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Chapter 7 – Annuities Part I
1.) What are annuities used for?
2.) What are the two main issues (risks) in retirement?
3.) If inflation averages 3.5%, how long will it take for purchasing power to be cut in half?
4.) What are three advantages to annuities?
5.) What are three disadvantages to annuities?
6.) Who are the parties to an annuity contract?
7.) What is a deferred annuity? Give an example of when it would make sense to invest in a
deferred annuity.
8.) What type of an annuity should a husband and wife consider?
9.) What are the three different types of annuities? Also known as three different investment
options during the accumulation phase?
10.) Name at least three different fees commonly associated with variable annuities.
11.) What are the three common annuity indexing methods for equity annuities?
12.) What are the key terms associated with annuities?
13.) Withdrawals from an annuity prior to annuitizing are taxed using the LIFO or FIFO method?
14.) What is a non-qualified annuity?
15.) When are annuities considered a prudent purchase?
16.) What is longevity insurance? When does it typically begin making payments?
6th Edition
Insurance Planning
James F. Dalton | Michael A. Dalton | Thomas P. Langdon | Joseph M. Gillice
CHAPTER 7:
ANNUITIES
Chapter 7
© 2018 Money Education
Insurance Planning
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
Understand how life expectancies have increased and the impact to retirement planning,
including superannuation.
Discuss the retirement life expectancy concept and the impact inflation has on
purchasing power.
Recognize the change from employer sponsored defined benefit plans to employer
sponsored defined contribution plans.
Explain the characteristics of an annuity including contributions and distribution options
and differentiating between immediate and deferred annuities.*
Identify the use of annuities in retirement planning.
List the parties to an annuity.
Differentiate between single and joint life annuities.
Explain term certain annuities.
Identify the characteristics of variable annuities.
Discuss equity-indexed annuities.
Distinguish between deferred and immediate annuities.
List the advantages and disadvantages of annuity contracts.
Illustrate the income taxation of annuities.
Recognize the estate taxation issues regarding annuities.
Define longevity insurance.
Describe and discuss the secondary market for annuities.
Outline the regulation of annuities.
Describe what happens if an annuity issuer fails.
* CFP Board Resource Document – Student-Centered Learning Objectives based upon CFP Board Principal Topics.
Chapter 7
© 2018 Money Education
Insurance Planning
INTRODUCTION TO ANNUITIES
• One of the common goals for most Americans is to live
comfortably in retirement – generally requires two
components:
â‘ Accumulation of assets
â‘¡ Reliable source of income
• Annuities are used to:
 provide income streams for retirees
 Accumulate assets on a tax-deferred basis
NOTE: most annuities are not annuitized
Chapter 7
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LIFE EXPECTANCY FOR ALL INDIVIDUALS AND 65-YEAR OLDS
2015
1960
1940
1930
Average Life Expectancy
78.8
69.7
62.9
59.7
Males Only
78.3
66.6
60.8
58.1
Females Only
81.1
73.1
65.2
61.6
2015
1960
1940
1930
All 65-Year Olds
19.4
14.3
13.8
Not reported
Males Only (age 65)
18.0
13.2
12.7
Not reported
Females Only (age 65)
20.6
17.4
14.7
Not reported
Note: It should be noted that the life expectancy in early 1900s is biased
due to a high infant death rate at the time.
Chapter 7
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Insurance Planning
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RETIREMENT ISSUES
• Retirement Life Expectancy – the period between
retirement and death – this period has increased due to:
 earlier retirement and
 extended life expectancy
• Inflation – the increase in the general price level of
goods and services
Chapter 7
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THE EFFECT OF INFLATION ON COST AND PURCHASING
POWER
Future Value
Cost
Purchasing
Power of $1,000
Decline in
Purchasing
Power of $1,000
Now (age 65)
$1,000
100%
0
In 5 Years (Age 70)
$1,188
84%
16%
In 10 Years (Age 75)
$1,411
71%
29%
In 15 Years (Age 80)
$1,675
60%
40%
In 20 Years (Age 85)
$1,990
50%
50%
In 25 Years (Age 90)
$2,363
42%
58%
In 30 Years (Age 95)
$2,807
36%
64%
In 35 Years (Age 100)
$3,334
30%
70%
Time Period
Chapter 7
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Insurance Planning
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RETIREMENT BENEFITS
• Historically, individuals received Social Security
retirement benefits and a fixed pension during
retirement. Pension payments are generally made from
retirement plans known as defined benefit plans.
• In 1985, there were about 175,000 defined benefit
plans. In 2012, there were fewer than 45,000 defined
benefit plans.
Chapter 7
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Insurance Planning
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800,000
180,000
700,000
160,000
140,000
600,000
120,000
500,000
100,000
400,000
80,000
300,000
60,000
200,000
Defined Benefit Plans
Defined Contribution Plans
DEFINED CONTRIBUTION VS. DEFINED BENEFIT PLANS
40,000
100,000
20,000
0
0
1975 1980 1985 1990 1995 2000 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Defined Contribution
Defined Benefit
Chapter 7
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Insurance Planning
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CHARACTERISTICS OF ANNUITIES (1 of 2)
• An annuity is a contract that is designed to provide a
specific income that is payable at stated intervals for a
specified period of time.
• Traditionally, individuals receive fixed annuities from:
 Employer defined benefit plans
 Government retirement plans
 Insurance companies
• Individuals can purchase commercial annuities; these
are not uniform in any respect.
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CHARACTERISTICS OF ANNUITIES (2 of 2)
• Annuities can be characterized based on several
factors:
 Length of payout (fixed or variable)
 Frequency and flexibility or premium (single
premium or flexible premium)
 The timing of when income is payable (immediate
or deferred)
 Tax considerations and funding vehicle
•
Annuities have two distinct phases:
â‘ Accumulation phase
â‘¡ Annuitization (not all annuities are annuitized)
Chapter 7
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ADVANTAGES AND DISADVANTAGES OF ANNUITIES
ADVANTAGES
DISADVANTAGES
Provides lifetime income
Complexity with so many choices is
often difficult for investors to
understand
Structure of income can be based on a
single life or multiple lives
Costs and fees reduce returns within the
annuity
Eliminates superannuation risk
May provide protection from creditors
Earnings are tax-deferred
Investment options allow for fixed or
variable earnings
Once funds are exchanged for the
annuity, they are no longer available for
bequests or other needs
Taxable benefits consist entirely of
ordinary income, as opposed to capital
gains and/or qualifying dividends
Chapter 7
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Insurance Planning
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PARTIES TO AN ANNUITY CONTRACT
There are generally four parties to an annuity contract:
â‘ Annuitant
â‘¡ Beneficiary
â‘¢ Owner
â‘£ Insurance company
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ANNUITY FEATURES (1 of 2)
Annuity Payout Period
•
May provide payments for a fixed term such as 20
years (term certain) or for an indefinite term such as
the lifetime of the annuitant (life annuity).
Immediate vs. Deferred
•
Immediate annuity: created when the contract owner
trades a sum of money in return for a stream of
income that begins immediately.
•
Deferred annuity: does not begin distributions
immediately, but waits until some future time to start
payments.
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ANNUITY FEATURES (2 of 2)
Flexible Premium vs. Single Premium
•
Flexible – allows the insured the option to vary
premium deposits over time
•
Single – annuity purchased with a single lump sum
Earnings
•
Fixed – invest in less risky investments and will
guarantee returns for a period of time
•
Variable – have a wider array of investment choices,
including equity investments
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ANNUITY BENEFIT OPTIONS (1 of 2)
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ANNUITY BENEFIT OPTIONS (2 of 2)
• Single life annuities




Straight or pure life annuities
Installment refund annuities
Cash refund annuities
Term certain annuities
• Term certain (Guaranteed Minimum Payment)
• Joint and survivor life annuities
 100% joint and survivor annuity
 75% joint and survivor annuity
 50% joint and survivor annuity
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TYPES OF ANNUITY CONTRACTS
Fixed Annuity
• Most conservative
• Principal protection
Variable Annuity
• Allows for participation in equity markets
• Higher costs and fees
Equity Indexed Annuity
• Fixed earnings
• Earnings based on some type of index
Chapter 7
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FIXED ANNUITY
Fixed Annuity:
• Most conservative
• Provides full principal protection combined with a
guaranteed rate of return
• Typically, the premiums paid for the annuity contract
will begin earning an interest rate, which is dependent
on current fixed income interest rates and known as the
initial rate.
• Once the initial interest rate guarantee period expires, a
renewal rate will go into effect.
Chapter 7
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VARIABLE ANNUITY
Features:
• Tax deferred earnings
• Avoid income tax when one investment in the annuity
contract is sold and replaced with another investment
(transfer among subaccounts)
• Death benefit protection options
• Living benefit protection options
• Lifetime income options
Since control of the underlying investments in the variable
annuity contract rests with the contract holder, variable
annuities offer potentially higher returns than fixed annuities
but also involve investment risk.
Chapter 7
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VARIABLE ANNUITY FEES (1 of 3)
â‘ Mortality and expense risk charges
• Insurance risks
• Cover the risks of annuitant living too long
• 1.15% to 1.85% annually
â‘¡ Administrative and Distribution Fees
• Costs associated with servicing and distributing
the annuity
â‘¢ Annual Fee
• Record keeping and administration
• $30 to $50
• Regularly waived
Chapter 7
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VARIABLE ANNUITY FEES (2 of 3)
â‘£ Sub Account Fee and Expenses
• Charged to the investment subaccounts inside the
annuity (mutual funds), and include investment
management fees.
• $0.7% to 2.5%
⑤ Surrender Charges
• Known as contingent deferred sales charges
(CDSC)
• Typically a percentage of the amount withdrawn
and declines over time
• 7% to 9%
Chapter 7
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VARIABLE ANNUITY FEES (3 of 3)
Variable annuities are offered by share class:
• B shares typically having a 6 to 8 year period of
surrender charges
• L shares having a 3 to 4 year surrender charge period
for each contribution
• C shares having no surrender charge
• B shares typically having slightly lower fees
Note: There is generally a direct link between the CDSC
and the commission the broker receives as part of the sale.
Chapter 7
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VARIABLE ANNUITY FEES EXAMPLE
Eddie purchases a variable annuity contract with a
$100,000 purchase payment. The contract has a schedule
of surrender charges, beginning with a 7% charge in the
first year, and declining by 1% each year. In addition, he
is allowed to withdraw 10% of the contract value each
year free of surrender charges. In the first year, Eddie
decides to withdraw $50,000, or one-half of your contract
value of $100,000 assuming the contract value has not
increased or decreased because of investment
performance). In this case, Eddie could withdraw $10,000
(10% of contract value) free of surrender charges, but he
would pay a surrender charge of 7%, or $2,800, on the
other $40,000 withdrawn.
Chapter 7
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GUARANTEED LIVING BENEFIT RIDERS
Basic Types of Living Benefits:
â‘ The guaranteed minimum accumulation benefit
(GMAB)
â‘¡ The guaranteed minimum income benefit (GMAIB)
â‘¢ The guaranteed minimum withdrawal benefit
(GMWB)
Chapter 7
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EQUITY-INDEXED ANNUITIES
• Fixed annuities, either immediate or deferred, that earn interest or
provide benefits that are linked to an external equity reference or
an equity index.
• One of the most commonly used indices for annuity products in the
Standard & Poors 500 composite stock price index (S&P 500)
• Credit interest using a formula based on changes in the index to
which annuity is linked
• A composite between a variable annuity and a straight fixed
annuity having little downside risk and modest upside potential
• Two Features:
â‘ Indexing methods specified in the contract
â‘¡ Participation rate
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INDEXING METHOD
Indexing Method:
â‘ The annual reset (ratcheting) method
â‘¡ The high watermark method
â‘¢ The point-to-point method
Chapter 7
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ANNUAL RESET METHOD
• Comparing the index value at the end of the contract
year with the index value at the beginning of the
contract year
• The advantage of the annual reset method is that the
interest earned is locked in and the index value is reset
at the end of each year
• Future decreases in the index will not affect the interest
already earned
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HIGH WATERMARK APPROACH
• Comparing the value of the index at various points
during the term (usually on anniversary dates)
• The interest credited is based on the difference between
the highest index values and the index value at the start
of the term
• This design may credit higher interest to the contract
than some other interest crediting designs if the index
reaches a high point early or in the middle of the term
and then drops off later
Chapter 7
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POINT-TO-POINT INDEX-LINKED CREDITING METHOD
• Based on the difference between an index value at the
end of the term compared with the index value at the
start of the term
• Permits a higher participation rate
• Since the term is typically 6 or 7 years, the annuitant
may not be able to receive the index-linked interest
until the end of the term
Chapter 7
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KEY TERMS
Index Term – period over which index-linked interest is
calculated, ranging from 1 to 10 years, with 6 to 7 being the
most common
Participation Rate – determines how much of the increase in
the index will be used to calculate the index-linked interest. For
example, if the calculated change in the index is 10 percent,
and the participation rate is 70 percent, the index-linked interest
will be seven percent
Cap Rate – some indexed annuities impose an upper limit on
the index-linked rate
Floor Crediting Rate – minimum index-linked interest rate
that will be credited to the contract in a given period
Chapter 7
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ADVANTAGES OF ANNUITY CONTRACTS
• Individuals concerned with the possibility of outliving
their retirement savings may transfer that longevity risk
to an insurance company by purchasing an annuity
• Opportunity to defer income taxation
• The ability to rebalance the portfolio inside the annuity
contract without incurring any immediate income
taxation on asset sales
• Annuities are protected from creditors in some states
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DISADVANTAGES OF ANNUITY CONTRACTS
• Complexity
• Costs and fees
• Tax consequences
• Annuities are protected from creditors in some states
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TAXATION OF ANNUITIES (1 of 3)
Income Taxation
• Distributions are not made to the annuitant until the contract is
annuitized
• Distributions taken from an annuity before annuitizing, it must be
included in the taxpayer’s gross income until all of the gain in the
contract has been distributed
• Further distributions are treated as tax-free returns of investment
dollars
• Annuity contracts follow a LIFO approach to income reporting
• Annuities issued prior to August 14, 1982 receive FIFO treatment
Chapter 7
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TAXATION OF ANNUITIES (2 of 3)
Income Taxation
• Annuities purchased with pre-tax dollars typically do
not have any basis
 401(k) plans
 Deductible traditional IRA
• Each annuity payment received from a non-qualified
annuity is split into two pieces:
 A tax-free return of basis
 Taxable income
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TAXATION OF ANNUITIES (3 of 3)
Income Taxation
• If annuitant takes a distribution of income from an
annuity contract before age 59½, a 10% penalty tax
applies
• If the annuitant is a high income taxpayer and the
annuity distribution is not made through an IRA or
qualified plan, a 3.8% Affordable Care Act surtax will
apply
Chapter 7
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TAXATION OF ANNUITIES EXAMPLE
Kevin invested $100,000 in an annuity contract. Many years later, he
annuitized the contract. The insurance company agreed to pay him
$1,388.89 per month for 15 years. His expected return, therefore, is
$250,000.02 (15 years x 12 months x $1,388.89 per month). The
exclusion ratio is 40%, calculated by taking Kevin’s investment in the
contract of $100,000 and dividing it by his expected return of
$250,000.20. The amount of each payment excluded from tax is
$555.56 (calculated by multiplying the exclusion ratio of 40% by the
payment of $1,388.89). The difference between the payment of
$1,388.89 and the portion excluded from income ($555.56) is $833.34
(60%), which is subject to income tax.
Chapter 7
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TAXATION SUMMARY CHART
Qualified Annuity
Non-Qualified Annuity
Qualified Plans, IRAs,
403(b) Plans
After-Tax Funds
Yes
Yes
Fully Taxable (generally)
Partially taxable and
Partially Return of Basis
10% early withdrawal penalty
applies to distributions prior to
age 59½
Yes
Yes
Required minimum distributions
at age 70½
Yes
No
Source of Funds
Tax-Deferred Earnings
Taxation of Distributions
Chapter 7
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SECTION 1035 EXCHANGES
Tax Treatment of Exchange for Life Insurance &
Annuities
Exchange To
Life Insurance
Annuity
Exchange From
Life Insurance
Annuity
Tax Free
Taxable
Tax Free
Tax Free
Chapter 7
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ESTATE TAXATION
• The remaining value of an annuity contract held by an
individual at death is included in the individual’s gross
estate for estate tax purposes.
• Annuities are considered IRD (income in respect of a
decedent) assets.
Chapter 7
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ESTATE TAXATION EXAMPLE 1
Pursuant to a retirement plan, ABC Company (ABC) was
paying Fred an annuity for life, and was to provide Helen,
Fred’s wife, upon his death after retirement, with a similar
annuity for life. Assume that Fred died at age 67, after the
annuity began, when he fell of a treadmill while working
out. The value of the wife’s annuity is includible in the
Fred’s gross estate.
Chapter 7
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ESTATE TAXATION EXAMPLE 2
Ira has always been a planner and very methodical about
his finances. Twenty years ago, he purchased a deferred
variable annuity that is now worth $1 million.
Unfortunately for Ira, he stepped on a piece of glass and
the wound got infected. The infection went untreated, and
he died. The value of the annuity, which was not
annuitized, is included in his estate.
Chapter 7
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LONGEVITY INSURANCE (1 of 2)
•
Sophisticated name for a deferred annuity purchased by an individual at
or before retirement that will not begin to make payments until that
person reaches an advanced age – typically age 85.
•
Cost of longevity annuity contracts are very reasonable for 2 reasons.
â‘ The contract is purchased at or before retirement, and payments do
not generally begin until age 85. This allows a 20+ year
accumulation period.
â‘¡ Since payments on contracts do not begin until age 85, and average
life expectancy is about 81 years, more than half of those
purchasing longevity annuities will not receive any payments,
preserving that capital for those who do live beyond average life
expectancy.
Chapter 7
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LONGEVITY INSURANCE (2 of 2)
• If a deferred annuity contract is purchased inside a qualified plan or
IRA, it can pose a problem since its value must be included when
determining required minimum distributions, but the money inside
of the annuity will not be available for distribution until the retiree
attains age 85.
• The longevity insurance regulations address this problem by
specifying that if a qualified longevity insurance contract is
purchased inside of a qualified retirement plan or IRA, the value of
the contract will not be considered when calculating required
minimum distributions.
• To be considered a qualified longevity insurance contract, the
premium for the deferred annuity purchased must not exceed the
lesser of 25 percent of the account balance or $125,000 ($130,000
for 2018), and upon issuance, the contract must be specified to be a
longevity annuity contract at issuance.
Chapter 7
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STRUCTURED SETTLEMENTS AND THE SECONDARY MARKET
• Sometimes these secondary market annuities are
called pre-owned annuities or in-force annuities.
• These annuities can be purchased from the original
owner at a discount or from a third party, and the stream
of income is assigned to the purchaser.
• Secondary market annuities typically offer a rate of
return or yield that is well above the yield available on
standard fixed annuities, immediate annuities, or even
bonds of a similar credit quality.
• Both sellers and buyers of annuities should conduct
substantial due diligence prior to entering into this type
of transaction.
Chapter 7
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STRUCTURED SETTLEMENTS AND THE SECONDARY MARKET
EXAMPLE (1 OF 2)
Alice is injured by Barb in an automobile accident. The claim is not
settled and ultimately goes to court. Alice wins the case and settlement
money is offered to pay Alice either a lump-sum payment or a structured
settlement making payments over Alice’s lifetime. Alice, who is now
unable to work, accepts the structured settlement annuity. The court order
specifies that Alice shall receive $2,000 per month for life, with a 20year guaranteed payment period. Neither Alice nor the court want Barb or
Barb’s auto insurance company to pay the annuity. Therefore, Barb’s
insurance company purchases an annuity from a major life insurance
carrier to pay the annuity of $2,000 per month with a 20-year guarantee.
Barb’s auto insurance company is the owner of the policy, the life
insurance company is the issuer, and Alice is the payee. If, by chance, the
life insurance company goes out of business and the state-guarantee funds
that guarantees insurance also go out of business (not likely), then Alice
can go back to the original automobile insurance company and demand
that they make the required payments as specified in the court settlement.
Chapter 7
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STRUCTURED SETTLEMENTS AND THE SECONDARY MARKET
EXAMPLE (2 OF 2)
Five years into the annuity, Alice needs money, and because she does not
work, she decides to sell some or all of her annuity payments in return for
a lump-sum payment. Alice sells the annuity at an 8.5% discount rate and
receives $203,000 from the structured settlement company. The
structured settlement company then re-offers the annuity for $253,000
(equating to a yield of approximately 5%) over the term of the annuity.
The yield is substantially higher than the yield on CDs or treasuries. A
similar 15-year guaranteed annuity of $2,000 per month might cost
$300,000 and yield 2.5%.
Chapter 7
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THE IMPORTANCE OF COMPANY CREDIT RATING
• The financial stability of the company issuing the
annuity contract is of major concern to contract holders,
and should be a consideration in determining which
annuity contract to purchase.
• Several rating agencies assess the financial strength of
insurance companies issuing annuity contracts. These
include A.M. Best (with a rating scale from A++ to S),
S&P (with a rating scale of AAA to R), and Moody’s
(with a rating scale from Aaa to C).
Chapter 7
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DEFAULT RISK FOR ANNUITIES
• All states have guarantee funds run by the state
insurance commission that act as the payor of last resort
in the case of an insurance company failure.
• While a few insurance companies have failed, no
annuity contract holder in the United States has been
deprived of promised payments to date.
Chapter 7
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CHAPTER 7:
ANNUITIES
Chapter 7
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