annuities......................................................................... 52 Total Surrender........................................................................................................................................ 52 Partial Withdrawal................................................................................................................................... 52 Aggregation Rule ..................................................................................................................................... 52 Exceptions to the Aggregation Rule......................................................................................................... 52 Taxation of Annuitization of Non‐Qualified Annuities............................................................................. 53 Taxation of Annuity Upon Death of the Owner....................................................................................... 53 If Owner Dies Prior to Annuitization........................................................................................................ 53 General Provisions ................................................................................................................................... 53 Annuitant Owned Annuities .................................................................................................................... 54 Spousal Beneficiary.................................................................................................................................. 54 Non‐Spousal Beneficiary.......................................................................................................................... 54 If Owner Dies After Annuitization............................................................................................................ 54 Taxation of Ownership Changes .............................................................................................................. 54 Exceptions to Taxation of Transfers......................................................................................................... 55 1035 Exchanges ....................................................................................................................................... 55 Life Insurance to Annuity......................................................................................................................... 55 Annuity to Annuity................................................................................................................................... 56 Partial 1035 Exchange.............................................................................................................................. 56 “One for Two” 1035................................................................................................................................. 56 Premature Withdrawal Penalty / Non‐Qualified Annuities ..................................................................... 57 Other Tax Considerations / Non Qualified Annuities .............................................................................. 57 Taxation of Qualified Annuities ............................................................................................................... 58 Contributions to Qualified Annuities ....................................................................................................... 59 The Roth IRA is an Exception ................................................................................................................... 59 Minimum Required Distributions (MRD)................................................................................................. 59 Retirement Plans Covered ....................................................................................................................... 59 Multiple Retirement Plans....................................................................................................................... 59 IRS Penalty for Under‐Distribution .......................................................................................................... 59 Calculating the MRD ................................................................................................................................ 60 Account Balance.................................................................................................................................. 60 Life Expectancy ................................................................................................................................... 60 Qualified Annuity Distributions Prior to Age 59½.................................................................................... 60 Exceptions to 10% Penalty…Qualified Annuities ..................................................................................... 61 Unreimbursed Medical Expenses ............................................................................................................ 61 Medical Insurance.................................................................................................................................... 61 Disability .................................................................................................................................................. 61 Death ....................................................................................................................................................... 61 Higher Education Expenses...................................................................................................................... 62 First Home Purchase................................................................................................................................ 63 Avoidance of the Pre 59 1/2 Distribution Penalty ................................................................................... 63 Primary Uses of Annuities........................................................................................................................ 64 Tax Deferred growth vs Taxable or tax Free growth ............................................................................... 64 Tax Free Growth ...................................................................................................................................... 65 Primary Uses of Annuities........................................................................................................................ 65 Guaranteed Lifetime Stream of Income ............................................................................................. 65 Annuitization Settlement Options ........................................................................................................... 65 Life Only .............................................................................................................................................. 65 Advantages ......................................................................................................................................... 66 Disadvantages ..................................................................................................................................... 66 Life Only with Guaranteed Minimum Option or Refund..................................................................... 66 Advantages ......................................................................................................................................... 66 Disadvantages ..................................................................................................................................... 66 Life With Period Certain...................................................................................................................... 66 Advantages ......................................................................................................................................... 66 Disadvantages ..................................................................................................................................... 66 Joint and Survivor ............................................................................................................................... 67 Advantages ......................................................................................................................................... 67 Disadvantages ..................................................................................................................................... 67 Period Certain Only............................................................................................................................. 67 Advantages ......................................................................................................................................... 67 Disadvantages ..................................................................................................................................... 67 Long Term Retirement Accumulation................................................................................................. 68 Potential to Avoid Probate.................................................................................................................. 68 Chapter 2 ‐ Review Questions.............................................................................................................. 69 CHAPTER 3 ............................................................................................................................... 70 NAIC ANNUITY SUITABILITY MODEL..................................................................................................... 70 Section 1 Purpose .................................................................................................................................... 70 Section 2. Scope....................................................................................................................................... 70 Section 3. Authority ................................................................................................................................. 70 Section 4. Exemptions ............................................................................................................................. 71 Section 5. Definitions............................................................................................................................... 71 Section 6. Duties of Insurers and of Insurance Producers....................................................................... 73 Section 7. Insurance Producer Training ................................................................................................... 77 Section 8. Mitigation of Responsibility .................................................................................................... 79 Section 9. [Optional] Recordkeeping ....................................................................................................... 79 Section 10. Effective Date........................................................................................................................ 80 DETERMINING CLIENT SUITABILITY ...................................................................................................... 80 How Annuity Provisions Affect Consumers ............................................................................................. 80 Personal Information .......................................................................................................................... 81 Consumer Financial Status.................................................................................................................. 81 Assets ‐ Investments and Life Insurance............................................................................................. 81 Endowments ....................................................................................................................................... 81 Annual Income .................................................................................................................................... 81 Liquid Net Worth ................................................................................................................................ 82 Liquidity Needs ................................................................................................................................... 82 Affect of IRS Early Withdrawal Penalty on Liquidity Needs ................................................................ 83 Tax Status............................................................................................................................................ 83 Consumer’s Risk Tolerance...................................................................................................................... 83 Intended Use of Annuity ..................................................................................................................... 84 Source of Funds Used to Purchase the Annuity.................................................................................. 84 Anticipated Retirement Age ............................................................................................................... 84 Consumer’s Financial Experience........................................................................................................ 85 Financial Concerns .............................................................................................................................. 85 Future Financial Considerations.......................................................................................................... 85 Social Security Benefits ....................................................................................................................... 85 Retirement Plan Distributions............................................................................................................. 85 Investing retirement Assets ................................................................................................................ 85 Other Financial Needs......................................................................................................................... 85 Health and Medical Care Access/Cost ................................................................................................ 86 Financial Support For Family Members .............................................................................................. 86 Cross‐Selling Reverse Mortgages........................................................................................................ 86 Other Information Or Considerations Used by Producer ................................................................... 86 Access to Account Value ..................................................................................................................... 86 Required Minimum Distributions ....................................................................................................... 87 Withdrawals in Excess of the Free Amount or Full Surrender ............................................................ 87 Annuitization....................................................................................................................................... 87 Disclosure as a Component of Suitability ................................................................................................ 87 Appropriate Sales Practices Require Disclosure ................................................................................. 87 Surrender Charge Terms ..................................................................................................................... 88 Comparison of Life Expectancy to Surrender Charge Period................................................................... 89 Annuity Tax Status and Potential Tax Penalties.................................................................................. 89 Mortality Charges and Expense Fees .................................................................................................. 89 Current Vs. Guaranteed Interest Rate ................................................................................................ 90 Investment Advisory Fees ................................................................................................................... 90 Riders or Endorsements...................................................................................................................... 90 Limitations on Interest Returns and Benefits ..................................................................................... 90 Insurance and Investment Components............................................................................................. 90 Market Risk ......................................................................................................................................... 91 Suitability of Replacing Existing Policies .................................................................................................. 91 Annuity Comparison When Exchanging or Replacing an Annuity...................................................... 91 If the Consumer Currently Holds an Annuity........................................................................................... 91 Surrender Charges Existing and New Annuity .................................................................................... 91 Costs for Annuity Benefits .................................................................................................................. 91 Will the Consumer Benefit from Enhancements in the New Policy.................................................... 92 Has the Consumer had Another Annuity Replacement in the Previous Three Years ......................... 92 Special Issues related to Sales to Seniors ................................................................................................ 92 Product Complexity............................................................................................................................. 92 legal capacity....................................................................................................................................... 93 diminished mental capacity ................................................................................................................ 93 probability of encountering diminished mental capacity ................................................................... 93 recognizing diminished mental capacity............................................................................................. 93 indicators of diminished mental capacity ........................................................................................... 94 additional indicators ........................................................................................................................... 95 explanation of indicators .................................................................................................................... 95 Ethical and Compliance Issue Unique to the Senior Market............................................................... 96 strategies for making better decisions................................................................................................ 96 including a trusted family member..................................................................................................... 97 senior related professional designations............................................................................................ 97 The Need for Complete Recordkeeping.............................................................................................. 97 Chapter 3 ‐ Review Questions.............................................................................................................. 99 Answers to Chapter ‐ Review Questions ............................................................................................ 100 Introduction
BRIEF HISTORY OF SUITABILITY ISSUES AT THE NATIONAL LEVEL
Annuities are complex financial instruments. As annuity producers, we sell an intangible
product that can not be evaluated like a tangible product. The value of what we sell is
often not easy for the client to grasp, and the contracts by necessity are full of legal terms,
exceptions, and contingencies. The average consumer will not fully understand an
annuity contract, so they must trust the person selling them the product. Most often this
trust is well deserved, but this does create an environment where the consumer can be
misled and enter into a transaction that is not in their best interest.
Over the past several years, Insurance Commissioners have been closely monitoring
complaints from consumers regarding annuity sales. While the total number of
complaints remains low relative to other lines of insurance, they show a troubling trend
over time. In the states that have reported data on annuity sales to the National
Association of Insurance Commissioners (NAIC), there was a marked increase in the
number of complaints in the categories of suitability, agent handling, and
misrepresentation over the period from 2004 thru 2007 (latest data). The total number of
complaints reported in these categories rose from approximately 1400 in 2004 to more
than 2300 in 2006. The proportion of these complaints attributed to suitability issues has
also increased each year, from just over 10% of that total in 2005, to more than 18% in
2007. Each and every complaint is reviewed and investigated by the respective state
Department of Insurance. Since 2004, more than 75% of the annuity complaints reported
by state regulators to the NAIC have been resolved in favor of the consumer.
NAIC WHITE PAPER ISSUED IN 2000
In light of the recent trends in complaints for annuity sales, the NAIC adopted a white
paper in 2000 that called for the development of suitability standards for non-registered
annuity products similar to the standards that existed under the Securities and Exchange
Commission (SEC) for registered products.
The result of that white paper was a working group under the NAIC Life Insurance and
Annuities Committee that drafted a model regulation, setting suitability standards for all
life insurance and annuity products.
MODEL REGULATION ADOPTED IN 2003
The committee decided to focus first on the area that had been identified as subject to the
greatest abuse: the inappropriate sales of annuities to persons over the age of 65.
1
The resulting Senior Protection in Annuity Transactions Model Regulation (“Suitability
Model”) was adopted by the NAIC in 2003. This new model was another tool that
regulators could use to protect consumers from inappropriate sales practices in addition to
the previous NAIC Annuity Disclosure Model Regulation.
DECEPTIVE USE OF SENIOR RELATED DESIGNATIONS:
A recent series of news articles in the New York Times and the Wall Street Journal have
pointed to problems with the use of professional designations that imply expertise in
providing investment advice to senior citizens, such as “Certified Senior Adviser,”
“Certified Retirement Financial Adviser,” “Chartered Senior Financial Planner” and
“Certified Financial Gerontologist.” Some claim that those designations involve little
actual training regarding the needs of this vulnerable population. It appears from these
news articles that these designations, which are granted by for-profit entities, serve more
as marketing tools than as actual evidence of education or professional development.
Most of the problems that have been reported against persons using these credentials
have dealt with the sale of unsuitable annuities to senior citizens. (From testimony of
Sandy Praeger, Kansas Insurance Commissioner and NAIC President Elect before the
Senate Select Committee on Aging, September 5, 2007)
While annuity suitability laws deal with the suitability of the sale of annuities to
individuals of all ages, it is the senior citizen that is most often targeted for annuity sales.
There are multiple reasons that senior consumers are the main focus of annuity sales
efforts, but the main reason is that they have accumulated more funds than younger
individuals and are often motivated to settle their financial matters as they enter their
golden years. As our population in the United States ages, senior sales issues will become
more prevalent and subject to additional regulations.
Several states have passed laws prohibiting the use of professional designations with the
words “Senior,” or “Retirement,” or similar wording that implies special qualifications in
the senior market, unless the entity offering the designation can demonstrate that
successful candidates possess additional training or education.
It should be noted that there are a number of well established industry designations with
rigorous training and continuing education requirements which are viewed as valid
designations by regulators and the industry as a whole.
NAIC REVISED MODEL IN 2006
Purchasing life and annuity products is often a complicated and confusing process for
consumers of all ages, and regulators felt that the protections of the Suitability Model
should not be limited to seniors. Addressing this issue in 2006, the NAIC membership
adopted revisions to the Suitability Model to have its requirements apply to all consumers
regardless of age.
2
NAIC ADOPTED FURTHER REVISIONS MARCH 2010
In March of 2010, the NAIC voted to adopt revisions to The NAIC Suitability in Annuity
Transactions Model Regulation. Several states have already adopted the revised Model
Regulation and more are expected to adopt the Model Regulation within the next year.
In order for the producer to have a clear understanding of the direction of regulation in
annuity sales, we will review the NAIC Model Regulation as part of this course. As each
state adopts the regulation they are likely to make changes to contemporize the Model
Regulation to local law and circumstance, so it is important for the producer to realize
that the Model Regulation is not a binding law.
This course examines fixed, variable, bond index, single premium, equity-indexed, taxsheltered, and market-adjusted annuities - all of which are available in the marketplace.
This course also highlights distribution opportunities and tax consequences that are a
fundamental component of annuity accumulation programs.
Chapter review questions are included at the end of each chapter to enhance retention of
key elements and confirm the student’s mastery of course content. An answer key is
included at the end of the course.
Whether the student is a new agent or a veteran, new insights will be gained into the
world of annuities. Current annuity information and regulations provided in this course
will enable the student to brush up on knowledge already acquired.
Annuities have been available in the United States for more than 100 years; in other
countries, they have been available for several hundred years. Although annuities are
sold only by the insurance industry (i.e., insurance agencies, brokerage firms, investment
advisors, financial planners, banks, and savings and loans institutions), they are not life
insurance or insurance coverage. Contractual guarantees contained in annuities depend
upon the type of annuity purchased.
3
Chapter 1
Types of Annuities and Contract Parties
Although a wide range of annuities exists, each separate type of annuity contains various
options and features. All annuities can be divided into two basic types: fixed or variable.
If a set rate of return is desired, the contract owner will most likely choose a fixed
annuity. A traditional fixed annuity guarantees that deposits will accumulate at a
minimum specified rate of interest. The insurance company, however, may pay a higher
rate of interest if its investment experience is greater than the minimum interest
guarantee. If a conservative to aggressive investment is desired, the contract owner may
choose a variable annuity. With a variable annuity, the contract owner can choose among
a variety of separate accounts. Many variable annuities also include, for a cost,
guarantees normally associated with a fixed annuity.
DOCUMENTATION
The purchase of an annuity is structured similar to the purchase of a certificate of deposit
(CD) or mutual fund: via an annuity application or agreement between the investor
(contract owner) and the financial or insurance organization (insurer).
The contract owner must complete an application and submit it to the insurer, furnishing
the following information:
•
Name
•
Current address
•
Social security number of the contract owner
•
Name, social security number, address, gender, and date of birth of the
annuitant
•
Investment options desired
•
Source of funds to be deposited
•
Signature of the contract owner
•
Signature of the annuitant
In the near future health questions may also be added to some annuity
applications due to a recent trend in Stranger Originated Annuity Transactions
(more later).
TYPES OF ANNUITIES
4
CLASSIFICATION OF ANNUITIES BY BENEFIT COMMENCEMENT
IMMEDIATE OR DEFERRED
IMMEDIATE ANNUITY
An immediate annuity begins making periodic payments right after the policy is issued.
(within one year after purchase). It is usually issued in exchange for a single lump-sum
premium that provides a guaranteed fixed-payment amount. These payments may be
made monthly, quarterly, semi-annually, or annually and are based on the annuitant’s life
expectancy or that of the annuitant and his or her spouse. In some cases an immediate
annuity can begin providing income as few as 31 days after purchase of the annuity.
For example, if the contract calls for monthly payments, the payments will begin one
month after the date of the annuity purchase. Immediate annuities are specifically
designed for those individuals who need to receive a specific amount of money each
month. Immediate annuities can be used as the sole source of income or as an income
supplement. The amount of the check the annuitant receives is in direct relationship to
the total annuity investment.
It is important to remember that if the insurance company begins paying the annuitant
shortly after the purchase of the contract, the immediate annuity must have been paid by a
single payment, or all premiums must be received within a 30 to 45 day period
immediately after the first premium is received.
DEFERRED ANNUITY
A deferred annuity is one that defers, or delays, making payments until a later date. It
delays an annuitant’s income stream and accumulates interest while delaying taxation of
earnings until withdrawal.
Deferred annuities are often purchased during a consumer’s working years in anticipation
of the need for retirement income. Most deferred annuities provide a great deal of
flexibility surrounding the timing and amounts of payout benefits.
A deferred annuity offers growth and flexibility over either a long or short period of time
and can be purchased with a single premium, periodic premiums, or flexible premiums.
The annuitant of a deferred annuity can elect to receive a certain dollar amount of income
each year and can direct how the balance is to be reinvested. This deferral process gives
the annuitant the flexibility of automatic reinvesting, withdrawal of a portion of the
principal, or termination of the investment.
NOTE: All annuities grow tax-deferred. In the context of the above discussion the word
deferred refers to the deferral of the commencement of benefit payment versus the taxdeferred treatment of internal growth that all annuities receive.
5
SPLIT ANNUITY
A split annuity is actually two or more (usually two) annuities strategically employed.
One annuity provides a monthly income for a defined time period while the other restores
the original principal invested over the same period of time.
The strategy of a split annuity uses a single-premium deferred annuity and a singlepremium immediate annuity. The immediate annuity pays a predetermined amount of
income over the chosen time period. The single-premium deferred annuity is left to grow,
with the goal being that at the end of the chosen income period the deferred annuity will
have grown to equal the amount originally invested in both annuities.
CLASSIFICATION OF ANNUITIES BASED ON PREMIUM PAYMENT
PERIOD
SINGLE-PREMIUM ANNUITIES
Single-premium annuities are purchased with a lump sum and payouts begin either
immediately or at some point in the future. This is the most common type of immediate
annuity. Single-premium annuities involve the payment of a single premium, and the
insurance company promises to pay the annuitant an amount over a certain period
(monthly, quarterly, semi-annually, or annually).
SINGLE-PREMIUM DEFERRED ANNUITY (SPDA)
A single-premium deferred annuity (SPDA) is an annuity that is purchased with only one
premium payment. Usually, that single premium is relatively large--but it does not have
to be. Insurance companies require minimum premiums for this type of contract and they
may range from a few thousand dollars to much larger amounts. The money placed in an
SPDA is left to accumulate for the future. When annuitant desires to have a stream of
income, he or she annuitizes the contract.
SINGLE-PREMIUM IMMEDIATE ANNUITY (SPIA)
A single-premium immediate annuity (SPIA) is an annuity that is also purchased with
only one premium payment. Like the SPDA’s premium, it is also relatively large and
subject to certain minimum amounts. An SPIA differs from an SPDA because the
annuitant chooses to receive an income stream immediately after making the annuity
purchase.
PERIODIC PREMIUMS
6
The second type of premium payment is periodic. In these annuities, the premiums are
paid in periodic payments over a number of years prior to the date on which the annuity
payout begins. The premiums can be paid monthly, quarterly, semi-annually, or
annually.
FLEXIBLE PREMIUMS
The final type of premium payment is a flexible-premium annuity. In these annuities, the
annuity owner has the option to vary the amount of each premium payment, so long as
they fall between minimum and maximum amounts.
PREMIUM COMPUTATION FACTORS
Insurance companies use multiple factors in determining annuity premiums:
•
The annuitant’s age.
•
Gender—because women live longer than men, women receive more
income payments than men of the same age (except for gender neutral
rates if required).
•
The assumed interest rate.
•
The amount of periodic income.
•
Contractual guarantees.
•
Insurance company operating expenses, or “loads.”
CLASSIFICATION OF ANNUITIES BASED ON POLICY OWNER RISK
Because fixed annuities guarantee fixed, monthly payments, those payments will vary
and will depend upon the performance of the investment options chosen by the insurer.
A variable annuity offers a wider range of investment options than a fixed annuity, and
the contract owner chooses those investment options. In a variable annuity the value of
the investments chosen by the contract owner varies in accordance with the total
investment performance of the contract. The fluctuation of the cash value and monthly
income is the main difference between variable and fixed annuities. Typically, variable
annuities allow equity investments and fixed investments, whereas a fixed annuity offers
only fixed investments.
VARIABLE ANNUITY
A variable annuity fluctuates in value according to the performance of its underlying
investments (separate or sub accounts), which are held by the company in a separate
account outside their general accounts. All variable annuities must be registered with the
Securities and Exchange Commission (SEC). We will cover suitability requirements
specific to variable annuities later in the text under our FINRA discussion.
Premiums paid for variable annuities are directed by the annuity owner into separate
accounts (known as sub-accounts) where the company is permitted more investment
7
freedom than with its general funds. Separate accounts are generally invested in common
stocks and other securities that are expected to increase in value as prices increase. The
purpose of a variable annuity is to provide an annuity income, which will maintain its
purchasing power in inflationary times.
Unless the owner of a variable annuity purchases additional riders (living benefits), they
have no guarantee of safety of principal and bear all of the investment risk associated
with their separate account choices.
FIXED
A fixed annuity does not fluctuate in value. The underlying investments are owned by
the insurance company as part of its general account. The insurance company guarantees
the value of each in-force annuity policy that is backed by its general assets. Every fixed
annuity policy contains an underlying guaranteed minimum nonforfeiture interest rate.
The minimum interest rate during the accumulation period may be different than the
minimum interest rate during the payout period. In addition to the guaranteed underlying
nonforfeiture interest rate, the annuity company usually declares a current interest rate
that is higher than the minimum nonforfeiture rate, and it is normally guaranteed for a
period of time, generally one year. At the end of this period, the insurer will declare a
new current credited rate.
Premiums paid for fixed annuities are invested with the insurance company’s general
funds, chiefly in fixed-income types of securities, with the ultimate purpose of providing
a level annuity income. Although the fixed annuity affords the contract owner a
guaranteed rate of return, that rate is dependent upon the length of time the funds will be
invested. The most common maturity periods for annuities are one, three and five years;
the longer the commitment, the higher the guaranteed rate of return for the contracted
period.
In a fixed annuity, the contract owner is protected against rising or declining interest
rates, stock market gains or losses, and insurance company profits or losses through
guarantees, the safety of principal, and knowing the exact amount of interest the annuity
investment will earn. These guarantees and assurances are appealing to the conservative
investor.
The moderate to aggressive investor can utilize this type of annuity as a stabilizing factor
in his overall portfolio. The guarantee a fixed annuity offers, when used along with other
investments (i.e., real estate, stocks, bonds, gold, mutual funds), can help a diversified
investor feel secure in his overall investment program.
IMPORTANT CHARACTERISTICS OF FIXED AND VARIABLE ANNUITIES
Some important shared characteristics of fixed and variable annuities are:
•
Retirement income is the primary purpose.
•
Purchase methods.
8
•
•
•
•
Annuity options.
Accumulation and annuity periods.
Partial surrender provisions.
The guarantee of expense and mortality.
IMPORTANT DIFFERENCES BETWEEN FIXED AND VARIABLE ANNUITIES
Some important differences between fixed and variable annuities are:
•
There is no guarantee of the principal, interest, or the amount of
payment in variable annuities.
•
The annuitant bears investment risks in variable annuities.
•
Variable annuities are regulated by the state and federal government.
DECLARED-RATE FIXED ANNUITIES
Fixed annuities pay an interest rate that is guaranteed for one or more years and have
surrender charges that typically decrease over one or more years. A fixed annuity refers
to the interest rate paid by the insurance company on the funds deposited into the annuity.
When an individual purchases a fixed annuity, he or she knows the current and
guaranteed interest rates; he or she also knows that fixed rates of interest will be earned
on the contract values as long as the contract remains in place.
Fixed annuities offer security because the rate of return is certain and declared in
advance. The risk of performance falls on the company issuing the annuity and the
annuitant does not have to assume responsibility for investing the money.
In addition, the fixed nature of these annuities applies to the amount of the benefit to be
paid out during the annuitization period, as well.
FIXED INDEXED ANNUITIES
Fixed indexed annuities are fixed annuities where the current credited interest rate is
determined based on a formula applied to an external financial index such as the Standard
and Poors 500 (S&P 500). Within the limits of availability in the contract, the annuity
owner determines which index (or multiple indexes) are used to determine the current
credited interest.
TWO-TIERED ANNUITIES
A Two-Tiered Annuity is a product containing three different values. These values are
tier-one value, the surrender value, and the tier-two value. The tier-one value is the
premium accumulated with interest earnings, just like a regular fixed annuity. This value
is available to clients who decide to surrender their contracts for lump-sum after the
surrender charge period.
9
The second value is the surrender value, which is the tier-one value less any applicable
surrender charge. The surrender value is available to clients who decide to surrender
their contracts for lump-sum during the surrender charge period.
The third value is the tier-two value, which provides a benefit that is typically higher
than the tier-one value; it is only available to clients who annuitize their contracts. Tiertwo benefits may include higher interest rates, higher index crediting, bonuses, or other
benefits that encourage the client to annuitize, thereby leaving assets longer with the
insurance company. In most two-tier annuity products, clients must wait a certain period
of time before they can access these higher tier-two values.
Why would a client buy a two-tier product? Two-tier products can be valuable in several
ways. If clients have a need for a lifetime stream of income, they may receive higher
lifetime benefits under a two-tier product than under a regular deferred or immediate
annuity that is annuitized. Secondly, due to the design and pricing of two-tier products,
tier-one credited rates could be higher than a non-tiered deferred annuity as a result of
better participation rates, caps, or fees.
What are some of the disadvantages of two-tier products? These products may not be
suitable for clients who have short-term liquidity needs or a desire to pass on lump-sum
benefits to their heirs. In addition, clients usually have to wait a specified period of time
before receiving the higher tier-two values. Keep in mind that annuitization is required to
receive those values, which spreads the benefits out over a longer period of time. Usually
the annuitization must occur over at least a 10 year period.
Insurance agents should make very clear to clients who are considering a two-tiered
annuity the different values, how to access their values, and the restrictions or
consequences when they do. Clients should assess their needs and examine all aspects of
an annuity product before determining if a particular annuity design fits their needs and
financial goals.
PARTIES TO AN ANNUITY CONTRACT
The participating parties in the annuity contract are the insurer (insurance company or
financial organization), the contract owner, the annuitant, and the beneficiary.
THE INSURER
Although annuities are not life insurance contracts, many reasons exist that permit life
insurance and annuity contracts to work hand-in-hand to offer the contract owner the
ultimate in financial protection. An annuity guarantees an income, no matter how long
the annuitant lives. While life insurance provides protection against dying too soon,
annuities provide protection against living too long.
CONTRACT OWNER
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It is the contract owner’s right to choose and manage the investment options:
•
Add additional funds.
•
Withdraw any portion of the funds already deposited.
•
Change contract parties (i.e., annuitant, contingent annuitant,
contingent owner, beneficiary).
•
Terminate the annuity.
The contract owner does not have to be one individual, but must be a legal adult. If the
contract owner is a minor, the policy must include the minor’s custodian or legal
guardian as co-owner. The contract owner can also be a couple, a partnership, a trust, or
even a corporation.
ANNUITANT
Any person whom the contract owner chooses to name as the annuitant (i.e., self, family
member, etc.) must be currently living and must meet the insurance company’s age
restrictions for issuing the annuity. Generally, the annuitant must be younger than 95
years old on the date of application, although the precise requirements will vary by
insurance company. The contract owner has the option to change the annuitant at any
time, but most annuities require that the new annuitant was alive when the original
contract was executed. In the majority of cases, the contract owner and the annuitant are
the same person. For purposes of this course, unless specified otherwise, all
discussion and examples will assume the contract owner and annuitant to be the
same individual.
An annuitant is the equivalent of the insured in a life insurance policy; however, the
annuitant cannot:
•
Control the contract.
•
Make withdrawals.
•
Make deposits.
•
Change the parties to the contract.
•
Terminate the contract.
A life insurance policy names an insured party and remains in effect until:
•
The owner terminates the contract.
•
The owner fails to make premium payments when due.
•
The insured dies.
An annuity contract remains in effect until:
•
The contract owner makes a change.
•
The annuitant dies,
BENEFICIARY OR MULTIPLE BENEFICIARIES
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The beneficiary(ies) named on the annuity contract receive the proceeds of the annuity
upon the death of the annuitant. The beneficiary(ies) are designated by the contract
owner and may be family members, one or more individuals, a trust, a corporation, or a
partnership. The annuity contract permits multiple beneficiary designations--at the
direction of the contract owner. For example, a beneficiary designation may be listed so
that the spouse of the contract owner will receive 70% of the annuity contract value, and
the contract owner’s three children will each receive 10% of the contract value.
The contract owner retains complete control over the annuity contract during his or her
lifetime by naming him or herself as contract owner and/or annuitant, and naming one or
more parties as beneficiary(ies).
Most insurers stipulate minimum and maximum age limits for the both owner and the
annuitant. Since the beneficiary is the party receiving the proceeds of the annuity upon
the death of the annuitant, and the contract is terminated at the payout, no age limits exist
pertaining to the beneficiary. The minimum and maximum ages are used to determine
the minimum age at which an annuity contract may be issued and the maximum age that
the annuity contract may be issued. The minimum age is typically 0 but, in some cases, it
is 18. Maximum age depends on the insurer and usually ranges between 60 and 90; the
majority of insurers stipulate maximum ages as being 85 or 90.
MULTIPLE TITLES FOR ONE INDIVIDUAL
The contract owner has the option of assigning multiple titles to himself or herself, the
annuitant, or the beneficiary. If the contract owner designates a living trust or a
corporation as beneficiary, the corporation or trust may only be the contract owner and/or
beneficiary. The annuitant must be a living individual meeting the insurer's age
restrictions.
STRANGER ORIGINATED ANNUITY TRANSACTION (STAT)
A Stranger Originated Annuity Transaction is a transaction initiated for the benefit of
an investor who has no relation to the person upon whose life the annuity is based,
and once the transaction is completed, neither the annuitant nor his or her
beneficiaries will have any further interest in the annuity benefits. These transactions
have occurred in several states and some of these transactions are being litigated.
CHARACTERISTICS OF A STAT
•
•
•
•
Single premium annuity with death benefit if annuitant dies before
annuitization date.
Owner has no clear insurable interest in annuitant.
Annuitant is an unrelated terminally ill person (often recruited through a
hospice).
Annuity application does not ask health questions.
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•
•
•
•
Originating transaction is small to fly under radar and more funds are added
later.
Multiple annuities issued on same day with different companies so annuitant
not on more than one annuity with a single insurer.
Annuitant paid a fee for participating and has no other interest in the annuity
or benefits.
Annuitant often unclear that they are participating in an annuity (often told
they are helping a charity).
REGULATORY ISSUES AND CONCERNS WITH STATS
INSURABLE INTEREST
Annuity owner is a stranger to the annuitant and has no insurable interest. Often the
annuitant is picked based on their diminished health or terminal illness.
REBATING
Annuitant is paid a fee “as an inducement” to participate in the annuity contract. This
could be a violation of rebating or commission sharing laws in most states.
RESCISSION
Do the insurers have a rescission right if the annuity owner had no insurable interest
in the annuitant?
So far the main concern for the annuity industry is with variable annuities that offer a
guaranteed living benefit (GLB) rider.
Currently the National Association of Insurance Commissioners (NAIC) and several
state regulatory offices are reviewing the issue of Stranger Originated Annuity
Transactions to determine if a regulatory response is indicated.
ANNUITY CONTRACT PROVISIONS
INTEREST RATE CREDITING
Regulations require that annuity companies invest most of their portfolios in a
conservative manner. With this in mind, insurers don’t have a large portion of their
general account invested in equities or real estate. Most insurers invest the majority of
these funds in bonds.
In building their bond portfolios, insurers have flexibility in determining the mixture of
bond ratings (quality) and average maturity. A bond’s rating can affect the yield of the
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bond. The higher a bond’s rating the lower the yield. The maturity date of the bond can
also affect yield: The longer the maturity date on a bond the higher the yield.
The company will invest the annuity premiums in one or more bond portfolios, but the
return is only loosely related to the performance of the bonds. The actual return to the
investor may be more or less than the performance of the underlying portfolio, especially
in the short term.
NEW MONEY RATE INTEREST CREDITING STRATEGY
The new money interest crediting strategy is also called bucket crediting strategy. In
utilizing the new money interest crediting strategy, an insurer places the incoming
annuity premium deposits during a given time period (the time the current bucket is open)
into a segregated portfolio (bucket). Incoming premiums are directed into the same
bucket as long as interest rates remain relatively stable. Once a significant change in
interest rates occurs the insurer closes the current bucket which means no new premiums
will be accepted into the bucket. A new bucket is now opened to accept future incoming
premiums. In a period of widely fluctuating interest rates, an insurer may open and close
a bucket in as short a period as one week.
At renewal time the insurer evaluates each bucket to determine the renewal rate. The cash
flows from the underlying investments, reinvestment of the undistributed cash flows, and
the market value of the investment portfolio within the bucket and several other businessrelated metrics affect the renewal rate.
The renewal rate for each bucket applies only to contracts issued while that particular
bucket was open.
PORTFOLIO-BASED INTEREST CREDITING STRATEGY
The portfolio-based interest crediting strategy is much simpler than the new money
strategy. One large portfolio is created and is not segregated as in the new money
strategy. All incoming annuity premiums are directed to this one portfolio. The return of
that portfolio is used to establish the interest rate for all annuity owners who buy that
particular annuity. At renewal time the insurer evaluates the portfolio to determine the
renewal rate for all who own that annuity.
Most insurers using the portfolio-based interest crediting strategy apply one interest rate
to all annuity owners within the portfolio.
Some insurers using the portfolio-based interest crediting strategy will credit interest on a
calendar-year basis. For example, let's say that an insurer using the portfolio-based
interest crediting strategy declares the rate for the annuity each year on January 10.
Regardless of when during the next year a consumer buys that annuity, they will earn that
declared interest rate until next January 10.
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There are many proponents and detractors for each of the above interest crediting
strategies.
INITIAL INTEREST RATE
Some insurance companies offer initial interest rates that are above market (or actual
portfolio return) for a limited period of time, typically one year.
At the end of the first year, the initial guarantee expires and the annuity begins to be
credited with "current credited" rate. This current credited rate is whatever the insurance
company decides to pay, limited only by a "guaranteed" rate contained in the contract.
MULTI-YEAR GUARANTEED INTEREST ANNUITIES (MYGIA)
This category of annuities contains products that guarantee interest for the same number
of years during which surrender charges exist. For example, annuity products that have a
5-year guaranteed interest rate and a 5-year surrender charge are examples of multi-year
guaranteed interest rate annuities. Often the term CD-type annuities is applied to these
annuities.
INTEREST RATES – GUARANTEED AND CURRENT
In general, insurance companies offer two interest rates in fixed annuities. The
guaranteed rate is the minimum rate of interest the insurance company will credit on all
funds in the annuity, regardless of interest rates available in the marketplace. The current
rate is a rate of interest that the insurance company credits based on the investment return
within its general accounts (discussed above). The current rate is generally revised once
a year but can be adjusted more frequently, depending upon the annuity.
BONUS ANNUITIES
First Year Bonus
The most common type of annuity bonus is a First Year Bonus, which offers a higher
first-year interest rate, usually guaranteed for one year. The "base rate" is the interest rate
the company projects it will pay in the second year and thereafter, but this rate is NOT
guaranteed in most cases. The difference between the actual rate in the first year and the
projected base rate for subsequent years is the bonus rate. Quite often, the renewal rate a
company declares on each contract anniversary date beginning in the second year is
different than the projected base rate. The first year bonus is used as an inducement to
move large blocks of money into an annuity.
Premium Bonus
Some annuity contracts will offer a premium bonus instead of a first year bonus. For an
individual who doesn’t have a large sum of money to deposit into an annuity, the
motivation is greater to elect a smaller “bonus” on all premiums paid into the annuity for
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a number of years. Some annuity contracts offer a premium bonus as high as two percent
for the first five years of premium payments into the contract.
Annuitization Bonus
Some annuities offer an annuitization bonus to encourage annuitization. While the terms
of annuitization bonuses vary from one annuity to another they do share common
characteristics such as:
•
•
•
A requirement for a minimum holding period before bonus is available.
A set amount (usually expressed as a percent of the contract value) is added to the
annuity value when annuitized. Examples: 2% added after the 5th contract year,
OR 1% added per contract year up to a maximum of 10%).
Minimum annuitization time period required (usually at least 5 year period
certain…some require lifetime annuitization).
Vesting of Bonus amounts
The bonus amounts calculated based on the specific bonus feature will be paid in addition
to the current rate; it may or may not be forfeited, depending upon the contract
provisions. In many cases, a bonus rate of interest is forfeited if the annuitant withdraws
funds prior to the end of the surrender period or earlier than a stated policy year of the
contract.
Generally, the larger the bonus the more restrictive the surrender terms on the bonus
amounts. Some annuity contracts stipulate that the bonus amounts are forfeited if the
annuitant makes withdrawals without annuitizing the contract. Other contracts begin a
multi-year vesting period after the traditional surrender period has expired. For example,
if the annuity has a seven-year surrender period, the bonus amounts may vest at 33 1/3
percent per year in years eight through ten. The multi-year vesting schedule is designed
to increase persistency.
RENEWAL INTEREST RATES
The renewal interest rate is credited to an annuity in the years following the initial rate
and will be calculated and declared using the interest rate crediting strategies discussed
earlier.
MINIMUM GUARANTEED RATES
The minimum interest rate that is guaranteed for the life of the annuity is also known as
the nonforfeiture rate. State departments of insurance mandate that annuities provide a
lifetime guaranteed interest rate (which can vary between 1.5% and 3%). An insurer may
guarantee a rate higher than the nonforfeiture rate but they are not required to do so.
16
ISSUE AGE GUIDELINES
Most insurance companies allow annuities to be purchased by individuals (both contract
owner and annuitant) until they are age 90. Minimum issue age is often set at age 0.
However, other insurance companies will set the maximum age for contract owners and
annuitants to be 80 or 85. Some annuities will have shorter surrender charge periods for
issues ages over a certain age (usually age 70). Many annuity companies will offer
multiple annuity products with some products not available for clients over a certain age.
The minimum and maximum issue ages are usually expressed as the age of the annuitant,
but many insurers will specify the minimum or maximum issue age applies to the owner
or annuitant.
ANNUITY DATE
The annuity date is the date at which the annuitant begins to receive annuity payments.
This date is the earlier of the optional date elected by the annuitant or the maturity date.
The maturity date is the latest date the annuitant may defer annuity payout options and is
stated in the contract. Many contracts stipulate that the annuitant may change the maturity
date; however, the new maturity date may be the last day of the term but may be no later
than the maximum age stated in the contract. The maturity date is often misunderstood.
It is typically the last date by which the annuitant must take receipt of the proceeds -and
not the first date on which proceeds may be withdrawn without surrender penalties.
The IRS does not require age limits when benefits are paid but most insurance companies
establish annuitization limits at age 80 to 85; others establish the maximum age at 100. It
is important for an agent to know what age maximums apply to both contract owners and
annuitants, since differing age limits will affect a variety of features of an annuity.
WITHDRAWAL/SURRENDER CHARGE WAIVERS
NURSING HOME WAIVER
Some insurance companies include a special feature to provide additional liquidity
without surrender charges. Their annuity contracts offer a waiver of the contract’s
surrender charges or withdrawal penalties in the event the annuitant is either hospitalized
or confined to a nursing home for a certain period of time, such as 30 days or longer.
This provision allows the contract owner to withdraw funds from the annuity to pay
expenses or replace lost income associated with the hospitalization or confinement.
Other annuity contracts allow medically-related surrenders that are not subject to
surrender charges. Generally, there is a requirement that the annuitant be confined in a
medical care facility for a certain period of time or be diagnosed with a terminal illness.
Some insurers also permit the confinement of a spouse of the annuitant in a nursing home
to trigger the waiver.
The IRS applies a 10% penalty (premature distribution penalty) to withdrawals from
annuities that are made before annuitants reach age 59 ½. This penalty does not apply if
17
the annuity owner qualifies as being disabled, disability here being defined by the
Internal Revenue Code (IRC). The IRC definition may differ from the definition used in
the annuity contract. For purposes of the 10% premature distribution penalty tax, IRC
defines disabled as follows: “being unable to engage in any substantially gainful activity
by reason of any medically determinable physical or mental impairment which can be
expected to result in death or to be of long-continued and indefinite duration.”
TERMINAL ILLNESS WAIVER
Some annuities will waive all or part of a surrender charge if the annuitant is terminally
ill. Terminal illness usually requires a life expectancy of 6 month or less. Some insurers
also permit the terminal illness of a spouse of the annuitant to trigger the waiver.
UNEMPLOYMENT
A small portion of annuities offer an unemployment surrender charge waiver. When this
waiver is available, it always specifies that the annuitant be under age 65 at time of issue
and/or unemployment. Some unemployment waivers require that you have been
employed fulltime for a certain number of years (usually 2 or more) prior to issue date in
order to benefit from the waiver. In addition, the unemployment waiver will specify a
minimum period of unemployment such as 30 or 60 consecutive days before you can
make a withdrawal free of the surrender charge.
DEATH AND DISABILITY
Many insurance companies will waive surrender charges if the annuitant dies or becomes
disabled. It should be noted that a number of annuities will waive the surrender charge
upon death only if the beneficiary draws the funds out over at least a five year period.
WITHDRAWAL PRIVILEGE
In addition to the partial and full surrenders previously discussed, annuitants frequently
need to access funds for a variety of reasons. Many annuities allow annuitants to
withdraw up to 10% of their account value each year without applying surrender charges.
Similarly, other contracts allow for withdrawals of the interest in the account, or 10% of
the contract value, whichever is greater. Still other contracts allow the 10% withdrawal
amounts to accumulate each year to allow for accumulated withdrawals of 20%, 30%,
40%, etc. as time goes by.
BAIL-OUT
Some fixed annuities may have a bail-out provision (sometimes called an escape clause).
This feature allows the contract owner to cash in the contract without surrender charges if
the interest rate credited to the annuity falls below a certain predetermined level. An
example involves a provision with the bail-out rate specified to be 1% below the current
credited rate. In this instance, if the declared interest rate is more than 1% below the
current interest rate, the contract owner could surrender the annuity and not pay any
18
surrender charges. This provision provides peace of mind for the contract owner who
wants to move money in times that experience dramatically falling interest rates but
would not otherwise be able to do so.
PREMIUM PAYMENTS
As stated earlier in the text, all annuities can be classified as either single-premium or
flexible-premium annuities.
SINGLE PREMIUM ANNUITY
A single-premium annuity can actually involve multiple premiums that are all paid within
the first 60 days of the policy. If a consumer is consolidating funds from several sources,
it is unlikely that all of the funds will be available on the same day, so a single premium
annuity will allow several premiums as long as they are all made within a short period of
time.
PERIODIC OR FLEXIBLE PREMIUMS
Another type of premium is a periodic premium, or flexible premium. With this premium
option, the annuity owner can establish a planned or target premium to contribute on a
periodic basis (usually monthly) and make the premium payment over an extended period
of time. This premium arrangement is “flexible” in that the annuity owner can stop,
decrease, or increase the premium payments at will.
REQUIRED PREMIUMS VS OPTIONAL PREMIUMS
Most annuities have a minimum annuity premium to purchase a single-premium annuity,
and a minimum amount that each additional premium must meet for a flexible-premium
annuity. These lower premium limits are set to achieve economy of scale and provide the
consumer with a viable product. In addition, in a flexible-premium annuity the annuity
owner must continue annuity premiums until the contract meets a minimum stated value.
Otherwise the insurer will close the annuity and return the funds to the owner.
Most annuities also have upper limits to annuity contributions. These upper limits are
usually more than the average consumer has to invest, so they are rarely a limiting factor.
In the case of a qualified annuity, such as an IRA or 401(k), the upper limit is based on
tax code, and the annuity company (acting as plan administrator) will have to report all
contributions to the IRS. There is a potential tax penalty ff the annuity owner contributes
more that the relevant tax code section allows.
SURRENDER CHARGES AND PENALTIES
While insurance companies independently determine how surrender charges and
penalties are structured (subject to state DOI approval), most utilize a charge that
decreases over a specified number of years. The charge is usually a percentage of the
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contract values and is also referred to as a contingent deferred sales charge (in the case of
a variable annuity). Most insurers apply a surrender charge when either funds are
withdrawn (a partial surrender) or the annuity is surrendered (a full surrender) in the early
years of the contract.
Although not common, some insurance companies apply the surrender charge to each
deposit made into the annuity. This type of surrender charge typically applies to flexiblepremium annuities. For example, each deposit is tracked by the company, and if
withdrawals are made or the contract is surrendered, the surrender charge is calculated
based on the amount of the withdrawal/surrender with respect to the size and date of the
deposits. For purposes of calculating the surrender charge, if the annuity owner makes a
withdrawal, then the funds are considered to be drawn first from the first premiums
contributed.
An example of a surrender charge schedule might look like the following:
Contract Year
Surrender Charge or
Penalty
8%
7%
6%
5%
4%
3%
2%
1%
1
2
3
4
5
6
7
8
Note: These surrender charges do not reflect the 10% penalty imposed by IRS if
withdrawals and surrenders are made prior to age 59 ½.
MARKET VALUE ADJUSTED ANNUITIES
Some fixed annuities impose a market value adjustment (MVA) on surrenders and
withdrawals prior to the end of the index period. MVAs adjust the amount surrendered or
withdrawn to reflect the effect of current economic conditions on the value of the
insurance company’s invested assets (generally bonds), supporting the guaranteed
crediting rate of fixed indexed annuities. Under some fixed indexed annuities, the MVA
adjustment can be positive--in which case the withdrawal or surrender proceeds will be
reduced--or negative--in which case these proceeds will be increased to reflect asset
gains. In every case, however, an MVA adjustment will not be allowed to reduce product
values below the minimum guaranteed values required by state insurance law. This
provision maintains the insurance status of the product by limiting the degree of
investment risk transferred to the owner by insurance company.
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MVAs on annuities and life insurance policies have been around for over a decade, but
MVAs on annuities have become much more popular, particularly since early 1990-when the Fed began decreasing rates at a rapid pace.
An MVA can be attached to a deferred annuity that features fixed interest-rate guarantees
combined with an interest rate adjustment factor. The MVA may cause the actual
crediting rates to increase or decrease in response to market conditions.
HOW THE MVA WORKS
The contract owner places money in an account that earns a fixed rate of interest. The
insurer holds the contract owner’s money in this account for the length of the designated
guarantee period. At the end of the guarantee period, there is usually a “window” when
no withdrawal charges or market value adjustment will apply.
At the end of the guarantee period, the insurer declares a new current interest rate, or
renewal rate, which may be higher or lower than the previous rate but will not be lower
the minimum interest rate guaranteed by the policy (typically 3% or 4%).
HOW THE MVA IS DIFFERENT
If a contract owner wants to surrender the annuity prior to the end of the guarantee
period, an adjustment will be made. The actual contract value received has the potential
to be positively or negatively affected by current market conditions. Because the issuing
insurance company has invested the premium to ensure it can pay the rate guaranteed in
their contract, it could lose money if it had to sell those investments at a discount to
refund premiums paid plus their earnings. The reverse can also be true.
RISK FACTOR
The MVA serves to protect the insurance company against investment losses incurred by
early withdrawals. When having a more predictable pattern of withdrawals, MVA
annuities offer a greater potential to credit higher interest rates than the traditional fixed
annuity does.
As with equities, bonds, and variable annuity products, MVA annuities provide
opportunities for market gain. But they also offer the security found in traditional fixed
deferred annuities, typically with no extra sales or administrative fees. In a declining
interest-rate environment, the annuitant has the security of a guaranteed rate common to
fixed annuities.
In addition, due to the bond-like mechanics of the MVA feature, the market-adjusted
value of the product actually increases as interest rates decline. In this environment, the
credited rate should be better than new money alternatives, which show a decline after
the annuity is issued.
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On the other hand, in an increasing rate environment, the market-adjusted value of the
contract may decrease, as with a bond. When this happens, insurers offer different
product architecture. One may sell a MVA where, unlike a bond, the annuitant is
guaranteed the surrender value will never be less than premium paid accumulated at
minimum guaranteed interest, less applicable surrender charges. Other insurers may not
offer this feature.
CONTRACT ADMINISTRATION CHARGES AND FEES
Most insurers charge an annual contract fee per annuity contract, expressed as a flat
dollar amount. Some insurers will only charge one annual contract fee per annuity owner
regardless of how many separate annuities the annuity owner has with their company.
The annual contract fee is usually a nominal amount ($20 to $45 annually) and rarely
exceeds $100 per year. The annual contract fee is disclosed in the contract.
CUSTODIAL FEES
In addition to the annual contract fee, there may be additional fees or charges if the
annuity is within a qualified plan and the annuity company is acting in a custodial or plan
administrator capacity. These additional fees are charged to offset the additional reporting
costs associated with a qualified annuity. The custodial/plan administrator fees are
usually $15 to $25 per year and will be disclosed in the policy.
SPREAD /ASSET OR MARGIN FEE
Some fixed indexed annuities charge a spread fee, or margin fee, as part of the interest
crediting formula. Insurance companies that use the spread, or margin, method calculate
the increase in the chosen index for that policy year or term, then subtract a percentage
from the change. This spread or margin fee is usually expressed as a percentage and will
be disclosed in the contract.
For example, if the gain in the chosen index for a policy year was 9% and the insurance
company used a spread of 2%, 7% would be credited to the contract for that year
(possibly subject to a cap).
LOADING AND MANAGEMENT FEES
ADMINISTRATIVE FEES
Variable annuities will often charge a separate fee for administration and a separate fee
for the annual contract fee. The issuing insurance company usually charges an
administrative fee expressed as basis points charged against the annuity value.
CONTRACT FEE
Many insurance companies charge a flat dollar amount varying from $20.00 to $40.00
per year.
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SUB-ACCOUNT FEES
The charges for the operation and management of the sub-account range from .15% to
1.5% of assets.
OTHER FEES
In addition to the fees and charges listed above, there can be additional charges for riders
such as a death benefit, guaranteed income benefit, or other living benefit. While these
charges don’t fall under the heading of Contract Administration Fee or Charges, they are
additional expenses that will be charged, and the consumer needs to understand them.
WITHDRAWAL PRIVILEGE OPTIONS
As discussed earlier, in addition to the partial and full surrenders previously discussed,
annuitants frequently need to access funds for a variety of reasons. Many annuities allow
annuitants to withdraw up to 10% of their account value each year without the surrender
charges applying to these withdrawals. Similarly, other contracts allow for withdrawals
of the interest in the account, or 10% of the contract value, whichever is greater. Still
other contracts allow the 10% withdrawal amounts to accumulate each year to allow for
accumulated withdrawals of 20%, 30%, 40%, etc. as time goes by.
WITHDRAWAL PRIVILEGE OPTIONS QUALIFIED ANNUITIES
If an annuity is a qualified annuity, the annuity will likely amend the wording of the
withdrawal privilege option to allow that the amount which can be withdrawn surrenderpenalty-free in any given year is the greater of either the stated percent (usually 10%) or
the required minimum distribution for that year. These annuities are often described as
“RMD friendly”.
ANNUITIZATION
All type of annuities will allow the annuity owner to annuitize the annuity. The process of
annuitization for each broad category of annuity is described below. It is possible with
any type of annuity to have some guaranteed lifetime income rider, annuitization bonus,
or other option or rider that will somehow enhance the annuity amounts calculated. Each
of these potential enhancements to the annuity amounts should be separately examined
for restrictions and benefits.
One thing that all annuity products have in common is that annuitization is effectively a
trade of the contract values for the annuity benefits (stream of payments) guaranteed in
the annuitization option. Annuitization is an irrevocable decision and once started can not
be reversed.
Most companies will allow an annuity owner to annuitize all or part of the annuity
contract.
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INFLATION DURING ANNUITIZATION
Many annuities offer an inflation adjustment or rider during the annuitization
(distribution) period. These inflation benefits vary from product to product and should be
evaluated separately.
ANNUITIZATION OF A FIXED ANNUITY
With the fixed annuity annuitization involves paying out the contract value over the
selected annuitization period or option (see annuitization settlement options below). The
contract will stipulate the interest rate and mortality tables to be used in the annuitization
calculations.
ANNUITIZATION OF A VARIABLE ANNUITY
Annuitization is one of the least utilized and most often misunderstood options of a
variable annuity contract. The contract owner may elect to allocate all or part of the
value of the contract to either the fixed account and/or the separate account. Allocations
to the fixed account will provide annuity payments on a fixed basis; amounts allocated to
the separate account will provide annuity payments on a variable basis reflecting the
investment performance of the underlying subaccount.
FIXED ACCOUNT
The contract owner may transfer all or part of the value of the contract to the fixed
account, sometimes called the guaranteed account, and elect to annuitize these funds. In
essence, for a fixed dollar amount the contract owner purchases a monthly income that
will be paid until the contract owner’s death.
For example, a 68-year old male could receive a monthly income that would be payable
to himself as long as he is alive, or to his beneficiary should he die within the first ten
years. This option is known as Life Annuity with Payments for a Guaranteed Period; in
this case, the guaranteed period is ten years.
Contracts include a payout table stating the minimum payout guaranteed by the insurance
company based on age and gender (depending upon state law). When the contract is
annuitized, the payout will be based on either the guaranteed amount stated in the table or
the current values used at that time, whichever is higher.
In this example, according to the payout table, for every $1,000 that is annuitized under
the Life Annuity with Payments Guaranteed for 10 Years Option, the monthly payout
would be $5.68. This is the amount that was guaranteed at the time the contract was
issued. The current payout rate the company is using is $7.93. All payout rates are
expressed as dollars per period (monthly, quarterly, semi-annually, annually), per $1,000
dollars.
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If this individual elected to annuitize $30,000, his monthly payout would be $237.90 per
month. This payout amount is guaranteed as long as he is alive. Should death occur in
the first ten years, his beneficiary would receive the difference between ten years of
monthly income and the amount he actually received.
SEPARATE ACCOUNT
The contract owner may transfer all or part of the contract value to one or more of the
sub-accounts that are available in the separate account. He or she may elect to annuitize
those funds.
For example, if there were 12 sub-accounts available in the separate account, the contract
owner could transfer $25,000 to the Growth & Income sub-account and $30,000 into the
international sub-account and annuitize each account.
The difference between annuitizing funds in the fixed account and the separate account is
that funds in the fixed account produce a guaranteed income that will not change from
period to period. Funds that are annuitized in the separate account produce an income
that will change from period to period based on the performance of the sub-account in
which funds are placed.
ANNUITIZATION SETTLEMENT OPTIONS
Settlement options are the methods by which an insurance company pays annuity
proceeds to the annuitant, contract owner, or beneficiary(ies).
Annuities offer a variety of options to provide annuitants with long-term income
payments. Regardless of the type of settlement option, the annuitant may choose to
receive payments, monthly, quarterly, semi-annually, or annually. In addition to the
settlement options listed below, many annuities offer guaranteed income streams without
the need for annuitization.
PERIOD CERTAIN ONLY
Period certain means that income payments will be made over a specified number of
years chosen by the annuitant. Payments will continue for the duration of the period
certain and at the end of that term, will cease. If the annuitant dies before the end of the
stated number of years, the beneficiary(ies) continue to receive payments for the
remainder of the period certain. Most annuity contracts only allow annuitization over a
limited choices of certain periods (3 yrs, 5yrs, 10 yrs etc), however; some annuity
contracts allow the annuity owner to specify a dollar amount of the periodic annuity
payment and then “back in” to the length of the period certain.
LIFE ONLY
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The life only option provides for payments that continue throughout the life of the
annuitant. The annuitant cannot outlive income. Upon the annuitant’s death, however,
payments cease, regardless of the length of time payment have been made.
LIFE AND PERIOD CERTAIN
Life and period certain means payments will continue for the rest of the
annuitant’s life but for no less than the stated number of years—even if the
annuitant dies. If the annuitant dies before the end of the period certain, the
beneficiary(ies) continue to receive the payments for the remainder of the period
certain.
LIFE ONLY WITH GUARANTEED MINIMUM OPTION
The annuitant receives payments that continue for life. If the annuitant dies
before the initial investment in the annuity has been repaid, the balance of the
initial investment will be paid in like installments to the beneficiary(ies).
JOINT AND SURVIVOR
When a joint and survivor annuity contract is issued on a couple (usually and husband
and wife), or if the beneficiary opts for a joint and survivor payout, the contract provides
a payout for as long as either of the two annuitants/beneficiaries is alive. The amount of
each payment is usually less than if it were based on a single individual. They may
choose to have payments either remain the same or decrease after the death of the first
annuitant. For example, after the first annuitant/beneficiary dies, the other may choose to
have payments reduce to two-thirds of the amount paid while both annuitants were alive.
This is called a joint and two-thirds annuity.
DEATH BENEFITS
Most annuities have a death benefit that will be paid to the annuity beneficiary if the
annuitant dies before annuitization begins. Once annuitization has begun, the
annuitization option will determine what amounts (if any) flow to the beneficiary when
the annuitant dies.
If the annuitant dies while a surrender charge still applies to the annuity, the amount and
timing of the death benefit may be impacted by the surrender charge and/or waivers
related to the surrender charge.
TRADITIONAL FIXED-ANNUITY DEATH BENEFIT
With a traditional fixed-annuity, the death benefit (prior to annuitization) usually pays the
beneficiary an amount equal to total contributions to the annuity, less any withdrawals or
loans made during the annuitant’s lifetime and plus the guaranteed interest or actual
interest credited.
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FIXED INDEXED ANNUITY DEATH BENEFIT
Since the Fixed Indexed Annuity credits interest based on a formula applied to an
external financial index and does so at the end of the index period (usually annually), it is
likely that, if the annuitant dies prior to annuitization, it will be during an index period.
Since a new index period begins the same day an old index period ends, the probability of
the annuitant dying during an index term is addressed in each fixed indexed annuity.
While each fixed indexed annuity can vary in the wording of the death benefit, they
generally follow the formula below. If the annuitant dies during an index period, and
there have been no partial withdrawals, the designated beneficiaries usually receive the
greater of:
•
The total of premiums paid premium.
•
The surrender value on the date of death.
•
The indexed value on the most recent anniversary.
If the annuitant were to happen to die on the day the index period ends, the designated
beneficiaries receive the surrender value. Upon death, the proceeds may be distributed in
a lump sum or in level amounts; these payments may be made over a certain period of
time or during the lifetime of each beneficiary.
VARIABLE ANNUITY DEATH BENEFIT
In event of the annuitant’s death during the accumulation period of a variable annuity,
most insurance companies include some form of Guaranteed Minimum Death Benefit
(GMDB). In a simplified version of the GMDB, the death benefit paid to the beneficiaries
is the greater of:
• The contract value at the time of death.
• The total premiums paid into the contract.
• The contract value on the prior (i.e., 5th, 6th, 7th) Anniversary Date of the
contract.
The particular wording of each GMDB can vary among variable annuities and often
include a ratchet, anniversary, or high water mark in the computation of the GMDB. The
GMDB is a feature that is offered on variable annuities, and a fee is paid by the annuity
owner to cover the mortality risks associated with this protection. Like most variable
annuity fees, it is expressed as basis points applied to the contract value.
DEATH BENEFIT SETTLEMENT OPTIONS
Regardless of the type of annuity, once the amount of the death benefit has been
determined, the beneficiary usually has several settlement options available.
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LUMP SUM VS. EXTENDED PAYOUT
If the beneficiary is a spouse of the annuitant they often have the option to “assume” the
annuity and continue as if they had always been the annuitant. There are potential tax
advantages to the assumption of the annuity, and these will be discussed in our Annuity
Taxation Chapter.
The beneficiary usually has the choice of taking the death benefit in a lump sum or
receiving the death benefit amount under one of the annuity settlement options discussed
above under Annuity Settlement Options.
DEATH BENEFIT SETTLEMENT OF A QUALIFIED ANNUITY
If the annuity death benefit is coming from a qualified annuity, there are several tax
considerations that can affect the settlement option chosen, and these will be discussed in
detail in our Annuity Taxation Chapter.
PRINCIPLE GUARANTEE
SAFETY
A fixed annuity is a safe investment. An authorized insurance company is required to
meet its contractual obligations to its policyholders. Its reserves must, at all times, be
equal to the actuarially-computed net withdrawal value of it annuity policies issued in a
particular risk pool. Additionally, in regulating reserves state law also requires certain
levels of capital and surplus to further increase policyholder protection. “Legal reserve”
refers to the strict financial requirements that must be met by an insurance company to
protect the money paid in premiums by policyholders. These reserves must be equal to
the withdrawal value (principal plus interest less any early withdrawal fees) of every
annuity policy.
A fixed annuity guarantees the safety of invested principal and a minimum rate of return.
As long as funds are not withdrawn when subject to a surrender charge, the annuity
owner is guaranteed to receive all of their principal and a minimum interest rate.
A variable annuity does not guarantee safety of principal unless the annuity owner
purchases a Guaranteed Minimum Accumulation Benefit or a Guaranteed Minimum
Account Balance, (GMAB…often called a “walk away” benefit), both of which are
considered living benefits. In order to take advantage of the GMAB, the annuity owner
must satisfy a minimum holding period (usually 3 years or longer) and pay an additional
fee for the guarantees offered by the GMAB. Since the underlying subaccounts in a
variable annuity can include equity investments, the annuity owner bears the risk to
principal unless they transfer this risk through the purchase of a GMAB.
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LOAN PROVISIONS
Most non-qualified annuities do not offer a loan provision. When a loan provision is
offered in a non-qualified annuity, there will be interest charged on the loan and a
required repayment schedule. Annuities are considered long-term accumulation vehicles
and should not be relied upon for short-term cash needs.
Many qualified annuities (particularly those used to fund 403(b) and 457 plans) offer a
loan provision. There are strict IRS guidelines on the amount that can be borrowed, how
it must be tracked, and when it must be repaid (see qualified annuity taxation in our
Annuity Taxation Chapter).
ADDITIONAL CONTRACT PROVISIONS FIXED INDEXED ANNUITIES
FIXED INDEXED ANNUITIES
Fixed indexed annuities were established in the mid-1990s by insurance companies to
compete with popular indexed mutual funds. An indexed annuity earns interest that is
linked to a stock or other, such as Standard & Poor's 500 Composite Stock Price Index
(the S & P 500). There are a number of different indexes used in indexed annuities, and
often the annuity owner can allocate funds within the annuity among several different
indexes concurrently.
The amount of interest credited to a fixed indexed annuity is determined by a formula
applied to one or more external indexes. This formulaic approach to calculating interest is
usually called the indexing method, and there are several indexing methods that are used.
Most of the indexing methods have “moving parts,” which are values within the indexing
calculation that can be adjusted periodically by the insurer. These “moving parts” within
the formula are usually guaranteed by the insurer to stay within a certain range (minimum
and maximums) for the lifetime of the annuity. These “moving parts” can only be
adjusted by the insurer on a forward-looking basis. For example: one of the “moving
parts” is often a cap rate (defined later). If a particular fixed indexed annuity has an
indexing period of one year, the company must set the cap rate (if any) at the beginning
of the indexing year and cannot change that particular moving part until the end of the
current indexing year. Another way to put it is that the insurer cannot change a “moving
part” on a retrospective basis.
The fixed indexed annuity, in its simplest form, is an annuity product that:
1. Provides some of the potential long-term growth of the chosen index.
This means that the interest rate credited by the insurance company at the
end of each index period (usually policy year) is based on the performance
of the chosen index as measured by the indexing formula. The method by
which the interest rate is calculated is referred to as the indexing method
and may be subject to several moving parts, such as a participation rate,
cap rate, floor rate, or administrative/asset fee (defined below).
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2. Is a financial product that provides the downside guarantees of an annuity.
This means that once the contract owner makes a premium payment, he or
she will never have less value in the account than the sum of premium
payments made. Once interest has been credited to the fixed indexed
annuity, the value of the annuity will never decrease unless a withdrawal
is made and/or a surrender charge applies--even if the chosen index
decreases.
INDEXED ANNUITIES VS. TRADITIONAL FIXED ANNUITIES
An equity-indexed annuity differs from other fixed annuities in the way it credits interest
to an annuity's value. Most fixed annuities credit interest calculated at a rate stated in the
contract. The rate that is credited is determined by the insurance company. Fixed indexed
annuities credit interest using a formula based on changes in the index to which the
annuity is linked. The formula decides how any additional interest is calculated and
credited. How much additional interest a contract owner earns, and when it is credited,
depends on the features of the particular annuity.
Many equity-indexed annuities promise to pay a minimum interest rate. The rate that is
credited to the annuity value is agreed to be no less than this minimum guaranteed rate-even if the index-linked interest rate is lower. The value of an indexed annuity will not
drop below a guaranteed minimum amount.
For example, many fixed indexed annuity contracts guarantee the minimum value will
never be less than 90 percent (100 percent in some contracts) of the premium paid, plus at
least 3% in annual interest (less any partial withdrawals). The insurance company will
adjust the value of the annuity at the end of each term to reflect any index increases.
TERMINOLOGY
PARTICIPATION RATE
PARTICIPATION RATE
The participation rate is usually a “moving part”. The participation rate determines how
much of the increase in the index will be used to calculate index-linked interest credited
to the contract for that year. For example, if the calculated change in the index is 9% and
the participation rate is 70%, the index-linked interest rate for the annuity will be 6.3%
(9% x 70% = 6.3%). An insurance company may set a different participation rate for
newly-issued annuities as often as each day. Therefore, the initial participation rate in the
annuity will depend on when it is issued by the insurance company, However, once the
participation rate is set by the insurer it cannot be changed for the duration of the
indexing period (usually one policy year).
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When that period is over, the company sets a new participation rate for the next period.
Some annuities guarantee that the participation rate will never be set lower than a
specified minimum or higher than a specified maximum.
The participation rate may vary greatly between one annuity to another and may fluctuate
over time within a particular annuity. It is important for a contract owner to know how
the annuity's participation rate works with the chosen indexing method. A high
participation rate may be offset by other features, such as averaging or a point-to-point
indexing method. On the other hand, an insurance company may offset a lower
participation rate by also offering a feature such as an annual reset indexing method.
CAP RATE
CAP RATE OR CAP ON INTEREST EARNED
The Cap Rate is usually a “moving part”. Some annuities put an upper limit, or cap, on
the index-linked interest rate. This limit is the maximum rate of interest the annuity will
earn, regardless of the performance of the index. In the previous example, if the contract
has a 6% cap rate, 6%, and not 6.3%, would be the amount of interest credited to the
annuity. Not all annuities have a cap rate.
While a cap limits the amount of interest earned each year, annuities with this feature
may have other product features as well, such as annual interest crediting or the contract
owner’s ability to take partial withdrawals. Annuities that have a cap may also have a
higher participation rate. The Cap Rate is usually a “moving part” and is guaranteed to
never drop below 0%. There is usually no maximum cap rate guarantee.
FLOOR RATE
The Floor Rate is usually a “moving part”. Since many fixed indexed annuities guarantee
a minimum interest rate regardless of the performance of the index the Floor Rate will
only be found in annuities that do not guaranteed a minimum interest rate. The floor rate
will state that the annuity will be credited with a minimum rate of return regardless of
index performance.
When a floor rate is present it is usually guaranteed to never fall below zero.
SPREAD/ MARGIN/ASSET FEE
The Spread/Margin/Asset fee is usually a “moving part”. Instead of a Cap Rate and/or
Participation Rate, some insurers use a fee (called a spread/margin or asset fee) whereby
they calculate the movement in the chosen index for that policy year or term, then
subtract a percentage from the change.
For example, if the gain in the chosen index for a policy year was 8% and the insurance
company used a spread of 2%, 6% would be credited to the contract for that year.
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When a company chooses to use this approach, the maximum fee that can be charged is
guaranteed for the life of the contract.
RATCHET OR ANNUAL RESET
Many people mistaken assume that a Ratchet or annual reset is an indexing method, and
that is not true. The ratchet, or annual reset, locks in the gain for the just-completed
interest-crediting term. It does so by using the ending index value from the justcompleted indexing term as the beginning value of the index for the ensuing indexing
period. Once the interest is credited to the contract, it becomes part of the value of the
annuity contract even if the index drops in future years. The index calculation for each
policy year stands alone.
Once an annuity contract has been credited with its gain for a particular year, the gain can
never be taken away. If the index should experience a drop in value, the fixed indexed
annuity is protected.
COMMON INDEXING STRATEGIES
INDEXING METHOD
One of the most confusing aspects of indexed annuities is the method the company uses
to calculate the interest credited to the contract. The indexing method is the approach
used to measure the amount of change, if any, in the index. Some of the most common
indexing methods are explained more fully below.
All indexing methods essentially measure the change in the chosen index over some
period of time. The time periods used are either the policy year, from the day the policy
is issued, or a specific term, a period of one or more years.
SPECIFIC TERM
The following example best explains how “specific term indexing” works. Assume the
chosen index is the S & P 500 and the specific indexing term for the annuity is 5 years.
The S & P 500 index had not reached 500 on the day Bob’s contract was issued. Over
the 5 year term of his contract, the highest point the S & P 500 reached was 700. The
gain of 200 points represents a 40% increase; therefore, the value of Bob’s contract
would be increased by 40%. An annuity contract with an initial premium of $100,000
would be credited with $40,000 of interest five years later—at the end of the specific
term.
POLICY YEAR
An example for illustrating the policy year calculation feature follows. Assume the
chosen index is the S & P 500 and the indexing term for the annuity is “policy year”. The
S & P 500 was at 500 on the day Steve’s contract was issued. During the policy year of
his contract, the highest point the S & P 500 reached was 550. The gain of 50 points
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represents a 10% increase, subject to any applicable caps; therefore, the value of Steve’s
contract would be increased by 10%. An annuity contract with an initial premium of
$100,000 would be credited with $10,000 of interest at the end of the policy year.
Both the specific term and policy year method examples above used the High Water
Mark Indexing Method (described below) in determining how much interest to credit to
the annuity for the index period just ended.
INDEXING METHODS CALCULATE PERCENTAGE CHANGE
The change in the chosen index from the beginning of the term to the end of the term is
expressed as a percentage. The term could be one policy year, five policy years, seven
policy years, etc. In years where the chosen index is negative, the percentage credited to
the contract is zero (0). In this case, there would be no change in the policy value.
Now let’s take a look at the most common indexing methods.
Remember that all of these indexing methods potentially involve a participation rate, cap
rate, floor rate, and annual reset.
FIXED INTEREST
Most Fixed Indexed Annuities allow the annuity owner to allocate part or all of their
annuity values to a fixed interest bucket where the fixed rate is announced in advance and
guaranteed for the year. This is very similar to a traditional fixed annuity.
MONTHLY AVERAGING
The averaging method of indexing calculates the change in the indexing by averaging the
closing index values for the same day each month during the index term. If the index
term is one year, the insurer would add the closing index values for each of the twelve
months during the index term and divide by twelve. The result of this calculation would
be used as the ending value of the index and then compared to the index value at the
beginning of the index term to determine percent change in the index.
DAILY AVERAGING
In addition to monthly averaging, some annuities offer daily averaging, which works the
same as monthly averaging except that the closing value of the index for every day of
underlying index is averaged together instead of just twelve month-end values.
On the following page is an example of monthly averaging.
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Below is an example of the Monthly Averaging Indexing Method
•
The first of each month is the measurement day.
•
For illustration, all index values are only expressed in whole numbers and
percents are only carried out two decimal positions.
•
Indexing term is one year.
Date
Jan 1, 2010
Feb 1, 2010
Mar 1, 2010
April 1, 2010
May 1, 2010
June 1, 2010
July 1, 2010
Aug 1, 2010
Sept 1, 2010
Oct 1, 2010
Nov 1, 2010
Dec 1, 2010
Jan 1, 2100
Total of 12 Monthly Index
Values
Average of 12 Monthly Index
Values
Month
Index Value
Begin
1
2
3
4
5
6
7
8
9
10
11
12
1,000
1,014
1,020
1,033
1,066
1,019
1,024
1,033
1,056
1,064
1,038
1,044
1,061
12, 472
1,039
This example is for agent use only and is not to be used with consumers. This is only an
illustration for understanding how Monthly Averaging Indexing works and is not a representation
of past history or a prediction of the future movement of any index.
In the above example, the average of the 12 monthly index values is 1,039, and this
number would be used as the ending index value in the calculation. The interest credited
would be as follows: Ending index value divided by beginning index value, minus 1:
Step 1: 1,039 ÷ 1, 000 = 1.039
Step 2: 1.039 – 1 = .039 or 3.9%
Unless there is a cap, participation rate, or spread/ margin/asset fee that limits the
calculation, the annuity would be credited with 3.9% interest for the year illustrated.
POINT-TO-POINT INDEXING
Point-to-point is one of the methods commonly used to measure the change in a chosen
index. The index-linked interest, if any, for point-to-point indexing is based on the
difference between the index value at the end of the term and the index value at the start
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of the term. Interest is credited to the annuity at the end of the term. The term period is
most commonly policy year (one year), but may be up to five policy years.
ANNUAL POINT-TO-POINT INDEXING
Annual Point-to-Point is the easiest indexing method for most people to understand.
Point-to-point indexing can be used as monthly point-to-point, annual point-to-point, or
long term point-to-point.
EXAMPLE
Below is an example of the Annual Point-to Point-Indexing Method using the following
assumptions:
•
Policy year runs from January1, 2010 to January 1, 2011.
•
For illustration, all index values are only expressed in whole numbers and
calculation are not carried beyond three decimal positions.
•
Indexing term is one year.
Date
Jan 1, 2010
Feb 1, 2010
Mar 1, 2010
April 1, 2010
May 1, 2010
June 1, 2010
July 1, 2010
Aug 1, 2010
Sept 1, 2010
Oct 1, 2010
Nov 1, 2010
Dec 1, 2010
Jan 1, 2100
Month
Index Value
Begin
1
2
3
4
5
6
7
8
9
10
11
12
1,000
1,014
1,020
1,033
1,066
1,019
1,024
1,033
1,056
1,064
1,038
1,044
1,061
This example is for agent use only and is not to be used with consumers. This is only an
illustration for understanding how Annual Point to Point Indexing works and is not a
representation of past history or a prediction of the future movement of any index.
In the example above Annual Point-to-Point Indexing would divide the ending index
value by the beginning index value and then subtract 1 as follows:
Step 1: 1,061 ÷ 1,000 = 1.061
Step 2: 1.061 – 1 =.061 or 6.1%.
35
In the example above the interest credited to the annuity for the index term just ended
would be 6.1% unless lowered by a participation rate, cap rate, or spread/margin/asset
fee.
MONTHLY POINT-TO-POINT INDEXING
Monthly point-to-point works differently. In monthly point-to-point the indexing term is
usually policy year, so that is how we will explain it, but it is available over a two or
three year period.
Monthly point-to-point indexing measures the movement in the index value from the
same day each month to the same day in the next month to determine the monthly
movement in the index. If the monthly movement in the index is positive, it is used in the
calculation, though there is usually a cap on how much monthly upward movement can
be used in the calculation (usually 2.5% to 3% per month maximum). If the monthly
movement in the index is negative, it is used in the calculation and there is usually no
limit on the amount of monthly downward movement in the index that can be used in the
calculation. At the end of the policy year the insurer will add up the twelve monthly
movements in the index value to determine the change in the index to be credited to the
annuity.
Since the monthly-point-to-point indexing formula is already subject to a monthly cap on
the upward movement, there is usually not a cap rate applied to the overall end result of
the twelve months. However, a Participation Rate or Spread/Margin/Asset fee may apply.
On the following page is an example of monthly point-to-point indexing using the
following assumptions:
•
A monthly cap of 2.5% per month on the amount of upward index movement
used in the calculation.
•
No monthly cap on the amount of downward movement of the index used in the
calculation.
•
The first of each month is the measurement day.
•
For illustration, all index values are only expressed in whole numbers and
calculation are not carried beyond three decimal positions.
•
Indexing term is one year.
36
EXAMPLE
Date
Jan 1, 2010
Feb 1, 2010
Mar 1, 2010
April 1, 2010
May 1, 2010
June 1, 2010
July 1, 2010
Aug 1, 2010
Sept 1, 2010
Oct 1, 2010
Nov 1, 2010
Dec 1, 2010
Jan1, 2011
Month
Index Value
% Change
Used in Calc
Cumulative
Begin
1
2
3
4
5
6
7
8
9
10
11
12
1,000
1,014
1,020
1,033
1,066
1,019
1,024
1,033
1,056
1,064
1,038
1,044
1,061
Begin
1.40%
0.59%
1.27%
3.19%
(4.41%)
0.49%
0.88%
2.23%
0.78%
(2.44%)
0.59%
1.63%
1.40%
0.59%
1.27%
2.50%
(4.41%)
0.49%
0.88%
2.23%
0.78%
(2.44%)
0.59%
1.63%
1.40%
1.99%
3.26%
5.76%
1.35%
1.84%
2.72%
4.95%
5.73%
3.29%
3.88%
5.51%
This example is for agent use only and is not to be used with consumers. This is only an
illustration for understanding how Monthly Point-to-Point Indexing works and is not a
representation of past history or a prediction of the future movement of any index.
In the above example, the monthly point-to-point indexing calculation would result in
interest crediting of 5.51% for the indexing year. The 5.51% represents the total of the
monthly up or down movements in the index value as measured by the calculation. If a
participation rate or Spread/Margin/Asset fee was present in the calculation, this would
reduce the amount credited to the annuity.
Note: In month 4 the index rose 3.19%, but only 2.5% was used in the calculation due to
the monthly Cap.
LONGTERM POINT-TO-POINT INDEXING
Long Term Point-to-Point indexing works like Annual Point-to-Point Indexing, except
that the indexing period is longer than one policy year. Usually it is a two or three year
indexing term.
HIGH WATER MARK INDEXING
With High Water Mark Indexing the highest index value (high water mark) during the
indexing period is used as the ending index value, and the beginning index value at the
beginning of the indexing period is used as the beginning value. Interest is based on the
difference between the highest index value (high water mark) and the index value at the
start of the term. The indexing term for most high water mark indexing is from 1 to 3
years.
37
Below is an example of the High Water Mark Indexing Method using the following
assumptions:
•
For illustration, all index values are only expressed in whole numbers and
calculation are not carried beyond three decimal positions.
•
Indexing term is one year.
Date
Month
Index Value
Jan 1, 2010
Feb 1, 2010
Mar 1, 2010
April 1, 2010
May 1, 2010
June 1, 2010
July 1, 2010
Aug 1, 2010
Sept 1, 2010
Oct 1, 2010
Nov 1, 2010
Dec 1, 2010
Jan 1, 2100
Begin
1
2
3
4
5
6
7
8
9
10
11
12
1,000
1,014
1,020
1,033
1,066
1,019
1,024
1,033
1,056
1,064
1,038
1,044
1,061
High Water
Mark
1,064
This example is for agent use only and is not to be used with consumers. This is only an
illustration for understanding how High Water Mark Indexing works and is not a representation
of past history or a prediction of the future movement of any index.
In the example above High Water mark Indexing would divide the ending index value
(which is the high water mark occurring in month 9) by the beginning index value and
then subtract 1 as follows:
Step 1: 1,064 ÷ 1,000 = 1.064
Step 2: 1.064 – 1 =.064 or 6.4%
In the example above the interest credited to the annuity for the just-ended index term
would be 6.4% unless lowered by a participation rate, cap rate, or spread/margin/asset
fee.
COMBINATION OF INDEXING METHODS
Many fixed indexed annuities allow the annuity owner to allocate funds among several
different indexes and indexing methods within the same policy year. In this case the
annuity owner could have three or more “buckets” of money using different indexes and
different indexing methods.
38
CONSUMER CHOICE TO ALLOCATE/REALLOCATE AMONGST
STRATEGIES
When the annuity owner has the ability to choose among several indexes and indexing
methods, they usually have the ability to reallocate the funds to other indexes and/or
indexing methods on an annual basis. An exception to the annual reallocation occurs
when some or all of the funds are currently in an indexing strategy that has an indexing
period of longer that one year.
INDEX STRATEGY PERFORMANCE
FLUCTUATION OF CAP AND PARTICIPATION RATES
As was discussed earlier in this text, Participation and Cap Rates are usually “moving
parts” in the interest crediting formulas used in fixed indexed annuities. Participation and
Cap Rates can be adjusted by the insurer (usually subject to minimums guaranteed for the
life of the contract).
The reason these rates are “moving parts” and will fluctuate has to do with how the
insurer invests the annuity premiums allocated to the indexing strategies. The majority of
annuity premium received is used to support the product’s minimum guarantees. As with
any fixed annuity, the funds used to back these guarantees are invested in bonds and other
long-term instruments.
INSURER INVESTING TO HEDGE INDEXING STRATEGIES
Once the minimum guarantees have been actuarially reserved, the remaining portion of
the premium can be used to cover expenses and purchase index options. These index
options provide the ability for the insurer to credit gains in the index to annuity contracts.
Different companies use different strategies to perform their index hedging, but they all
utilize index options in one way or another to provide index-linked interest to their
annuity owners. The cost of these index options will vary during different economic
environments, and most companies do not spend their entire options budget up front due
to the fluctuation in the costs of index options. If the cost of index options increases
significantly, the insurer can adjust the Cap Rate or Participation Rate on a prospective
basis to sufficiently lower the future liability to the annuity owners to bring the option’s
cost within budget.
Most insurers purchase index options with a “strike date” (option life) one year or less in
the future. This helps to understand why the Cap Rate and Participation Rates are usually
guaranteed for a year at a time. Each year the insurer has to purchase index options to
cover any index gains that may be credited during the ensuing year. If the cost of index
options were to decrease, the insurer could afford to increase the Participation and Cap
Rates for the upcoming year.
39
Option costs fluctuate year to year based on market conditions, so if the price of options
is higher in a given renewal year than what was assumed at the time the policy was
issued, fewer options can be purchased. The end result in this scenario is that renewal
caps on the policy will have to be lowered (fewer options purchased translates in to a
lower cap). Conversely, lower option costs result in higher renewal caps.
FACTORS AFFECTING INDEX OPTIONS PRICES
There are two main factors that drive the costs of index options: market volatility and
guaranteed rates of return.
MARKET VOLATILITY
The performance of the equity markets do fluctuate and the greater the “swing” in
performance and the shorter the time frame, the more volatile the equity markets are.
Market volatility affects the likelihood that an option will pay off and is used to predict
the standard deviation expected for the coming year in a specific stock index. This has a
big impact on the pricing of index options.
Depending on the indexing method used within a particular annuity, a different type of
index option will be purchased. The price of an index option purchased to hedge against a
Monthly Point-to-Point indexing method will react differently to increased market
volatility than an index option purchased to hedge an Annual Point-to-Point indexing
method.
RISK FREE RATE OF RETURN
The most commonly used benchmark for Risk-Free Rate of return is the rate of return on
U.S. Government-issued Treasuries.
An increase in the Risk-Free Rate of Return usually causes the price of options to
increase, and a decrease in the Risk Free Rate of Return will usually cause a decrease in
the price of options.
MID - TERM WITHDRAWALS
With most fixed indexed annuities, if a withdrawal is made during the index term, no
index credits are granted on funds withdrawn. Because the amount of interest to be
credited is calculated based upon the index movement during the index term (which has
not yet occurred), the insurer doesn’t know what amount of interest to credit to a
withdrawal or surrender during the index term. If an insurer took the approach of
determining the interest that would be credited if the calculation were performed on the
withdrawal date (in effect shortening the index term), it might place them at risk of an
annuity owner trying to time the withdrawal at a point when the interest would be the
greatest.
The longer the index term, the greater the likelihood that any unplanned withdrawal made
by the annuity owner will be mid-term. Liquidity is always a suitability issue when
40
selling an annuity, and this is another good example indicating that the annuity owner
needs to have other funds within their financial household that can serve as an emergency
fund.
Lack of interest being credited to a midterm withdrawal is a separate issue from the
surrender charge.
MINIMUM NONFORFEITURE RATE VS. MINIMUM ANNUAL CREDITED
RATE
THE MINIMUM NONFORFEITURE RATE
Annuity issuers are required to comply with the minimum nonforfeiture interest rate
requirements in the state of issue. Most states require between 1% and 3% minimum
nonforfeiture rates for the life of the annuity, with the amount to be guaranteed
potentially fluctuating with the 5 year Constant Maturity Treasury Rate less 125 basis
points. If dealing with an indexed annuity that allows “substantive” participation in the
performance of an index, up to 225 basis points can be deducted from the 5 year Constant
Maturity Treasury Rate. In addition, an insurer can re-determine the nonforfeiture amount
as economic conditions change. This re-determination is not used often due to the
administration and tracking required. The method for calculating the minimum
nonforfeiture rate and amount does not have to be disclosed in the annuity contract in
most states.
THE MINIMUM ANNUAL CREDITED RATE
The contractual guaranteed interest rate to the consumer must meet or exceed the
statutorily required minimum non-forfeiture value. Unlike the minimum nonforfeiture
rate and amount, the minimum guaranteed value must be clearly defined in the contract.
In some annuities these rates and amounts are the same because the guaranteed value is
going to equal the non-forfeiture value, but they can be different.
The annuity contract must define clearly what the guaranteed minimums are, and the
company needs to demonstrate separately to the commissioner that the contractual
guarantees listed in the contract meet or exceed the required minimum non-forfeiture
value. A typical minimum credited annual rate for a fixed indexed annuity is 90 percent
of principal growing at 3 percent.
An interesting note is that the most states’ minimum nonforfeiture regulations require a
separate bucket if a fixed indexed annuity has a fixed account in it. In this situation, there
is a non-forfeiture rate associated with the fixed account or the fixed option, and this rate
would be the 5 year Constant Maturity Treasury Rate minus 125 basis points. There can
also be a separate rate for the indexed money, which would be the five-year Constant
Maturity Treasury Rate minus 225 basis points.
41
HISTORICAL PERSPECTIVES
HYPOTHETICAL MODELS
Hypothetical illustrations are susceptible to manipulation in various ways. The most
common way a hypothetical illustration can be manipulated is by “cherry picking” the
period of time to illustrate. In theory a hypothetical return is an illustration of a “what- if”
scenario that is “back tested” with some period of actual results. The hypothetical
illustration usually compares two or more investment vehicles over the same time period
to show that one is superior to the other. When hypothetical illustrations are used in
marketing literature, rest assured that the marketing department will never pick an
unfavorable period of time to illustrate. Rather, they will pick the period that tells a happy
story.
ACTUAL RETURNS
A truer test of the anticipated future performance of a financial vehicle is the actual past
performance of that same vehicle with all of the associated fees and expenses shown as
well as illustrations of the “walk away” value the product owner was able to take with
them, net of all transaction fees.
RENEWAL RATES
It is often asked why the caps on newly-issued policies are often different than renewal
caps on older policies. This difference is primarily driven by the bonds that were
purchased to back the policies. If, for example, interest rates have risen since a policy was
issued, newly-issued policies will be supported by bonds that offer a higher yield. With
higher yields, less money is needed to support the minimum guarantees and more money
can be allocated to the purchase of index options. With more options, of course, higher
caps can be offered on new policies than the renewals.
The reverse would be true in a falling interest rate environment; new policies would
have less money allocated for option purchases, which would result in lower caps as
compared to caps offered on renewals.
Option prices fluctuate year to year based on current market conditions, so if the price of
options is higher in a given renewal year than what was assumed or budgeted at the time
the policy was issued, fewer options can be purchased. The end result is that renewal caps
on the policy will have to be lowered (fewer options purchased translates in to a lower
cap). Conversely, lower option prices result in higher renewal caps.
COMMON INDEXES USED IN FIXED INDEXED ANNUITIES
The two most commonly used indexes in fixed indexed annuities are the S & P 500 and
the Dow Jones.
42
STANDARD & POOR’S 500
This is an index which was devised a number of years ago by the Standard & Poor's
Company. Today the S & P 500 Index is widely regarded as the benchmark index by
which U.S. stock market performance is measured.
The S & P 500 includes a representative sample of common stocks traded on the New
York Stock Exchange, American Stock Exchange, and NASDAQ National Marketing
System. It is one of the U.S. Commerce Department’s leading indicators. In addition, it
represents over 70% of the total domestic U.S. equity market capitalization.
The S&P 500 Index originated in 1923 when Standard & Poor's introduced a series of
indexes that included 233 companies and covered 26 industries. The Index, as it is now
known, was introduced in 1957. Today, the S & P 500 encompasses 500 companies
representing 90 specific industry groups.
The S & P 500 does not contain stocks of the 500 largest companies as many think.
Although many of the stocks in the Index are among the largest, some relatively small
companies are also included. However, these small companies are generally leaders
within their industry groups.
VARYING VIEWS
Some individuals are skeptical of the use of the S & P 500 index for fixed indexed
annuities. The heart of this skepticism lies in the fact that the S & P 500 does not include
dividends. Dividends have accounted for a large percentage of total investment return
over the past 20 years. Skeptics feel that foregoing dividends while experiencing a cap
on market capital gains may be too severe a penalty for some investors to pay for
protection against periodic market losses.
COMPARISON TO THE DOW JONES INDUSTRIAL AVERAGE
The Dow Jones Industrial Average is the oldest index and, probably, the most well
known gauge of stock market performance. The Dow is composed of 30 large
capitalization blue-chip stocks and measures the performance of a relatively small sector
of the market. The Dow does adjust for dividends.
AVAILABLE ANNUITY RIDERS
LIFE INSURANCE RIDERS
Some annuities offer a life insurance rider as an option when purchasing an annuity.
Offering a life insurance rider on an annuity will sometimes (but not always) involve
medical underwriting similar to when purchasing a life insurance policy. In light of the
recent examples of Stranger Originated Annuity Transactions, look for more annuity
issuers to require medical underwriting when a life insurance rider is offered on an
annuity.
43
Unlike most other assets, annuities do not receive a step-up in cost basis at the death of
the owner/annuitant; therefore the beneficiary will owe ordinary income tax on all of the
earnings in the annuity. If an annuity is being used as a wealth transfer vehicle, the
annuity owner may want to consider using life insurance to provide a tax-free death
benefit to their annuity beneficiary to help the beneficiary pay taxes on the annuity
proceeds. For this reason some annuity companies will offer a death benefit equal to 25%
-35% of the annuity value at death. The reasoning used in determining the amount of the
life insurance death benefit is that 25% to 35% approximates the potential tax liability if
the beneficiary liquidates the annuity in one tax year.
LONG-TERM CARE RIDERS
Some annuities offer a long-term care rider. These long-term care riders will occasionally
qualify as a “qualified” long-term care rider under the Heath Insurance Portability and
Accountability Act, but most often do not. These LTC riders are designed to help pay the
costs associated with long-term care services. Some annuities will provide this benefit if
the annuitant suffers an illness or injury that requires a home health aide or nursing home
care confinement. Some annuities will provide this benefit if the annuitant AND/OR their
spouse meets the above benefit trigger. The amount of the benefit will usually be a
percent or factor of the annuity values at the time of claim. The duration of the benefit
will depend on the spend rate and the amount of the benefit.
There are several ways these LTC riders are structured. In all three basic LTC
approaches, if the annuity is charged a premium for an LTC rider that provides some of
the LTC benefits, the account value of the Annuity also provides part of the benefit. In
most annuities with an LTC rider, the annuity account value can be exhausted in the
process, leaving the annuity owner without any remaining annuity values. The three basic
approaches to LTC riders are discussed below.
ACCOUNT BALANCE FIRST LTC APPROACH
One approach to the LTC benefit is to first spend the account balance of the annuity to
provide the LTC benefit, and then use the insurance that was purchased to provide a tail
balance.
ACCOUNT BALANCE LAST LTC APPROACH
Another approach first uses the insurance purchased via the rider premium until it is
exhausted, and then begins to exhaust the annuity account value.
COINSURANCE LTC APPROACH
Yet another approach employs both the account balance and the LTC insurance
purchased with the rider simultaneously. In this case the LTC insurance pays a portion of
the benefit and the account balance pays the remaining amount.
There are differences in the premiums charged for each of these approaches and in the
taxation of premiums and annuity account balances as they are liquidated.
44
WAIVER OF SURRENDER CHARGE VS. LTC RIDER
While most annuities offer some level of waiver of the surrender charge if the annuitant
is confined to a LTC facility (and this is a good thing), the waiver should not be confused
with a long-term care rider. The LTC rider can provide a benefit that will pay for a wider
array of LTC services than the surrender charge waiver applies to (the waiver of
surrender charge usually requires confinement).
In addition the waiver is not LTC insurance and does not increase the ability of the
annuitant to pay for LTC services beyond what they can withdraw penalty-free form the
annuity.
GUARANTEED MINIMUM WITHDRAWAL BENEFIT RIDERS
A guaranteed Minimum Withdrawal Benefit Rider is a rider that can be added to an
annuity (for a fee), and the rider will guarantee either that a certain minimum withdrawal
amount can be taken from the annuity for a specified minimum time period or that a
certain minimum percent of the account balance can be withdrawn annually for the life of
the annuitant. Unlike annuitization, the annuity owner retains some liquidity in the
contract plus the account can still be annuitized in the future if the annuitant chooses to
do so.
GUARANTEED MINIMUM WITHDRAWAL BENEFITS IN VARIABLE ANNUITIES
Many fixed annuities now offer some form of a Guarantee Minimum Withdrawal
Benefit, but the genesis of this benefit is within the variable annuity market.
When GMWB benefits were first introduced with variable annuities, they came in two
basic versions, both of which were designed to protect the initial investment in the
contract by giving back the initial deposit in the event the market value of the annuity
dropped below the original investment amount. However, the annuitant did not get back
the principal in a single, lump sum payment. Rather, the payout was made in systematic
payments over a period of years. Some products offered withdrawals of 7% of the initial
balance every year for 14.2 years. Other products offered withdrawals of 5% per year for
20 years.
If the annuitant elected one of these options and the investments performed well, they
may have found additional money left in the contract at the end of the withdrawal period.
Later versions of GMWB benefits began offering withdrawals of 5% guaranteed for the
rest of the annuitant’s life. At older ages, because life expectancy gets shorter and shorter,
the annuitant is commonly offered higher withdrawal rates.
VARIATIONS
45
One attractive feature of GMWB benefit is that it offers the ability for withdrawal
amounts to increase if the future market value goes up or the ability for amounts to be left
in the annuity at the end of the withdrawal period, all without annuitization.
Keep in mind, however, what it would take for that to happen. If an annuitant makes
withdrawals of 5% or more from the account, and the annuity itself carries total charges
in the neighborhood of 3%, that’s a total of 8% coming out of the account value every
year. Each year that the investment portfolio produces a gross return of less than 8%, the
account value will decrease and, therefore, gross returns in excess of 8% are necessary to
grow the account value and produce future increases in withdrawal amounts (using the
expense and withdrawal assumptions above). As such, these guarantees provide great
peace-of-mind knowing that, even if the account balance goes to zero, income
distributions will continue.
INVESTMENT RESTRICTIONS WITH GMWB
Because high volatility in the annuity account value increases the cost of GMWB
benefits, GMWB products also commonly include some sort of investment restriction to
control account value volatility. Many contracts accomplish this by requiring all funds to
be allocated to specified model portfolios. Even then, the more aggressive model
portfolios are often not available when wanting to take advantage of the GMWB features.
These products also commonly contain incentives for delaying withdrawals. For some
products, the annuitants are rewarded for waiting a specified number of years after the
annuity is issued. Other products reward annuitants if they reach a certain age before
withdrawals begin. Some will include BOTH incentives.
GUARANTEED MINIMUM WITHDRAWAL BENEFIT RIDERS IN FIXED ANNUITIES
A number of fixed annuities now offer a GMWB, and they share many of the
characteristics with the GMWB offered in a variable annuity. The terminology used in
the fixed annuity riders varies somewhat from the variable annuity rider.
Most GMWB s offered in a fixed annuity will have a “roll-up period,” which is the
period of time after the account is established and before benefit is elected from the
GMWB rider. During this “roll-up period” many fixed annuities increase the base on
which the GMWB will be calculated by either the actual index interest credit or a
specified minimum percentage, whichever is greater. It should be noted the Guaranteed
Minimum Withdrawal BASE is only a value that can be accessed via the GMWB rider
and does not represent a surrender value or the value to be used for annuitization.
One the GMWB rider is elected, the annuitant can withdraw up to a certain percentage
(based on how long “the roll-up period” was and the annuitant’s age and/or their spouse’s
age in the case of a joint withdrawal). As long as withdrawals do not exceed the
maximum amount allowed in the GMWB rider, most of the fixed annuities with the
46
GMWB rider will provide this benefit for life (or joint life as the case may be). This
sounds a lot like annuitizing without actually annuitizing, except that there are some
taxation differences. Since you are taking withdrawals and not annuitizing, the gain in the
annuity is recognized under the “interest-first method,” which is different from gain
recognition during annuitization. See the chapter on Annuity Taxation for a discussion on
this issue.
Once the GMWB benefit has been elected and withdrawals have begun, the annuity
owner still has some liquidity in the contract and can vary the amount they withdraw
above or below the calculated withdrawal amount and/or surrender. They can also
annuitize the contract.
GUARANTEED MINIMUM DEATH BENEFIT RIDER
A guaranteed minimum death benefit rider has always, in effect, been offered in some
form or another by fixed annuities because they have always had to comply with
nonforfeiture rules. It was the variable annuity which popularized this rider in order to
satisfy the prospective variable annuity owner’s fear of dying at a time when their market
based annuity value was low.
The first major innovation to begin the variable annuity revolution was the Guaranteed
Minimum Death Benefit (GMDB). This new feature gave variable annuities the ability to
do something no other equity-based investment did – provide upside market potential
while protecting from the downside of adverse market performance. To begin to
understand the history of the variable annuity revolution, let’s look a little more closely at
how these death benefits worked.
When guaranteed minimum death benefits first arrived on the scene, they were designed
to prevent an investor from losing money in the market. Insurance companies made this
assertion by guaranteeing investors that, if they died at a time when the market was
down, they would never get back less than the original principal invested. This guarantee
gave them a return of their money and protected their beneficiaries against market losses.
Although the excitement of this protection gave new life to the sales of variable annuities,
innovation pressed on, and soon new improvements began reshaping the landscape of
variable annuity death benefits.
The first enhancement was the introduction of death benefits that guaranteed to return
more than the initial principal. These enhanced death benefits generally came in one of
two forms.
GMDB - BASIC FORM
In an effort to address the downside risks associated with equities, the insurance
companies began to offer a Guaranteed Minimum Death Benefit Rider. It offered
downside market protection at death. In its original form, the rider promised that if the
annuitant died, the beneficiaries would be guaranteed either the account value at death or
47
a return of principal, whichever was greater. This basic GMDB rider appealed to
investors and covered markets risks associated with equity investing--but only did so if
the client died.
GMDB - ENHANCED
Insurance companies began to enhance the basic GMDB by stipulating that, in addition to
a guarantee of a return of principal at death (or account value if higher), the company
would add a nominal interest rate to the guarantee. The enhanced GMDB offered a
guarantee equaling more than the original investment. These enhanced benefits generally
came in one of two forms.
Principal compounded at a fixed rate
The enhanced GMDB guarantees a return of all principal plus interest compounded at a
specified annual percentage rate. Often, this enhanced benefit is not effective until at least
the third contract anniversary. The contract owner is assured that if death occurs while
owning the variable annuity, the beneficiaries will receive the principal invested plus a
reasonable rate of return if this amount is greater than the actual annuity value at death.
The annual percentage rates offered in this form of enhanced GMDB are usually set
slightly above those of most fixed instruments such as CDs and bonds for the purpose of
being competitive. It should be noted that a GMDB does not protect the owner from
market risks, but rather protects the beneficiaries.
Anniversary Ratchet GMDB
Sometimes called the high water mark anniversary guarantee, this form of enhanced
GMDB takes a snapshot of the annuity value at each anniversary and guarantees the
beneficiary the minimum of the amount invested, actual account value at death, or (if
greater) the highest value of the annuity on any previous contract anniversary date.
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Chapter 1 - Review Questions
(Answers are in the back of the text)
1. A variable annuity fluctuates in value according to the performance of which of the
following?
(a)
(b)
(c)
(d)
Trust accounts
General accounts
Separate or sub accounts
Bank accounts
2. Which of the following best describes the growth inside an annuity?
(a)
(b)
(c)
(d)
Tax-free
Tax-deferred
Annuities do not experience growth
Annuities are not subject to taxation
3. Single Premium annuities can be classified into two types. Which of the following
best describes the two types of Single Premium annuities?
(a)
(b)
(c)
(d)
Variable and Fixed
Immediate and Deferred
Guaranteed and non-guaranteed
Tax-free and taxable
4. An annuity that makes payments to two individuals for the lifetimes of each person is
called which of the following?
(a)
(b)
(c)
(d)
Joint, or Joint and Survivor
Period Certain
Annuities cannot make payments to two people
Variable
5. Indexed annuities credit interest using a formula based on which of the following?
(a)
(b)
(c)
(d)
An external financial index
A fixed rate of interest
The stock market
Indexed annuities do not credit interest
6. Which of the following terms applies when an insurance company credits interest by
subtracting a percentage from the index increase?
(a) Interest rate decrease
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(b) Unfair trade practice
(c) Spread margin or asset fee
(d) Taxable income
50
Chapter 2
Annuity Taxation and Primary Uses of Annuities
TAXATION OF NON-QUALIFIED ANNUITIES
A non-qualified annuity is an annuity that is not inside of a qualified retirement plan such
as an IRA or 401(k).
The money deposited into an annuity (contributions) is referred to as a premium, and in a
non-qualified the premium becomes the income-tax cost-basis for determining which
portion of the annuity is subject to taxation upon withdrawal. Premiums contributed to a
non-qualified annuity are made with after-tax money and are not deducted from taxable
income. Since income taxes have already been paid on the premiums contributed to a
non-qualified annuity, those premium dollars are never again subject to income taxation.
The money deposited into an annuity may earn interest, receive dividend income, or earn
capital-gain distributions. For the purposes of this discussion on annuity taxation we will
collectively refer to these various increases in the value of an annuity as earnings. These
earnings--unlike earnings in a savings account, mutual fund, or certificate of deposit--are
not taxed in the year in which they are earned. Thus the earnings continue to grow and
compound, tax-deferred, until withdrawn.
NOTE: All earnings on all annuities are taxed as ordinary income when
withdrawn. Capital-gains tax treatment is NOT available for earnings from
ANY annuity.
WHEN AN ANNUITY IS OWNED BY A NON-NATURAL PERSON
A non-natural person could be a corporation, partnership, or trust. In most cases, an
annuity owned by a non-natural person is not treated as annuity for federal income tax
purposes; therefore, earnings on annuities owned by non-natural persons are taxed in the
year received (or credited to the annuity) as ordinary income.
EXCEPTIONS
There are several exceptions to an annuity owned by a non-natural person not being taxed
as an annuity.
•
Immediate annuities are excepted from this rule.
•
An annuity contract will be treated as owned by a natural person if the owner is a
trust or other entity which holds the annuity as an agent for a natural person.
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NOTE: This exception does not apply in the case of an employer who is
the owner of an annuity contract under a nonqualified deferredcompensation arrangement for its employees.
NOTE: If owner of an annuity is a grantor trust, the death of grantor
triggers mandatory distribution. This does not apply to annuities issued
prior to January 19, 1985.
TAXATION OF WITHDRAWALS FROM NON-QUALIFIED ANNUITIES
TOTAL SURRENDER
When a non-qualified annuity contract is fully surrendered in a single lump sum
transaction, the owner must pay income tax on all of the earnings in the contract.
Earnings are determined as the excess amount received over the amount of premiums
paid, calculated upon surrender.
PARTIAL WITHDRAWAL
Partial withdrawals from a non-qualified annuity that are not payments under an annuity
settlement option are taxed on a last-in, first-out (LIFO) basis. This is actually called the
earnings-first method of gain recognition. In order words, withdrawals from an annuity
are made earnings-first, and the owner is taxed on the payments until all of the earnings
have been distributed. This assumes the cost-basis is the last portion of be withdrawn
from the annuity.
There is an exception to the earnings-first rule for contributions made to annuity contracts
prior to 8/14/82 (also called a pre-TEFRA annuity). These contributions are distributed
on a first-in, first-out (FIFO) basis and the owner is not taxed until such contributions are
fully recovered.
NOTE: If a pre-TEFRA annuity is exchanged for another annuity, it
keeps pre-TEFRA tax treatment described above.
AGGREGATION RULE
There is an aggregation rule which requires that all annuity contracts issued by the same
company, to the same owner, in the same calendar year are treated as one annuity
contract for purposes of determining the taxable portion of any distributions.
EXCEPTIONS TO THE AGGREGATION RULE
The following are exceptions to the aggregation rule:
•
Immediate annuities
52
•
•
•
Annuities that are annuitized
Distributions required at the death of the annuity owner
Annuities issued prior to October 21, 1988
Note: If an annuity issued prior to October 21, 1988 is exchanged or
transferred to another annuity, the new annuity is subject to
aggregation.
TAXATION OF ANNUITIZATION OF NON-QUALIFIED ANNUITIES
When a non-qualified annuity is annuitized, a portion of each annuity payment represents
a return of cost-basis and is not taxed, and the remainder of each annuity payment is
considered earnings and taxed as ordinary income. The taxable and non-taxable portions
of the annuity payments are determined using an exclusion ratio.
The exclusion ratio for an annuity is the ratio the cost basis (premiums paid) in the
contract bears to the expected return under the contract. Calculating the expected return
involves actuarial assumptions if the annuitization is based on a single or joint life.
Once the total cost-basis in the non-qualified annuity is recovered using the exclusion
ratio, the remaining annuity payments are fully taxable. If the owner dies before the total
cost basis is recovered, and annuity payments cease as a result of his death, the unrecovered cost-basis is allowed as a deduction to the owner on their final income-tax
return.
TAXATION OF ANNUITY UPON DEATH OF THE OWNER
IF OWNER DIES PRIOR TO ANNUITIZATION
GENERAL PROVISIONS
Unlike most other assets, annuities do not receive a step-up in cost-basis at the death of
the owner/annuitant; therefore the beneficiary will owe ordinary income tax on all of the
earnings in the annuity.
If the beneficiary annuitizes the contract, a portion of each annuity payment will be
considered a return of cost-basis and not taxable. Determining the taxable portion of each
annuity payment was discussed above.
NOTE: Variable annuities issued prior to October 21, 1979 do receive a
step-up in cost basis for income tax purposes, and no income tax is
payable on the earnings accumulated during the life of the owner when
received by the beneficiary.
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ANNUITANT-OWNED ANNUITIES
In most cases the owner of the annuity is also the annuitant. The examples in this section
will assume the annuitant and the owner are the same person.
SPOUSAL BENEFICIARY
A surviving spouse beneficiary of an annuity can be treated as the new owner. This will
allow the surviving spouse of the owner/annuitant to step into the shoes of the deceased
owner/annuitant and continue to experience tax-deferred growth until he or she dies.
NON-SPOUSAL BENEFICIARY
Unlike a spouse, non-spouse beneficiaries of non-qualified annuities can't assume
ownership, but must take the benefits within five years. If the annuity is distributed
within five years, taxation of earnings is calculated the same as lump sum (if the annuity
is distributed in a lump sum) or as partial withdrawals (if the annuity is distributed in
more than one distribution).
A non-spousal beneficiary does have the option of annuitizing the annuity; however, they
must annuitize the contract within 60 days of the owner/annuitant’s death. In addition the
annuity payments must begin within one year after the owner/annuitant dies. This option
allows the non-spousal beneficiary to spread the taxation of earnings out over a
potentially longer period. If the annuitization option is chosen by the non-spouse
beneficiary, taxation of earnings is calculated using the exclusion ratio.
NOTE: If an annuity contract has joint owners, the distribution at death
rules are applied upon the first death.
IF OWNER DIES AFTER ANNUITIZATION
If the annuitant dies after annuitization, any remaining payments must be paid out at
least as rapidly as under the annuity payout option in effect at the time of the owner's
death. Taxability of earnings will be determined using the exclusion ratio described
earlier.
TAXATION OF OWNERSHIP CHANGES
If the owner(s) add or delete a joint owner, it will be considered a transfer and will trigger
taxation of earnings attributable to the transfer of ownership. These transfers of
ownership can take the following forms:
•
•
•
Adding, changing or deleting a joint owner.
Transfer of ownership to another person or entity.
Collateral assignment of the annuity if the annuity was issued after August 13,
1982. If the entire annuity is pledged as collateral, all future earnings within the
annuity will be taxed as partial withdrawals in the year credited.
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In addition to taxation of earnings there may be a 10% penalty (assessed on the earnings
only) if the owner is younger than 59 ½ .
Depending on the nature and amount of the transfer gifts taxes may also be payable.
EXCEPTIONS TO TAXATION OF TRANSFERS
The following are exceptions to the taxation of annuity earnings when ownership is
transferred:
•
•
•
Transfers of ownership incident to divorce (qualified domestic court order).
Transfers of ownership between spouses.
Transfers of ownership between an individual and their grantor trust.
1035 EXCHANGES
1035 exchanges refer to a provision in the tax code that allows for the direct transfer of
accumulated funds in a life insurance policy, endowment policy, or annuity policy to
another life insurance policy, endowment policy, or annuity contract without creating a
taxable event.
Title 26, Subtitle A, Chapter 1, Sub-chapter O, Part III, Section 1035 states that "no gain
or no loss shall be recognized on the exchange" of a life insurance policy for another life
insurance policy or endowment or annuity policy...an endowment for another
endowment with a maturity no later than the maturity date of the endowment being
replaced...an annuity policy for another annuity policy.
LIFE INSURANCE TO ANNUITY
Donald purchased a life insurance policy 20 years ago with a death benefit of $100,000, a
premium of $1,000 a year, and has accumulated a cash value of $75,000. Donald is now
retiring and has adequate life insurance protection provided by another life insurance
policy.
Donald doesn't need any income at this time, but has decided to purchase an annuity that
is paying a 6% guaranteed rate of interest. The cash value of the life insurance policy is
$75,000, the premiums paid total $20,000, and if Donald surrenders his policy, the gain
of $55,000 would be subject to taxation.
The solution is to execute a 1035 Exchange. Donald will fill out a 1035 Exchange form
which directs the life insurance company to send the $55,000 cash value directly to the
insurance company issuing his annuity policy. Donald never takes constructive receipt of
the money (he never has it in his hands or bank account), so he is not taxed. The cost
basis of the life insurance policy (his original $20,000 investment) is also transferred into
the new annuity contract for future tax calculations.
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ANNUITY TO ANNUITY
1035 exchanges are used between annuity and variable annuity contracts in the same
fashion as when transferring from a life insurance policy to an annuity. The most
common reason to execute a 1035 exchange between annuities is to earn a higher rate of
interest. It is suggested that before a contract owner considers such a 1035 exchange, that
he or she discover if any penalties or surrender charges would be imposed before
exchanging an existing annuity contract.
PARTIAL 1035 EXCHANGE
In an outcome that surprised some, the Tax Court held that a proper Section 1035
exchange had taken place when an annuity holder transferred only a portion of the funds
in one annuity to a second newly-issued annuity. This approval of a partial exchange
may increase the planning opportunities typically associated with Section 1035 tax-free
exchanges.
In its opinion, the court examined the regulations for Section 1035, legislative history,
and a case dealing with the exchange of Section 403(b) annuities and concluded that there
is no requirement stipulating that the entire annuity contract must be exchanged. The
court's opinion stated that the only requirements under the applicable regulations are that
the contracts be of the same type (e.g., an annuity for an annuity) and that the obligee
under the two contracts be the same person.
“ONE FOR TWO” 1035
Under Section 1035, exchanges are not actually tax-free, but tax-deferred. The
investment in the original contract is carried over to the new contract, so the gain is
deferred until payments begin or a withdrawal from the new policy is made.
An owner of a deferred annuity requested a ruling on whether the exchange of one
annuity contract for two annuity contracts would qualify as a Section 1035 exchange.
The two replacement contracts were to be issued by the same insurance company that
issued the original annuity contract. The exchange would not have resulted in a change of
owner or annuitant.
The reason this became an issue is because the language of Section 1035 says that an
exchange can be made of "an annuity contract for an annuity contract," which might lead
some to believe it means that one contract may be exchanged for only one new contract.
In the case at hand, one of the new annuities was to be a variable annuity. The other was
to have a guaranteed minimum income feature so that regardless of the performance of
the underlying investments of the annuity, a minimum amount will be paid out each
month.
In its ruling, the IRS pointed out that if two or more annuities were purchased with the
same consideration, the annuities would be treated as one annuity contract for income tax
56
purposes. The IRS also said that Section 1035 is similar to Section 1031, which governs
exchanges of other types of property such as real estate. Under Section 1031, one piece
of property may be exchanged for multiple pieces of property on a tax-deferred basis,
such as one piece of real estate for two or more.
Therefore, the IRS concluded that the proposed exchange would qualify for Section 1035
treatment, and that the two new annuity contracts would be treated as one contract for
income tax purposes. Finally, the IRS ruled that any transfer of funds between the two
new annuities would not be treated as a taxable distribution from the annuity. The ruling
for this is Private Letter Ruling 200243047.
PREMATURE WITHDRAWAL PENALTY / NON-QUALIFIED ANNUITIES
The IRS deems withdrawals made from all annuities (non-qualified and qualified) prior
to the owner’s age 59 ½ to be premature distributions. Not only are the earnings taxed at
ordinary income-tax rates, an additional penalty of 10% is charged on the earnings
withdrawn.
No penalties are due on distributions that meet any of the following criteria:
• Made after the owner’s age 59 ½.
• Made on or after the death of the owner of the annuity.
• Made after the owner becomes disabled.
• Made as part of a series of substantially equal periodic payments (not less than
annually) for the life (or life expectancy) of the taxpayer or joints lives (or joint
expectancies) of the taxpayer and his or her designated beneficiary.
• Made under a single-premium immediate annuity with a starting date no later than
one year from the annuity purchase date.
• Made under certain annuities issued in connection with a structured settlement
agreement.
• Annuitization (for the owner's life or life expectancy).
Note: An exchange from a deferred to an immediate annuity does not
qualify as an immediate annuity for the purposes of avoiding tax penalty.
OTHER TAX CONSIDERATIONS / NON QUALIFIED ANNUITIES
Since the growth that occurs within a non-qualified annuity is tax-deferred, it is not added
to the annuity owner’s income until it is withdrawn from the annuity. This gives rise to a
potential benefit of an annuity to certain individuals.
The tax-deferred earnings that occur within an annuity do not count towards income
thresholds for the purpose of determining if the annuity owner pays federal income taxes
on their Social Security benefits.
This will be a benefit to an individual (versus other investments without this benefit) if
the earnings within the annuity would cause the individual to pay taxes on their Social
Security benefits had they occurred outside of an annuity.
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To determine if this will accrue as a benefit to an individual, the agent will need to know
the individual’s overall tax situation in considerable detail.
Taxation of Social Security benefits is tied to exceeding certain income thresholds, which
vary depending on tax-filing status. Below is a brief discussion of how to determine if an
individual (or couple) will pay taxes on part of their Social Security benefits.
This usually happens only if you have other substantial income (such as wages, selfemployment, interest, dividends and other taxable income that must be reported on your
tax return) in addition to your benefits.
First determine “combined income” as follows
Your adjusted gross income
+* Nontaxable interest
+ ½ of your Social Security benefits
= Your "combined income"
*Non-taxable income would also include income from municipal bonds.
Then check the “combined income” against the threshold below to see how much (if any)
of Social Security benefits are taxable.
If you:
•
•
•
file a federal tax return as an "individual" and your combined income* is
o between $25,000 and $34,000, you may have to pay income tax on up to
50 percent of your benefits.
o more than $34,000, up to 85 percent of your benefits may be taxable.
file a joint return, and you and your spouse have a combined income* that is
o between $32,000 and $44,000, you may have to pay income tax on up to
50 percent of your benefits
o more than $44,000, up to 85 percent of your benefits may be taxable.
are married and file a separate tax return, you probably will pay taxes on your
benefits.
TAXATION OF QUALIFIED ANNUITIES
A qualified annuity is an annuity that is within a qualified retirement plan. Once an
annuity has been placed within a qualified retirement plan it is taxed identically to any
other qualified account such as an IRA, 401(k), profit sharing plan or other tax-deferred
retirement account. Another way to explain it is that the annuity ceases to be taxed as an
annuity and assumes all of the tax characteristics of the qualified retirement plan it is
placed within.
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CONTRIBUTIONS TO QUALIFIED ANNUITIES
Almost all contributions to qualified annuities are made with before-tax dollars. Since, by
definition, a qualified annuity is within a qualified retirement plan, all contributions are
deducted from taxable income. In employer-provided qualified retirement plans, these
contributions are actually excluded from taxable income for federal income tax purposes.
All growth or earnings that occur within a qualified annuity is tax-deferred and will not
be taxed until withdrawn. When withdrawn all taxable amounts from a qualified annuity
will be taxed as ordinary income.
THE ROTH IRA IS AN EXCEPTION
Due to the tax nature of a ROTH IRA, Qualified annuities within a ROTH do not result in
a deduction from taxable income for contributions. The ROTH IRA is also an exception
to most of the other tax aspects related to other qualified retirement plans.
MINIMUM REQUIRED DISTRIBUTIONS (MRD)
Once the annuity owner has reached age 70 ½ they must begin to distribute the qualified
annuity. Generally speaking, the annuitant MUST make the first withdrawal no later than
April 1st .of the year following the year they reach age 70 ½. In subsequent years,
withdrawals must be made by the end of each calendar year.
RETIREMENT PLANS COVERED
If the annuity owner has an IRA, 401(k), 403(b), 457, SEP, or SIMPLE Plan, he or she is
also required to begin minimum distributions by age 70½. Roth IRAs are not covered by
the MRD rule.
MULTIPLE RETIREMENT PLANS
If the annuitant has more than one retirement plan from which minimum required
distributions must be made, he or she must calculate the amount required for each plan
and make appropriate withdrawals. The actual minimum distribution may be taken from
one plan to satisfy the MRDs of all plans. The value used to calculate the MRD is the
total value of each plan as of December 31st of the preceding year.
IRS PENALTY FOR UNDER-DISTRIBUTION
Failure to make the required minimum distribution by the end of the calendar year results
in a penalty equal to 50% of the amount of the distribution. In addition, ordinary income
taxes are due on the entire amount, as well.
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CALCULATING THE MRD
Calculating the Minimum Required Distribution (MRD) is easy. The annuitant calculates
the account balance as of December 31st of the preceding year and divides it by his or
her life expectancy.
ACCOUNT BALANCE
Contributions - Include all contributions made in the immediate preceding year for which
the calculation is being made.
Distributions - When calculating the distribution for the second year only, it is reduced
by any distribution made in that year to satisfy the minimum distribution requirement for
the first year. The first year distribution year is the year in which the annuity owner
reached age 70½.
LIFE EXPECTANCY
Single Life Expectancy - The annuity owner’s life expectancy as set forth by the IRS and
declared on a life expectancy table.
Joint Life Expectancy - The life expectancy of both the owner and designated beneficiary
as set forth by IRS and declared on a life expectancy table.
Death of Owner - If the contract owner dies before distributions have begun, the
remaining life expectancy of the beneficiary is calculated, as set forth by the IRS and
declared on a life expectancy table.
QUALIFIED ANNUITY DISTRIBUTIONS PRIOR TO AGE 59½
As discussed in the section on taxation of non-qualified annuities, if the annuity owner
makes a withdrawal prior to age 59 ½, the IRS imposes a 10% penalty on the distribution.
This penalty is 10% of the part of the distribution that must be included in gross income.
Since we are discussing distributions from a qualified annuity, in most cases 100% of the
distribution will be included in gross income. This 10% penalty is in addition to any
regular income tax on the amount included in gross income.
Qualified annuities, because they are funding vehicles for qualified retirement plans, have
a wider range of exceptions to this 10% early withdrawal penalty.
NOTE: Don’t confuse the additional exceptions to the 10% early
distribution penalty (covered below) available to qualified annuities and
assume they also apply to non-qualified annuities.
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EXCEPTIONS TO 10% PENALTY…QUALIFIED ANNUITIES
UNREIMBURSED MEDICAL EXPENSES
Even if younger than age 59½, an owner does not have to pay the 10% tax on amounts
withdrawn that are not more than the amount paid for unreimbursed medical expenses
during the year of the withdrawal, minus 7.5% of the adjusted gross income for the year
of the withdrawal. The annuitant may only take into account unreimbursed medical
expenses that would be included in figuring a deduction for medical expenses on
Schedule A, Form 1040. Deductions do not have to be itemized to take advantage of this
exception to the 10% additional tax.
MEDICAL INSURANCE
Even if younger than age 59½, an owner may not have to pay the 10% tax on amounts
withdrawn during the year that are not more than the amount paid during the year for
medical insurance for themselves, their spouse, and their dependents. Owners will not
have to pay the tax on these amounts if all four of the following conditions apply:
1. They lost their jobs.
2. They received unemployment compensation paid under any federal or state law
for 12 consecutive weeks.
3. They made the withdrawals during either the year they received the
unemployment compensation or the following year.
4. They made the withdrawals no later than 60 days after they became re-employed.
DISABILITY
If the owner becomes disabled before reaching age 59½, any amounts withdrawn because
of disability are not subject to the 10% additional tax. The owner is considered disabled
if they furnish proof that they are unable to do any substantial, gainful activity because of
their physical or mental condition. A physician must determine that the condition can be
expected to result in death or to be of long, continued, and indefinite duration.
DEATH
If the owner dies before reaching 59 1/2, the assets in the annuity can be distributed to
beneficiaries or to the owner’s estate without having to pay the 10% additional tax.
However, if an individual inherits a traditional IRA from a deceased spouse and elects to
treat it as his or own IRA, any distribution they later receive before reaching age 59 1/2
may be subject to the 10% additional tax.
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HIGHER EDUCATION EXPENSES
Even if the owner has not yet reached 59 1/2, if he or she paid expenses for higher
education during the year, part (or all) of any withdrawal may not be subject to the 10%
tax on early withdrawals. The part not subject to the tax is generally the amount that is
not more than the qualified higher education expenses for the year for education
furnished at an eligible educational institution. The education must be for the owner, a
spouse, or the children or grandchildren of the owner or the spouse.
When determining the amount of the withdrawal that is not subject to the 10% tax,
include qualified higher education expenses paid with any of the following types of
funds:
• An individual's earnings.
• A loan.
• A gift.
• An inheritance given to either the student or the individual making the
withdrawal.
• Personal savings (including savings from a qualified state tuition program).
Do not include expenses paid with any of the following funds:
Tax-free distributions from an education IRA.
•
•
•
Tax-free scholarships, such as a Pell grant.
Tax-free employer-provided educational assistance.
Any tax-free payment (other than a gift, bequest, or devise) due to enrollment at
an eligible educational institution.
Qualified higher education expenses. Qualified higher education expenses are tuition,
fees, books, supplies, and equipment required for the enrollment or attendance of a
student at an eligible educational institution. In addition, if the individual is at least a
half-time student, room and board expenses are qualified higher education expenses.
Eligible Educational Institution
An eligible educational institution is any college, university, vocational school, or other
post-secondary educational institution eligible to participate in the student aid programs
administered by the Department of Education. It includes virtually all accredited public,
non-profit, and proprietary (privately owned profit-making) post-secondary institutions.
The educational institution should be able to tell the annuitant if it is an eligible
educational institution.
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FIRST HOME PURCHASE
To qualify for penalty-free withdrawal treatment as a first-time homebuyer distribution, a
distribution must meet the following requirements:
• It must be used to pay qualified acquisition costs before the close of the 120th day
after the day they received it; or
• It must be used to pay qualified acquisition costs for the main home of a first-time
homebuyer who is any of the following:
o The annuity owner.
o The annuity owner’s spouse.
o The child of the annuity owner or his or her spouse.
o The grandchild of the annuity owner or his or her spouse.
o The parent or other ancestor of the annuity owner or his or her spouse.
When added to all the prior qualified first-time homebuyer distributions, if any, the total
distributions cannot be more than $10,000. If both husband and wife are first-time
homebuyers, they may each withdraw up to $10,000, penalty-free, for a first home.
Qualified Acquisition Costs
Qualified acquisition costs include the costs of buying, building, or rebuilding a home
and any usual or reasonable settlement, financing, or other closing costs.
First-Time Homebuyer
A first-time homebuyer is, generally, any individual (and his or her spouse, if married)
who had no present ownership interest in a main home during the two-year period ending
on the date the individual acquires the main home to which these rules apply.
Date of Acquisition
The date of acquisition is the date that the first-time homebuyer enters into a binding
contract to buy the main home to which these rules apply or the building or rebuilding of
the main home to which these rules apply begins.
AVOIDANCE OF THE PRE 59 1/2 DISTRIBUTION PENALTY
If an annuity owner adheres strictly to one of three withdrawal methods of which the IRS
approves, he or she may make withdrawals prior to age 59 1/2 and avoid the Premature
Distribution Penalty Tax.
The annuitant may receive distributions that are part of a series of substantially equal
payments over the annuitant’s lifetime (or life expectancy), or over the lifetimes (or joint
life expectancies) of the annuitant and the beneficiary, without having to pay the 10%
additional tax, even if such distributions are received before the annuitant reaches age 59
1/2.
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The annuitant must use an IRS-approved distribution method and at least one distribution
must be received annually for this exception to apply. One IRA-approved method is
known as the "life expectancy method," and unlike the purposes used for minimum
distributions, this method results in the exact amount required, not the minimum amount.
The payments under this exception must continue for at least five years, or until the
annuitant reach age 59 1/2, whichever is the longer period. This five-year rule does not
apply if a change from an approved distribution method is made because of the death or
disability of the annuity owner.
For example, if the annuitant received a lump-sum distribution of the balance in an
annuity before the end of the required period for the annuity distributions, and they did
not receive it because of disability, the annuitant would be subject to the 10% additional
tax. The tax would apply to the lump-sum distribution and all previous distributions
made under the exception rule.
There are two other IRS-approved distribution methods. They are generally referred to as
the amortization method and the annuity factor method. These two methods are complex
and require the assistance of a tax professional. For more information about these
methods, see IRS Notice 89-25 in Internal Revenue Cumulative Bulletin 1989-1.
PRIMARY USES OF ANNUITIES
TAX-DEFERRED GROWTH VS TAXABLE OR TAX-FREE GROWTH
Earlier in the section on annuity taxation we learned that the money deposited into an
annuity may earn interest, receive dividend income, or earn capital gain distributions
(collectively referred to as earnings). These earnings--unlike earnings in a savings
account, mutual fund, or certificate of deposit--are not taxed in the year in which they are
earned. Thus the earnings continue to grow and compound, tax-deferred, until
withdrawn.
We learned some of the restrictions in the tax code associated with the benefit of taxdeferred growth.
We also learned how, when and to whom these earnings are ultimately considered taxable
income.
The value of difference in taxable growth versus tax-deferred growth will vary from one
individual to another based on a number of factors including their current marginal
income tax bracket as well as their anticipated retirement tax bracket. While the value of
tax deferral will vary from one to another most agree that tax deferral is a valuable tool
for wealth accumulation. The longer one has to experience tax-deferred growth the
greater the potential benefit they can receive.
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TAX-FREE GROWTH
There are very few places where one can experience tax-free growth within the current
tax structure in the United States. Some Municipal Bonds are exempt from Federal and
State income taxes, and the interest paid by these instruments is priced with the this
advantage in mind. As with tax deferral, the value of tax-free growth will vary from one
taxpayer to another based on a number of factors.
Another place where tax-free growth can be obtained is through the use of a Roth IRA.
Earlier in this chapter we learned that the Roth IRA is an exception among qualified
plans in that it does not allow a deduction from current taxable income for contributions
but can provide tax-free income from that point forward. The Roth IRA is also an
exception among qualified retirement plans in that it is exempt from the required
minimum distribution requirements.
The intent here is not to write a section on the Roth IRA, but to point out that many
annuities can be placed within a Roth IRA and most annuity issuers offer an annuity that
can be used inside of a Roth.
PRIMARY USES OF ANNUITIES
GUARANTEED LIFETIME STREAM OF INCOME
Another popular use of annuities is to guarantee the owner a stream of income they can’t
outlive. The owner can annuitize the annuity under one of the annuity payout options and
enjoy a pre-defined stream of income.
As we learned earlier in a deferred annuity, annuitization often occurs many years after
purchase when the owner has accumulated sufficient values to produce a meaningful
income stream.
With a single-premium immediate annuity the owner is likely repositioning monies that
were accumulated in some investment other than an annuity and now wishes a guaranteed
stream of income upon retirement.
ANNUITIZATION SETTLEMENT OPTIONS
Settlement options are the methods by which an insurance company pays annuity
proceeds to the annuitant, contract owner, or beneficiary(ies).
Annuities offer a variety of options to provide annuitants with long-term income
payments. Regardless of the type of settlement option, the annuitant may choose to
receive payments monthly, quarterly, semi-annually, or annually. In addition to the
settlement options listed below, many annuities offer guaranteed income streams without
the need for annuitization.
LIFE ONLY
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The life only option provides for payments that continue throughout the life of the
annuitant. The annuitant cannot outlive income. Upon the annuitant’s death, however,
payments cease, regardless of the length of time payment have been made.
•
•
•
•
ADVANTAGES
Results in the highest payout among the life assumptions.
Provides an income stream for life of annuitant.
DISADVANTAGES
Does not offer a refund or guarantee to the heirs if the annuitant dies before
receiving all of the initial premium back.
No income stream to spouse if married.
LIFE ONLY WITH GUARANTEED MINIMUM OPTION OR REFUND
The annuitant receives payments that continue for life. If the annuitant dies before the
initial investment in the annuity has been repaid, the balance of the initial investment will
be paid to the beneficiary(ies).
•
•
•
•
ADVANTAGES
Guarantees that if the annuitant dies before receiving at least their initial
investment in the annuity the heirs will receive the balance.
Provides an income stream for life.
DISADVANTAGES
Pays a smaller income to the annuitant than life only due to the cost of the
minimum guarantee to the heirs.
No income stream to spouse if married.
LIFE WITH PERIOD CERTAIN
Life and period certain means payments will continue for the rest of the
annuitant’s life but for no less than the stated number of years—even if the
annuitant dies. If the annuitant dies before the end of the period certain, the
beneficiary(ies) continue to receive the payments for the balance of the period
certain.
•
•
•
ADVANTAGES
Provides an income stream for life
The period certain guarantee supports a larger amount to the heirs than the refund
or guaranteed minimum should the annuitant die early. Also potentially would
provide a benefit to the heirs when the refund wouldn’t.
DISADVANTAGES
Pays a smaller income amount to the annuitant due to the increased costs of the
period certain guarantee.
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•
No income stream to spouse if married.
JOINT AND SURVIVOR
When a joint and survivor annuity contract is issued on a couple (usually and husband
and wife), or if the beneficiary opts for a joint and survivor payout, the contract provides
a payout for as long as either of the two annuitants/beneficiaries is alive. The amount of
each payment is usually less than if it were based on a single individual. They may
choose to have payments remain the same or decrease after the death of the first
annuitant. For example, after the first annuitant/beneficiary dies, they may choose to
have payments reduce to two-thirds of the amount paid while both annuitants were alive.
This is called a joint and two-thirds annuity.
•
•
•
•
ADVANTAGES
Provides an income stream for life of annuitant and/or spouse.
Most companies allow a reduced survivor benefit (as in the 2/3 example) to
minimize impact on income while both live.
DISADVANTAGES
Pays a smaller income amount than would any of the other life assumption
options.
If spouse predeceases annuitant, annuitant is stuck at lower income level.
PERIOD CERTAIN ONLY
Period certain means that income payments will be made over a specified number of
years chosen by the annuitant. Payments will continue for the duration of the period
certain and at the end of that term, will cease. If the annuitant dies before the end of the
stated number of years, the beneficiary(ies) continue to receive payments for the balance
of the period certain. Most annuity contracts only allow annuitization over a limited
choice of certain periods ( 3 yrs, 5yrs, 10 yrs etc), however; some annuity contracts allow
the annuity owner to specify a dollar amount of the periodic annuity payment and then
“back in” to the length of the period certain.
•
•
•
ADVANTAGES
Usually provides a larger income stream than any of the life assumption options.
Exceptions would be if period certain was longer than life expectancy of
annuitant.
Amount of income needed is driver for the options and the amount paid under
period certain meets short-term income goals better than a life assumption option.
DISADVANTAGES
No life assumption, therefore annuitant and/or spouse could outlive income
stream.
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LONG-TERM RETIREMENT ACCUMULATION
One of the most common uses for an annuity is long-term saving for retirement. Since the
annuity grows tax-deferred, the annuity owner benefits from the lon- term deferral of
taxes on the growth inside the annuity. This is true whether the annuity is qualified or
non-qualified.
When utilizing an annuity for retirement the annuity owner makes a long-term
commitment to save for retirement and understands that it takes consistent saving over an
extended period to build retirement wealth. Long term can be defined a number of ways,
but usually is interpreted to mean at least 5 to 10 years. When selling an annuity the term
“long term” should be at least equal in length to the duration of the surrender charge
period of the annuity being recommended.
POTENTIAL TO AVOID PROBATE
Most states exempt from probate an intangible personal property with an operative
beneficiary designation. Life insurance death benefits and proceeds from annuities are
exempt from probate in most states, provided the beneficiary designation is operative. An
operative beneficiary designation is where the named beneficiary is a valid person or
trust, can be uniquely determined from the contract (life policy or annuity), and is
unambiguous.
If the primary beneficiary has predeceased the owner of the life policy or annuity, the
beneficiary designation is still operative provided there is a secondary beneficiary
designation.
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Chapter 2 - Review Questions
(Answers are in the back of the text)
1. Which of the following describes a premature distribution?
(a)
(b)
(c)
(d)
Selecting annuitization prior to age 70 ½
Withdrawing funds from an annuity before the annuitant’s age 59 ½
A settlement option
A non-forfeiture option
2. Withdrawals from a qualified annuity may be postponed until what age?
(a)
(b)
(c)
(d)
55
59 ½
65
70 ½
3. Failure to make the required minimum distributions from an annuity by the annuitant’s
age 70 ½ results in a penalty of what amount?
(a)
(b)
(c)
(d)
10%
15%
38%
50%
4. MRD is an acronym for which of the following?
(a)
(b)
(c)
(d)
Minimum Required Deposit
Maximum Required Deposit
Minimum Required Distribution
Maximum Required Distribution
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Chapter 3
NAIC ANNUITY SUITABILITY MODEL
NAIC SUITABILITY IN ANNUITY TRANSACTIONS MODEL REGULATION
NOTE: This section covers the current status of the NAIC Suitability in
Annuity Transactions Model Regulation. This Model Regulation can be
viewed as a template to be used in drafting the law to be passed at the
state level. In several sections there are blanks where reference to state
laws will be inserted and/or choice will be made by state legislators.
The NAIC will be publishing best practices for additional guidance to
insurers and producers to use to comply with Section 6.
While all sections of this Model Regulation are important, Section 6
contains the duties of the insurer and producer under this regulation and
should be reviewed carefully.
SECTION 1 PURPOSE
A. The purpose of this regulation is to require insurers to establish a system to supervise
recommendations and to set forth standards and procedures for recommendations to
consumers that result in a transaction involving annuity products so that unsuitable sales
are deterred and the insurance needs and financial objectives of consumers at the time of
the transaction are appropriately addresses.
B. Nothing herein shall be construed to create or imply a private cause of action for a
violation of this regulation.
SECTION 2. SCOPE
This regulation shall apply to any recommendation to purchase, exchange or replace an
annuity made to a consumer by an insurance producer, or an insurer where no producer is
involved, that results in the purchase, exchange or replacement recommended.
SECTION 3. AUTHORITY
This regulation is issued under the authority of [insert reference to state enabling
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legislation].
SECTION 4. EXEMPTIONS
Unless otherwise specifically included, this regulation shall not apply to
recommendations involving:
A. Direct response solicitations by insurers where there is no recommendation based on
information collected from the consumer pursuant to this regulation;
B. Contracts used to fund:
(1) Any of the following, unless there is a recommendation to an individual plan
participant regarding an annuity, in which case this regulation does apply with
respect to the recommendation:
(a) An employee pension or welfare benefit plan that is covered by the Employee
Retirement and Income Security Act (ERISA);
(b) A plan described by sections 401(a), 401(k), 403(b), 408(k) or 408(p) of the
Internal Revenue Code (IRC), as amended, if established or maintained by an
employer;
(c) A government or church plan defined in section 414 of the IRC, a
government or church welfare benefit plan, or a deferred compensation plan of a
state or local government or tax exempt organization under section 457 of the
IRC;
(d) A nonqualified deferred compensation arrangement established or maintained
by an employer or plan sponsor;
(2) Settlements of or assumptions of liabilities associated with personal injury
litigation or any dispute or claim resolution process; or
(3) Formal prepaid funeral contracts.
NOTE: When adopted by states this section often does not exempt
employer-provided retirement plans where individual annuities are
used to fund the plan and/or where the plan participants have a
choice of two or more annuity vendors within the plan.
SECTION 5. DEFINITIONS
A. “Annuity” means an annuity that is an insurance product under State law that is
individually solicited, whether the product is classified as an individual or group annuity.
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B. “Continuing education credit” or “CE credit” means one continuing education credit
as defined in [insert reference in State law or regulations governing producer continuing
education course approval].
C. “Continuing education provider” or “CE provider” means an individual or entity
that is approved to offer continuing education courses pursuant to [insert reference in
State law or regulations governing producer continuing education course approval].
D. “FINRA” means the Financial Industry Regulatory Authority or a succeeding agency.
E. “Insurer” means a company required to be licensed under the laws of this state to
provide insurance products, including annuities.
F. “Insurance producer” means a person required to be licensed under the laws of this
state to sell, solicit or negotiate insurance, including annuities.
G. “Recommendation” means advice provided by an insurance producer, or an insurer
where no producer is involved, to an individual consumer that results in a purchase,
exchange or replacement of an annuity in accordance with that advice.
H. “Suitability information” means information that is reasonably appropriate to
determine the suitability of a recommendation, including the following:
(1) Age;
(2) Annual income;
(3) Financial situation and needs, including the financial resources used for the
funding of the annuity;
(4) Financial experience;
(5) Financial objectives;
(6) Intended use of the annuity;
(7) Financial time horizon;
(8) Existing assets, including investment and life insurance holdings;
(9) Liquidity needs;
(10) Liquid net worth;
(11) Risk tolerance; and
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(12) Tax status.
SECTION 6. DUTIES OF INSURERS AND OF INSURANCE PRODUCERS
A. In recommending to a consumer the purchase of an annuity or the exchange of an
annuity that results in another insurance transaction or series of insurance transactions,
the insurance producer, or 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:
(1) The consumer has been reasonably informed, in general terms, of various features
of the annuity, such as the potential surrender period and surrender charge, potential
tax penalty if the consumer sells, exchanges, surrenders or annuitizes the annuity,
mortality and expense fees, investment advisory fees, potential charges for and
features of riders, limitations on interest returns; insurance and investment
components and market risk;
(2) The consumer would benefit from the purchase of the annuity certain features of
the annuity, such as tax-deferred growth, annuitization or death or living benefit;
(3) The particular annuity as a whole, the underlying subaccounts to which funds are
allocated at the time of purchase or exchange of the annuity, and riders and similar
product enhancements, if any, are suitable (and in the case of an exchange or
replacement, the transaction as a whole is suitable) for the particular consumer based
on his or her suitability information; and
(4) In the case of an exchange or replacement of an annuity, the exchange or
replacement is suitable including taking into consideration whether:
(a) The consumer will incur a surrender charge, be subject to the commencement
of a new surrender period, lose existing benefits (such as death, living or other
contractual benefits), or be subject to increased fees, investment advisory fees or
charges for riders and similar product enhancements;
(b) The consumer would benefit from product enhancements and improvements;
and
(c) The consumer has had another annuity exchange or replacement and, in
particular, an exchange or replacement within the preceding 36 months.
B. Prior to the execution of a purchase or exchange of an annuity resulting from a
recommendation, an insurance producer, or an insurer where no producer is involved,
shall make reasonable efforts to obtain the consumer’s suitability information
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C. An insurer is ultimately responsible for compliance with this regulation. If a violation
occurs, either because of the action or inaction of the insurer or its insurance producer,
the insurer is responsible for taking appropriate corrective action, including, but not
limited to, canceling a transaction that is not suitable, and is subject to sanctions and
penalties, subject to section 8 of this regulation.
D. Except as permitted under subsection E, an insurer shall not issue an annuity
recommended to a consumer unless there is a reasonable basis to believe the annuity is
suitable based on the consumer’s suitability information. The penalty for a violation of
this subsection is subject to section 8C of this regulation.
E
(1) Except as provided under paragraph (2) of this subsection, neither an insurance
producer, nor an insurer where no producer is involved, shall have any obligation to a
consumer under Subsection A or D related to any annuity transaction if a consumer:
(a) Refuses to provide relevant information requested by the insurer or insurance
producer, or decided to enter into an annuity transaction that is not based on a
recommendation of the insurer or insurance producer, but there is a reasonable
basis to believe the annuity transaction is suitable; or
(b) Fails to provide complete or accurate information
(2) An insurer or insurance producer’s recommendation subject to Paragraph (1) shall
be reasonable under all the circumstances actually known to the insurer or insurance
producer at the time of the recommendation.
(3) Where the customer refuses to provide suitability information, the insurance
producer, or an insurer where no insurance producer is involved, must provide the
customer with an explanation of the purpose of requesting the suitability information
and the potential repercussions of not providing the suitability information.
F. An insurance producer or, where no insurance producer is involved, the responsible
insurer representative, shall at the time of sale:
(1) Make a record of any recommendation subject to section 6A of this regulation;
(2) Obtain a customer signed statement documenting a customer’s refusal to provide
suitability information, if any; and
(3) Obtain a customer signed statement acknowledging that an annuity transaction is
not recommended if a customer decides to enter into an annuity transaction that is not
based on the insurer producer’s or insurer’s recommendation.
G
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(1) An insurer shall establish a supervision system that is reasonably designed to
achieve the insurer’s and its insurance producers compliance with this regulation,
including, but not limited to, the following:
(a) The insurer shall maintain reasonable procedures to inform its insurance
producers of the requirements of this regulation and shall incorporate the
requirements of this regulation into relevant insurance producer training
manuals;
(b) The insurer shall establish standards for insurance producer product training
and shall maintain reasonable procedures to require its insurance producers to
comply with the requirements of section 7 of this regulation;
(c) The insurer shall provide product-specific training and training materials
which explain all material features of its annuity products to its insurance
producers;
(d) The insurer shall maintain reasonable procedures to confirm consumer
suitability information that supports a recommendation to the extent reasonably
appropriate to identify, and to deter, insurance producer submission of inaccurate
information;
(e)
(i) The insurer shall maintain reasonable procedures for review of each
recommendation, including each insurance producer recommendation, that
are reasonably designed to ensure that there is a reasonable basis to
determine that a recommendation is suitable. An insurer’s procedures under
this paragraph may be accomplished electronically applying a system of
selection criteria to identify selected recommendations for review that is
reasonably designed to ensure that there is a reasonable basis to determine
that recommendations are suitable. Such an electronic system may be
designed to require staff review only of those transactions identified for staff
review by the selection criteria.
(ii) Nothing in this subparagraph:
(I) Restricts the FINRA member broker-dealer safe harbor provided
under paragraph (2); or
(II) Prevents an insurer from contracting as provided under paragraph (3)
for performance of the procedures required under this subparagraph;
(f) The insurer shall maintain reasonable procedures to detect recommendations
that are not suitable. This may include, but is not limited to, systematic customer
surveys, interviews, confirmation letters and programs of internal monitoring;
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(g) The insurer shall maintain reasonable procedures for examination of its
insurance producers and their affiliated insurance agencies at reasonable periodic
intervals. The examination shall be reasonably designed to assist in detecting and
preventing violations of this regulation. Nothing in this paragraph prohibits an
insurer from accepting an examination conducted, and report certified, by an
independent qualified firm or contracting under paragraph (3) for performance of
the examination. Any such examination shall comply with the requirements of
this subparagraph; and
(h) The insurer shall annually provide a report to senior management, including
to the senior manager responsible for audit functions, which details a review,
with appropriate testing, reasonably designed to determine the effectiveness of
the supervision system, the exceptions found, and corrective action
recommended, if any.
(2)
(a) A FINRA member broker-dealer supervision system that complies with
FINRA suitability rules shall satisfy the insurer’s supervision requirements under
subsection G
(b) An insurer shall:
(i) Monitor the FINRA member broker-dealer, using information collected in
the normal course of the insurer’s business; and
(ii) Provide to the FINRA member broker-dealer information and reports that
are reasonably appropriate to assist the FINRA member broker-dealer to
maintain its supervision system.
(3)
(a) Nothing in this subsection restricts an insurer from contracting for
performance of a function required under this subsection. An insurer is subject
to, and is required to comply with this subsection G regardless of whether the
insurer contracts for performance of a function and regardless of the insurer’s
compliance with subparagraph (b) of this paragraph.
(b) An insurer’s supervision system under paragraph (1) shall include reasonable
supervision of contractual performance under this subsection. This includes, but
is not limited to, the following:
(i) Reasonable monitoring and, as appropriate, audits to assure that the
contracted function is properly performed; and
(ii) Annually obtaining a certification from a senior manager who has
responsibility for the contracted function that the manager has a reasonable
basis to represent, and does represent, that the function is properly
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performed.
(4) An insurer is not required to include in its system of supervision an insurance
producer’s recommendations to consumers of products other than the annuities
offered by the insurer.
H. An insurance producer shall not dissuade, or attempt to dissuade, a consumer from:
(1) Truthfully responding to an insurer’s request for confirmation of suitability
information;
(2) Filing a complaint; or
(3) Cooperating with the investigation of a complaint.
I. A registered representative recommendation of an annuity that is a security that
complies with the FINRA rules pertaining to suitability shall satisfy the requirements
under this section for the recommendation of annuities. However, nothing in this
subsection shall limit the insurance commissioner’s ability to enforce the provisions of
this regulation.
SECTION 7. INSURANCE PRODUCER TRAINING
A. An insurance producer shall not solicit the sale of an annuity product unless the
insurance producer has adequate knowledge of the product to recommend the annuity and
the insurance producer is in compliance with the insurer’s standards for product training.
An insurance producer may rely on insurer-provided product-specific training standards
and materials to comply with this subsection.
B.
(1) An insurance producer who engages in the sale of annuity products shall
complete a one-time four (4) credit training course approved by the department of
insurance and provided by the department of insurance-approved education provider.
(2) The minimum length of the training required under this subsection shall be
sufficient to qualify for at least four (4) CE credits, but may be longer.
(3) The training required under this subsection shall include information on the
following topics:
(a) The types of annuities and various classifications of annuities;
(b) Identification of the parties to an annuity;
(c) How fixed, variable and indexed annuity contract provisions affect
consumers;
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(d) The application of income taxation of qualified and non-qualified annuities;
(e) The primary uses of annuities; and
(f) Appropriate sales practices, replacement and disclosure requirements.
(4) Providers of courses intended to comply with this subsection shall cover all topics
listed in the prescribed outline and shall not present any marketing information or
provide training on sales techniques or provide specific information about a
particular insurer’s products. Additional topics may be offered in conjunction with
and in addition to the required outline.
(5) A provider of an annuity training course intended to comply with this subsection
shall register as a CE provider in this State and comply with the rules and guidelines
applicable to insurance producer continuing education courses as set forth in [insert
reference to State law or regulations governing producer continuing education course
approval].
(6) Annuity training courses may be conducted and completed by classroom or selfstudy methods in accordance with [insert reference to State law or regulations
governing producer continuing education course approval].
(7) Providers of annuity training shall comply with the reporting requirements and
shall issue certificates of completion in accordance with [insert reference to State law
or regulations governing to producer continuing education course approval].
(8) The satisfaction of the training requirements of another State that are substantially
similar to the provisions of this subsection shall be deemed to satisfy the training
requirements of this subsection in this State.
(9) Insurance producers who hold a life insurance line of authority on the effective
date of this regulation shall complete the requirements of this subsection within six
(6) months after the effective date of this regulation. Individuals who obtain a life
insurance line of authority on or after the effective date of this regulation may not
engage in the sale of annuities until the annuity training course required under this
subsection has been completed.
(10) An insurer shall verify that an insurance producer has completed the annuity
training course required under this subsection before allowing the producer to sell an
annuity product for that insurer. An insurer may satisfy its responsibility under this
subsection by obtaining certificates of completion of the training course or obtaining
reports provided by commissioner-sponsored database systems or vendors or from a
reasonably reliable commercial database vendor that has a reporting arrangement
with approved insurance education providers.
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SECTION 8. MITIGATION OF RESPONSIBILITY
A. The commissioner may order:
(1) An insurer to take reasonably appropriate corrective action for any consumer
harmed by the insurer’s, or by its insurance producer’s, violation of this regulation;
(2) An insurance producer to take reasonably appropriate corrective action for any
consumer harmed by the insurance producer’s violation of this regulation; and
(3) A general agency or independent agency that employs or contracts with an
insurance producer to sell, or solicit the sale, of annuities to consumers, to take
reasonably appropriate corrective action for any consumer harmed by the insurance
producer’s violation of this regulation.
B. Any applicable penalty under [insert statutory citation] for a violation of section 6A,
B, E or F of this regulation may be reduced or eliminated [, according to a schedule
adopted by the commissioner,] if corrective action for the consumer was taken promptly
after a violation was discovered.
C. Any applicable penalty under [insert statutory citation] for an insurer’s violation of
section 6D of this regulation may be reduced or eliminated [, according to a schedule
adopted by the commissioner,] if:
(1) Corrective action for the consumer is taken promptly after a violation is
discovered; and
(2) The insurer reviewed the recommendation and approved issuance of the annuity
after consideration of the customer’s suitability information as required under section
6G(1)(e) of this regulation, and the documentation received by the insurer reasonably
led the insurer to believe that the sale was suitable for the customer at the time the
annuity issued. The review and approval may be made applying selection criteria as
permitted under section 6G(1)(e) of this regulation.
D. The powers vested in the commissioner through this regulation shall be additional to
any other powers vested in him or her under law.
SECTION 9. [OPTIONAL] RECORDKEEPING
A. Insurers, general agents, independent agencies and insurance producers shall maintain
or be able to make available to the commissioner records of the information collected
from the consumer and other information used in making the recommendations that were
the basis for insurance transactions for [insert number] years after the insurance
transaction is completed by the insurer. An insurer is permitted, but shall not be required,
to maintain documentation on behalf of an insurance producer.
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B. Records required to be maintained by this regulation may be maintained in paper,
photographic, micro-process, magnetic, mechanical or electronic media or by any process
that accurately reproduces the actual document.
SECTION 10. EFFECTIVE DATE
The amendments to this regulation shall take effect six (6) months after the date the
regulation is adopted or on January 1, 2011, whichever is later.
DETERMINING CLIENT SUITABILITY
So far we have learned that as a producer selling annuities of any kind, we must obtain
information from the prospective customer to ascertain suitability. We have also
reviewed the NAIC Annuity Suitability Model Regulation. These regulations spell out the
duties of insurers and producers relative to recommendations to consumers for annuity
transactions (purchase or exchange).
Before an annuity transaction is recommended the agent or the insurer (if no agent is
involved) must document, in writing, a reasonable basis for making the recommendation.
As we saw earlier in this chapter, The NAIC Suitability in Annuity Transactions Model
Regulation defines twelve categories of “Suitability Information” that should be collected
to determine the suitability of a recommended annuity transaction. Most of the suitability
forms that have been and will be developed revolve around these twelve categories of
information.
With this in mind we offer the following chapter as a primer to the producer to consider.
In the following pages we cover many elements of a consumer’s lifestyle that can affect
the suitability of an annuity transaction. If the producer transacts business in a state with a
mandated form or transacts business for an insurer with their own information gathering
requirements, we recommend they follow those requirements.
HOW ANNUITY PROVISIONS AFFECT CONSUMERS
As we cover the different categories of information to be gathered from the prospective
annuity owner, we will attempt to explain why this information is important and how
provisions within an annuity contract can affect a consumer based on differing scenarios.
Since annuities impose surrender charges the current and future liquid resources and
needs of the consumer should be a major consideration in determining annuity suitability.
A big issue with annuity sales is overselling an annuity. Overselling is taking a situation
where an annuity makes sense for the consumer but the agent recommends that too much
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of their assets be put into an annuity. When an annuity is oversold the consumer often
finds themselves needing cash for some reason and the only place they can turn (short of
borrowing) is the annuity which may still be within the surrender charge period.
While most regulations affecting annuity suitability do not require all of the below
information to be collected, we list many facets of the consumers current situation that
can have a bearing on suitability and provide a short narrative of how and why it is
important.
Whether or not the producer decides to embrace all of the suggestions in this chapter, It is
certain that the more relevant information one obtains from the consumer the more likely
one is to consistently make suitable recommendations.
PERSONAL INFORMATION
Personal Information This category includes information such as: name, age,
sex, address, marital status and dependents and their ages. This information
should be collected for all parties to the annuity.
CONSUMER FINANCIAL STATUS
Current financial situation: The consumer’s current financial situation includes
information related to their current assets, income-tax circumstances, liquidity
needs, and resources.
ASSETS - INVESTMENTS AND LIFE INSURANCE
Existing assets: Information should be collected about all of their
investments. For each asset the type of asset, value, original purchase date,
intended use, tax status (qualified or non-qualified), type of ownership (single,
joint, trust), and current income (if any) provided by the asset.
ENDOWMENTS
Endowments: If the consumer is the beneficiary of an endowment the start
date (or maturity/endowment date) and form and amount of payment will be
important to determining their future financial outlook. Conversely, if the
consumer wishes to fund an endowment for the benefit of others, the desired
contribution amount and date of contribution will need to be considered in
their overall future financial considerations.
ANNUAL INCOME
Applicant's annual income: The consumer’s income and sources of income
need to be determined. Some retirement plans and financial institutions will
withhold estimated taxes as a convenience for the income recipient. If the
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income stream has already had estimated taxes withheld then the agent needs
to know if the amounts withheld have been adequate in past years. If in the
past the consumer has been required to pay additional taxes at year end this
will be evidence of an annual need for liquidity. If no taxes are withheld from
some or all of the consumer’s income streams then the need for liquidity at tax
time will be greater.
The nature of the income is also important as well as past history of the
income stream versus inflation. If the income tends to fluctuate this also needs
to be known as well as a range of the expected fluctuation. If an income
stream has a known ending point that is also important. For example, the
consumer might have sold a piece of real estate and owner financed the sale
but the payments will end in 5 years because the property will be paid off.
If the client is still working and producing income the intended retirement date
is important as well as any predicted changes in future earnings.
LIQUID NET WORTH
While some of the recommendation below are not specifically required by
suitability laws, we submit them as additional measures to forecast future
needs for liquidity and explore areas that may result in future needs for
liquidity that may not be readily apparent to most consumers. Following these
recommendations may ultimately result in a smaller annuity sale but should
also result in a more thorough analysis of potential future needs for liquidity.
The consumer’s liquid net worth should represent only the net value of assets
after being converted to cash. Assets such as real estate (including the
principal residence) should not be included in a liquid net-worth calculation
because of the speculative nature of the sale of the real estate. Assets such as
automobiles and household belongings should not be included as liquid assets,
even if they could be sold with relative ease, because they are utilized in the
consumer’s daily life and are not likely to be sold. If liquidation of an asset
involves imposition of a surrender charge or other penalty, only the net value
after imposition of the surrender charge or penalty should be considered.
LIQUIDITY NEEDS
If an asset is exposed to market risks, the future amount available for liquidity
is difficult to gauge. Additionally, if the consumer is not yet 59 ½ years old,
the qualified retirement assets should not be counted as liquid due to the 10%
early withdrawal penalty. Another consideration is the required minimum
distribution requirement at age 70 ½. If the consumer is subject to this
requirement, they should have sufficient retirement assets available for
liquidation without penalty, surrender charge, or market risk to comply with
the required distributions. Laddering of assets over time is a good strategy for
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providing future liquidity. It involves projecting liquidity needs into the
future and determining which assets will provide that liquidity stream without
penalty, surrender charge, or potential market loss.
AFFECT OF IRS EARLY WITHDRAWAL PENALTY ON LIQUIDITY NEEDS
If the one of the consumers is under 59 ½ their qualified retirement assets or
any annuity should not be counted as liquid due to the 10% early withdrawal
penalty imposed by the IRS on withdrawals from retirement plans or annuities
prior to age 59 1/2.
On the other side of this issue, if the consumer is already under the required
minimum distribution requirement they should have sufficient retirement
assets in a position to be liquidated without penalty, surrender charge, or
market risk to comply with the required distributions. Laddering of assets is a
good strategy to provide future liquidity and involves projecting liquidity
needs into the future and determining which assets will provide that liquidity
stream without penalty, surrender charge or potential market loss.
TAX STATUS
Tax status: The insurer and/or agent need to know the consumers tax filing
status (married, head of household, single, qualifying widow, etc.) as well as
any taxes in arrears. If, because of how the consumer receives their income,
they end up having to pay taxes at the end of the year, this is important in that
it affects liquidity needs.
Consumer Financial Objectives
The insurer or agent needs to get information from the consumer(s) about their
investment objectives. Often the consumer needs to be asked numerous follow up
questions for them to fully articulate their investment objectives. The timing and
amount of future access to the intended funds should be determined to the best of
the client’s ability. This is a good time to question about the need for and
existence of an emergency fund. It sometimes helps if the insurance agent repeats
to the client what they think they heard as the stated investment objective. This
gives the consumer an additional chance to sharpen their definition of their goals.
CONSUMER’S RISK TOLERANCE
Many insurers use some form of questionnaire designed to help determine risk
tolerance. This completed questionnaire is often retained by the insurer to show
that an attempt was made to determine risk tolerance. Generally speaking, the
more financial risk the product would pose to the client, the more likely the
insurer is to require a risk tolerance questionnaire. Many of these suitability
questionnaires are structured so that they can be scored in the field by the agent
and result in a numerical score that determines if the consumer’s risk tolerance is
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within the range suitable for the product being recommended. When there is more
than one person purchasing the annuity (such as husband and wife) the risk
tolerance of both should be determined.
INTENDED USE OF ANNUITY
Intended use of the annuity: The stated goal that the consumer hopes to
accomplish by purchasing or exchanging the annuity should be determined. If
the consumer states as their goal “to guarantee a stream of income that I can’t
outlive” then it appears that the annuity is designed to meet that goal. If,
however, the consumer has non-qualified funds and states that their goal is “to
invest this money and let it grow and pass to my children upon my death”
(which is classified as a wealth transfer goal) then the annuity might not be the
best answer.
Since annuities are one of the few assets that do not “step up” in cost basis for
federal income-tax purposes, the client needs to be informed of this fact.
While the annuity will grow tax-deferred during the consumer’s life, upon
their death all of the growth in the annuity (that was tax-deferred during
accumulation) will be taxed when withdrawn as ordinary income.
SOURCE OF FUNDS USED TO PURCHASE THE ANNUITY
Source of funds to be used for purchase of annuities: The insurer or
insurance agent should determine the source of the funds used to purchase the
annuity. If the source of funds would require liquidation and has unrealized
capital gains that would be realized as part of the transaction, the agent should
disclose to the consumer that it will be a taxable event when they liquidate the
asset to provide the funds to purchase the annuity. Unless the insurance agent
is also a CPA, they should not give specific tax advice to the consumer, nor
should they attempt to estimate the amount of taxes that would be due. Many
assets incur fees, penalties, surrender charges and/or tax consequences when
liquidated, surrendered, cancelled, or otherwise converted to cash. The
consumer needs to understand these additional costs to the overall transaction.
ANTICIPATED RETIREMENT AGE
Retirement age preference: Retirement is not always a clear line in the sand.
Often retirement is partial and involves re-hire-ment, where the retiree seeks
some form of part-time employment to supplement their retirement. The
retirement date desired by the consumer will obviously affect their retirement
planning and liquidity needs. The anticipated retirement lifestyle and debt
structure (if any) at the time of retirement will help determine the income
needs at retirement.
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CONSUMER’S FINANCIAL EXPERIENCE
The ability of the consumer to understand complex financial products will be
affected by their level of financial experience. The producer needs to ascertain
this level of experience and should never assume that the consumer
understands a product.
FINANCIAL CONCERNS
FUTURE FINANCIAL CONSIDERATIONS
This category of information can involve many consumer goals. It could
involve the future purchase of a recreation item (RV or boat), the purchase of
real estate, the funding of education for loved ones, providing for potential
long term care costs, cessation of employment, future cessation of a current
stream of income, caring for a dependent (which could include a parent, child
or grandchild), wealth transfer, or many other goals. The time horizon and
amount needed to satisfy each of these future considerations will affect future
needs for asset growth and liquidity.
SOCIAL SECURITY BENEFITS
The beginning date and amount of Social Security retirement benefits should
be factored into the overall retirement plan of the consumer. This is facilitated
by the fact that each Social Security taxpayer receives an annual report that
estimates their retirement benefits. Of course, if they are already receiving
Social Security retirement benefits, those amounts would have been captured
under Annual Income earlier in the information gathering process.
RETIREMENT PLAN DISTRIBUTIONS
If the consumer is anticipating any retirement plan distributions in the future,
those amounts need to be estimated as to amount, start date and duration. If
possible, these numbers should be expressed net of income tax.
INVESTING RETIREMENT ASSETS
If the consumer has assets that are currently earmarked for retirement, the
amount and current status of these funds needs to be determined.
OTHER FINANCIAL NEEDS
Other financial needs: If the consumer has other financial needs that were
not disclosed by them under the previous categories, now is the time for them
to disclose them. There could be considerable overlap among several of these
areas of financial considerations, but thorough questioning by the insurance
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agent can assure that the consumer has had ample opportunity to disclose all
foreseeable financial needs, goals, and considerations.
HEALTH AND MEDICAL CARE ACCESS/COST
Medical care concerns: With healthcare costs soaring, the ability to afford
future medical care is a concern for many. Obviously the 65 year old or older
consumer can usually rely on Medicare Part A & B to form the base of their
primary healthcare delivery strategy. In addition, they will need to consider
some form of supplementation to the traditional Medicare as well as Medicare
part D to gain access to prescription drug coverage. In the case of a couple in
which one of the consumers is not yet 65, the couple needs a strategy to afford
health care for the younger spouse until he/she reaches Medicare eligibility.
The potential cost of the need for custodial care should not be ignored and is
often addressed through the purchase of a long term care policy. Many states
now have a long term care partnership-program, and the consumer should
investigate the viability of insuring this risk. If a consumer needs long term
care services and does not have coverage, even the best-laid financial plans
can be devastated.
FINANCIAL SUPPORT FOR FAMILY MEMBERS
Financial support for family members: If the consumer is currently
supporting or may in the future support family members (that weren’t counted
when determining dependents earlier), the cost of providing this support needs
to be estimated. Often there is a degree of uncertainty as to whether this
support will be needed or not. A very common concern in this area is a child
who is a single parent and struggling to make ends meet.
CROSS-SELLING REVERSE MORTGAGES
One recent concern among state insurance regulators is the sale of annuities
where the source of the funds is a reverse mortgage. There are currently laws
in place at the federal level to prevent the same individual from selling both
the reverse mortgage and an annuity to the same individual.
OTHER INFORMATION OR CONSIDERATIONS USED BY PRODUCER
Any other information considered by the agent or insurer in making
recommendations to consumers regarding the purchase or exchange of an
annuity contract. If there is any other information that the insurance agent or
insurer used in forming their reasonable basis for the recommendation, they
need to document and quantify it to the highest degree possible.
ACCESS TO ACCOUNT VALUE
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REQUIRED MINIMUM DISTRIBUTIONS
If the consumer holds or is purchasing a qualified annuity, care must be taken
to make sure that sufficient liquidity (without surrender charges or market
risks) to provide for the required minimum distributions.
WITHDRAWALS IN EXCESS OF THE FREE AMOUNT OR FULL SURRENDER
In the event of a withdrawal, access to annuity values in excess of the allowed
penalty-free withdrawals should be considered as well as the likelihood of a
full surrender. The consumer should understand the worst case scenario if they
were to exceed the free-withdrawal limit.
ANNUITIZATION
The consumer should understand the annuitization options available to them. It is best to
have those numbers quantified and applied to their overall retirement plan to understand
how the annuity fits within their goals, resources and objectives.
DISCLOSURE AS A COMPONENT OF SUITABILITY
Disclosure is an integral part of suitability in that the consumer must have access to
certain facts and information in order to make an informed decision. When consumers are
considering financing the purchase of another insurance contract using some or all of the
values of an existing contract, they need to understand their rights and values in the
insurance or annuity contract they already own.
In this course we will review the general disclosure requirements related to all annuity
sales. We will also focus on replacement requirements where a “Financed Purchase” is
involved. To make a generalization, most financed purchases could accurately be called
replacements. There are numerous strategies used by unscrupulous agents to circumvent
replacement regulations, such as not listing the existing policies as a source of funds for
the purchase of the new contract and then surrendering the existing contract after the new
contract is issued. Another strategy is to borrow funds from or take a partial surrender of
the existing contract to initially fund the new contract (at application), and then surrender
or liquidate the remainder of the existing contract and funnel the proceeds into the newly
established contract
The goal of various state regulations is to detect the most common strategies used to
circumvent traditional replacement law, for the consumer to have sufficient information
disclosed to them by the existing insurer and the new insurer.
APPROPRIATE SALES PRACTICES REQUIRE DISCLOSURE
Disclosing to the consumer that the purchase of an annuity is designed to address longterm needs and goals is essential to an appropriate and suitable sale. Failure of the
producer to disclose these facts is both unethical and illegal. Failure on the part of the
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consumer to understand these facts may lead to undesirable taxable events and/or the loss
of principal.
The following information concerning annuity contract benefits and features is typically
contained in an annuity disclosure form and should be reviewed with the applicant
alongside pertinent examples of each element in the contract:
•
•
•
•
•
•
•
•
The guaranteed, non-guaranteed, and determinable elements of the contract—
along with their limitations and how those limitations operate.
The initial crediting interest rate of the annuity, including any bonus or
introductory interest rates, the duration of such rates, and the fact that interest
rates may change in the future and are not guaranteed.
Guaranteed and non-guaranteed periodic options.
Value reductions (surrender charges, contingent deferred sales charges) caused by
withdrawals from, or surrender of, the annuity and the situations in which these
value reductions will be assessed.
How contract values may be assessed by the consumer, and any applicable
reductions in annuity values and benefits resulting from access to contract values.
Any available death benefits and the method of their calculation.
A summary of the federal tax status pertinent to the contract, and any applicable
tax penalties for withdrawal from the contract.
Impact, restrictions and cost of any rider.
In addition, the full disclosure and explanation to the consumer of the following elements
of the proposed annuity will help them make an informed decision.
SURRENDER CHARGE TERMS
Terms of Surrender Charges: For each existing annuity the surrender charge
needs to be explored. If it happens to be a two tier annuity, additional
understanding of the surrender charge is in order. If the annuity involves bonus
amounts, the consumer’s entitlement to those amounts needs to be determined and
disclosed. Specifically the details of the surrender charge that should be
determined and disclosed are as follows:
Dollar Amount and surrender charge percentage: The percentage of the
surrender charge, and to what values the percentage is applied, is important to
understand and can be best determined by reading the contract. The actual
resulting dollar amount of the surrender charge might need to be calculated if
not shown.
Number of years in length: The length of the surrender charge (usually
expressed in contract anniversaries or contract years) needs to be determined.
Obviously, if the contract is old enough so that the surrender charge no longer
applies, the consumer would need to understand this as well.
NOTE: If the existing annuity is a source of funds for the
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proposed annuity transaction and surrender charges will be
assessed as part of the transaction the consumer needs to
understand the dollar amounts and percents. These
surrender charges represent part of the overall cost of the
proposed transaction, and it can be misleading if these
certain costs (in the form of a surrender charge) are offset
against a bonus in the proposed annuity. Receipt of the
bonus in the proposed annuity is contingent upon the
consumer holding the proposed annuity for a certain period
of time; whereas, the surrender charges (if any) imposed by
the existing annuity are certain to occur.
COMPARISON OF LIFE EXPECTANCY TO SURRENDER CHARGE PERIOD
Comparison to life expectancy of applicant: The length of the surrender
charge (in both the existing and proposed annuity) as it relates to the
remaining life expectancy of the owner is also very important. If the surrender
charge exceeds the consumer’s life expectancy then in essence they are
making a lifetime commitment to this product, because in order to access
funds (in excess of any free withdrawal allowed) at any time during their
expected lifespan they will experience a surrender charge.
Waiver of surrender charge provision: Most annuities allow some waivers
to their surrender charge. The various waivers and how they work were
discussed earlier in this text. The more waivers and the more generously
worded they are, the less restrictive the surrender charge is viewed. However,
if the consumer needs access to funds during the surrender charge period and
their withdrawal does not fit into one of the waivers, they will experience
shrinkage of annuity values due to surrender charges.
ANNUITY TAX STATUS AND POTENTIAL TAX PENALTIES
In the section on annuity taxation we covered many aspects of how the tax code
impacts annuity owners. Where appropriate you should explain relevant tax
aspects of the annuity to the consumer. If the consumer has tax questions specific
to their tax situation, they should probably seek professional advice.
MORTALITY CHARGES AND EXPENSE FEES
If any charges and fees apply at any point during the term of the annuity contract, the
producer should clearly disclose either specific dollar amounts or actual percentages and
explain the circumstances under which these fees apply. A variable annuity disclosure
(since the product is a securities product) is required to contain more details of fees
and/or charges than fixed annuity or fixed indexed annuity disclosures. An example
showing this difference involves premium taxes.
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The variable annuity will disclose the premium taxes while the fixed annuity generally
will not. The fixed annuity disclosure is not attempting to hide the premium tax—the tax
is included in the cost structure of the fixed annuity and affects the guarantees of the
product, and therefore it is not readily apparent. On the other hand, it would not be a fair
comparison to state that the variable annuity has a charge for premium taxes and the fixed
annuity does not. While the charge for premium taxes is not disclosed separately in the
fixed annuity, it is part of the product’s overall costs. Producers should understand these
differences and be able to explain them in a fair, understandable manner.
CURRENT VS. GUARANTEED INTEREST RATE
The consumer must understand the difference between the current and guaranteed interest
rates and the fact that the current interest rate may change. In addition, the consumer
should understand the mechanism that could cause a change in current interest, whether
the mechanism is a decision by the insurance company, a movement in an index, or the
change in the value of an underlying equity account.
INVESTMENT ADVISORY FEES
If any investment advisory fees are charged they will be disclosed in the prospectus, and
the consumer should understand how they are charged.
RIDERS OR ENDORSEMENTS
Contract riders or endorsements: There are many contract riders and endorsements
that can be incorporated into annuities. The more common riders or endorsements are a
death benefit (life insurance rider), some form of living benefit (discussed earlier), some
form of living benefit based on loss of functional capacity/critical
illness/dismemberment, or some form of living benefit based on terminal illness. They
may also be in the form of a loan provision as part of an endorsement as a qualified
retirement plan (403(b) or 401(k)). Many of the riders or endorsements are optional and
are offered for a fee (usually expressed in basis points), while some are hard-coded in the
product and built in to the guarantees offered by the product. The benefit and costs of
each should be determined and disclosed to the consumer.
LIMITATIONS ON INTEREST RETURNS AND BENEFITS
As with most contracts, each annuity contract designs benefits for a particular set of
circumstances. The contract contains limitations to clearly define the intent and
parameters of each benefit and/or interest credit. Limitations commonly include a
required holding period, a surrender charge, and upward limit on the benefit or interest
credit. The consumer should understand these contract limitations.
INSURANCE AND INVESTMENT COMPONENTS
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When the contract has separately identifiable insurance and investment components, they
should be separately disclosed to the consumer.
MARKET RISK
If the consumer has a risk for loss of principal in an annuity it should be disclosed.
SUITABILITY OF REPLACING EXISTING POLICIES
ANNUITY COMPARISON WHEN EXCHANGING OR REPLACING AN ANNUITY
If a consumer is exchanging an existing annuity for a new annuity, a comparison between
the contracts should be performed. This comparison and disclosure involves revealing
relevant facts about both the current annuity and the proposed annuity; the producer
should contrast and compare each feature and benefit, item by item.
IF THE CONSUMER CURRENTLY HOLDS AN ANNUITY
If the consumer currently has an annuity (whether it is considered for exchange or
not) the following information needs to be collected as part of the suitability
determination process.
SURRENDER CHARGES EXISTING AND NEW ANNUITY
If the consumer will experience a surrender charge as they exit the annuity that is
being used as a source of funds for the transaction, the amount of the surrender charge
should be disclosed to the consumer. The consumer should consult with their current
insurer to see if changes are available within the existing annuity that meet the
requirements they seek in a new annuity.
The annuity that is being purchased as part of the replacement transaction will most
likely have surrender charges and the consumer needs to understand how these work.
COSTS FOR ANNUITY BENEFITS
Benefits: All benefits of each annuity, including riders, options, and
endorsements, should be disclosed and compared. Rarely will any two annuities
be identical in benefits, so the comparison will not always be symmetrical and
will demonstrate benefits in one contract that do not exist in the other and viceversa.
With many of the benefits offered by annuities, it is difficult to quantify (in dollar
terms) the value of each benefit, and often the consumer has to make a value
judgment based on their understanding of the benefit as it applies to them. As an
insurance agent you can assist the consumer by disclosing all relevant information
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in a fair and straightforward manner.
WILL THE CONSUMER BENEFIT FROM ENHANCEMENTS IN THE NEW POLICY
Part of determining suitability is to determine if the product being sold to replace an
existing product has a benefit or enhancement that the consumer does not possess in
their current product.
Whether or not the enhancement is of value to the consumer is a decision they can
only make when they understand the full cost (monetary and otherwise) of the
replacement transaction. If the consumers believe that the new product will allow
them benefits they don’t currently have and they feel that these benefits are worth the
cost of the transaction, then they have made a value decision.
HAS THE CONSUMER HAD ANOTHER ANNUITY REPLACEMENT IN THE PREVIOUS
THREE YEARS
If the consumer has had an annuity replacement within the previous three years, the
potential is high that they will bail out of the product being sold to them today while a
surrender charge is still effective.
Since 2008 part of the regulations for the suitability of deferred variable annuities has
required additional scrutiny of any annuity replacement where the consumer has had
an annuity replacement within the previous 36 months.
SPECIAL ISSUES RELATED TO SALES TO SENIORS
PRODUCT COMPLEXITY
As financial products become richer in benefits and attempt to address multiple needs
within the same product, they can be more cost-effective. As financial products become
more multifaceted, they are also becoming more complex. This is not necessarily a
criticism of the products, but rather a statement that they are becoming more difficult to
understand.
As we age our ability to recognize, absorb and make sense of complex and abstract ideas
diminishes. This is not a linear process and will proceed at different rates for different
individuals. The concern with seniors, and I’ll let the reader determine their own
definition of ‘senior’, is that they may have a difficult time understanding some of these
more complex products. Regulators in several states have defined a senior as someone
aged 65 or older, so this discussion will use that benchmark.
The following section deals with recognizing diminished mental capacity and also with
some of the unique ethical issues related to selling financial products to seniors.
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LEGAL CAPACITY
The issue of legal capacity often arises in cases involving senior consumers. Legal
capacity is the term used to define someone who is able to understand and appreciate the
consequences of his/her actions. A person who lacks legal capacity cannot, for example,
enter into a contract, give a power of attorney, make a will, consent to medical treatment,
or transfer property. The older we become, the more likely we are to develop a mental
disease or disability such as Alzheimer’s disease or dementia.
If a producer sells an annuity to an individual who lacks legal capacity, it could be argued
that the sale is inappropriate even if neither the producer nor the consumer was aware of
the lack of mental capacity. Since basic contract law requires “competent parties” it could
further be argued that the contract is not valid and binding on the incompetent individual.
DIMINISHED MENTAL CAPACITY
As part of this Annuity Training Course we include information to help producers
recognize when a prospective insured may lack the short-term memory or judgment to
knowingly purchase an annuity. To accomplish this goal we will first distinguish between
legal capacity (as described above) and diminished mental capacity.
One of the most troubling issues related to the sale of insurance products to seniors is the
potential for diminished mental capacity. This is a difficult and sensitive issue that is
becoming more common with the aging of our population. Diminished mental capacity
does not necessarily mean that one does not have legal capacity, but it does indicate that
they do not function as well as they previously did. Since each individual is unique and
possesses varying degrees of decision-making capabilities at various stages of their lives,
it is a considerable challenge to recognize diminished mental capacity in someone that
you have only just met.
For the purposes of this course we will make the assumption that if someone lacks legal
capacity, the agent should not need training to recognize lack of judgment and short-term
memory in an individual so affected. Therefore we will focus on the recognition of
diminished mental capacity which, while the lines are blurred, can be a precursor to lack
of legal capacity.
PROBABILITY OF ENCOUNTERING DIMINISHED MENTAL CAPACITY
A recent study published by the National Institute on Aging reveals that impaired
cognitive ability (diminished mental capacity) affects approximately 20 percent of people
aged 85 years or older.
RECOGNIZING DIMINISHED MENTAL CAPACITY
For an individual not formally trained in a mental health discipline, assessing diminished
capacity is possible in some very clear cases, but in general, diagnosing mental and
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physical capacity is well beyond the professional training and expertise of the average
insurance producer.
Several factors make assessing diminished mental capability difficult. Many individuals
have occasional memory problems due to the natural aging process and take longer to
make decisions.
Loss of memory and/or the onset of diminished mental capacity is usually a gradual
process that can accelerate over time. It is entirely possible that a senior could make an
insurance-related decision today when they appear to be cognitive and two or three years
later (when a consumer complaint arises) be considered cognitively impaired.
First, it is always important that the marketing and provision of any financial services to
senior citizens be done in an appropriate manner, and that the financial services and
products be appropriate to these consumers with regards to age, risk tolerance, and
understanding of the product being offered.
Diminished mental capacity may sometimes be difficult to identify, or may have
pronounced symptoms.
Below is a listing of several indicators of diminished mental capacity that can alert the
producer. Not all of these indicators will be observable in the context of a typical meeting
between an insurance producer and consumer. Additionally, some of these indicators
require a prior knowledge of the consumer in order to determine if there has been
deterioration in a particular aspect of their behavior.
INDICATORS OF DIMINISHED MENTAL CAPACITY
•
Memory loss: The senior is repeating questions, forgetting details, forgetting
appointments, misplacing items or losing track of time.
•
Disorientation: The senior is confused over time, place, or simple concepts.
•
Difficulty performing simple tasks: The senior lacks the ability to remember
the order of performance of the steps necessary to complete a simple task,
such as tying their shoes.
•
Difficulty speaking: The senior uses words that do not fit the context of their
use.
•
The senior appears unable to appreciate the consequences of decisions.
•
The senior makes decisions that are inconsistent with his or her current longterm goals or commitments.
•
The senior seems overly optimistic.
•
Difficulty following simple directions: The senior has difficulty with
directions, particularly when the directions include multiple steps that must
be performed in a certain order.
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•
Deterioration of handwriting and signature: The senior appears unable to
accurately write the letters of the alphabet. They may write a C or an R
backwards.
•
Drastic mood swings: The senior may exhibit a swift change in mood within
a short period of time with no obvious reason for the mood change.
•
The senior does not remember or understand recently completed financial
transactions.
•
Disorientation: The senior appears to be disoriented with surroundings or
social setting.
•
Lack of attention to personal hygiene: The senior appears
uncharacteristically unkempt.
•
Confusion as to date and time: The senior may be confused as to the season
of the year, the current month, the day of the week or the time of the day.
•
ADDITIONAL INDICATORS
Below is an additional list of indicators that can best be judged by someone (such as a
close relative or long time friend) with day to day exposure to the senior or someone who
has known the senior for a long time, even if their exposure is infrequent.
•
Changes in personality.
•
Increased passivity.
•
Poor judgment.
•
Are they taking their medication when they should?
•
Do they open their mail and pay their bills on time?
EXPLANATION OF INDICATORS
The Alzheimer’s Association has a listing of explanations for some of the indications of
Alzheimer’s Disease. While this information relates to the recognition of Alzheimer’s, it
also puts these indicators into perspective. These can be of value to a producer in
recognizing signs of short term memory loss and/or lack of judgment.
Memory loss that affects job skills. It's normal to occasionally forget an item at the
grocery store, deadline or colleague's name, but frequent forgetfulness or
unexplainable confusion at home or in the workplace may signal something wrong.
Difficulty performing familiar tasks. Busy people get distracted from time to time.
For example, you might leave something on the stove too long or not remember to
serve part of a meal. People with Alzheimer's disease might prepare a meal and not
only forget to serve it but also forget they made it.
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Problems with language. Everyone has trouble finding the right word sometimes,
but a person with Alzheimer's disease may forget simple words or substitute
inappropriate words, making his or her sentences difficult to understand.
Disorientation of time and place. It's normal to momentarily forget the day of the
week or what you need from the store. But people with Alzheimer's disease can
become lost on their own street, not knowing where they are, how they got there or
how to get back home.
Poor or decreased judgment. Choosing not to bring a sweater or coat along on a
chilly night is a common mistake. A person with Alzheimer's, however, may dress
inappropriately in more noticeable ways, wearing a bathrobe to the store or several
blouses on a hot day.
Problems with abstract thinking. Balancing a checkbook can be challenging for
many people, but for someone with Alzheimer's disease, recognizing numbers or
performing basic calculation may be impossible.
Misplacing things. Everyone temporarily misplaces a wallet or keys from time to
time. A person with Alzheimer's disease may put these and other items in
inappropriate places -- such as an iron in the freezer or a wristwatch in the sugar bowl
-- and then not recall how they got there.
Changes in mood or behavior. Everyone experiences a broad range of emotions -it's part of being human. People with Alzheimer's disease tend to exhibit more rapid
mood swings for no apparent reason.
Changes in personality. People's personalities may change somewhat as they age.
But a person with Alzheimer's can change dramatically, either suddenly or over a
period of time. Someone who is generally easygoing may become angry, suspicious
or fearful.
Loss of initiative. It's normal to tire of housework, business activities or social
obligations, but most people retain or eventually regain their interest. The person
with Alzheimer's disease may remain uninterested and uninvolved in many or all of
his usual pursuits.
ETHICAL AND COMPLIANCE ISSUE UNIQUE TO THE SENIOR MARKET
STRATEGIES FOR MAKING BETTER DECISIONS
In order to increase the likelihood of the senior making an informed decision there are
several strategies that can be used. They are as follows:
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•
Try to arrange your meetings with seniors as early in the morning as
convenient. When they are well rested they tend to make better decisions
and have better cognitive function.
•
Ask the senior to include a trusted family member to attend the meeting and
assist with the decision making.
•
Ask the senior to repeat their understanding of your explanations of the
different elements of the financial product being presented.
•
Break the explanations and decisions down into smaller components and
make sure the senior has a firm understanding at each juncture before
proceeding.
INCLUDING A TRUSTED FAMILY MEMBER
In discussing the practice of asking a trusted family member to attend the meeting, it
should be noted that privacy regulations may have an impact in this area.
Another complication regarding involving a trusted family member is that when senior
financial abuse is discovered it is often a trusted family member who is the perpetrator.
SENIOR-RELATED PROFESSIONAL DESIGNATIONS
State insurance regulators are concerned about certain producers using “industry
designations” that imply a heightened, unique or special qualification and/or specialized
education that would make them better qualified to address the insurance needs of elders.
Many of these “senior affinity” designations lack the underpinning of traditional
designations such as:
•
Rigorous education and testing requirements for designation candidates.
•
An enforceable code or canon of ethics.
•
Continuing education requirements to maintain the designation.
As a result of the proliferation of these designations, many states have adopted rules
prohibiting the use of misleading senior designations and have provided a mechanism for
creditable designation to be accredited.
THE NEED FOR COMPLETE RECORDKEEPING
As a producer in the financial services industry it is imperative that you become a good
record keeper. Not only do regulations require adequate records be retained, but it also
helps the producer to better serve the consumer.
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As part of the NAIC Annuity Suitability Model Act, a producer must have reasonable
grounds for believing that a recommendation to a consumer is appropriate. In order to
substantiate the belief that a recommendation was appropriate, the producer needs a
record of the information collected from the consumer that was used to formulate the
recommendation.
Most insurers have developed forms to meet the requirements of suitability, and
transactions will be reviewed at the carrier level to ensure suitability. Producers are bestpositioned to gather and document accurate consumer information.
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Chapter 3 - Review Questions
(Answers are in the back of the text)
1. The NAIC Suitability in Annuity Transactions Model Regulation shall apply to any
recommendation to ________________ an annuity made to a consumer by an insurance
producer, or an insurer where no producer is involved, that results in the purchase,
exchange or replacement recommended.
(a)
(b)
(c)
(d)
Purchase
Exchange
Replace
Purchase, exchange or replace
2. The NAIC Suitability in Annuity Transactions Model Regulation applies to:
(a)
(b)
(c)
(d)
Group annuities only
Individual annuities only
Group and/or individual annuities
Only annuities used to fund qualified employer retirement plans
3. The NAIC Suitability in Annuity Transactions Model Regulation requires that if a
customer refuses to provide suitability information, the insurance producer, or an insurer
where no insurance producer is involved, _____________.
(a) Must provide the customer with an explanation of the purpose of
requesting the suitability information and the potential repercussions of not
providing the suitability information.
(b) Proceed with the sale since the consumer was given the opportunity to
provide the information.
(c) Must not transact an annuity transaction with the customer.
(d) Must estimate the information not provided to the best of their abilities.
4. The NAIC Suitability in Annuity Transactions Model Regulation requires that an
insurance producer who engages in the sale of annuity products shall complete a one-time
________ training course approved by the department of insurance and provided by the
department of insurance-approved education provider.
(a)
(b)
(c)
(d)
Two hour
Four hour
Six hour
Eight hour
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Answers to Chapter - Review Questions
Chapter 1
1.
2.
3.
4.
5.
6.
The correct answer is: C (page 7)
The correct answer is: B (page 5)
The correct answer is: B (page 6)
The correct answer is: A (page 26)
The correct answer is: A (page 9)
The correct answer is: C (page 31)
Chapter 2
1.
2.
3.
4.
The correct answer is: B (page 57)
The correct answer is: D (page 59)
The correct answer is: D (page 59)
The correct answer is: C (page 59)
Chapter 3
1.
2.
3.
4.
The correct answer is: D (page 70)
The correct answer is: C (page 71)
The correct answer is: A (page 74)
The correct answer is: B (page 77)
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