Variable, Indexed, Fixed Annuities, Living Benefits and 2821

Introduction

Course Description

This course was designed, constructed, and written to provide you with continuing education for insurance professionals in the area of annuities, with special attention to the various types and issues specific to the world of accumulation and distribution through annuities.

It acknowledges and includes examination of fixed, variable, CD-type, bond index, single premium, equity indexed, tax sheltered, market adjusted, and impaired risk annuity categories. It also highlights distribution opportunities and tax consequences for withdrawals, which are fundamental components of annuity accumulation programs.

Beyond the goal of fulfilling your continuing education requirement, it is our hope that you will acquire a new level of competency and insight into this highly critical area of your clients’ financial futures: Saving and accumulating dollars for use in the future.

As time goes by, individual situations change with respect to available discretionary income, tax brackets, and family situations. In addition, tax law changes, program availability, and feature modifications are constantly being reviewed and updated. Some people save specifically for retirement and education, whereas others save for the future (retirement) exclusively, and take care of education as best they can when it occurs.

Yet the fundamentals seldom change. Accumulating funds for the future depends on money, time, a vehicle, and consistency. With so many ways to save, the real key is to start putting aside funds. The more one puts away today, the more it grows for tomorrow. The higher yield or growth each dollar earns makes it compound faster and greater. The smaller the amount of taxes paid upon contribution and during growth, the faster funds accumulate for their intended purpose. And, when people plan for certain amounts to be available at specific times in the future, they are more motivated to put money aside on a regular basis to meet that goal.

There are chapter review questions included at the end of each chapter to improve your retention of key elements as well as to confirm your mastery of the material content.

Whether you are a newer agent or a veteran, we’re confident that you will gain new insight as well as to brush up on current information and regulations.

If an individual purchases an annuity, he/she is protected by a state guaranty association in the unlikely event that the insurance company has financial trouble. Guaranty associations are created by state law to assure that the claims of an insolvent insurance company’s resident policyholders will be paid, subject to the limits of the law. All insurers authorized to write life insurance, health insurance, and annuities in the state are required to be members of the association.

Annuities are tax-deferred savings that are offered by life insurance carriers and are widely used for retirement purposes. The main advantage of all annuities is their tax‑deferred feature, which allows an annuity owner to accumulate more money as compared to fully‑taxed investments. This is one of the main reasons many people choose tax‑deferred annuities as the foundation of an overall financial/retirement plan.

An annuity is a sum of money payable annually or at other regular intervals. The actual sum of money is based upon a contractual relationship between the person covered (the contract owner) by the annuity and the insurance company (insurer) through which the investment is made.

Annuities have been around a long time. They have been available in the United States for more than 100 years and several hundred years in some other countries.

Although annuities are sold only through the insurance industry (i.e., insurance agencies, brokerage firms, investment advisors, financial planners, banks, savings and loans institutions), they have nothing to do with life insurance or insurance coverage. Guarantees are dependent upon the type of annuity purchased.

Chapter 1

Annuity Overview

Though there is a wide range of annuities with various options and features, all annuities may be divided into two basic types: Fixed and Variable.

If a set rate of return is desired, the contract owner can choose the fixed annuity. This type of annuity guarantees that money will accumulate at a minimum specified rate of interest. However, the insurance company may pay a higher rate of interest if its investment experience is better than the minimum guarantee.

If a conservative to aggressive investment is desired, the contract owner can choose the variable annuity. With a variable annuity, the owner can choose where the money is invested. These annuities also have death benefit provisions, including an insurance company guarantee that an annuity holder is entitled to the face amount of their annuity contract, regardless of what happens to the contract’s investments.

Documentation

The purchase of an annuity is structured in the same way as the purchase of a CD or mutual fund—through an application and/or agreement between the investor (contract owner) and the financial institution (insurer).

The contract owner must supply an application furnishing the following information.

· Name

· Current address

· Social Security number of the contract owner

· Name, Social Security number, address, sex and date of birth of the annuitant

· Investment options

· Type of money used

· Signature of the contract owner

· Signature of the annuitant

Principals Involved In An Annuity Contract

The participating parties in the annuity plan are the insurance company, the contract owner, the annuitant and the beneficiary.

The Insurer

There are many reasons why life insurance and the annuity can work hand‑in‑hand to offer the contract owner the ultimate in protection.

An annuity guarantees the contract owner an income, no matter how long they live. While life insurance provides protection against dying too soon, annuities provide protection against living too long.

The annuity contract defines specific requirements, such as additional investing opportunities, withdrawal and cancellation requirements, and contract penalties and guarantees.

Contract Owner

It is the contract owner’s right to choose and manage the investment options. The contract owner can:

· Add additional funds;

· Withdraw any portion of the monies;

· Change contract parties (i.e., annuitant, beneficiary);

· Will any and/or all portions of the contract; and

· 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 list the minor’s custodian. The contract owner can also be a couple, a partnership, a trust or even a corporation.

The contract owner has the freedom to name any individual or group of individuals as beneficiary, change beneficiary at anytime and without consent from present beneficiary, and hold multiple titles.

The contract owner has the option of assigning multiple titles to him/herself, the annuitant, or the beneficiary.

If the contract owner designates a living trust or a corporation as the beneficiary, the corporation or trust can only be the contract owner and/or beneficiary. The annuitant must be a living individual meeting the insurer's age restrictions (couples excluded).

Annuitant

Any person who the contract owner chooses to name as the annuitant (i.e., him/herself, family member or friend) must be currently living and must meet the insurance company’s age restrictions for the annuity. Generally, the annuitant must be under a specified age at date of signing, though this may vary depending upon the insurance company’s regulations. In addition, though the contract owner has the option of changing the annuitant at any time, most annuities require the stipulation that the new annuitant was alive when the original contract was executed.

An annuitant is like the insured in a life policy; however, the annuitant cannot:

· Control the contract,

· Make withdrawals,

· Make deposits,

· Change the parties to the contract, or

· 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; or

· The insured dies.

An annuity remains in effect until the contract owner makes a change or the annuitant dies.

Beneficiary or Multiple Beneficiaries

The beneficiary(ies) of the annuitant can be family members of the annuitant, individual(s), trusts, a corporation or a partnership. The annuity application has the flexibility of allowing multiple beneficiary designations, at the prior discretion of the contract owner. For example, a beneficiary designation may be apportioned so that the spouse of the contract owner will receive 70% of the annuity, and his three children will receive 10% each.

The contract owner can retain complete control over the annuity investment during his/her lifetime by naming him/herself as contract owner and annuitant, while naming another as beneficiary(ies).

Most annuity contracts have minimum and maximum age limits for the owner and the annuitant. Since the beneficiary is the one receiving the proceeds of the annuity at death and the contract is terminated at the payout, there are no age limits on the beneficiary. The minimum and maximum ages refer to the ages at which an annuity contract may be issued. Some annuity contracts state the minimum and maximum age of both the owner of the annuity contract and the annuitant. Typically the minimum age is 0, but in some cases it is 18. Maximum age depends on the insurer and ranges between 60 and 90 with the majority being 85 or 90.

Basic Structure

A client investing in an annuity must complete an application. Once the application has been submitted to the insurer, the contract owner receives the contract, which contains a summary of the application, the rate of expected return on the investment(s) and type(s) of investments selected.

Though there is a wide range of annuities with various options and features, all annuities may be divided into two basic types: Fixed and Variable.

Annuity Date

The annuity date is the date at which the annuitant begins to receive annuity payments. This date is the earlier two dates: The maturity date or the optional date elected by the contract owner. The maturity date is the latest date to which annuity payout options can be deferred and is stated in the contract. Many contracts stipulate that the owner may change the maturity date, and 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. The maturity date is typically the LAST date by which the client must take receipt of the proceeds, not the first date on which they may do so without surrender penalties.

Other Uses for Annuities

· College Education

· Insurance settlements

· Uninsurability

· Charitable giving

Basic Structure Of The Annuity Process

Single Payment Immediate Annuity

$$’s invested

Annuity Period

Single Payment Deferred Annuity

$$’s
invested

Accumulation Period

Annuity Period

Periodic Payment Deferred Annuity

$$’s
invested

Accumulation Period

Annuity Period

Table 1.1

Remember, with a single payment immediate annuity, the accumulation period is eliminated. After the purchase of the annuity, the annuitant goes directly into the annuity period.

Renewal Rates

The interest rate is credited to an annuity in the years following the initial rate. The renewal rate and the new money rate differ in the following respects.

· The investments that the insurer is buying today are known as the new money rate.

· The investments the insurer bought when the annuity was originally purchased are known as the renewal rate.

The contract owner should carefully investigate the insurer’s renewal rate strategy for any differences.

Annuity Premium Amounts

Single premium annuity can be bought with a lump sum and begin payouts at once. This is the most common type of single premium annuity. It affords the contract owner a single premium, where the insurance company promises to pay the annuitant an amount each period (monthly, quarterly, semiannually, or annually).

The second method is level premium. Here the premiums are paid in periodic payments over the years prior to the date at which the annuity income begins. The premiums can be paid yearly, semi‑annually, quarterly, or monthly.

The next premium payment option is the flexible premium payment method. This is where the purchaser has the option to vary the amount of each premium payment, as long as it falls between contract‑specified minimum and maximum amounts.

Premium Computation Factors

Insurance companies use multiple factors in determining the premiums.

· The annuitant’s age will determine how long the company will have to make income payments to the annuitant.

· Statistics say that the annuitant’s gender plays a role. Statistics will show that women live longer than men. Therefore, a woman would receive more income payments than a man of the same age.

· An assumed interest rate as calculated by the insurance company.

· The next factor is the annuitant’s amount of periodic income and the guarantees the insurance company made to the annuitant in regard to the total number of payments the annuitant will receive.

· The last factor is the “loading fee” charged for the insurance company’s operating expenses.

Lifetime Guaranteed Rate (Fixed-Dollar Annuities)

The minimum interest rate that is guaranteed for the life of the annuity is known as the lifetime guaranteed rate. Each state department of insurance, through their own jurisdiction, mandates that annuities provide a lifetime guaranteed interest rate; therefore, most insurance companies offer rates of three to five percent on this type of annuity. The contract owner can opt for receipt of guaranteed income payouts on a monthly, quarterly, semi‑annual or annual basis.

Money Back Guarantee

This is a major selling feature in many annuity contracts because the contract owner is protected and the insurer assumes the risks involved. Contract owner satisfaction is guaranteed, depending upon the insurer’s language relating to the principal. If the contract owner is not satisfied with their annuity, they can get all of their money back, provided that they act within the timeframe specified in the contract. The insurer may also provide a guarantee that surrender charges will not affect the principal, thereby allowing the contract owner to get back their entire initial premium.

Surrender Charges

Insurance companies vary in principal language (contract content relating to the principal) to protect the insurer, just as guarantee of principal protects the contract owner. In most annuities, surrender charges decrease over time, such as over a five‑ to ten‑year period (10% free partial withdrawal not included). There may be an annual percentile decrease in surrender penalties, or the annuity may have a fixed surrender charge, such as the first six month’s interest.

Bailout Clause or Escape Clause

The bailout clause (aka escape clause) is another protection for the contract owner. Most insurers will waive surrender charges under certain circumstances (i.e., nursing home confinement, terminal illness diagnoses, death or disability). In addition, the agreement between the insurer and the contract owner can allow for utilization of the bailout clause if the interest rate decreases below a certain level, called the bailout rate.

Accumulation & Payout Periods

Both the fixed rate and the variable annuity have an accumulation period (effective the moment investments are selected) and a payout period.

Deferred annuities are more common than immediate annuities. An annuity holder pays money, which is accumulated at interest over a period of years. Thus, the payments are deferred for a number of years. While the money is being accumulated, the deferred annuity has tax advantages as the interest credited to the funds is deferred from current taxation. Thus, income tax is not owed until the annuitant starts receiving payouts or distributions from the annuity.

Accumulation Period

· Fixed Annuity – Interest is credited

· Variable Annuity – Investment results are credited

Payout Period

· Benefits are disbursed

· Can provide a guaranteed amount for a guaranteed period of time

A Single Premium Deferred Annuity

· Investment is made in one payment

Flexible Premium Deferred Annuity

· Contract owner can make one or more payments of various amounts

Risks

The potential for long-term growth in an annuity is exceptional. However, as with any type of investment, caution and scrutiny are necessary. Their potential is dependent upon the market and the investments chosen.

Advantages

· An annuity is a safe vehicle for investment and can be easily monitored.

· An annuity offers tax-deferred growth on earnings.

· An annuity provides resources that can last as long as needed.

· An annuity can offer a money back guarantee.

Before getting into the specifics of the many and varied types of annuities, let’s take an overall look at annuities.

In looking ahead to their retirement years, many individuals plan on Social Security and pension plans from their employers to provide needed income for their retirement. However, these only provide for a small portion of what is needed for income security at retirement. Because of this shortfall, people should supplement these two sources, and the purchase of nonqualified annuities is one way to accomplish this.

In addition to retirement savings, many people use annuities to provide an income from the proceeds from lump sums received life insurance policies, business ventures, etc.

Annuity Defined

The dictionary defines annuity as “a yearly grant or allowance” and “an investment of money entitling an investor to a series of equal annual sums over a stated period.”

An annuity’s basic purpose is to provide a series of payments over a period of time. Usually this period of time is over the lifetime of the annuitant named in the annuity policy. This is a unique feature and is not found in any other investment or accumulation vehicle. It provides a stream of income that the annuitant cannot outlive, no matter how long that is. This lifetime guarantee of income is also unique in that it promises to continue payments even after all of the annuitant’s accumulated contributions and earnings are used up.

Another important feature of a nonqualified annuity is that, unlike other savings vehicles like savings accounts, CDs, and the like, the growth inside the annuity during the accumulation period is “tax‑deferred” and not subject to current income taxation. This allows for the full amount of the value of the annuity to compound,

An annuity is a contract between two parties: (1) the insurance company and (2) the owner of the annuity policy. The policy is a written document that sets forth the terms and conditions of the contract.

The applicant or owner pays a sum of money to the insurance company. This could be a single premium or a series of periodic payments.

The period of time during which the policyowner’s funds are accumulating at interest is called the accumulation or deferral period. At a specific, predetermined point in time, the insurance company starts paying money back to the owner (annuitant). This is called the payout period. The annuitant has a number of options available for withdrawing the money accumulating in their policy. The will be discussed further on in the text.

If a policyowner names a beneficiary of their annuity, any sums of money due and payable at the annuitant’s death will pass directly to the person named and will do so outside of probate.

Qualified or Nonqualified

The Internal Revenue Code drives federal taxation and individual states follow suit. The term “qualified” in regard to an annuity refers to whether the annuity is a part of an employee benefit plan that has met certain requirements, or becomes “qualified” under the IRC, such as an IRA (Individual Retirement Account) or a TSA (Tax Sheltered Annuity). A qualified annuity is one that is used in connection with a qualified retirement plan. Simply put, a qualified retirement plan differs from a nonqualified arrangement in that contributions made into the qualified annuity are income tax deductible to the employer and to the account holder in the case of an IRA and TSA.

A nonqualified annuity may be purchased by any individual and is not associated with any employer‑sponsored retirement plan or an IRA or TSA. The contributions to a nonqualified annuity are not tax deductible. While “nonqualified” may sound like a negative, it has nothing to do with the qualifications of the policy or the company issuing the annuity.

Immediate or Deferred

An immediate annuity begins making periodic payments quickly (within one year after purchase) to the annuitant right after the policy is issued. It is usually issued for a single lump sum premium that will give an annuitant and/or their spouse a guaranteed fixed payment. These payments may be monthly, quarterly or annually and are based on one's life expectancy or that of the annuitant and their spouse. An immediate annuity can provide income, in some cases, in as little as 31 days after purchase of the annuity. For example, if the contract calls for monthly installments payments, they will begin one month after the date of purchase. These annuities are specifically designed for those customers 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. Payments may be made on a monthly, quarterly, or annual basis. The amount of the check the client receives will not fluctuate, and the actual dollar amount of the checks is in direct relationship to the total annuity investment.

An important note to remember: If the insurance company is going to begin paying the annuitant shortly after the purchase of the contract, then 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.

The market for annuities and large investments is very competitive. Several insurance companies should be compared. Consumers should check rates and specific payout intervals (i.e., five, ten, fifteen and twenty years) on the intended annuity investment amount. Then compare the differences in the returns on the investment.

A deferred annuity is one under which the annuity owner defers or delays receiving payments until a later date. A deferred annuity accumulates at interest for a specific period of time before the company begins making payments to the annuitant. It delays an annuitant’s income stream, accumulating interest without earnings being taxed until withdrawn. People often purchase deferred annuities during their working years in anticipation of the need for retirement income later in their lives. Most deferred annuities provide a great deal of flexibility surrounding the timing and amounts of payout benefits. A deferred annuity can be paid for by a single premium, annually, semi‑annually, quarterly, or by monthly installments over a period of time.

Unlike the immediate annuity, the deferred annuity payments to the annuitant begin after a designated period of time has elapsed from the purchase date.

The contract owner can receive a certain dollar amount of income each year and can direct how the balance is to be reinvested. This deferral process gives the contract owner the flexibility of automatic reinvesting, withdrawing a portion of the principal, or terminating the investment.

Investment Options

A variable annuity offers a wide range of investment options. The value of the investment varies in accordance with the value of the total investment performance. If fixed annuities guarantee fixed monthly amounts, annuity monthly payments vary and will depend on the performance of the investment options an annuity holder chooses. The fluctuation of the cash value and monthly income is the main difference between variable and fixed annuities. Typically, variable annuities are invested in mutual funds.

Fixed Or Variable

As you know, annuities come in two basic forms: (1) Fixed and (2) Variable.

Fixed Annuity

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, which is backed by the general assets of the company. Every fixed annuity contract contains an underlying guaranteed minimum credited 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 interest crediting rate, the annuity company usually declares a current interest rate that is higher than the minimum guaranteed rate, and it is normally guaranteed for a period of time, generally one year. At the end of this period the company 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.

Though 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. Common maturity periods for annuities are one, three, and five years. The longer the commitment is, the higher the guaranteed rate of return for the contracted period.

Fixed annuities offer security because the rate of return is certain and known beforehand. The risk for performance falls on the company issuing the annuity, and the annuity holder does not have to take on the responsibility of investing the money.

In addition, the ‘fixed’ nature of these annuities also applies to the amount of the benefit to be paid out during the annuitization period.

With 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 by assuring safety of principal and ascertaining the exact interest the money will earn. This assurance is very appealing to the conservative investor, allowing the knowledge of specific projections.

However, the moderate to aggressive investor can utilize this type of annuity as a stabilizing factor in his overall portfolio. A diversified investor can use the fixed annuity’s guarantee along with other investments (i.e., real estate, stocks, bonds, gold, mutual funds) to add security to their overall investment program.

Variable

A variable annuity fluctuates in value according to the performance of its investments, 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).

Premiums paid for variable annuities go into separate accounts, where the company is permitted more investment freedom than with its general funds. Separate accounts are generally invested in common stocks and other securities expected to increase in value as prices increase. The ultimate purpose is to provide an annuity income that will maintain its purchasing power in inflationary times.

Shared Characteristics

Shared characteristics between variable annuities and fixed annuities:

· Retirement income is their primary purpose;

· Purchase methods are the same;

· The same types of annuity options;

· The same concept of accumulation and annuity periods;

· Partial surrender provisions; and

· The guarantee of expense and mortality.

Important Differences

The following are true of variable annuities but not of fixed annuities:

· There is no guarantee of the principal, interest or the amount of payment;

· The annuitant bears investment risks; and

· Both state and federal government regulated.

A Hybrid Annuity

Investors may also invest in an annuity that provides diversification among several different subaccounts. This part‑fixed, part‑variable annuity is known as a hybrid annuity. Hybrid annuities are a flexible tool that can be used for a broad range of unique income situations, including:

• Multigenerational income: For anyone who wants to set up an income stream that will pay out over two or more generations.

• Income before age 59½: If under age 59½ and want to take income from the retirement assets—but concerned about the tax penalty on early retirement income withdrawals.

• Income for someone who isn’t a spouse: Perhaps for a sibling, a friend, a domestic partner or a business partner as beneficiary of the annuity.

• 1035 exchange by beneficiary: An inherited nonqualified annuity that can be exchanged for one with different features, benefits, investment options or more flexibility.

• Trusts: Can be owned in a trust in order to offer tax-advantaged income and wealth transfer strategies.

• Lifetime gifting: May provide a tax-efficient way to gift nonqualified assets.

Living Benefit Annuity

This annuity is a special type of variable annuity, which is also known as a “Guaranteed Retirement Income Benefit” (GRIB). The best living benefit annuities guarantee at least a five percent return over seven years, or the highest attained value on each anniversary during the surrender period, whichever is greater. However, in exchange for this living guarantee, the living benefit annuity has a surrender charge, or penalty for early withdrawal, no upfront bonus, and a slightly higher annual fee.

The basic death benefit offered by a variable annuity is a guarantee that after the annuitant’s death, the contract beneficiary will receive at least the amount paid into the contract (minus any withdrawals). The living benefit annuity, commonly referred to as a contract rider, creates an enhanced death benefit. A rider may be purchased which locks in a guaranteed income stream regardless of market performance.

Long-Term Care Riders

A long-term care rider provides long-term care insurance in addition to a steady stream of income. If a variable annuity holder suffers an illness or injury that requires a home health aide or nursing home care, this feature will cover costs without cutting into the monthly payments.

· Advantages — A very expensive need is covered. According to the U.S. Census Bureau, the need for long‑term care will rise substantially with the coming years.

· Disadvantages — This option in variable annuities is very expensive. In some variable annuities, this feature is activated only when the annuitant suffers a serious accident or is diagnosed with a severe medical condition. Some companies sell variable annuity riders that specify a certain period of time before the annuity holder can activate the rider.

Waivers

Aside from the riders mentioned above, some annuities might contain waivers that trigger payments that are not subject to the usual surrender fees.

Death Benefit Waiver

This waiver passes on the annuity to the beneficiary if the annuity holder dies before receiving payments from the annuity.

Nursing Home Waiver

With the nursing home waiver option, an annuity holder won’t be charged surrender fees and he/she will be allowed access to some or all of the annuity, in case the annuitant is confined to a nursing facility.

Terminal Illness Waiver

An annuity might also contain a provision that waives surrender charges if the annuity holder becomes terminally ill. In this case, the annuitant is allowed access to the funds when needed the most.

Note: For the Nursing Home and Terminal Illness waivers, some contracts will stipulate that the waiver is available if the annuitant and/or their spouse is confined to a nursing home or becomes terminally ill.

Disability Waiver

Relatively few insurance companies offer the disability waiver, as the risk of disability is greater than the risk of death at all ages between 20 and 65.

Annuity Comparison

Types of Annuities

Fixed

Variable

Immediate

· Single Premium

Deferred

· Single Premium

· Level Premium

· Flexible Premium

Payout Options

Life Annuities

· Straight Life

· Refund Life

· Life with Period Certain

· Joint Life

· Joint and Survivor

Temporary Annuities

· For a designated period

· For a designated amount

Table 1.2

Phases Of An Annuity

There are three basic phases in the life of an annuity: (1) Contribution, (2) Accumulation, and (3) Distribution. More specifics on each of these key areas will be explored further in this course.

Contribution

Contribution refers to the methods, timing, and amounts of money set aside in the annuity policy. Contributions can be a lump sum as well as periodic payments over time.

The threshold of entry is not limited to people of wealth; many can put aside money for as little as $50 or less on a monthly basis.

Accumulation

Accumulation is the time between the contributions and the distribution/payout period. During this period the annuity builds up and accumulates the funds that will provide the annuitant with the income stream desired during the distribution phase. The growth during this period is tax‑deferred and thus allows funds to grow unencumbered and much larger by current income taxation not being applied.

Distribution/Annuitization

Distribution or annuitization refers to the period when the insurance company provides the annuity payments over a specific period of time, or over the annuitant’s lifetime.

Interest Rates – Guaranteed and Current

In general, companies offer two interest rates on fixed annuities. The guaranteed rate is a minimum rate that the company will credit on the funds in the annuity regardless what interest rates are available in the overall marketplace. The current rate is a rate of interest that the insurance company credits based on their success with their investment program within their general accounts underlying the company. The current rate is generally revised and changed once a year, but can be adjusted more frequently on some annuities if specified.

Premiums – Single or Flexible

A single premium annuity is what its name implies—a single lump sum paid to an insurance company to be put into an annuity. The annuitant will then let the company know when they want the payments to begin and under what payment option they want it to be paid.

A flexible premium annuity is also what its name implies—varying amounts (within minimum/maximum amounts) of payments and varying time intervals between payments. All amounts at those intervals accumulate to build a fund for future payments at the direction of the annuitant/owner in line with the various payout options provided by the contract.

Maximum Ages for Issue and Benefits

Typically, most companies allow for annuities to be purchased and issued to contract owners and annuitants until these persons reach their late 80’s. There are, however, others that will set the maximum age in the low 80’s for annuitant and owner categories.

For maximum payout ages, there is no age maximum required by the IRS, but most companies set their own maximum age for annuitization at 80 to 85, while others allow a maximum age of 100. An annuitant should check the contract for these requirements before purchase, especially if they desire to annuitize the contract at an older age.

Settlement Options

Settlement options are the methods by which an insurance company pays annuity policy proceeds to the annuitant, contract owner, or beneficiary.

The distribution phase of annuities is the fundamental purpose for which the annuity vehicle holds its uniqueness over all other saving and investment vehicles. There are many options, methods, and techniques in this area that provide alternatives to best match the annuitant’s needs.

Annuities offer a variety of options so that annuitants may tailor their income schedule to suit their needs. They can choose to receive payments, monthly, quarterly, semi‑annually or annually. The following takes a look at many of the payment options available.

Period Certain Only

Period certain means that income payments will be made over the number of years the annuitant chooses. Payments will continue for the duration of the number of years they chose, and then cease. If they should die before the end of the stated number of years, their beneficiary would continue to receive the payments for the remainder of those years.

Life Only

The life only option provides for payments that will continue for the rest of their life. They cannot outlive the income. Upon their death, payments stop.

Life and Period Certain

Life and period certain means that payments will continue for the rest of their life, but for no less than the stated number of years. If they should die before the end of the stated number of years, their beneficiary would continue to receive the payments for the remainder of those years.

Life Only with Guaranteed Minimum Option

The annuitant receives payments that will continue for the rest of their life. If they should die before they have been repaid their initial investment, the balance of their initial investment will be paid in like installments to the beneficiary.

Joint and Survivor

This option provides payments that are guaranteed during the lifetime of two people. After the death of one person, payments continue for the lifetime of the surviving person. The annuitant can choose to have either full payments, or a percentage they chose to continue for the lifetime of the survivor. They can also specify a period certain, and if both individuals were to die within the period certain, payments would continue to the named beneficiary for the remainder of the period certain.

In addition to the settlement options listed above, many annuities offer guaranteed income streams without the need for annuitization. These income options will be discussed in the living benefits section later.

Surrender / Penalty Charges

While many companies vary in how they arrange their surrender charges, most follow a decreasing percentage charge over a number of years. This charge is also referred to as a “deferred sales charge,” and it applies to the amount of the funds withdrawn or surrendered. Some companies charge this decreasing percentage each year, counting from the issuance date of the annuity contract. This simple format typically applies to single deposit premium contracts. Others apply the decreasing percentage for the number of years to each deposit that the annuity holder makes into the annuity. This typically applies to flexible premium annuities. Each deposit is subject to its own decreasing surrender percentage over the specified number of years.

An example of a surrender charge schedule might look like the following.

Contract Year

Surrender/Withdrawal Charge

Table 1.3

Note: These surrender charges do not reflect the 10% penalty imposed by the IRS if withdrawals and surrenders are made prior to age 59½.

Death and Disability

Most companies include a waiver of the surrender charges if the annuitant dies or becomes disabled. Many companies also allow a portion of the value of the annuity to be withdrawn each year without imposing surrender or withdrawal penalties.

Nursing Home Waiver

Some 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 that the annuitant is either hospitalized or confined to a nursing home for a certain period of time, such as 30 days or longer. This provision allows the contract owner to extract funds from the annuity contract to meet the expenses or lost income associated with the longer‑term hospitalization or confinement. Other annuity contracts allow medical related surrenders that are not subject to the contract’s 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.

Although not part of the contract, the IRS 10% premature distribution penalty tax may also be applicable to a withdrawal for this same reason if the person is under age 59½. To avoid the imposition of this penalty, the taxpayer must be able to qualify as being “disabled” based on the definition in the Internal Revenue Code. The Code’s definition may differ from the definition used in the annuity contract. In the IRC, for purposes of the 10% premature distribution penalty tax, “disabled” is defined as:

“being unable to engage in any substantial 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.”

Withdrawals

In addition to the partial and full surrenders that we have discussed earlier along with their corresponding surrender charges, contract holders frequently need to access funds for a variety of reasons. Many annuities allow their annuity holders to withdraw up to 10% of their account value each year without surrender charges applying to these withdrawals. Similarly other companies allow for withdrawals of either the interest in the account or 10%, whichever is greater. And, still others allow the 10% withdrawal amounts to accumulate each year to allow for accumulated withdrawals of 20%, 30%, 40%, etc., as time passes.

The Bailout Clause

As you’ve already learned, some fixed annuities contain a bailout provision. This feature allows the annuity owner to cash in their contract without surrender charges if the interest rate credited to their annuity falls below a certain predetermined level.

Example:

An annuity contract contains a provision in which the bailout rate is set at one percent (1%) below the current rate being credited. In this case, if the interest rate declared is more than one percent below the current interest rate, the owner of the annuity could surrender the annuity and not have to pay any of the surrender charges that are normally charged for surrender.

This provides a measure of peace of mind for the annuity owner who wants to move their money in times of dramatically falling interest rates.

Bonus Annuities

First Year Bonus

The first year bonus is the most common. This annuity usually offers a higher first‑year interest rate, which is guaranteed for one year. The base rate is the interest rate that the company projects it will pay in the second year and thereafter, but 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, which a company declares on each contract anniversary from 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 annuities will offer a premium bonus instead of a first-year bonus. People just beginning to save (without a large sum of money to contribute to an annuity) will be more motivated by a smaller bonus on all premiums paid for a number of years. Some annuity contracts will offer a premium bonus of as high as two percent (2%) for the first five years of premium payments.

Vesting of Bonus Amounts

The bonus amounts calculated based on the bonus feature will be paid in addition to the initial rate and may or may not be forfeited depending on the contract provisions. In many cases, a bonus rate of interest is forfeited if a person takes the money either 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 will be on the bonus amounts. Some annuity products will stipulate that the bonus amounts are forfeited if you don’t annuitize the contract. Some annuity contracts will begin a multi‑year vesting period after the traditional surrender period is over.

For example, if the annuity has a seven‑year surrender period, the bonus amounts may vest at 33 1/3% per year in years 8 thru 10. The multi‑year vesting schedule is designed to increase persistency.

CD-Type Annuities

As we saw earlier, this category contains those annuity products where the number of years that the interest rate is guaranteed is equal to the number of years the surrender charge exists. For example, annuity products that have a five‑year guaranteed interest rate and a five‑year surrender charge are examples of CD‑type annuities.

In the following example, a single premium annuity offers an interest rate of 5.50%, which is guaranteed for five years, and the duration of the surrender charge is also five years.

Interest Rate 5.50% - Guaranteed for 5 Years

Years

Percentage
Surrender Charge

5.0%

4.0%

3.0%

2.0%

1.0%

Table 1.4

Equity Indexed Annuities

This is a unique class of annuities that use an equity index as the basis for calculating the interest that will be credited to the annuity policy. These annuities have all the guarantees of a fixed annuity contract plus the potential of stock market returns, with no downside risk.

Two-Tiered Annuities

A Two-Tiered Annuity is a product with three different values. These values are the tier‑one value, the surrender value and the tier‑two value.

1. The first value is the tier-one value, which is the premium accumulated with interest earnings, just like a regular fixed annuity. This value is available to the client if they decide to surrender their contract as a lump sum after the surrender charge period.

2. The second value is the surrender value, which is the tier-one value less the surrender charge. This value is available to the client if they decide to surrender their contract as a lump sum during the surrender charge period.

3. The third value is the tier-two value, which provides a benefit typically higher than the tier‑one value and is only available to the client if they annuitize the contract. Tier‑two benefits could 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 some 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 for the right client in several ways. If clients have a need for a lifetime stream of income, they could receive higher lifetime benefits under a two‑tier product than under either a regular deferred annuity that is annuitized or an immediate annuity. Secondly, due to the design and pricing of two‑tier products, tier‑one credited rates could be higher than a non‑tiered deferred annuity in the form 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 that 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 period of time to receive the higher tier‑two values, and annuitization is required to receive those values, which spreads the benefits over a period of time.

Insurance agents should be very clear that their clients who are considering a two‑tiered annuity understand the different values, how to access their values, and the restrictions or consequences of doing so. As always, clients should assess their needs and examine all aspects of an annuity product before determining if that particular annuity design fits their needs and financial goals.

Many states have declared two‑tier annuities illegal due to unscrupulous marketing practices that could be involved in their sales.

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